EBA sets out the framework for the SREP for investment firms

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1.  Based on the principle of proportionality, the srep framework for investment firms is defined in line with the srep for banks

The SREP is one of the main supervisory tools, through which the competent authorities can get an overview of a supervised entity:

  • Itsthe Business Model ;
  • Its risk profile of the entity ;
  • Its overall viability ;
  • Its overall sustainability.

As part of the SREP, based on the comprehensive assessment, the competent authorities shall set additional P2R capital requirements and apply other supervisory measures as necessary. The results of the SREP shall be communicated individually to each entity subject to prudential supervision, ensuring that its specific situation and risk profile are duly considered and that all material risks are adequately addressed through capital or other supervisory measures.

The common SREP framework introduced in these guidelines is built around thesemain elements:

  • Business model analysis ;
  • Assessment of internal governance and control arrangements at the level of the investment firm ;
  • The assessment of risks to own funds and the adequacy of own funds to cover these risks;
  • The assessment of liquidity and funding risks and the adequacy of liquidity resources to cover these risks;
  • The systemic risk assessment of the investment firm;

 

Consistency and comparability of the assessment are facilitated by the common scoring framework, which differentiates  risk and sustainability scores. The scores of individual risks and SREP elements are aggregated to be an overall SREP score, reflecting the assessment of the sustainability of the investment firm.

The results of the assessment are the basis for the adoption of any necessary monitoring measures to address specific risks and concerns.

Therefore, guidance is provided on the application of supervisory measures, including quantitative capital and liquidity measures, as well as other qualitative measures, where appropriate.

The guidelines specify common procedures and methodologies for SREP that are commensurate with the different sizes and business models of investment firms and the nature, scale, and complexity of their activities.

2.  Objectives of the guidelines

These guidelines are addressed to the competent authorities supervising Class 2 and Class 3 investments firms ,specify the procedures and methods for the prudential supervision and the related assessment.

The main objective is to ensure consistency of supervisory practice in the assessment of Class 2 and Class 3 investment firms and in the application of capital and other supervisory measures, thereby contributing to a level playing field for these investment firms across the EU.

3.   SREP analysis of investment firms

In line with the SREP framework for the assessment of credit institutions, the SREP framework introduced in these guidelines is structured around the following main components

  • Categorisation of the investment firm and periodic review of that categorization ;
  • Monitoring of key indicators ;
  • Business model analysis ;
  • Assessment of internal governance and enterprise-wide controls;
  • Capital risk assessment ;
  • Assessing liquidity and funding risks;
  • Assessing the capital adequacy of the investment firm;
  • Assessing the adequacy of the investment firm’s liquidity resources;
  • The overall evaluation of the SREP;
  • Monitoring measures (and early intervention measures if necessary).

For the proportionate application of these guidelines, the frequency, intensity, and granularity of SREP assessments, as well as the level of engagement, should depend on the category of the company.

Regular monitoring of key financial and non-financial indicators supports the SREP. It should enable competent authorities to monitor developments in the financial conditions and risk profiles of investment firms. It should prompt updates to the assessment of SREP items when it highlights new material information outside the expected items.

4.  Description of supervision activities in the framework of the srep

4.1.   Business model analysis

Without prejudice to the responsibility of the management body of the investment firm for the organization and management of its activities, the Business Model Analysis (BMA) should:

  • Focus on assessing the viability of the investment firm’s current business model and the sustainability of its strategic plans.
  • Help reveal key vulnerabilities facing the investment firm that may not be revealed by other elements of the SREP.
  • Enable an assessment of the risk to the viability of an investment firm arising from its business model and strategy, bearing in mind that the objective of the BMA is not to introduce a prudential rating of various business models.

4.2.   Assessment of governance and risk management

The assessment of the internal governance and risk management framework at the enterprise level should focus on:

  • Ensuring that internal governance and firm-wide controls are appropriate to the risk profile, business model, size and complexity of the investment firm.
  • Assessment of the extent to which the investment firm complies with the requirements and standards of good internal governance and risk control arrangements.

