Prudential Committee update 1 April 2014

IMA presentation at Covington & Burling Speakers: Irving Henry, Prudential Specialist, IMA Jared Siddle, Head of Risk, Vanguard Andrew Lowin, Technical Director, Kinetic Partners Agenda: An introduction to the IMA’s Prudential Committee and its current issues

Introduction to the IMA’s Prudential Committee Chairman: Jared Siddle, Head of Risk, Vanguard Secretary: Irving Henry, Prudential Specialist, IMA Meetings: scheduled quarterly, but more often if required Sub-committees: Remuneration and COREP Related committees: Business and Enterprise Risk, and Risk and Regulation

The Prudential Committee’s terms of reference To consider all issues affecting IMA Member firms in the area of prudential regulation, including capital requirements, risk management, consolidated supervision and other prudential requirements. To advise the IMA Executive on the impact and significance of current issues and proposed developments in the area of prudential regulation, and to assist in prioritising such issues and developments. To assist the IMA Executive in developing responses to regulatory proposals in the area of prudential regulation. To assist the IMA Executive in developing initiatives relevant to Member firms in the area of prudential regulation, independent of specific regulatory proposals. To advise the IMA Executive on how best to consult the wider membership on particular issues. As requested, to assist the IMA Executive in its representational and lobbying activities.

Who the Prudential Committee engages Financial Conduct Authority HM Treasury European Securities and Markets Authority European Banking Authority (for firms in scope of CRD IV / R / IFPRU) European Commission Basel Committee on Banking Supervision / CPSS International Organisation of Securities Commissions Financial Stability Board

CRDIV Scope

Investment Firm Definition and CRD Scope MiFID Art. 4(1) vs. CRR Art. 4(2) Investment Firm Definition MiFID Investment Firm - one undertaking MiFID Services and/or Activities unless Exempt (e.g. as a consequence of either MiFID Art. 2 or 3) CRR Investment Firm - per CRR Art. 4(2) any MiFID Investment Firm which is not a Credit Institution is not a Local Firm (i.e. one which trades in Derivatives for its own account only or only with other Members of the same Futures and Options Exchange) but exclude MiFID Investment Firms which are permitted only to undertake one or more of the following MiFID Activities A1 – Reception and Transmission of Orders… A2 – Execution of Orders on behalf of Clients A4 – Portfolio Management A5 – Investment Advice and are expressly prohibited from undertaking MiFID Ancillary Service B1 – Safekeeping and Administration of Client Assets/Money…. or Safeguarding and Administering Client Assets and/or Money

Investment Firm Definition and CRD Scope cont… An IFPRU Firm is, therefore, a MiFID Investment Firm which is not excluded by the CRR Art. 4(2) Definition Typical, but not exhaustive, examples which tip MiFID Investment Firms into being classified as IFPRU Investment Firms are those permitted, by their Part IV Permission and/or MiFID Passport, to undertake any one or more of the following MiFID: Ancillary Activity B1 (which could now bring into CRD scope some Exempt CAD Firms) Activity A3 (Dealing on Own Account) Activity A6 (Underwriting of Financial Instruments and/or Placing on a Firm commitment basis) Activity A7 (Placing of Financial Instruments without a Firm commitment basis) and/or Activity A8 (Operation of a Multilateral Trading Facility)

Investment Firm Definition and CRD Scope cont… A BIPRU Firm is, therefore, a MiFID Investment Firm which is excluded by the CRR Art. 4(2) Definition (other than an Exempt CAD Firm) Typical, but not exhaustive, examples of permitted Activities of MiFID Investment Firms which do not, in themselves, tip the Firm into being classified as IFPRU Investment Firms are those which hold the following Regulated Activities and Limitations Only undertake one or more of the following MiFID Activities A1 Reception and Transmission of Orders… A2 Execution of Orders on behalf of Clients A4 Portfolio Management A5 Investment Advice Hold relevant Limitations which prevent it undertaking MiFID Activities which would make them an IFPRU Firm, for example A7 (Placing…..without a Firm Commitment basis) which can be seen as part of Regulated Activity of ‘Arranging (bringing about)’ Do not hold MiFID Passports permitting the Firm to undertake MiFID Activities other than A1, 2, 4 and 5.

