Calibration issues under the EU capital regime for investment firms
| Date | 02 May 2023 |
| Pages | 483-502 |
| DOI | https://doi.org/10.1108/JFRC-12-2022-0146 |
| Published date | 02 May 2023 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Mete Feridun |
Calibration issues under the EU
capital regime for investment firms
Mete Feridun
Faculty of Business and Economics, Eastern Mediterranean University,
Famagusta, Cyprus
Abstract
Purpose –The EU prudential regime for investment firms comprising the Directive (EU) 2019/2034 (IFD) and
Regulation (EU) 2019/2033 (IFR) introduces a fit-for-purposecapital framework for investment firms. The capital
impact on the practice of investment management can be material depending on firms’specific business models
andriskprofiles, which may require them to take strategic decisions with respect to the services they provide.
Despite the importance of this issue for thepractice of investment management, there exists no study among the
existing studies that focuses on this issue. This study aims to fill this gap in the literature.
Design/methodology/approach –This paper reviews the calibration approaches the European Banking
Authority (EBA) has used by exploring the deficiencies of the regime with respect to the calibration of
categorization thresholds and coefficients that are used by the EBA to calculate regulatory capital requirements.
Findings –This paper sets out that the choice of the relevant percentilefor setting the firm categorization
thresholds was not based on any theoretical rule.It also discusses that the calibration of the K-factors was
subjective and lacked consistency.In addition, it criticizes the sample that the EBA used for business model
coverage on the grounds that it was unbalanced, resulting in certain K-factors driving the overall capital
impact.
Research limitations/implications –Further research is needed on the calibration of thresholds as
this will remain a crucialfactor for the effectiveness of the new regime. In particular, a moredata-driven and
transparentapproach would be necessary to ensure the accuracyand consistency of the thresholds.
Practical implications –This paper leadsto the policy implication that, despite its meritsthat overweigh
its shortcomings, potential market competition and financial stability issues that may stem from
inconsistenciesand a general lack of objectivity in certain aspects of the regime should not be underestimated
by the EU policy makers.
Originality/value –The present paper contributesto the existing knowledge primarily by reviewing the
EBA’s calibration approaches with respect to the K-factor coefficients and firm categorization thresholds,
concluding that lack of objectivityand precision in the relevant methodologies could distort capitalallocation
decisionsin the practice of investment management.
Paper type Technical paper
1. Introduction
The new prudential regime for investment firms comprising the Directive (EU) 2019/2034 (IFD)
and Regulation (EU) 2019/2033 (IFR) introduces a bespoke prudential framework where
regulatory capital requirements depend on the risks that investment firms pose to their clients,
markets or themselves. While the new capital framework aims to strike a balance between risk
sensitivity and achieving a level of capital requirements on an aggregate level that does not
diverge excessively from the level in the previous regime, its capital impact on individual firms
depends very much on the calibrations of firm categorization thresholds and the K-factor
metrics, which suffer from a number of inconsistencies and a general lack of objectivity.
The new regime, which is defined as a “truly proportional regime”bythe industry, aims
to address these issues by introducing a bespoke prudential framework. The framework is
Calibration
issues
483
Received9 December 2022
Revised23 February 2023
Accepted29 March 2023
Journalof Financial Regulation
andCompliance
Vol.31 No. 4, 2023
pp. 483-502
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-12-2022-0146
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1358-1988.htm
RETRACTED
based on categorizing firms into different classes according to their specific risks and
captures the vast majority of investment firms in the EU, which means that they are no
longer subject to rulesthat were originally designed for banks. The new regime representsa
major shift in the regulatory approach to investment firms,moving from a “one-size-fits-all”
approach to a more risk-sensitive framework. So, it allows smaller investment firms to better
tailor their capital requirements to their risk profiles, helping them to differentiate themselves
from larger competitors and potentially attract more investors (Meulbroek and Vermaelen,
2021). However, the regime’s complexity may also pose challenges for smaller firms, leading to
a widening gap between large and small firms in terms of compliance costs (Salloum and
Schmit, 2021). Also, the new regime may create challenges for investment firms in terms of
managing their capital and liquidity (Lombardo et al.,2021).
While the regime’srisk-sensitive approach may ultimately benefitsomefirms in scope, it may
also pose challenges in terms of compliance costs and changes to risk management processes.
Despite the importance of the new regime, the existing literature (De Angelis and Ferrara, 2021;
Voutsinas and Pagoulatos, 2021;andFabozzi et al.,2021) generally covers market impact of the
regime. The literature that focuses on the calibration issues is still at its infancy (see, inter alia,
Pelizzon et al.,2021;De Jonghe et al., 2021a,2021b,2021c;Claeys and Vander Vennet, 2021;
Angeloni and Faia, 2021). The purpose of this article, theref ore, is to contribute to this literature
by focusing on the deficiencies of the regime with respect to the calibration of categorization
thresholds and coefficients that are used to calculate regulatory capital requirements.
The capital impact on the practice of investment management can be material depending on
firms’specific business models and risk profiles, which may require them to take strategic
decisions with respect to the services they provide. Despite the importance of this issue for the
practice of investment management, there exists no study among the existing studies that
focuses on this issue. The present study aims to fill this gap in the literature by exploring the
deficiencies of the regime with respect to the calibration of categorization thresholds and
coefficients that are used by the European Banking Authority (EBA) to calculate regulatory
capital requirements.
The present article contributes to the existing knowledge primarily by reviewing the EBA’s
calibration approaches with respect to the K-factor coefficients and firm categorization
thresholds, concluding that lack of objectivity and precision in the relevant methodologies
could distort capital allocation decisions in the practice of investment management. It also leads
to the policy implication that, despite its merits that overweigh its shortcomings, potential
market competition and financial stability issues that may stem from inconsistencies and a
general lack of objectivity in certain aspects of the regime should not be underestimated by the
EU policy makers.
2. Materials and methods
2.1 Investment firms and their regulation
Investment firms play a critical role in facilitating savings and investment flows, while at
the same time giving investors access to a wide range of securities and derivative
instruments. While some of the services they provide to investors and corporate clients
overlap with those of the banks, such as investment advice, portfolio management, trading
in financial instruments and fund raising, they have very different business models than
banks (European Commission, 2017a). The services provided by investment firms are
essential for the functioning of the financial markets and generally include, among others,
the reception and transmission of orders,portfolio management, handling client money and
assets and the provision of investmentadvice.
JFRC
31,4
484
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