RTS on Pillar 2 add-ons for investment firms

Background

The European Banking Authority (”EBA”) has released a final report on draft Regulatory Technical Standard (“RTS”) on Pillar 2 add-ons for class 2 and class 3 investment firms complying with Article 12(1) of Regulation (EU) 2019/2033 (“IFR”). The proposed draft elaborates on the method for authorities to address all material risks to which the investment firms may be exposed in accordance with Article 40(1) of Directive (EU) 2019/2034 (“IFD”). A key component of the RTS is the clarification of the methodology for assessing risks associated with unorderly wind-downs.

Capital requirement

The purpose of the RTS is to clarify how authorities should measure the risks that investment firms face or pose to others, that are currently not covered by the own funds requirement set out in IFR. The approach builds on the current structure of the own funds requirement for class 2 and class 3 investment firms and includes an assessment of an own funds add-on to cover risks related to an unorderly wind-down. The add-on should be determined by assessing the complexity, risk profile, and operation of the investment firm and the potential impact on its clients and markets. These comprise an estimate of the wind-down timeframe, and the operational and legal tasks included in that window. The identification and assessment of material fixed and variable costs, likewise for material risks or elements of risks that could materialize during the process.

The proposed methodology for assessing the internal capital requirement is based on Figures 1 to 3 below and includes,

The permanent minimum capital requirement (PMR),
The fixed overhead requirement (FOR),
The K-factor requirement (KFR) for class 2 firms,
The unorderly wind-down requirement, and
The internally estimated KFR for class 2 firms.

The total capital requirement is determined by assessing these requirements in accordance with the examples below.

Figure 1: (Example) A class 2 firm where the FOR is insufficient to cover the risk of an unorderly wind-down, the pillar 2 add-ons reflect the capital necessary to cover this risk and represent the total capital requirement.

Figure 2: (Example) A class 2 firm where the KFR covers potential wind-down risks and is equal to capital to cover risks from ongoing activities. The pillar 2 add-on thus equals capital to cover other risks, resulting in the total capital requirement.

Figure 3: (Example) A class 3 firm and does therefore not include KFR. The FOR is not adequate to cover the risk of an unorderly wind-down, the total capital requirement thus includes a pillar 2 add-on.