From 26 June 2021, the new Investment Firms Directive and the Investment Firms Regulation (‘IFR/IFD’) regime will overhaul the capital requirements rules for MiFID investment firms in the EU.

One of the major innovations in the IFR/IFD regime is adoption of K-factors in the calculation of capital requirements for certain firms. So what are K-factors and when do they come into play?

In summary, K-factors are a series of risk parameters/indicators representing the specific risks investment firms face and the risks they pose to customers/markets. The IFR uses nine K-factors, which fall into three categories: Risk-to-Customer (‘RtC’) K-factors, Risk-to-Market (‘RtM’) K-factors and Risk-to-Firm (‘RtF’) K-factors. The nine K-factors are defined in Article 4 of IFR and the EBA is mandated to develop regulatory technical standards for measuring these K‐factors. The EBA has published a draft of that RTS and it is currently under consideration by the Commission.

K-factor calculations will be most relevant to ‘Class 2’ firms under IFR, as those firms will be required to hold minimum own funds based of the higher of their permanent minimum capital requirement, their fixed overhead requirement or the new K-factor own funds requirement

As IFR/IFD requires the largest and riskiest investment firms (‘Class 1’ and ‘Class 1 minus’ firms) to remain subject to the CRR2/CRDV prudential regime, K-factors do not form part of the calculation of their ongoing capital requirements. At the other end of the scale, smaller ‘Class 3’ firms will be required to hold minimum own funds based on the higher of their permanent minimum capital requirement or their fixed overhead requirement and so will not be subject to the new K-factor requirement.

For more about IFR/IFD, K-factors and the categorisation of firms under IFR/IFD, read our briefing here.

Overall, the harm an investment firm might cause to others may, in general, be expected to arise from some combination of the “size, internal organisation, nature, scope and complexity” of its business […]
The K-factor approach is risk-based and would capture the on-going impact an investment firm can have on others.

https://www.eba.europa.eu/sites/default/documents/files/documents/10180/1647446/cf75b87e-2db3-47a3-b1f3-8a30fa6962da/Discussion%20Paper%20on%20a%20new%20prudential%20regime%20for%20Investment%20Firms%20%28EBA-DP-2016-02%29.pdf