The European Union has reached substantial internal agreement on a new prudential rule book for investment firms. Its contents are relevant to compliance officers at wealth management firms, as well as others.

The various organs of the EU are now very close to agreeing upon a reform of prudential rules for wealth management firms, advisors, investment management firms, hedge funds and other financial institutions regulated in the UK by the Financial Conduct Authority. The proposals came out formally in December 2017 and the present agreement is not much different, suggesting that there will be only minor variations from now on. Investment firms which carry out bank-like activities and pose risks that are similar to those posed by banks will continue to fall under their existing regime.

In the UK, the FCA regulates (according to its website) more than 18,000 financial firms for the purposes of prudential regulation. Compliance Matters spoke to Michael Chambers, the head of prudential matters at the world-girdling compliance consultancy firm of ACA, about the likely outcome. Chambers sits on the prudential committee of the UK's Investment Association.

"I think all these firms are quite relieved that a deal has practically been done. There are two watchwords of the proposal: (i) to simplify the capital requirements and (ii) to make the capital requirements more proportionate. It's a matter of opinion whether the EU has achieved that.

"As far as simplification is concerned, the number of rulebooks is going down from four to two. That simplifies things for the regulator at least. In terms of making things more proportionate, firms are no longer to be required to calculate credit risk and market risk. Those things are more bank-like. They will replace those calculations with K-factors (risk factors) linked a firm’s activities, such as assets under management (AuM) and assets under advisement (AuA), or client assets being safeguarded, etc.

"The Alternative Investment Fund Managers' Directive or AIFMD is the overriding EU directive that governs fund management. Anyone who does business under the Markets in Financial Instruments Directive or MiFID - the regime that runs parallel to the AIFMD - will be under these rules. The rules will apply to plenty of AIFMD firms, but only insofar as they are subject to MIFID."

Chambers referred to the firms that the FCA regulates for prudential purposes as "the lion's share of firms, but not by weight." He thought that the way in which firms inhabit this group was the product of a PRA policy setback in 2013, when the outgoing Financial Services Authority split into the FCA and PRA. The FCA divided the firms into categories P1, P2 and P3, scrutinising each one less and less in succession, and category P4 (companies being wound down). Anecdotal evidence that Compliance Matters gleaned at the time suggests that the selection process was far from rigorous and systematic.

Compliance Matters asked Chambers about the work that the FCA now has to do to accommodate the dictates of the EU. He pointed out that two rulebooks that belong to the FCA - BIPRU and IFPRU - were going to be changed over for investment firms that entered the new prudential regime. He thought that the IFPRU rulebook would probably endure in its present form for those systemically important firms remaining in the current regime.

"I would see this new regime as exclusively an FCA issue. The thresholds for being included in, or excluded from, this regime dictate that firms remaining under the old regime (with total assets of more than £30 billion) are likely to dwell under the Prudential Regulation Authority [PRA]. I would be very surprised if this were not the case.

"So the EU is splitting everybody into two groups. The first step is deciding who's going into the new regime (practically everybody) and who's staying. The ones who are staying are in the first group.

"For those moving over to the new regime, there are two buckets. One is based on nine criteria - £100 million or less on the balance sheet, a turnover of £30 million or less, AuM or AuA of £1.2 billion or less, and various other things. The firms in this bucket are called small, non-interconnected companies, so they are not part of a bigger group. The other bucket is everybody else.

"We're calling those who are staying class 1; those who fulfil those eight criteria class 3; and everybody else class 2."

Nobody knows when the rules are going to come into force, although popular opinion holds that it might be before the next elections to the European Parliament, on the theory that the EU wants anything that that body has rubber-stamped to come into force in the same term as the vote.

* Michael Chambers can be reached on +44 33 141 9647 or at michael.chambers@acacomplianceeurope.com