The UK Version of the Bespoke Prudential Regime For Investment Firms Is Close to Completion: Are Firms in Scope Ready?

The European Union’s Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR) came into force on 26 December 2019 and entered into effect on 26 June 2021. As discussed in an earlier OBLB blog post, the new regime is wide-ranging and spans capital, liquidity, reporting, Pillar 3 disclosure, remuneration and the underlying supervisory approach. The new rules substantially develop the prudential framework for investment firms in the EU and represent a step change to how they will be prudentially supervised.

When the United Kingdom was a member of the EU, the Financial Conduct Authority (FCA) strongly supported the introduction of a new prudential regime for the investment firms in the UK, and was actively involved in policy discussions with its counterparts in the EU. Hence, broadly in line with the EU’s implementation timeline, it published the first stage of its implementation of the IFR and the IFD in the UK last summer with a planned implementatıon date of Summer 2021.

Although the FCA subsequently decided to defer the implementation of the UK version of the new regime (Investment Firm Prudential Regime - IFPR) by 6 months, it is expected to come into force on 1 January 2022. This will be the first EU initiative to be implemented by the UK regulators post Brexit transitional period, rather than ‘on-shored’ through legislation. Therefore, implementation by this date will be subject to the Treasury enacting the necessary secondary legislation under the Financial Services Act, which was introduced last year in October.

So what does this mean for the UK investment firms going forward? UK investment firms are not subject to the IFR and the IFD as its applicability date is set after the end of the EU Exit transition period. As to the IFPR, the FCA has already set out its proposals across key requirements under IFPR through Consultation Papers (CPs) and Policy Statements (PSs) PS21/6, PS21/9 and CP21/26, which propose a broad range of rules including capital requirements, Pillar 3 disclosures, own funds, technical standards, depositaries and the UK resolution regime. It is expected to publish a policy statement and to set out the final rules in autumn 2021.

Given that the FCA had a hand in developing the new regime in the EU prior to Brexit, the IFPR is quite similar to the IFR and the IFD but it includes certain amendments to account for the specifics of the broad range of UK investment firms in terms of their number and size, as well as the nature of the UK market structure and how it operates. The current prudential regime for the UK investment firms is based on requirements designed for globally active systemically important banks and is not aligned to the different business models of FCA investment firms. The IFPR introduces a bespoke prudential regime which captures the potential harm posed by these firms to their clients and the markets in which they operate.

While the IFPR will not apply to those relatively more significant ‘designated’ investment firms which are currently under the supervision of the Prudential Regulation Authority, it will overhaul the prudential rules for around 3,600 investment firms regulated by the FCA. Specific firms in scope include Collective Portfolio Management Investment Firms (CPMIs), ‘local’ investment firms, matched principal dealers, depositaries and specialist commodities derivatives investment firms that use the current exemption on capital requirements and large exposures such as oil market participants and energy market participants, requiring them to adequately prepare for the changing prudential standards. The new regime will also apply to regulated and unregulated holding companies of groups that contain an investment firm authorised and regulated by the FCA and that is currently authorised under MiFID and/or a CPMI.

The IFPR is expected to streamline and simplify the prudential requirements for a large number of investment firms in scope with a single prudential regime for all FCA investment firms. The relevant prudential rules for FCA investment firms are expected to be understandable and accessible, with most rules brought into a new single prudential sourcebook (MIFIDPRU), which will replace BIPRU and IFPRU prudential sourcebooks. This is expected to simplify the current approach, reduce barriers to entry and ensure a more level playing field among investment firms. Building on the FCA’s financial resilience framework of FG20/1, the IFPR also considers the amount of capital and liquid assets an FCA investment firm should hold so that if it does have to wind down, it can do so in an orderly manner without threatening financial stability.

Despite its challenges, introduction of a fit-for-purpose prudential framework for capital requirements computation may present an opportunity for change in business strategy and approach for some investment firms. But it will also represent a major regulatory and operational challenge for others, requiring adjustments to their internal systems and controls, as well as to their corporate governance. Currently, only the FCA investment firms which are supervised as per the Capital Requirements Regulation are subject to meaningful and consistent prudential requirements, and not all UK investment firms. This means that, with the introduction of the IFPR, many firms in scope will have capital and liquidity requirements for the first time commensurate with the potential risks they carry. The IFPR also considers the amount of capital and liquid assets the FCA investment firm should hold so that if it does have to wind down, it can do so in an orderly manner.

Of particular note from a supervisory standpoint is the proposed replacement of the current Internal Capital Adequacy Assessment Process (ICAAP) with a new Internal Capital and Risk Assessment (ICARA) process, which is expected to introduce additional regulatory challenges for many firms. To ensure timely compliance, firms in scope of the new regime would be well-advised to familiarise themselves with the FCA’s publications, particularly those identifying the stages required to implement the new ICARA, group consolidation, governance and remuneration practices and policies, as well as look out for the subsequent near-final rules which are expected to be published soon.

Mete Feridun is a Professor of Finance at the Eastern Mediterranean University.