Cleared from scrutiny; drawn to the attention of the Treasury Committee
(a) Proposal for a Regulation on prudential requirements for investment firms; (b) Proposal for a Directive on the prudential supervision of investment firms
(a) Article 114 TFEU; ordinary legislative procedure; QMV; (b) Article 53 TFEU; ordinary legislative procedure; QMV
(a) (39397), 16017/17 + ADD 1, COM(17) 790; (b) (39400), 16011/17 + ADD 1, COM(17) 791
7.1As part of the Single Market, the EU has put in place a substantial body of law governing the prudential stability of the financial services sector. However, the investment services industry—for example the provision of brokerage services or portfolio management—has to date not been made subject to a specific prudential regime calibrated to ensure their financial stability, or orderly wind-down, in the event of an economic downturn or a liquidity crisis. Instead, investment firms in the EU are covered by European rules drafted for the banking industry under the Capital Requirements Directive and Regulation.
7.2Following a review of whether this approach remained appropriate for the investment services industry, the European Commission concluded that the banking rules were not “fully suited to all investment firms” because they do not “capture the actual risks faced by the majority” of such companies. Therefore, in December 2017, the Commission tabled —a Regulation and a Directive—for a new, calibrated prudential regime for investment firms (referred to as the “Investment Firm Review” or IFR).
7.3As summarised in our previous Reports of and , the new legislation will create a new classification system for investment firms, ranging from Class 1 (systemically-important investment banks) to Class 3 (the smallest investment firms). For Class 2 and Class 3 firms, the legislation will establish new, tailored prudential and organisational requirements, whereas Class 1 firms would remain subject to the Capital Requirements Directive for banks (as they are at present) because they “typically incur and underwrite risk” on a scale that makes them important for the EU’s overall financial stability. In addition, Class 1 investment firms based within the Eurozone would be supervised directly by the European Central Bank’s Single Supervisory Mechanism (SSM) rather than their national regulator.
7.4In addition, the Commission proposals also sought to modify the way in which non-EU firms could access the EU market for investment services. Driven to a large extent by the UK’s withdrawal from the European Union, they would amend the provisions of the 2014 (MiFIR) related to ‘equivalence’. The equivalence regime currently allows the Commission, with the support of a qualified majority of Member States, to declare the regulatory regime of a ‘third country’ equivalent to the EU’s. If such a determination is made, firms from that country can provide investment services to EU-based professional and institutional clients on a cross-border basis (i.e. without the need for a legal presence in the EU itself). Equivalence decisions can be withdrawn unilaterally by the EU, with no right of appeal or other recourse for the non-EU country affected. This is the legal framework on which the UK will need to rely to provide investment services into the EU after it leaves the Single Market.
7.5Because of the UK’s large financial services sector, its decision to withdraw from the EU has led to concerns that a significant volume of investment services—currently regulated directly by European law—could be provided from outside the EU’s direct jurisdiction if the UK were to obtain equivalence after Brexit. The Commission’s Investment Firm Review therefore sought to attach more stringent conditions before equivalence can be granted, by requiring a “detailed and granular process for the assessment” that also takes into account the third country’s “supervisory convergence”. The clear purpose was to give the Commission more leeway to make any UK request for equivalence conditional on a very close alignment with the EU’s regulatory regime for investment firm after Brexit. The Commission also called for close monitoring of the activities of non-EU investment firms operating in the EU which do not rely on ‘equivalence’, such as delegated or outsourced activities by EU-based firms to UK service providers.
7.6Based on an submitted by the Treasury in early 2018, we described the substance and potential implications of the proposal in more detail in our initial . We took into account the Government’s request for a transitional period after the UK is due to formally leave the EU, during which it would temporarily stay in the Single Market and bound by new European law—including, potentially, the Investment Firm Review after its adoption by the EU institutions.
