Investment firm regulation

The regime sorts firms by what they do and how large they are. A class 1 firm deals on own account or underwrites on a firm commitment basis with consolidated assets of at least 30 billion euro: it is treated as a credit institution, needs a banking authorization and stays under the Capital Requirements Regulation. A class 1 minus firm carries the same activities at a smaller scale, above 15 billion euro or above 5 billion euro where the authority decides, and remains under CRR without the banking license.

A class 2 firm is the ordinary case: it exceeds at least one of the size thresholds the regulation sets, or holds client money, or deals on own account, and it calculates the full requirement including the K-factors. A class 3 firm is small and non-interconnected, meaning it stays under every threshold, holds no client money and takes no positions, and it never calculates a K-factor.

The thresholds that decide class 2 against class 3 include assets under management below 1.2 billion euro, client orders handled below 100 million euro a day for cash trades, no client money held, no assets safeguarded, no daily trading flow, and balance sheet totals below 100 million and revenue below 30 million euro. A firm crossing one of them moves class, which changes the capital calculation and not only the reporting.

Part Three of the IFR replaces risk-weighted assets with nine quantitative factors, each a coefficient applied to a measured volume, grouped by whose risk it is.

Risk to client covers four: K-AUM on assets under management, including advice of an ongoing nature; K-CMH on client money held, with a lower coefficient for segregated accounts; K-ASA on assets safeguarded and administered; and K-COH on client orders handled, split between cash trades and derivatives. Risk to market covers two: K-NPR on net position risk under the market risk rules of the CRR, or K-CMG, the margin a clearing member requires, where the authority permits that alternative. Risk to firm covers three: K-TCD on the default risk of a trading counterparty, K-DTF on the firm's daily trading flow, and K-CON on concentrated exposures in the trading book.

The measurement method and observation period differ between K-factors. K-CMG is the third-highest daily amount of total margin required over the preceding three months, multiplied by 1.3. For factors based on historical averages, changes in business volumes can affect the capital calculation with a delay.

A class 2 firm holds own funds equal to the highest of three numbers. The permanent minimum capital requirement under Article 14 is a fixed amount set by activity: 750,000 euro for a firm dealing on own account or underwriting, 150,000 euro for most other services, and 75,000 euro for a firm that only receives and transmits orders, manages portfolios or gives advice without holding client money or assets. The fixed overheads requirement under Article 13 is one quarter of the previous year's fixed overheads. The K-factor requirement is the sum of the nine factors.

For a class 3 firm the test drops the third number. For most asset managers the fixed overheads requirement binds, which means a firm's capital need is driven by its own cost base, and a cost increase raises the requirement a year later. A class 3 firm also has to calculate and monitor the test even when the answer is stable, because the obligation is to know the number, not to report a change.

Article 43 IFR requires a firm to hold liquid assets of at least one third of its fixed overheads requirement, in the categories the regulation defines, which include the high quality liquid assets of the bank regime plus unencumbered cash and, with the authority's permission, trade receivables and fees receivable within 30 days subject to a haircut. A class 3 firm may be exempted by its authority.

Article 54 adds the reporting on concentration risk: a class 2 firm reports its largest exposures to counterparties, its concentration of client money, of assets safeguarded, of its own cash deposits, and of its earnings from a single client, plus its trading book exposures that exceed the Article 37 limits. The limit itself applies to the trading book; the rest is reported and supervised instead of capped.

Germany transposed the IFD through the Wertpapierinstitutsgesetz, in force since 26 June 2021, and in doing so moved investment firms out of the Kreditwesengesetz. Section 86 of the WpIG transfers specified existing KWG authorizations for investment business to the WpIG. Other financial services remain subject to the applicable KWG requirements. The WpIG distinguishes small, medium and large Wertpapierinstitute, matching the three classes of the European regime.

Secondary legislation followed the law: a reporting ordinance, an audit report ordinance, an owner control ordinance and a remuneration ordinance, each specific to Wertpapierinstitute. BaFin supervises them, and a large Wertpapierinstitut whose activity makes it a class 1 firm comes back under the KWG as a credit institution. Firms often find the practical difference in the detail: a license under the WpIG does not cover deposit business, and a firm that wants to hold deposits needs the banking authorization instead.

Articles 25 to 34 IFD set the internal requirements: a management body that defines and oversees the governance arrangements, a risk management framework proportionate to the firm, treatment of risks to the firm, to clients and to the market, and remuneration policies with a balance between fixed and variable pay and deferral and instrument requirements for material risk takers.

The proportionality here is explicit and useful. A small and non-interconnected firm is exempt from the pay-out rules on deferral and instruments, and member states may exempt firms below a balance sheet threshold or staff whose variable pay stays below a set amount. The governance duties themselves remain, which means a three-person advisory firm still needs a documented risk framework, just not a deferred bonus scheme.

In what it measures. Basel III, as implemented through the CRR, asks how risky a bank's assets are and derives capital from risk-weighted assets, because a bank's main risk is that borrowers do not repay. The IFR asks how much harm a firm could do and how much business it runs, and derives capital from volumes of client assets, orders and trading flow, because an asset manager's main risk falls on its clients and on the market, not on its own balance sheet.

That is why the two regimes produce different numbers for similar-looking firms, and why class 1 exists at all: a firm whose risk profile really is a bank's goes back to the bank rules. Our page on Basel III for banks in Germany covers the other side, and ICAAP and the SREP covers the Pillar 2 process, which has its own form for investment firms under the IFD.

Quarterly for most firms, annually for a small and non-interconnected one, on templates the EBA publishes as implementing technical standards. The reporting covers own funds and their composition, the own funds requirement with each K-factor shown, the level of activity against the class 3 thresholds, the concentration risk items and the liquidity requirement.

Article 46 adds public disclosure for a class 2 firm: own funds, the requirement, governance arrangements, the risk management framework and the remuneration policy, published with the annual financial statements. A class 3 firm discloses only where it issues Additional Tier 1 instruments.