European Union: EU Prudential Framework For Investment Firms

Last Updated: 29 March 2018
Article by Barbara Jamieson

Current position

At the moment, investment firms that are authorised under MiFID are largely regulated under the Capital Requirements Directive ("CRD IV") and Capital Requirements Regulation ("CRR"), which also establish the prudential framework for credit institutions. The Commission is proposing to change this for certain categories of investment firm and introduce a more bespoke set of prudential standards which will fall under the umbrella of an Investment Firms Directive.


Under the proposals, there will be three categories of investment firm, with two of the categories being subject to the new regime and one category remaining subject to CRD IV and CRR. The categories are as follows (the reference to class reflects the descriptive terminology used by the European Banking Authority):-

  • Class 1 – these are systemically important firms which will be classified as credit institutions and will be subject to the prudential regime operating under CRD IV and CRR. This will include investment firms with total assets above EUR 30billion and which provide underwriting services or deal on own account. The Commission suggests that only about 8 firms will qualify and these are all based in the UK.
  • Class 2 – all other investment firms which do not have systemic risk and are not classified as small and non-interconnected firms. These will come within the new prudential regime.
  • Class 3 – small and non-interconnected investment firms. These are firms which satisfy a number of detailed requirements related to size and risk and will come within the new prudential regime but with lighter touch regulation.

What is a small and non-connected firm?

A small and non-connected firm must satisfy all the following requirements. This means that if a firm fails to meet any of the tests and is not systemically important, it will be a class 2 firm. It must:

  • Have assets under management (both discretionary and advisory) of less than EUR 1.2 billion (calculated on a group basis that is all investment firms within group)
  • Client orders handled is less than either EUR 100 million a day for cash trades or EUR 1 billion for derivatives (calculated on a group basis)
  • Assets safeguarded and administered is zero
  • Client money is zero
  • Daily trading flow (orders on own account or client orders executed in its name) is zero
  • Trading counterparty default risk is zero
  • Net position risk or clearing member guarantee is zero
  • Balance sheet total is less than EUR 100 million (calculated on a group basis)
  • Total annual gross revenue from investment services and activities is less than EUR 30 million (calculated on a group basis).

Capital requirements for class 2 firms

Class 2 firms will have a minimum capital requirement which is the highest of:

  • Its fixed overhead requirement

    • As with previous prudential requirements this is a figure which shall amount to a quarter of fixed overheads for the preceding year. Or, where there are no overheads for the previous year, the figure is based on projected overheads
  • Initial minimum capital

    • The figures here depend on the types of investment services undertaken but range from EUR 750,000 for firms dealing on own account or underwriting, to EUR 75,000 to those firms which do not take on principal risk and do not hold client money or assets
  • The K factor requirement

    • This K factor requirement is a somewhat complex calculation and the main issues are detailed below.

K factor requirement

The K factor requirements are split into three main categories, namely: (i) risk to customers (RtC); and for firms who deal on own account or execute client orders in their own name: (ii) risk to market (RtM), and (iii) risk to firm (RtF). The intention is that these are factors which are relevant to capital to be held against risk, the K Factors being the areas which are most likely to generate risk

RtC K factors are:

  • K-AUM (being the K factor in relation to assets under management or subject to investment advice)
  • K-CMH (being the K factor in relation to client money held)
  • K-ASA (being the K factor for assets safeguarded and administered)
  • K_COH (being the K-factor in relation to client orders handled). This factor and brings into the capital requirement an assessment of the client orders which a client processes for clients, such as through execution of orders.

The K factor is a risk co-efficient which is set out in the new regulation and applied to the four factors set out above. The RtC requirement is the aggregate of K-AUM+K-CMH+K-ASA+K-COH.

RtM K factors are:

  • K-NPR (or K factor in relation to net position risk), which takes account of the value of transactions recorded in the trading book of firm
  • K-CMG- (a risk factor for any clearing member guarantees), relating to margins posted with a clearing member, where investment firm deals on their own account

Basically, a firm must assess the net risk position, which is based on the market risk requirement of CRR applied to the value of transactions recorded in the trading book. There are different options available reflecting the CRR position. This is intended to capture trading positions of the firm dealing on own account either for itself or for clients.

Instead of using the K-NPR position in certain circumstances, the firm may use K-CMG for trades that are centrally cleared. This factor applies a K-factor based on initial margin posted with clearing members for trades guaranteed by clearing member or settled on delivery against payment. This requires the permission of the competent authority of state involved and is subject to a number of other criteria. K-CMG is based on highest amount of margin posted in preceding three months.

In the case of RtM, the higher of K-NPR and K-CMG is applied.

RtF factors are:

  • K-CON (being K factor in relation to concentration risk), which deals with capital to be held against exposures under a trading book to a client or group of clients which exceed certain limits
  • K-DTF (or K factor in relation to daily trading flow), which is capital held relative to daily value of transactions for own account, the transaction covered including derivatives and long settlement transactions
  • K-TCD (being K factor in relation to counterparty default)

The RtF factor is calculated as K-TCD+K-DTF+K-CON

The new regulation which will give effect to much of the detail of the froposals detail how each of the risk factors is to be calculated using a predetermined co-efficient applied against each of the factors. In the case of RtC, the relevant risk factors are aggregated to arise at the required amount.

Finally, in the case of RtF, the requirement is arrived at by adding the individual factors together.

Level of application

Investment firms must apply these provisions on an individual basis generally but there is a derogation for small and non- interconnected firms subject to consolidated supervision.

A competent authority can require consolidated supervision on a group basis where certain factors exist.

Concentration risk

There are specific proposals that require investment firms to monitor and control their concentration risk in their trading book by sound administrative and accounting procedures and robust internal control mechanisms. In the case of Class 2 firms, they are to report annually on level of concentration risk and there are limits placed on amount of concentration risk.


In addition to the foregoing provisions, there are also proposals to mitigate liquidity risks. Firms are required to have internal procedures to monitor and manage their liquidity needs and to hold a minimum of one third of the fixed overheads requirements (in effect 1/12 of the requirement in total) in liquid assets.


Firms are required to report each year to their regulator on compliance with the requirements set out above. However in addition firms will be required to make public a good deal of information about how they meet the prudential requirements.


The proposals are currently being considered by the European Parliament and Council.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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