Investment Firm Definition and CRD Scope cont… Regulated Activities that do not, in themselves, bring Firms into IFPRU Scope: Arrange Safekeeping and Administration of Client Assets Control Client Money Dealing in Investments as Principal with Matched Principal Limitation Dealing in Investments as Principal with Box Management Limitation

Initial Requirement, Own Funds and Own Fund Requirements

Own Funds/Capital Resources BIPRU Firms GENPRU 2.2 (same as previously incl. Tier 3 Capital) IFPRU Firms CRR Part 2 Common Equity Tier 1 (‘CET1’) – Chapter 2 Additional Tier 1 (‘T1’) – Chapter 3 Additional Tier 2 (‘T2’) – Chapter 4 IFPRU Firms must hold at least: 4.5% of Risk Weighted Assets by CET1 6.0% of Risk Weighted Assets by CET1 plus Additional T1 8.0% of Risk Weighted Assets by Total Own Funds (incl. Additional T2) These are ‘at least’ thresholds, there is, for example, no reason why a Firm cannot meet its 8.0% of Risk Weighted Assets entirely from CET1

Capital Resources Requirement – BIPRU Firms BIPRU (same as previously) i.e. ‘Capital Resources Requirement’ Limited Liability basis still applies Higher of Base Capital Requirement (i.e. €50k) and Variable Capital Requirement Where the Variable Capital Requirement is the higher of Sum of Credit Risk Capital Component and Market Position Risk Capital Requirement; and the Fixed Overhead Requirement GENPRU/BIPRU BIPRU 3 Credit Risk (BIPRU 3.5 Simplified Standardised approach remains available) BIPRU 7 Market Risk BIPRU 13/14 (where BIPRU Firms hold a Dealing as Principal with a Matched Principal Limitation) GENPRU 2.1 Capital Resources Requirement including Fixed Overhead Requirement

Capital Resources Requirement – Fixed Overhead Requirement Investment Firms Fixed Overhead Requirement basis of calculation will be subject to EBA Regulatory Technical Standard (at this link) Basis of Fixed Overheads calculation will apply to all Firms subject to the Fixed Overhead Requirement, i.e. IFPRU Investment Firms holding Limited Authorisation BIPRU Firms UCITS Firms; and AIFM Firms EBA RTS Article 1 Defines which expenditure may be deducted from the most recent Audited Financial Statement’s Audited Expenditure in order to determine Audited Fixed Expenditure Fixed Overhead Requirement remains 25% of Audited Fixed Expenditure

Own Funds Requirement – IFPRU Firms Limited Authorisation (€50k/125k) IFPRU Investment Firms Risk Weighted Asset/Exposure = 100% Credit Risk Weighted Amount - CRR Art. 92(3)(a) & Title II Credit Risk Annex II and Credit Derivatives – CRR Art. 92(3)(f)(i) & Title II Repo. Securities/Commodities lending/borrowing – CRR Art. 92(3)(f)(ii) & Title II Margin Lending on Securities/Commodities – CRR Art. 92(3)(f)(iii) & Title II Long Settlement – CRR Art. 92.(3)(f)(iv) Risk Weighted Asset/Exposure = 1,250% Non-Trading Book Foreign Currency – CRR Art. 92(3)(c) & Art. 351 Non-Trading Book Settlement Risk – CRR Art. 92(3)(c) & Title V Non-Trading Book Commodity Risk – CRR Art. 92(3)(c) & Art 356 Fixed Overhead Requirement – CRR Art. 97 (and EBA RTS)

