Capital adequacy of investment firms and credit institutions

In order to ensure more effective financial risk management, the Capital Adequacy Directive (CAD) ensures equal treatment between credit institutions and investment firms by harmonising capital requirements. It also introduces a common framework for measuring the market risks faced by credit institutions and investment firms.

ACT

Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast) [See amending acts].

SUMMARY

This Directive aims to ensure the consistent application of the new international guidelines for capital requirements adopted by the Basel Committee on Banking Supervision (“Basel II”) in June 2004. It determines, along with Directive 2006/48/EC, the prudential framework for investment firms and credit institutions. This prudential framework establishes different approaches to capital adequacy for each risk, which enables investment firms to put in place risk management systems which best suit their risk profile or area of activity. The supervisory authorities shall assess the amount of capital which investment firms must have at their disposal in order to cover their risks.

Types of risk and capital adequacy approaches

The amount of capital which investment firms must have at their disposal is assessed depending on the type of risk: whether this be credit risk, market risk and operational risk. While Directive 2006/48 relates to credit risk, Directive 2006/49/EC sets out the rules relating to the market risks faced by investment firms and credit institutions. This Directive also provides for additional rules regarding the supervision of market risks and operational risk.

Directive 2006/49 has been amended by Directive 2010/76 in particular to reinforce the standards of the internal models that the credit institutions and investment firms can use, after receiving authorisation from the supervisory authorities, to calculate their capital requirements, particularly for taking into account the credit risk in the trading book and the results of the strengthened stress tests.

Capital adequacy

Investment firms and credit institutions must have a minimum capital of EUR 125 000 if they:

• hold clients’ money and/or securities;
• receive, transmit and/or execute investors’ orders;
• manage portfolios of investments or financial instruments.

All other investment firms must have an initial capital of EUR 730 000. Provision is made for derogations from the capital requirements for certain specified cases in order to take account of the various kinds of investment firm and the type of operation they carry out.

The Directive also lays down a “base” requirement according to which each investment firm is required to hold own funds equivalent to one-quarter of the previous year's fixed overheads. This requirement is intended to:

• cover all risks faced by an investment firm, e.g. the risk of market collapse, reducing a firm's brokering income to a level insufficient to cover its expenses;
• safeguard the ongoing financial soundness of such firms. Capital requirements are laid down to cover the market risks to which they are exposed.

Investment firms and credit institutions are required to assess their positions daily at market prices. Similarly, they are required to transmit to the competent authorities in their Member State of origin any information necessary for those authorities to check that the rules laid down in the Directive are being observed.

Trading book

The concept of a “trading book” comprises positions in securities and other financial instruments which are held for trading purposes and are subject mainly to market risks and exposures relating to certain financial services provided to customers.

The first requirement concerns the position risk. According to the rules proposed, each firm must keep in the form of capital a given percentage of its long and short positions, after allowance has been made for its hedging operations.

Secondly, there is a foreign-exchange risk requirement in respect of losses which the firm may suffer in the event of adverse exchange-rate movements. However, two important points should be made:

• there is only a capital requirement for foreign-exchange risk if the institution's overall net foreign exchange position exceeds 2 % of its total own funds;
• the foreign exchange position is calculated on the basis of the institution's entire books and is not calculated in relation to trading book transactions alone.

The third requirement relates to the treatment of risk arising from unsettled transactions and other transactions where counterparty risk arises.

The concept of a “trading book” also applies to positions in commodities or commodity derivatives which are held for trading purposes and are subject mainly to market risks.

The European Banking Authority carries out the supervisory functions.

RELATED ACTS

Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) [Official Journal L 177 of 30.6.2006]. This Directive lays down the conditions for the taking up and pursuit of the business of credit institutions. It contains provisions concerning the freedom of establishment, free provision of services, relations with third countries and the principles and technical instruments for prudential supervision.

Last updated: 18.03.2011