7.4 Meeting requirements under cyclical economic fluctuations

For investment firms that do not meet the conditions for qualifying as small and non-interconnected investment firms set out in Article 12(1) of Regulation (EU) 2019/2033, competent authorities should determine the adequacy of the investment firm’s own funds in case of adverse cyclical economic fluctuations and whether supervisory measures, including guidance on additional own funds (P2G), revised capital planning and other measures as set out in Title 10, are necessary to address potential inadequacies.

When considering adverse cyclical economic fluctuations, competent authorities should assess how risks or elements of risks the investment firms pose to others or are exposed to may evolve over multi-year period, taking into account the investment firm’s business cycle. The level of details of this assessment should vary depending on the complexity of the business model and risk profile of the investment firm.

To assess capital adequacy in case of adverse cyclical economic fluctuations, competent authorities should consider the qualitative and quantitative outcomes of:

• a. where available, supervisory stress tests or sensitivity analyses;
• b. where available and sufficiently reliable on the basis of the assessment conducted in Title 5, investment firms’ stress tests or sensitivity analyses; or
• c. other assessment of cyclical economic fluctuations performed by competent authorities, or by the investment firm on the basis of the assessment conducted in Title 5, if considered sufficiently reliable; or

Based on the assessment pursuant to paragraph 301, competent authorities should determine whether the investment firm’s own funds are sufficient to cover applicable own funds requirements, including additional own funds requirement, under adverse cyclical economic fluctuations.

7.4.1 Determining and setting P2G

Competent authorities should determine P2G as specified in this section, and at a time specified in paragraph 271. Where the determination leads to a positive value, they should set P2G to address supervisory concerns about the sensitivity of the investment firm to adverse cyclical economic fluctuations.

P2G is the amount of capital considered adequate that should be set to allow for cyclical economic fluctuations while protecting against any potential breach of relevant own funds requirements in accordance with Article 9 of Regulation (EU) 2019/2033 and additional own funds requirement calculated in accordance with Article 39(2), point (a) of Directive (EU) 2019/2034 and against any threat to the ability of the investment firm to orderly wind-down. Where competent authorities conclude the investment firm is not concerned by such impediments under adverse economic conditions, competent authorities may decide not to set P2G.

Competent authorities should determine and set P2G based on the outcomes of the assessment of cyclical economic fluctuations in line with paragraph 301. Such analyses should take into account the investment firm’s strategy and business model, as well as the environment in which it is operating, as the basis to identify vulnerabilities and risks of harm at investment firm’s level, and reflect relevant economic fluctuations that may be system-wide as wide spread disruption to the provision of financial services caused by an impairment of a large part of the financial system or wide spread volatility across asset prices or specific to the investment firm’s business model as shock specific to the nature and duration of financial instruments the investment firm is trading) over a forward looking horizon.

For the purpose of paragraph 305, competent authorities should ensure that the analyses conducted for the setup of the P2G adequately cover:

• a. all the material risks contributing to the additional own funds requirement set out in accordance with Article 39(2), point (a) of Directive (EU) 2019/2034; and
• b. situations where the investment firm incurs material losses impeding the run of its businesses or where it may have to cease activities in an orderly manner.

Competent authorities should generally not use P2G to cover aspects of risks that should be covered by additional own funds requirement in accordance with Section 7.2 of these guidelines.

When determining the size of P2G, competent authorities should ensure that it is set at a level appropriate to cover the maximum anticipated variations of the investment firm’s CET1 and ensure coverage of applicable own funds requirements.

When determining the size of P2G, competent authorities should consider, where relevant, the following factors:

• a. where P2G is determined based on stress tests, the time when the maximum stress impact occurs in relation to the starting point and time horizon of the scenarios used in the stress tests;
• b. the outcome of a reliable investment firm’s internal stress test or sensitivity analysis of the investment firm, taking into account the specific scenario definitions and assumptions, in particular where they are deemed more relevant for the business model and risk profile of the investment firm or where the internal scenarios are more severe than the supervisory scenarios, where such supervisory scenarios are available;
• c. relevant management mitigating actions of the investment firms if sufficiently credible and highly certain following their supervisory assessment;
• d. information about and supervisory views on the relevance of supervisory or investment firm’s own stress tests or sensitivity analyses to the investment firm's strategy, financial plans and business model;
• e. reduced certainty on the actual sensitivity of the investment firm to adverse scenarios;
• f. any potential overlaps with the applicable additional own funds requirement;
• g. whether or not the investment firm is under restructuring or resolution.