7.7In its Memorandum, the Government expressed support for the new classification system and prudential and organisational requirements for the investment industry, subject to further fine-tuning of the specific capital requirements that would apply to the different classes. However, the Government has—understandably—been much more sceptical about the proposed modifications to the equivalence process for non-EU companies to provide services within the Single Market without the need for a subsidiary there, given these are aimed at making it more difficult for the UK to provide investment services into the EU while retaining domestic regulatory flexibility.
7.8When the proposals were first published in late 2017, the Economic Secretary to the Treasury (John Glen MP) told us that the UK did not want to rely on equivalence at all to access the EU market after Brexit, instead seeking “stable, reciprocal arrangements” for trade in financial services that did not rely on equivalence. However, the November 2018 accompanying the draft Withdrawal Agreement on the UK’s exit from the EU instead commits the Commission to “start assessing equivalence […] as soon as possible after the United Kingdom’s withdrawal” and to keep its “respective equivalence frameworks….. under review”. This shows the Government has accepted that, for investment services and other financial sectors, UK market access into the EU after Brexit will be based on equivalence. The EU has made no specific commitments as to what its ‘reviews’ of this framework should lead to, and has only consented to an ambition—rather than an obligation—to conclude its assessments of the UK’s regulatory approach in the various financial sectors where equivalence is a possibility by June 2020 (if the House of Commons ratifies the Withdrawal Agreement).
7.9The EU Member States discussed the Investment Firm Review throughout 2018, with the most politically contentious issues being the treatment of the most important (Class 1) investment firms, and the precise conditions for granting non-EU countries access to the Single Market for investment services under ‘equivalence’. We issued our last Report on the state of play in the negotiations .
7.10In early 2019, the Member States’ Permanent Representatives in Brussels (‘COREPER’) —a ‘General Approach’—to the Commission proposals, and asked the Romanian Presidency of the Council to discuss these with the European Parliament (which must also agree on the new legislation for it to take effect). The European Parliament’s Economic & Monetary Affairs Committee (ECON) had already adopted its on the Investment Firm Review in September 2018. Negotiations between the two institutions began in January 2019, and by dated 19 March 2019, the Economic Secretary informed us that the Parliament and the Member States had on the Investment Firm Review in late February.
7.11The final compromise on new prudential rules for investment firms operating in the EU, as summarised by the Minister, consists of the following key elements:
7.12The new legislation is expected to take effect throughout the European Union by autumn 2020. Giving full effect to the rules will also require the European Commission to adopt a number of Delegated and Implementing Acts, for example on risk measurements for prudential capital; the format of information exchanges between national financial authorities; and the criteria for assessment of the potential systemic importance of non-EU investment firms operating in the EU.
7.13The Minister’s letter explains that the Government “believe that the overall agreement creates a regime that support more proportionate regulation, upholds market integrity and financial stability, and which will also benefit the industry and ultimately the wider economy”. He therefore asked the Committee to clear the Investment Firm Review from scrutiny, so that the Government can vote in favour of its adoption if it is brought to the Council before the UK ceases to be a Member State.
7.14The precise impact of the new legislation for the UK is currently unclear, even after it exits the European Union. If the Withdrawal Agreement is ratified, the Investment Firm Review would be binding on the UK as a matter of EU law from its date of application in late 2020 until the end of the post-Brexit transitional period (which could, potentially, last until 31 December 2022). At the junction where both the Investment Firm Review has taken effect and the UK has left the Single Market (including in a ‘no deal’ scenario), the new legislation would not as a matter of EU law apply to British firms. However, if the Government wanted to maintain ‘equivalence’ to ensure cross-border market for investment firms, it would need to stay broadly aligned with the prudential requirements set out in the new EU rules. It is therefore also an important piece of legislation even for the UK as a ‘third country’ outside the Single Market.