As part of the risk management assessment and the framework for assessing internal governance and enterprise-wide controls, competent authorities should:

  • Review the Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP) frameworks.
  • Assess the ability of the investment firm to implement risk strategies consistent with risk appetite and sound capital and liquidity plans.
  • Evaluate the stress testing capabilities, programs and performance of investment firms;
  • Assess the risk to the viability of an investment firm arising from failures in governance and control arrangements.

4.3.   Assessment of capital and liquidity risks

The assessment of risks to capital and liquidity should focus on the assessment of the significant risks to which the investment firm is or may be exposed, including risks to its clients and markets. This includes :

  • Exposure to risk ;
  • On the quality of management ;
  • Controls used to mitigate the impact of risks.

Competent authorities should analyse the scale of the potential prudential impact that the risks pose for most investment firms that provide investment services such as reception and transmission of orders, execution of orders on behalf of clients, portfolio management, investment advice, placement of financial instruments, operation of an MTF or an OTF.

4.3.1.    Liquidity risks

These risks may arise from funding risk where, under stressful conditions (e.g. declining client base), investment firms may not be able to meet current and future unanticipated cash inflows and outflows and collateral requirements without affecting either day-to-day operations or the firm’s financial position.

Therefore, liquidity risk must be forward-looking and the competent authorities must assess it under normal and severe but plausible conditions.

For investment firms that trade on proprietary activities, funding risk arises from market activities that correspond to different maturities of different traded instruments or types of traded contracts (e.g. listed futures versus OTC contracts) and from margin calls.

For these investment firms, the interaction between liquidity funding exposures and the liquidity risk arising from their market activities should be considered more important:

  • Investment firms engaged in market making activities play a crucial role in the provision of liquidity to markets within the EU and their clients depend on the ability of market makers to provide liquidity to the market;
  • Since market makers may need to take short positions to perform this role and the relevant time frame for market makers is generally short term, market makers are vulnerable to liquidity risk, including intraday liquidity risk;
  • However, investment firms that engage in matched principal transactions may be less exposed to liquidity risk.

In assessing the adequacy of the investment firm’s liquidity resources, the competent authorities shall determine whether :

  • The liquidity held by the investment firm shall ensure that liquidity risks are adequately covered;
  • The imposition of specific liquidity requirements is necessary to capture the liquidity risks to which an investment firm is or may be exposed.

 

4.3.2.       Risks affecting capital

Since an investment firm may face risks which are not covered or not fully covered by own funds, in assessing the capital adequacy of the investment firm, competent authorities should :

  • Determine the amount of additional P2R capital required to cover these risks. These requirements should be set in a legally binding manner and investment firms should be required to meet them at all times.
  • Determine whether the applicable capital requirements can be met under difficult conditions.
  • Assess the viability of the investment firm in terms of the amount and composition of equity held.

Where the quantitative results of the relevant stress tests or sensitivity analysis suggest that an investment firm may not be able to meet the applicable capital requirements under stress conditions or is excessively sensitive to plausible scenarios, competent authorities should take appropriate supervisory action to ensure that the investment firm is adequately capitalised. This includes communicating to investment firms their capital expectations in addition to their overall P2G capital requirements.

5.  Overall evaluation of the SREP

Having assessed the above SREP elements, the competent authorities should perform  an overview of the risk profile and viability of the investment firm – the overall SREP assessment – and summarise this view in the overall SREP assessment.

This summary should reflect any supervisory findings since the last supervisory review and any other developments that have led the competent authority to form a view of the risks and viability of the investment firm. The results of the overall assessment of the SREP should form the basis for the adoption of any supervisory measures necessary to address the concerns.

To facilitate communication within competent authorities and colleges of supervisors, to promote comparability and a level playing field between investment firms, and to prioritize resources and supervisory measures, in assessing the elements of the SREP, competent authorities should be given a score ranging from “1” (low risk) to “4” (high risk), to reflect the “supervisory view” for each element as specified in the guidelines.

These guidelines introduce two types of ratings:

  • Risk scores to be applied to individual capital, liquidity and funding risks that indicate the likelihood of the risk having a significant prudential impact on the investment firm (e.g. potential loss);
  • Sustainability scores to be applied to the four SREP elements and the overall SREP score that indicate the extent of risk to the sustainability of the investment firm arising from an assessed SREP element.

