Lessons Learnt from an IFR EU Go-Live

With the EUs Investment Firm Regulation (IFR) now live as of 26^th June 2021, firms are quickly turning their attention to the UK’s Investment Firm Prudential Regime (IFPR) which will apply from 1^st January 2022. This presents a great opportunity for firms to leverage key lessons learnt and avoid the challenges faced by their EU counterparts.

The IFR introduces new requirements for smaller EU investment firms, which up until 25^th June 2021 had been captured under the wider EU framework Capital Requirements Regulation (CRR). It applies a tailored capital framework for smaller investment firms to better reflect their size and type of activity, classifying clients into three categories: Class 1 systemically important large investment firms with assets >EUR30BN which will remain under CRR and need to re-authorise as a Credit Institution, Class 2 non-systemically important firms with assets >EUR15BN who hold client money and assets are subject to full IFR requirements, and Class 3 small non-interconnected investment firms with assets <EUR15BN subject to reduced IFR requirements. It also introduces changes to remuneration, governance, regulatory reporting templates, internal capital and risk assessments and external disclosures.

Regulatory Uncertainty and Delayed Regulatory Response Times

UK rules remain draft with the final paper not expected until Q4 2021. Given the large amount of similarity expected between EU and UK rules, firms are typically progressing the UK analysis based on the EU IFR rules and the two FCA consultation papers received to date. Until finalised, rules are of course subject to change, the impact of which was illustrated with the recent publication of a draft Regulatory Technical Standards (RTS) by the EBA regarding the group threshold tests for determining a firm’s classification. The EBA draft RTS suggested threshold tests must include Global entities not just EU entities putting entities previously considered to be Class 2 firms on an EU group basis at risk of being Class 1 and needing to re-authorise as a Credit Institution. Re-authorising as a Credit Institution is a large amount of work, not only regarding completing the authorisation process itself but also in addressing the subsequent uplift in external reporting requirements and other cross functional impacts.

Of course, the EBA RTS is still draft and there is ongoing lobbying but this provides a real example of the importance of keeping very close to the latest publications, regulator hearings and other external advice. We have also seen a delay in regulatory response times due to the heavy demand placed on the regulators at this time. A close relationship with the Joint Supervisory Team and other external advisory bodies has proved to be beneficial in gaining early insights ahead of formal feedback and preventing implementation delays.

K-Factor Scoping and Data Collection

Here is where the real complexity lies. K-Factors are an entirely new means of calculating the capital requirements specific to the individual firm. Under IFR, the pillar 1 capital requirement is the higher of Permanent Minimum Requirement, Fixed Overhead Requirement, and the sum of the in-scope K-Factor Requirement. Even if the K-Factor total is not driving the overall capital requirement, the K-Factor outputs must be reported to the regulator and an ongoing process for monitoring changes will be required.

Some K-Factors require historic data of 6-9 months, some of which is not currently required for reporting and is therefore hard to source. To monitor for ongoing changes to K-Factor scope (driven by new products or changes to business activity), firms must consider how this would be identified and addressed. For example, this may be through a control within the NPA process or the internal capital reporting cycle.

Cross Functional Impact

Whist a majority of the requirements impact Finance and external capital and liquidity reporting, there are several other functions directly and indirectly impacted by the regulation, who must not be forgotten. The fundamental changes to the capital calculations and internal risk assessments require considerable support from Treasury and Risk, in addition to new and discrete Governance and Remuneration requirements directly impacting Legal and HR. Risk and Treasury departments must incorporate the new K-Factor methodologies alongside the internal assessment of other risks. For example, previous methods of calculating operational risks for the entity may be partially or wholly covered by in scope K-Factors. Ensuring all risks are accounted for whilst not ‘double counting’ is of course essential to producing an accurate capital requirement that is compliant yet allows for optimal profitability.

K-Factor scoping also requires a clear and accurate view of all revenue generating activity which will require sign-off across the front office, middle-office, back-office, in addition to Legal and Compliance. The breadth of the organisational impacts are clear to see, so careful consideration is required to ensure the programme is correctly structured and all impacted stakeholders are identified from the outset. We have seen this causing problems to date!

Conclusion

The complexity and impact of the regulation should not be underestimated, so UK entities and firms must initiate impact assessments as early as possible, leveraging key lessons learnt from EU implementations and staying close to regulatory and industry developments. As with all new regulations, draft rules provide clear direction of travel and should be used to proactively progress early implementation phases, rather than being used as an excuse to delay. EU firms with this mindset found themselves playing last minute catch-up and rushing to get over the finish line.

For more information on BCS Consulting’s IFR and IFPR services, please contact Dan Ridler.