7.15The importance of the Investment Firm Review for the UK financial services industry is also underlined by the Government’s decision to include it in the scope of the , which is awaiting its Report stage in the House of Commons. Once passed, this Act would allow the Treasury to implement a range of new EU financial services legislation currently awaiting formal adoption by means of Statutory Instruments, in the eventuality that the UK leaves the EU without a Withdrawal Agreement—and therefore a transitional period—in place. The Economic Secretary Parliament on 26 February 2019 that the Bill would allow for rapid implementation of the Investment Firm Review (and other new pieces of EU financial services legislation) in a way that “maintains the functionality, reputation and international competitiveness of [the UK] financial sector”. However, it is not strictly correct to refer to the Financial Services Bill as part of the Government’s ‘no deal’ preparations, as the EU legislation covered by it by definition will not be in force on ‘exit day’ and therefore there is no risk of a legal vacuum. (For example, as noted, the Investment Firm Review will not apply until autumn 2020, well beyond the current ‘exit date’ for the UK’s withdrawal.)
7.16We are grateful to the Economic Secretary for his overview of the final substance of the EU’s Investment Firm Review. As we noted in our last report, the way the European Union regulates the investment services industry is of direct relevance to the UK given its sizeable financial services trade surplus and large-scale operations in the remaining EU Member States. The new EU rules are likely to take effect from autumn 2020. In the short-term, if the Withdrawal Agreement is ratified by the House of Commons, this means the new prudential legislation for investment firms would apply directly in the UK during the post-Brexit transitional period (and particularly if it is extended beyond its original end date of 31 December 2020 until 2022).
7.17It is unclear at this stage whether the Government will have a formal vote on the final legislation in the Council of Ministers, because the date for the vote has not yet been set. Once the Article 50 period ends and the UK is no longer a Member State, the UK will lose its representation in the Council. Similarly, at that stage, the Treasury, Bank of England and Financial Conduct Authority will not be formally involved in the drafting or approval of any of the Delegated or Implementing Acts necessary to give full effect to the Investment Firm Review, even though they would be binding domestically until the end of any transitional period if the Withdrawal Agreement is ratified. It is concerning that no other country, including the non-EU members of the European Economic Area, must automatically accept new EU legislation on which they did not have a vote (although we accept, of course, that the Treasury has been closely involved in the EU negotiations and the Minister’s reassurance that the outcome of the legislative process is acceptable to the UK Government).
7.18As noted, the Investment Firm Review would not apply directly in the UK by virtue of EU law in a ‘no deal’ scenario, or beyond the end of any transition period under the Withdrawal Agreement. However, the Treasury could still choose to implement it anyway, even if there is no EU legal obligation to do so. This, the Government has said, would be a means of ensuring the UK financial industry’s “functionality, reputation and international competitiveness” after EU exit. If the Financial Services (Implementation of Legislation) Bill is passed, such changes could be made to domestic law without the need for primary legislation. Although the Bill would prohibit the Treasury from making “major” changes when implementing EU financial services legislation by means of regulations in a ‘no deal’ Brexit scenario, we urge the House to pay close attention to any differences introduced by the Treasury compared to the Investment Firm Review as adopted at EU-level.
7.19The inclusion of the Investment Firm Review in the Bill is also relevant with respect to any attempt by the Government to obtain ‘equivalence’ under the Markets in Financial Instruments Regulation after Brexit. In the final legislation as adopted by the Council and Parliament, the granting of equivalence for the provision of cross-border investment services from the UK into the EU is more difficult than under current EU legislation. The scale of the UK’s investment industry means it is highly likely the European Commission would use its new powers to conduct a “granular assessment” of the potential systemic importance of investment services provided in the EU by UK firms after Brexit, and attach stricter conditionality that would tie the UK closely to European legislation in this area even as a non-Member State. The Treasury’s ability to implement the EU rules domestically by means of regulations would facilitate seeking equivalence in due course, since it makes it easier to amend UK law on investment services to reflect EU legislation in this area after Brexit.
