What do the EBA’s final SREP guidelines and RTS mean for investment firms?

The European Banking Authority (EBA) final regulatory products regarding the Investment Firms Directive (IFD) issued on 21 July 2022 are expected to harmonize prudential practices regarding the Supervisory Review and Evaluation Process (SREP) of firms of investment. The new regime covers a wide range of prudential areas ranging from capital and liquidity to Pillar 3 information and remuneration.

EBA publications include final guidance on common procedures and methodologies for the SREPs and the final draft regulatory technical standards (RTS) on Pillar 2 supplements for investment firms. The final SREP guidelines, which were developed jointly with the European Securities and Markets Authority (ESMA) on the basis of Article 45(2) of the
Directive (EU) 2019/2034, set the common criteria for risk assessment in accordance with the requirements of the Investment Firms Regulation (IFR) and the Investment Firms Directive (IFD). The final RTS draft on Pillar 2 add-ons, on the other hand, was drawn up in consultation with ESMA on the basis of Article 40(6) of the same directive.

These documents mainly contain detailed guidance on the measurement of capital risks and granular criteria for the assessment of the main elements of the SREP. They also reflect an implicit prudential expectation that targeted companies strengthen the link between their risk profiles, their risk management processes and their risk mitigation systems. This will require companies to put in place strong governance and internal control arrangements.

The quality and quantity of disclosures reflect the EBA’s regulatory expectations that subject undertakings establish robust, effective and prudent strategies and processes to continuously assess and maintain capital commensurate with their risk profiles. Key areas covered by the Guiding Principles include not only capital risk and capital adequacy, liquidity risk and liquidity adequacy, but also business model, governance arrangements and controls enterprise-wide. While complying with strict regulatory expectations will present compliance challenges, it should be noted that the procedures and methodologies introduced are generally commensurate with the nature, size and activities of the businesses involved.

From a prudential perspective, the guidance collectively represents a sea change in the SREP process of investment firms. For example, the application of a rating system and key indicators should facilitate much-needed comparability between companies, while some proposed provisions regarding the application of SREP in the cross-border context should result in more effective monitoring. Similarly, the technical details introduced in the final draft RTS should facilitate consistent EU-wide determination of regulatory capital requirements under SREP, as well as ensure standardized supervisory practices across the EU. EU regarding Pillar 2 processes.

More specifically, these technical details include a number of specific indicative parameters to assist supervisory authorities in the identification, assessment and quantification of material risks and risk elements not otherwise taken into account or insufficiently taken into account by the Pillar 1 requirements set out in Article 11 of Regulation (EU) 2019/2033. More importantly, the parameters introduced reflect the size, the complexity of the activities and the business models of the different investment firms in the European Union.

The final RTS draft also reflects the EBA’s prudential expectations that companies have sufficient capital and liquidity to ensure sound management and coverage of their risks, to which they are or could be exposed, as well as the risks that companies can pose to the financial system. They generally set out more detailed and proportionate guidance on measuring the risks to capital. This means that affected companies will now have more specific and granular indicative measures to use in assessing materiality and determining the level of capital considered adequate to cover their risks.

However, class 1 investment firms, i.e. systemically important investment firms, are still subject to the relevant provisions of
Directive 2013/36/EU and Regulation (EU) No. 575/2013. This means that class 1 companies are still treated as credit institutions in terms of capital requirements and neither the guidelines nor the final RTS apply to them. For class 2 and 3 investment firms, on the other hand, supervisors are expected to determine an additional capital requirement to cover the risk of an unordered liquidation, which could pose a threat to their clients, their counterparties and the broader markets in which they operate in the event of default.

In addition, for Class 2 investment firms only, competent authorities will be required to determine additional capital requirements to reduce the likelihood of default, by covering material risks related to their ongoing activities. This means that supervisors will focus more on risks for clients, for markets, for investment firms themselves and for any other risk that is not covered by any capital requirement.

In conclusion, despite the challenges they may introduce, the EBA’s final joint SREP guidelines and the final draft RTS on Pillar 2 top-ups generally present a more granular prudential framework, specific and tailored to the supervisory purpose. investment firms. They also present a significant opportunity for a change in strategy and business approach for some affected investment firms, as well as an opportunity for others to update their systems and internal controls, as well as improve their governance structures. corporate governance.