To facilitate supervisory processes and to promote comparability, the rating system introduced in these guidelines for the assessment of investment firms is like that applicable in the assessment of credit institutions. These guidelines do not imply that rating is automatic: ratings are assigned based on supervisory judgement.

Competent authorities should :

  • Use the accompanying “considerations” provided as guidance to support their supervisory judgement. Competent authorities are not precluded from applying a more granular rating in addition to the basic requirements specified in the guidelines if they consider it useful for supervisory planning.
  • Determine the overall SREP score based on the specific considerations using their prudential judgement. In doing so, they may define the weights assigned to each component considering the specificities of the investment firms using their prudential judgement.

These guidelines do not suggest any automatic link between scores and the level of supervisory response, nor do they link additional capital requirements to scores.

6.  Interaction between SREP and other supervisory processes, including cooperation between authorities

6.1.   General principle of cooperation between SREP and other monitoring processes

Competent authorities should consider available information and the results of all other monitoring activities in SREP assessments, including

  • On-site inspections ;
  • Internal model approvals and reviews;
  • Suitability assessments of management board and key functions holders ;
  • Licence approvals;
  • Evaluation of recovery plans ;
  • Market behaviour ;
  • Investor protection activities ;
  • AML/CFT monitoring.

Similarly, the findings of the assessment of the SREP elements, if any, should be shared with other relevant supervisory authorities, including AML/CFT supervisors and competent authorities, as they may have an impact on other supervisory processes.

This mechanism for cooperation and exchange of information between competent authorities allows for comprehensive risk analysis and supervision of investment firms, improving the overall view of the supervision of investment firms, their viability, and risks, and ensuring that identified failures/vulnerabilities are adequately addressed by appropriate measures within the respective competencies of each authority concerned.

6.2.   Synergy between SREP and preventive recovery plans

An example of these synergies and the complementarity of the analysis is the interaction between the SREP and the assessment of recovery plans, where these are needed and/or available.

On the one hand, the results of the evaluation of recovery plans feed into:

  • The SREP assessment of internal governance;
  • Risks at the level of the investment firm;
  • Information from the recovery plan itself that may assist the supervisory authorities in their Business Model Analysis;
  • Assessment of governance and internal controls;
  • The determination of additional P2R capital requirements to address the risk of disorderly winding up, as a source of additional information.

On the other hand, the conclusions of the assessment of the SREP elements should feed into the assessment of the recovery plans. This includes :

  • Internal governance and enterprise-wide controls;
  • Business model analysis ;
  • Assessment of capital adequacy and liquidity;
  • The establishment of additional P2R capital and liquidity requirements.

This interaction between the SREP and recovery plan assessments is also consistent with the principle that investment firms’ own recovery planning activities should be integrated into their risk management framework.

6.3.   Synergy between the SREP and the AML/CFT system

Competent authorities are expected to cooperate with AML/CFT supervisors. The failure of investment firms to address money laundering and terrorist financing risks can have adverse effects on the financial soundness of these firms and on the integrity of the internal market and financial stability. Therefore, prudential supervisors :

  • Should address, to the extent possible, the risks of laundering/TF from a prudential perspective in the SREP;
  • Shall cooperate with authorities and bodies responsible for monitoring compliance with AML/CFT requirements to collect the necessary information.

For example, competent authorities should make use of established AML/CFT colleges where they exist. It should be emphasized that competent prudential authorities are not intended to duplicate the work and mandate of AML/CFT supervisors, who are responsible for monitoring the compliance of investment firms with AML/CFT requirements.

However, it is important that they seek feedback from AML/CFT supervisors in the context of the SREP regarding AML/CFT risks and the effectiveness with which they are managed by institutions.

Conversely, where the assessment of any of the elements of the SREP reveals information relating to increased exposure to money laundering risks or failures in the management of money laundering risk by investment firms, the relevant information should be communicated to the AML/CFT supervisory authorities. To ensure the most effective and consistent supervisory response, any supervisory measures or sanctions in this area should be implemented in coordination with the AML/CFT supervisors.