IFPRU Limited Licence Investment Firm

Standardised Credit Risk (as distinct from Simplified) With effect from 1 January 2014 IFPRU Investment Firms are not permitted to use the Simplified Standardised Credit Risk Approach (i.e. that available at BIPRU 3.5) as the Capital Resources Regulations (‘CRR’) does not include this basis. IFPRU Investment Firms are no longer subject to BIPRU (except BIPRU 12 Liquidity). CRR Title II outlines the basis of calculating the Standardised Credit Risk Approach. Standardised Credit Risk Approach requires Exposures to be calibrated in terms of the entity to which the Firm is exposed by way of its Credit Rating (or if none exists a Default Weighting percentage) Credit Ratings are calibrated in terms of External Credit Assessment Institutions (‘ECAI’) or Export Credit Agency (‘ECA’) basis. The current accredited ECAI can be found at this Link. ECAI tables can be found at this Link and at this Link. FCA Table linking ECAI to Credit Step at this Link. Each Exposure Type is assigned its own ECAI Credit Step Table, for example; CRR Art. 133 = Equity CRR Art. 120 = Rated Institutions CRR Art. 121 = Un-Rated Institutions CRR Art. 122 = Corporates CRR Art. 123 = Retail CRR Art. 128 = Particularly High Risk There are examples where the Weighting under the Standardised Basis results in a lower Weighting (e.g. 20% instead of 100%) than under the Simplified Standardised Approach (for example where non-UK Credit Institutions hold Cash denominated in another currency than its domestic currency, e.g. a French Bank holding STG).

Country by Country Reporting

Country by Country Reporting From when – 31 July 2014 By whom – all CRDIV Institutions, its Branches and all Subsidiaries, if any. What; From 1 July 2014 and beyond; Name, Nature of Activities and Geographical Location of the Institution; Turnover; Average number of employees on a full time equiv. basis; By 31 December 2015 only (except Globally Systemic Institutions); Profit or Loss before Tax; Corporation Tax Paid; and Public Subsidies Received (if any).

Country by Country Reporting (‘CbCR’) Format; In accordance with accepted Accounting Standards; and In relation to the Institutions most recent Financial Year. How often – at any time prior to 31 December in each year. How – The Annual Report would best form part of the Institution’s Statutory Financial Statement (1 July 2014 on the Institutions Website as unlikely to coincide with Financial Year End and Audit) in order to meet the ‘accepted Accounting Standards’. Globally Systemic Institutions must submit this report to HMRC by 1 July 2014. UK CbCR Regulations UK CbCR Guidance

Significant IFPRU Firms

Significant IFPRU Firms Defining a “Significant IFPRU” An IFPRU Firm would be defined as “Significant” if any one of its Total Assets exceed £530m (from FSA001 20A + 20B) Total Liabilities exceed £380m (from FSA001 41A) Annual Fees and Commission Income received in relation to a Regulated Activity exceeds £160m (applies on a rolling basis) (from FSA002 7A) – was £120m in CP Client Money received or held by the Firm exceeds £425m (from CMAR 9A) or Assets belonging to Clients but held by the Firm in the course of, or connected with, a Regulated Activity exceeds £7.8billion (from CMAR 11A) IFPRU 1.2.9G and PS13/10 – 2.45 states that the FCA has the power to deem Significant IFPRU Firms which fall below all of these Thresholds and equally may formally Waive some of the requirements laid upon a Significant IFPRU Firm The Policy Statement also stated that ‘some degree Supervisory Judgement’ may be appropriate as ‘size’ does not, necessarily, equate to ‘complexity’

