Topic Eleven

Question 1

Capital Adequacy

Answer 1

● Institutions must have adequate capital to ensure deposits are not placed at risk.
● Any losses made (i.e. if loan isn’t repaid) should be borne by shareholders and not by depositors

Question 2

Superseded by Basel II

Answer 2

Came in 2007

● Basel II incorporated into the Capital Requirements Directive (CRD)

● Basel III incorporated:
o CRD IV – January 2014
▪ Capital Requirement Regulations (CRR)
▪ Capital Requirements Directive (CRD)

Question 3

Purpose of Basel 2 was….

Answer 3

o Increase the level and quality of the bank’s capital
o Enhance risk coverage
o Reduce procyclicality
o Increase bank’s disclosure requirements
o Provide a basis for EU liquidity standards
o Introduce leverage disclosure requirements

Question 4

Minimum capital requirements are given in terms of a bank’s solvency ratio, which is:

Answer 4

o The ratio of the banks own funds as a percentage of its risk adjusted assets (mainly loans)
o Solvency ratio must be at least 7%

Question 5

Investment Services Directive (ISD) allows:

Answer 5

● investment firms to provide services across the EU

● Now superseded by MiFID

Question 6

● Capital Adequacy Directive (CAD) set the capital requirements for investment firms
● Now replaced by CRD, which works in conjunction with MiFID

CRD sets out the minimum as:

Answer 6

● CRD sets out the minimum as:
o Own account dealers are required to hold capital of €730,000
o Matched principle brokers (dealing for others) are required to hold capital of €125,000
o Broker/managers must hold capital of €125,000 or €50,000 if they don’t hold client money
o Advisers are required to hold capital of €125,000 or €50,000 if they don’t hold client money
o SIPP firms are required to hold capital of €20,000

Question 7

Solvency Margins for Life Insurance Companies

Answer 7

● Life assurance companies must maintain an adequate solvency margin
● 4% solvency margin for policies that carry an investment risk
● Assets must be at least 104% the liabilities
● The percentage is less for non-investment risk because actuaries are more confident about mortality rates than future yields on investments
● Competent Authorities – The PRA – Can relax the rules in extreme circumstances on a temporary basis

Question 8

Solvency Margins for Life Insurance Companies

Answer 8

● Life assurance companies must maintain an adequate solvency margin
● 4% solvency margin for policies that carry an investment risk
● Assets must be at least 104% the liabilities
● The percentage is less for non-investment risk because actuaries are more confident about mortality rates than future yields on investments
● Competent Authorities – The PRA – Can relax the rules in extreme circumstances on a temporary basis

Question 9

Financial Services Action Plan (FSAP)

Answer 9

● Encourages a single insurance services market

● EU companies can operate with a single licence in member countries

Question 10

Pillar 1

Answer 10

▪ Balance sheet evaluation
▪ Requirement
▪ Minimum Capital Requirement

Question 11

Pillar 2 Qualitative Requirements

Answer 11

•Qualitative Requirements
▪ System of Governance
▪ Own Risk and Solvency Assessment
▪ Supervisory Review Process

Question 12

Pillar 3 – Disclosure

Answer 12

▪ Annual published solvency & financial condition report
▪ Information provided to the supervisors
▪ Links with IFRS2

Question 13

Key points of Solvency II

Answer 13

o Based on principles not rules
o The firm must demonstrate governance and risk management to match its risk profile
o The key to governance is effective risk management
o If a firm uses an internal model it must be embedded into the firm including strategic decision making
o Firms must establish a risk management function

Question 14

Solvency Capital Requirement (SCR) is:

Answer 14

the new standard by which solvency will be measured
o The risk-based capital required to ensure there is a 99.5% probability that the firm will meet its obligations over the next 12 months
o The Minimum Capital Requirement (MCR) sets a lower solvency standard of 85% probability that a firm will meet its obligations for a firm to represent an unacceptable risk

Question 15

Liquidity

Answer 15

● The ease and speed in which an asset can be turned into cash without significant loss of value

Question 16

A banks asset can provide liquidity in three ways

Answer 16

●
o Being sold for cash
o Reaching maturity
o Being used as security for borrowing

Question 17

Regulators liquidity risk standards are:

Answer 17

The requirements are:

o Banks and deposit takers are required to have risk management systems in place to identify, measure and monitor liquidity risk

o Carry out stress testing

o Document their policy for managing liquidity

Question 18

National regulatory bodies only have authority over:

Answer 18

firms in their country

Question 19

Overall European Financial Services is the responsibility of three European Supervisory Authorities (ESAs)

Answer 19

o THE European Securities and Markets Agency (ESMA)

o The European Banking Agency (EBA)

o The European Insurance and Occupation Pensions Agency (EIOPA)

Question 20

Financial Services Action Plan (FSAP) objectives

Answer 20

● Launched in June 1999 at the request of the European council

● FSAP objectives;

o Establishing a single market in wholesale financial services

o Making retail markets open and secure

o Strengthening the rules on prudential supervision

Question 21

Philosophy behind MiFID

Answer 21

▪ A firm subject to MiFID has the right to operate throughout the EU based on its authorisation from its home sate

▪ There is a high level of home state regulatory control. Each state must appoint its own competent authority to carry out the provisions under MiFID and be given the necessary supervisory and investigative powers to perform their function

Question 22

Firms affected my MIFID are:

Answer 22

▪ Securities and futures firms

▪ Banks conducting securities business

▪ Recognised investment exchanges

▪ Alternative trading systems

Question 23

Does NOT apply to:

Answer 23

▪ Life assurance
▪ Pensions
▪ Mortgages

Question 24

MiFID II took affect from 4 January 2018. The MiFID revisions had four main objectives:

Answer 24

o Strengthen investor protection

o Reduce the risk of disorderly markets

o Reduce systemic risks

o Increase the efficiency of financial markets and reduce unnecessary costs for participants

Question 25

There are over 40 pieces of secondary legislation forming the implementing measures. Firms affected by MiFID II include:

Answer 25

o Investment firms

o Credit institutions

o Portfolio managers

o Broker-dealers

o Stockbrokers

o Corporate finance companies

o Commodity firms

o Market operators

o Data service providers

Question 26

Financial Services Action Plan (FSAP)

Answer 26

● FSAP objectives
o Establishing a single market in wholesale financial services
o Making retail markets open and secure
o Strengthening the rules on prudential supervision

Question 27

Main provisions of MiFID

Answer 27

aim to improve transparency and weaknesses in the MiFID regime, focusing on non-equity trades i.e. commodities

Question 28

● The financial instruments covered by the Directive are as follows MiFID

Answer 28

o Transferable securities
o Money-market instruments
o Units in collective investment undertakings
o Derivative contracts relating to financial instruments, commodities, and other less common items such as energy products etc
o Contracts for differences

Question 29

● The key elements of MiFID II are as follows:

Answer 29

o Product governance
▪ Providers must establish and maintain product approval process aimed at the relevant target market and assesses risks
▪ Advisory firms must understand product features, and which markets they’re aimed at
▪ Distributors of products must provide information to manufacturers to show products are being sold to the target market
o Suitability
▪ Firms required to determine suitability when recommending buying, selling, or continuing to hold an instrument
▪ Must provide clients with periodic reports
▪ Firms must consider the clients investment knowledge, experience, financial position and investment objective
o Appropriateness
▪ Must complete an appropriate test for execution only business for complex products
▪ Not required for non-complex products when clients request this approach and is advised they wont be protected by standard rules of suitability
o Costs and charges
▪ Firms must provide information about costs and charges that show the effect the charges will have on investment return
o Independent advice
▪ Firms must inform clients whether their advice is provided on an independent basis
o Inducements
▪ Investment firms providing portfolio management or independent advice cannot receive fees, commission or monetary benefits from any third party.
o Best execution
▪ firms must provide clients with detail about their execution policy, and have controls to ensure they provide the best execution
o Reporting to clients
▪ statements must be provided quarterly and customers must be notified the same day if their investment falls by 10%
o Record keeping
▪ firms must keep records for all services, activities, and transactions, including recording conversations and communications intended to result in transactions and client order services, even if the transactions or services are not concluded.
▪ Must inform conversations and communication recorded and be kept for 5 years or 7 years if requested by FCA.
o Product intervention
▪ ESMA and EBA and national regulators have power to restrict marketing, distribution or sale of products causing investor protection concerns.

Question 30

Current regulations require credit institutions to keep a solvency ratio of at least 7%. What does this mean in real terms?

Answer 30

Their own funds must amount to at least 7% of their risk- weighted assets

Question 31

The speed with which assets can be turned into cash is a measure of which of the following?

Answer 31

Liquidity

Question 32

The regulator will require an insurance company to establish a recovery plan to bring its capital up to the required level if capital held means that the insurer’s solvency ratio falls below?

Answer 32

99.5%