The use of fixed overheads, which is essentially an expenditure-based method, has drawbacks: • basing prudential standards upon expenditure/fixed overheads can discourage firms from
investing in their business, as they will face an increased capital requirement (before such an investment can bear fruit);
• this metric can also lead to different treatment being afforded to different firms according to their business model and how they structure their firm, rather than the risks they run (for example, a firm could operate with self-employed staff or through tied agents); and • it can also be ‘gamed’ fairly easily, with firms reporting figures much lower than what would be realistic for operating the business; for example, it may be booked in a group service company or even borne by an entity outside a consolidation group (although the regulatory technical standard on the FOR seeks to mitigate this risk).18
The use of the FOR also has advantages:
• notwithstanding any discussions on which costs should be deemed fixed and which costs should be deemed variable, it represents a relatively easy and straightforward minimum Pillar 1 capital requirement;
• for firms falling under Article 96 of the CRR, the FOR alleviates the need to apply the current Pillar 1 operational risk requirements (although it does not remove the need to consider, assess and quantify operational risk under Pillar 2); and
• under the AIFMD, the use of the FOR is combined with a liquidity requirement, whereby capital must be held in liquid assets, which helps ensure AIFMD management firms keep funds readily available with which to make good any harm arising in respect of ‘risks to investors’ (albeit that this approach is not tailored to address the specific liquidity risks of an individual firm).
62 These examples would suggest that, if accepting the use of the FOR as a continuing requirement, modifications would need to be made to better capture the costs of a firm (for helping to ensure a more orderly wind-down or to manage the impact of the firm’s failure on customers). The FOR should, for instance, better account for the costs of the group to which the investment firm belongs, to prevent it from effectively outsourcing expenditure on overheads by booking the cost to another group entity outside any consolidation group. The period for which the firm might need to continue to exist to take care of both its affairs and those of its customers would also need to be further explored.
3.3.3
Qualifying holdings outside the financial sector
a.
Concepts and definitions
Basel Committee/Joint Forum guidance states that, for the purposes of conglomerate capital assessments, supervisors must ensure that all group-wide risks are appropriately captured, including those arising from non-regulated entities. It also recommends that risks arising from non-regulated entities should be captured either through a capital charge, which represents a proxy of these risks, or through a deduction of the amount invested in those entities. Where risks have been transferred from a regulated entity to a non-regulated entity of the group, supervisors must be able to look through and assess the size and quality of the underlying risk exposures. Examples of situations where additional capital requirements could be considered are:
• insufficient sector-level capital requirements;
• concerns about contagion risks caused by the complexity of the group structure;
• concerns about the risks posed by any specific investments that a financial conglomerate has entered into.
But that brings us back to the question of why are we keeping securities firms alive? Is the CRR’s treatment of qualifying holdings outside the financial sector appropriate for such firms, which are often part of smaller financial or mixed activity groups, rather than part of financial conglomerates? In keeping securities firms alive, we seek to protect investors, promote fair, efficient and transparent markets, and, where relevant, reduce systemic risk. The sections below consider whether and how the CRR’s treatment of qualifying holdings outside the financial sector helps to achieve these goals.
Qualifying holding rules limit the ability of institutions to invest in certain entities. On the other hand, these rules limit the amount of financial sector capital used to support non-financial sector entities and, as with banks, there is the potential that an investment firm may be part of a wider mixed business activity group—therefore, the risks that the qualifying holding rule seeks to mitigate can be relevant for investment firms as well as banks.
63 In this regard, it should be noted that the CRR consolidated supervision rules apply at the level of a parent financial holding company or a parent mixed financial holding company (of a conglomerate). In practice, the holding companies of some investment firms are mixed activity holding companies (Article 4(22) of the CRR) and these may contain substantial and varied group- wide risks. Consolidated supervision would not apply in the case of a mixed activity holding company serving as a parent. In addition, it should be noted that, even where consolidated supervision does apply, non-financial entities are out of the scope of the actual consolidation because prudential consolidation is different to accounting consolidation, so consolidation is not necessarily going to capture the risks that those entities may pose. Therefore, there may be a reason for keeping the CRR treatment of qualifying holdings outside the financial sector for investment firms, or at least for seeking to address these prudential risks in another way.