6.4.   Synergy in consumer protection

To ensure consistent investor protection across financial services, prudential supervisors should:

  • Cooperate with market authorities ;
  • Consider relevant information received from these authorities in the SREP.

In particular, considering the role of market authorities in areas such as governance, to ensure consistent supervision and avoid duplication of effort, relevant information should be exchanged and the application of any supervisory measures in those areas should be coordinated between the competent prudential and market authorities.

7.   Link between SREP, early intervention and resolution

The assessment of the viability of an investment firm allows the results of the SREP assessment to be used to take appropriate supervisory action if necessary. Competent authorities can use the results of the SREP to identify triggers for early intervention measures.

The guideline also determines whether an investment firm can be considered as “failing or likely to fail”. If so, this activates the formal procedure for interaction with the resolution authorities.

Investment firms falling within the scope of these guidelines, but not eligible for resolution, are expected to be wound up in an orderly manner in the event of failure rather than going through the resolution process. In such cases, enhanced engagement by the competent authority may be required to ensure an orderly winding up.

This link between the SREP and the application of early intervention measures, where appropriate, and the determination of whether an investment firm is failing is based on the focus on sustainability of the overall SREP assessment and the assessment of individual SREP elements, as expressed by sustainability scores, and on the fact that the results of all monitoring activities are considered in SREP assessments.

In particular, the results of SREP assessments may lead competent authorities to take monitoring measures or to decide to apply early intervention measures. Rather than considering the overall SREP score as a prescriptive tool, competent authorities can use it as a guide when deciding to apply monitoring or early intervention measures.

In addition, if the competent authority considered an investment firm to be unviable under the SREP, the competent authorities would consider that investment firm to be “failing or likely to fail” (as indicated by an overall SREP “F” score).

The failure of an investment firm to comply with previous supervisory and/or early intervention measures may indicate that the measure has been exhausted and form part of the rationale for the competent authority to consider the investment firm as “failing or likely to fail”.

In addition, competent authorities are expected to cooperate with resolution authorities on an ongoing basis, not just in the context of failing or potentially failing investment firms. They are required to notify the competent resolution authorities of any additional capital requirements or P2G.

8.  Proportionality in the SREP

Given that investment firms vary considerably in size, risk profile and scope of activities, ranging from simple one-man businesses to large, complex international companies, it is particularly important to reflect the principle of proportionality appropriately in supervisory processes.

Smaller non-interconnected investment firms should be subject to SREP based on a case-by-case decision of the competent authority, only where this is deemed necessary due to the size, scale, and complexity of the activities of these investment firms.

Thus, the Guideline recognizes the principle of proportionality by:

  • Categorizing investment firms into four distinct categories: in this respect, Class 2 firms are divided into three categories according to their size and risk profile, while small Class 3 investment firms form a separate category.
  • Developing a minimum model of supervisory engagement, in which the frequency, depth and intensity of assessments vary according to the category of investment firm.
  • Recognizing the possibility of adjusting the granularity of the assessment according to the size and business model of the investment firm and the nature, scale and complexity of its activities.
  • Considering a more thorough assessment of governance arrangements and controls at the firm level, given that investment firms with a more complex or larger scale organization need more sophisticated governance arrangements.
  • Setting proportionate expectations regarding the arrangements, strategies, and processes that investment firms are required to establish in order to assess and maintain on an ongoing basis the amounts, types and distribution of internal capital and liquidity that they consider adequate to cover the nature and level of risks that they may pose to others and to which the investment firms themselves are or may be or may become exposed (ICAAP and ILAAP)

References

  • EBA/CP/2021/35
  • Draft Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP) under IFD

Abbreviations

  • EBA: European Banking Authority
  • RTS: Regulatory Technical Standards
  • OTFs: organised trading systems
  • SREP: Supervisory Review Evaluation Process
  • RTS: Regulatory Technical Standards
  • CRR2: Capital Requirement Regulation 2
  • IFR- Regulation (EU) 2019/2033
  • IFD – Directive (EU) 2019/2034
  • CRR – Regulation (EU) No 575/2013
  • CRD – Directive 2013/36/EU