Significant IFPRU Firms IFPRU 1.2.1G - Significant IFPRU Firms should adhere to CRD Art. 76 – Establishment of an Independent Risk Committee SYSC 7.1.18R (which may be Waived by the FCA per IFPRU 1.2.9(2)(c)) Art. 88 – Establishment of an Independent Nominations Committee SYSC 4.3A.9R (which may be Waived by the FCA per IFPRU 1.2.9(2)(b)) Art. 91 – the limitation on the number of directorships an individual may hold SYSC 4.3A.7R (which may be Waived by the FCA per IFPRU 1.2.9)2)(a)) Art. 95 – Establishment of an Independent Remuneration Committee SYSC 19A.3.12R (which may be Waived by the FCA per IFPRU 1.2.9(2)(d)) Art. 100 – ICAAP Stress Testing to facilitate Art. 97 SREP Significant IFPRU Firms Art. 129 – Capital Conservation Buffer (where these apply) Art. 130 – Countercyclical Buffer (where these apply)

Significant IFPRU Firms IFPRU 1.2.1G - Significant IFPRU Firms should adhere to CRR: Art. 6(4) – Solo Liquidity Reporting Scope Applies to Significant ILAS IFPRU Firms but not to; Exempt Full Scope Investment Firms as Non-ILAS Investment Firms irrespective of Significance; and Art. 450 – Remuneration Disclosure What is dis-closable Relaxation possible via Proportionality Levels

Remuneration Code

Remuneration – UK still to consult on this Overview CRD IV reproduces, to a large extent, remuneration provisions introduced by CRD III. Note that remuneration rules under CRD III were ALREADY subject to the principal of proportionality Regulatory Technical Standards must be published by 31 March 2014 and set out criteria to identify staff whose activities have a direct contribution to the “risk profile” of the firm CRDIV Remuneration Code likely only to apply to the first full/complete Performance Period post 31 December 2013 FCA published proportionality guidance for IFPRU and BIPRU Investment Firms Bonus Limits Article 94(1)(g) of the Directive sets out the following “hard limits” to apply to the variable component of a salary: Basic ratio 1:1 Can be increased to 1:2 ratio subject to the firm getting Shareholder approval of >66% of votes if 50% quorate reached; or Shareholder approval of >75% if quorum is not present A maximum of 25% of the total variable remuneration may be discounted with reference to factors reflecting risks inherent to the instrument. (EBA guidance on this point to be published by 31 March 2014)

SYSC19A Remuneration Code – Significance/Proportionality SYSC19A General Guidance on Proportionality Section B Table 2 Proportionality Level 1 Firm UK Credit Institutions and €730 Full Scope Investment Firms with Total Assets which exceed £50bn Proportionality Level 2 Firm UK Credit Institutions and €730 Full Scope Investment Firms with Total Assets which exceed £15bn but not £50bn Proportionality Level 3 Firm €730 Full Scope Investment Firms with Total Assets which don’t exceed £15bn and all Limited Licence and Limited Activity Investment Firms (irrespective of size)

SYSC19C Remuneration Code – Proportionality SYSC19C General Guidance on Proportionality FCA’s SYSC19C Proportionality Guidance Automatically Proportionality Level 3 Firm By definition all BIPRU Limited Licence Firms (irrespective of size) Remuneration Disclosure (BIPRU 11.5) BIPRU 11.5.18(1) – Information of RemCode BIPRU 11.5.18(2) – Link between Performance and Pay BIPRU 11.5.18(6) – Aggregate Quantitative – Business Area BIPRU 11.5.18(7) – Aggregate Quantitative – Snr. Man & Other RemCode Staff: (a) – Fixed vs. Variable + numbers of staff. (b) – Paid in cash, shares etc. (c) – Outstanding Deferred, split vested and unvested. (d) – Deferred awards in performance yr., paid out/reduced. (e) – Golden Hello and Severance paid and number paid to. (f) – amount of severance payments awarded in performance period, number and highest amount.