7.20Overall, whether the EU grants equivalence—especially in an economically valuable area like investment services—will not merely be a technocratic exercise where regulatory regimes are compared. Given the wider state of UK-EU relations, particularly in the context of an abrupt economic rupture that a ‘no deal’ Brexit would trigger, it will also be inherently political. Even if the UK respects the EU’s Investment Firms Review to the letter as a ‘third country’, there is no guarantee that it will be deemed equivalent. Moreover, even if it is granted, equivalence may come with conditions or time-limits, as shown by the EU’s recent decision to extend its recognition of Switzerland’s stock exchanges as equivalent for only six months. Access for UK financial services firms to the EU market is likely to be, implicitly, linked to the wider trade negotiations. These are issues the House will want to scrutinise closely as and when negotiations on the UK’s future, post-Single Market economic partnership with the EU begin.
7.21Given the likely impact of the EU’s Investment Firm Review in the UK irrespective of Brexit, the new legislation is clearly of substantial political importance. However, in view of the imminent adoption of the proposals by the Council and the European Parliament, we are content to now clear them from scrutiny. We also draw these developments to the attention of the Treasury Committee, given its interest in the regulation of the UK’s financial services industry.
(a) Proposal for a Regulation on prudential requirements for investment firms: (39397), 16017/17 + ADD 1, COM(17) 790; (b) Proposal for a Directive on the prudential supervision of investment firms: (39400), 16011/17 + ADD 1, COM(17) 791.
59 The main difference between investment firms and banks is that the former do not take deposits or make loans, meaning there is less risk of a ‘run’ where customers want to withdraw their funds en masse, endangering the continued viability of the institution.
60 See Commission document . We also elaborated the reasons for new prudential rules for the investment services industry in our .
61 The categorisation of individual companies would be based primarily on the worth of a firm’s assets, but also the specific type of investment services offered.
62 Under the original Commission proposal investment firms would fall into “class 2” if they exceed any one of a number of size thresholds, such as assets under management valued at more than €1.2 billion (£1.1 billion) or a balance sheet higher than €100 million (£88 million). Firms would also fall into this category if they administer any client assets or hold any client money. For most Class 2 firms, the new capital requirements would be calculated according to a new “K-factor approach” for measuring risks in three categories (to the firm, to its customers and to the market) from the services and activities undertaken. The necessary capital buffer would be derived from the volume of each activity.
63 For firms in Class 3, the minimum capital would be either the level of initial capital required for their authorisation in line with the new prudential regime—€75,000 (£67,000)—or a quarter of their fixed costs (overheads) for the previous year, whichever is higher. The European Banking Authority that most Class 3 firms “ought to comfortably meet the new requirements based on their existing levels of own funds”.
64 The transfer of supervisory responsibility to the ECB was included to address suspicions that UK investment firms, wishing to retain a foothold in the EU market after Brexit, might otherwise ‘shop around’ for the lightest-touch national prudential approach within the Eurozone. Although the Commission proposal would not make class 1 investment firms subject to the Single Supervisory Mechanism if they relocated from the UK to a non-Eurozone EU country, the Commission said in late 2017 that “based on anecdotal information, at this stage the indications are that the preferred locations for these firms’ EU27-operations are in financial centres in Euro Area Member States (Germany, Ireland, Netherlands, Luxembourg, France)”.
65 No ‘third country’ currently has an under MiFIR. However, the Regulation only took effect in January 2018.
66 The UK is due to leave the Single Market after a post-Brexit transitional period which, if the Withdrawal Agreement is ratified, could last until 31 December 2022. In a ‘no deal’ Brexit scenario, the UK is due to leave the Single Market on 12 April 2019.
67 Article 61 of the Regulation as proposed by the Commission reads: “Where the services provided and the activities performed by third-country firms in the Union following the adoption of the [equivalence] decision (…) are likely to be of systemic importance for the Union, the [third country’s] legally binding prudential and business conduct requirements (…) may only be considered to have equivalent effect to the [EU’s] requirements (…) after a detailed and granular process for the assessment. For these purposes, the Commission shall also assess and take into account the supervisory convergence between the third country concerned and the Union.”