Without prejudice to paragraph 271, competent authorities should timely review the level of the P2G if such level is deemed inaccurate based on all relevant information available to the competent authorities. They should at least assess whether the existing P2G level remains appropriate and revise it if necessary, whenever the qualitative and quantitative outcomes referred to in paragraph 305 display significant changes as compared to the analysis used previously for setting the P2G.

P2G set by competent authorities is additional to the highest component of own funds requirements in accordance with Article 11 of Regulation (EU) 2019/2033 and to the additional own funds requirement set out in accordance with Article 39(2), point (a) of Directive (EU) 2019/2034.

7.4.2 Communication and composition of P2G

Where P2G is set or updated, competent authorities should communicate to the investment firm its level and the relevant time limits for its establishment in accordance with paragraph 316 316. Competent authorities should also explain the potential supervisory reaction to situations where P2G is not met.

In case of a review in accordance with paragraph 310310, where supervisory reviews in accordance with Article 36 of Directive (EU) 2019/2034 are not carried out, competent authorities should communicate the new level of P2G.

Competent authorities should communicate to investment firms that P2G is expected to be met with CET1 eligible own funds and that P2G is expected to be incorporated into their capital planning and risk management frameworks, including the risk appetite framework and, where applicable, recovery planning.

Competent authorities should also communicate to investment firms that own funds held for the purposes of P2G cannot be used to meet other own funds requirements.

When setting and communicating to the investment firm time limits to establish P2G, competent authorities should consider at least the following:

• a. whether or not an investment firm is under the restructuring or resolution; and
• b. the potential implications that CET1 denominated P2G may have for other parts of the capital requirements and the ability of investment firms to issue additional Tier 1 (AT1) or Tier 2 (T2) instruments.

7.4.3 Capital planning and other supervisory measures to address capital adequacy in stressed conditions

Capital planning

When the quantitative outcomes referred to in Section 7.4 indicate that, under the given adverse scenarios, an investment firm will not be able to meet the applicable capital requirements, competent authorities should require the investment firm to submit a credible capital plan that addresses the risk of not meeting its applicable capital requirements.

To determine the credibility of the capital plan, the competent authority should consider, as appropriate:

• a. whether the capital plan covers the entire assumed adverse time horizon;
• b. whether the capital plan put forward a set of credible mitigating and management actions;
• c. whether the investment firm is willing and able to take such actions in order to address the breaches of the applicable capital requirements under adverse conditions;
• d. whether those mitigating and management actions are subject to any legal or reputational constraints;
• e. the probability that mitigating and management action would enable the investment firm to fully meet its applicable capital requirements within an appropriate timeframe;
• f. whether the proposed actions are broadly in line with macroeconomic considerations and with known future regulatory changes affecting an investment firm within the scope and timeline of the assumed adverse scenarios; and
• g. where applicable, the range of recovery options and their analysis as set out in the investment firm’s recovery plan.

When assessing capital plans, competent authorities should, where appropriate, following an effective dialogue with the investment firm, require it to make changes to those plans as appropriate, including to the proposed management actions, or require investment firms to take additional mitigating actions that would become relevant given the scenarios and current macroeconomic conditions.

Competent authorities should expect investment firms to implement the revised capital plan, including further changes made based on the results of the supervisory assessment and supervisory dialogue.

Additional supervisory measures

Competent authorities should, where relevant, consider the application of additional supervisory measures specified in Title 10, to ensure that the investment firm is adequately capitalised under adverse conditions.

In particular, where the quantitative outcomes of the stress tests or sensitivity analyses indicate that the investment firm is likely to breach its applicable capital requirements under the adverse scenario within the following 12 months, competent authorities should, where appropriate, treat such information as one of the possible circumstances within the meaning of Article 38, point (b) of Directive (EU) 2019/2034. In such cases, the competent authorities should apply appropriate measures in accordance with Article 39(2) of Directive (EU) 2019/2034 aimed at ensuring sufficient levels of own funds. In particular, when such measures relate to capital, competent authorities should in particular consider one or both of the following, as defined in Article 39(2), points (a) and (f):

• a. requiring investment firms to hold an appropriate amount of additional own funds in the form of a nominal amount, considering the outcome of the SREP assessment;
• b. requiring a reduction of the inherent risk in the activities, products and systems of the investment firm.