Calibration issues under the EU capital regime for investment firms

Abstract

Purpose The EU prudential regime for investment firms comprising the Directive (EU) 2019/2034 (IFD) and Regulation (EU) 2019/2033 (IFR) introduces a fit-for-purpose capital framework for investment firms. The capital impact on the practice of investment management can be material depending on firms’ specific business models and risk profiles, which may require them to take strategic decisions with respect to the services they provide. Despite the importance of this issue for the practice of investment management, there exists no study among the existing studies that focuses on this issue. This study aims to fill this gap in the literature. Design/methodology/approach This paper reviews the calibration approaches the European Banking Authority (EBA) has used by exploring the deficiencies of the regime with respect to the calibration of categorization thresholds and coefficients that are used by the EBA to calculate regulatory capital requirements. Findings This paper sets out that the choice of the relevant percentile for setting the firm categorization thresholds was not based on any theoretical rule. It also discusses that the calibration of the K-factors was subjective and lacked consistency. In addition, it criticizes the sample that the EBA used for business model coverage on the grounds that it was unbalanced, resulting in certain K-factors driving the overall capital impact. Research limitations/implications Further research is needed on the calibration of thresholds as this will remain a crucial factor for the effectiveness of the new regime. In particular, a more data-driven and transparent approach would be necessary to ensure the accuracy and consistency of the thresholds. Practical implications This paper leads to the policy implication that, despite its merits that overweigh its shortcomings, potential market competition and financial stability issues that may stem from inconsistencies and a general lack of objectivity in certain aspects of the regime should not be underestimated by the EU policy makers. Originality/value The present paper contributes to the existing knowledge primarily by reviewing the EBA’s calibration approaches with respect to the K-factor coefficients and firm categorization thresholds, concluding that lack of objectivity and precision in the relevant methodologies could distort capital allocation decisions in the practice of investment management.