68 Separately, the Commission also proposed a reporting requirement for third country firms registered with ESMA under the equivalence regime […]. They would have to inform the Authority annually about the scale and scope of their activities; their turnover and assets; the arrangement for investor protection; and their risk management policy.
69 For example, UK investment firms could provide services in specific EU Member States via a branch (a place of business which is a part of an authorised investment firm, but which has no legal personality of its own and is not subject to separate authorisation within the EU). Under EU law, branches can provide services to retail and elective professional clients in those EU Member States which allow this. Wholesale services to professional and institutional investors can only take place on a cross-border basis after ‘equivalence’ has been granted, or via a fully-authorised subsidiary within the EU.
70 Indeed, until the middle of 2018, the Chancellor of the Exchequer was still insisting that equivalence should categorically not form the basis for the UK’s future trading relationship with the EU in financial services.
71 If the Withdrawal Agreement is not ratified, the EU has given no indication that it will consider any short-term equivalence decisions in relation to the UK financial services industry, other than for clearing of over-the-counter derivatives by British central counterparties under European Markets Infrastructure Regulation (EMIR) until the end of 2019.
72 The Economic Secretary wrote to us in advance of this meeting, indicating that the outstanding issues being discussed where the prudential treatment of ‘Class 1’ firms and the new framework for equivalence assessments of non-EU countries.
73 In December 2018, the Treasury told us the UK continued to advocate for a regulatory approach for Class 1 investment firms “which would not unduly impact the [Prudential Regulation Authority’s] approach to systemic investment firms’ designation and supervision”.
74 These new rules mirror parallel developments in the regulation of remuneration practices in banks under the for financial stability in the banking sector.
75 By extension, the bonus cap would remain in place for Class 1 investment firms covered by the banking rules under the Capital Requirements Regulation.
76 Specifically, the Commission could require that non-EU firms operating under equivalence would have to comply with articles 20, 21, 23, 26 and 28 of the Markets in Financial Instruments Regulation, which cover requirements related to public post-trade disclosures; reporting of individual transactions to an EU-based regulator; and use of authorised exchanges or trading venues.
77 However, the European Parliament abandoned its earlier proposal that certain activities—underwriting and dealing on own account—should be excluded from the equivalence regime altogether (which would have “de facto impos[ed] a relocation requirement for [non-EU] firms” who want to provide such services to EU-based customers). In a win for the UK, these activities will therefore remain in scope of the new equivalence regime, meaning non-EU firms can in principle provide them on a cross-border basis after an equivalence determination is made. However, they would be subject to a new reporting requirement to ESMA to measure the size of such activities by ‘third country’ firms.
78 Initially, the transition period would last only until 31 December 2020. If the Withdrawal Agreement is ratified but the transition is not extended, the Investment Firm Review would therefore only be directly binding on the UK as a matter of EU law for a few months.
79 The full list of ‘in-flight’ EU financial services proposals to which the Treasury’s regulation-making powers would apply are set out in the .
80 If the EU legislation covered by the 2019 Act was already in effect on ‘exit day’ there would be no need for the Act, because it would have been covered by the regulation-making powers of the European Union (Withdrawal) Act 2018.
81 The European Council has foreseen the possibility of a further extension until 22 May 2019 if the Withdrawal Agreement is approved by the House of Commons. In the absence of ratification, the EU expect the Government to put forward proposals to unblock the Brexit process to avoid ‘no deal’ by 12 April, which could involve a further extension of the Article 50 process (including the holding of European elections in the UK).
82 Unlike for Central Counterparties for derivatives trades, the EU has not adopted a pre-emptive contingency equivalence decision for UK investment services in case of a ‘no deal’ Brexit.
83 European Commission press release, ““ (17 December 2018).
Published: 2 April