Remuneration Code and Groups Highest Proportionality Level applies across Group Lower Proportionality Level Firms within the Group may be granted Proportionality Level that would otherwise apply on a Solo Basis via application to the FCA

Other CRDIV Implementation Issues

CRD IV: Some UK Issues yet to be Clarified The Treatment of Groups: UK Consolidation Groups approach, e.g. if a Group contains a Significant IFPRU Firm. The interaction of CRD IV and Financial Conglomerates Directive The Group application of Governance Obligations due to being a Significant IFPRU Firm Basis of calculating the Deferred Tax Asset deductions in terms of the Transitional Period Defined Benefit Pension Scheme FRS17 Deficits (CRR no longer has relevant prudential filters). And also impact from DTAs from this. The loss of the Simplified Credit Risk approach – FCAs expectations.

CRD IV: AIFMD and UCITS CPMI’s (from 22 July 2014): BIPRU CPMI (IPRU(INV)11 plus BIPRU/GENPRU) IFPRU CPMI (IPRU(INV)11 plus IFPRU) ‘Initial Capital’ in Article 4(51) of the Regulation (Base Capital - €125k); ‘Own Funds’ in Article 4(118); and, ‘fixed overheads’ requirement in Article 97 of the Regulation (supplemented by an EBA technical standard). IFPRU only applies to the portfolio manager’s MiFID business, but IFPRU 2.2 (Internal Capital Adequacy Assessment Process) and IFPRU 2.3 (Supervisory Review and Evaluation Process: Internal capital Adequacy Standards) apply to the whole of the business.

CRD IV: Issues to consider The amount and nature of capital; Reporting requirements (‘CoRep/FinRep’); The ICAAP and SREP processes, and stress testing; SYSC controls; Recovery and resolution plans; Existing waivers; Consolidation.

AIFM Own Funds and Own Funds Requirement

Types of AIFM – Summary Applicable Prudential Regime Transitional UK AIFM = Remain subject to existing Prudential obligations (not beyond 21 July 2014). Small Authorised UK AIFM; Existing Prudential Requirement continue to apply or IPRU(INV)5 is only an Operator. Small Registered UK AIFM (i.e. Sub-Threshold Internally Managed AIF which does not undertake Regulated Activities) = No Prudential requirements apply. Full Scope UK AIFM; CPM = IPRU(INV) 11 CPMI; BIPRU CPMI = Higher of GENPRU/BIPRU and IPRU(INV)11 IFPRU CPMI = Higher of IFPRU and IPRU(INV)11

Key Prudential Requirement Definitions Funds Under Management; Used for calculating; Funds Under Management Requirement IPRU(INV) 11.3.2 for CPM/CPMI and Internally Managed AIF. Funds Managed by the Firm, calculated as the sum of the absolute value of all assets of all Funds Managed by the Firm including assets acquired through the use of leverage and, for such purposes, derivative instruments shall be at their market value. This includes Funds where the Firm has delegated the management function but excludes Funds it is managing as a delegate. Assets Under Management; Professional Negligence Capital Requirement (Regulation Art. 14); and PII Capital Requirement (Regulation Art. 15). Same as FuM post

Professional Liability Risks Management – AIFMR Art Professional Liability Risks Management – AIFMR Art. 13 - does this look familiar? An equivalent to the CRD Pillar 2 Requirement; Essentially an Operational Risk Management Framework, Stress Testing and Capital Requirement. AIFMD Regulation Art. 13; Effective internal operational risk management policies and procedures. Maintain and historical loss database. Scenario and Stress Tests. Obligation to monitor and manage Risks. Policies, procedures and predetermined Management Action to be properly documented; At least documented annual review (e.g. similar to the annual ICAAP review document); AIFM shall maintain adequate financial resources

Other Issues

Other issues ICAAP update Review of EU’s capital adequacy rules for investment firms Recovery and Resolution Financial stability / macro-prudential regulation

Prudential matters: Further information For further information, please visit the IMA’s website and contact Irving Henry E-mail: ihenry@investmentuk.org Tel: 020 7831 0898 Website: http://www.investmentuk.org