Simplifying the Regulatory Capital framework for Investment Firms
Table of Contents
This question frequently arises when examining the current framework for FCA investment firms. There’s a clear need for robust regulations to ensure financial stability, yet the present system introduces significant complexity for those responsible for compliance.
The challenge begins with the approach taken when establishing the current rules. When the Investment Firm Prudential Regime (IFPR) was implemented in January 2022, rather than developing tailored rules specifically for investment firms, the FCA adopted an expedient approach. They incorporated the UK Capital Requirements Regulation (UK CRR) by reference – a framework originally designed for banks, not investment firms.
As a result, approximately 3,100 FCA investment firms now find themselves navigating between the MIFIDPRU sourcebook and a “frozen-in-time” version of banking regulations that are not fully aligned with their business models. It is comparable to consulting a manual designed for one type of vehicle when maintaining a completely different one.
Key challenges in the current framework
The current framework presents several significant challenges:
The first is structural complexity. Investment firms must navigate multiple rulebooks and interpret banking terminology that was not specifically designed for their operational context.
There is also considerable fragmentation. Requirements are distributed across MIFIDPRU 3, UK CRR Articles, technical specifications, and various deduction rules. For instance, understanding Common Equity Tier 1 (CET1) requirements necessitates consolidating information from MIFIDPRU 3, specific UK CRR articles (26-31), MIFIDPRU annexes, and various deduction rules. This creates a situation where essential information is dispersed across multiple sources.
Additionally, many rules are not well-aligned with investment firm operations. Banks typically maintain more complex capital structures with sophisticated instruments requiring intricate adjustments. The UK CRR includes requirements for global systemically important banks that are not applicable to investment firms.
This complexity heightens the risk of regulatory misinterpretation. Furthermore, as the PRA continues to update its own rules, the static version of the UK CRR referenced in MIFIDPRU becomes progressively outdated. New market entrants encounter significant obstacles in understanding and implementing compliance requirements.
Despite all these structural complexities, the basic principle remains simple: regulatory capital represents high-quality capital that firms must hold to absorb losses and maintain financial resilience during tough times. The framework includes elements like CET1, Additional Tier 1 (AT1), and Tier 2 (T2) capital from the Basel standards, along with key requirements like the Permanent Minimum Requirement (PMR), Fixed Overheads Requirement (FOR), and K-factor Requirement (KFR).
The fix on the horizon
Here is where things get more hopeful. The FCA has put forward plans in Consultation Paper CP25/10 to address these structural challenges. The core proposal? Stop referencing the UK CRR entirely and simply integrate the relevant requirements directly into the FCA Handbook under MIFIDPRU 3.
The benefits could be substantial:
- The volume of legal text would shrink by roughly 70% according to CP25/10
- Rules would be consolidated into a single coherent framework
- Compliance costs would decrease
- The risk of misinterpreting rules would be reduced
- Barriers to entry for new firms would be lowered
- Rules would better align with investment firm business models
- The FCA would gain flexibility to adjust rules as needed
Some specific improvements include consolidating all CET1 requirements into a single framework, clarifying exposure calculations, and rethinking the “look through” policy for fund investments.
The capital reduction test: A big improvement
One change I find particularly interesting relates to when firms can buy back their own capital instruments.
Currently, if you want to reduce your capital (maybe to return money to shareholders), you need the FCA’s permission based on whether you will “continue to exceed the applicable capital requirements by a margin that the FCA considers necessary.”
This criterion contains considerable subjectivity – it is challenging to anticipate precisely what margin the FCA would consider sufficient. It introduces an element of uncertainty comparable to predicting evaluation criteria in qualitative assessments.
The proposed new test is way clearer: you need to show you will “continue to exceed your own funds threshold requirement by a margin sufficient to ensure adequate financial resilience for the foreseeable future.”
This shift from subjective to objective criteria would make a real difference in how firms evaluate potential capital reductions:
- The revised approach shifts from regulatory interpretation to evidence-based assessment allowing you to demonstrate compliance through your firm’s internal metrics and analysis
- The test aligns with your firm’s existing Internal Capital Adequacy Risk Assessment (ICARA) process
- You can predict and plan your capital management decisions better.
- The clearer standard reduces the risk of misinterpretation
- Your compliance team can save time by leveraging projections they already create
How this would work in real life
Let’s say your investment firm (we’ll call it ‘Firm A’) wants to buy back £3 million of its own CET1 capital. Here’s how you would approach this under the new rules:
First, you would calculate your current own funds – let’s say it’s £15 million.
Next, you would determine your Own Funds Threshold Requirement (OFTR) by referring to your latest ICARA process. This is the higher of your own assessment or any amount specified by the FCA. If neither requires additional capital above the base requirements, it’s the higher of your PMR, FOR, and KFR. Let’s assume your assessment determines you need £10 million to be resilient.
Then you would calculate your position after the planned £3 million buyback: £15 million – £3 million = £12 million, leaving a £2 million buffer above your OFTR.
But here is where the real work begins. You now need to demonstrate that this £2 million buffer is “sufficient for adequate financial resilience for the foreseeable future.” This is not just a simple snapshot comparison – it’s about proving long-term resilience.
You would therefore need to:
- Use your stress test scenarios to show that even under tough conditions, your capital would not drop below the OFTR
- Consider your business strategy and expected risk profile changes over the next 12-24 months
- Demonstrate that you can maintain compliance continuously, not just immediately after the reduction
- Document everything clearly, explaining why the £2 million buffer is sufficient
This approach links your capital reduction decisions directly to your own documented understanding of your financial resilience needs, rather than trying to guess what margin the FCA might deem necessary.
What's not changing
It’s important to note what these proposals do not change. The amount of capital firms are required to hold stays exactly the same. You don’t need to change your capital arrangements at all.
The fundamental principles of what constitutes own funds remain intact, including the Basel-derived quality standards, the distinction between different capital tiers, and consolidated capital safeguards.
This consultation is part of a broader effort to move away from relying on banking regulations and create rules that actually make sense for investment firms. By maintaining capital quality standards while enhancing transparency and accessibility, the FCA aims to ensure markets function well and protect the integrity of the financial system.
In summary, the current framework represents a complex, fragmented collection of banking-centric rules that are not optimally suited to investment firms. The proposed framework would replace this with simplified, consolidated, and tailored definitions directly in MIFIDPRU 3, enhancing clarity for investment firms while preserving high prudential standards.
This appears to be a timely and beneficial regulatory evolution.
This article is provided for general informational purposes only and doesn’t constitute legal, investment, or regulatory advice.
Date: 01 May 2025
Written by: Zaynah Mosafeer