Clash of the Titans: When the BRRD2 meets the MiFID2

Note: I started writing this post at the end of February. By the time the post was ready in early March, the COVID-19 crisis had violently hit Italy. I decided to suspend publications on SoundandPrudent. I just did not feel that publishing posts on a financial regulations’ blog was appropriate in the circumstances, if anything out of respect for those closely affected by the crisis. I did not like the #milanononsiferma (#milandoesn’tstop) rhetoric and even less so the boasting variations on the theme that mushroomed among us lawyers. I do think there are times when one must stop. Today Italy officially enters “Phase 2” and I think that time has come to resume publications. This is my symbolic contribution (insignificant as it is, I am well aware), to going back to normal.

This post analyzes certain Q&As published by ESMA concerning the implementation of the new article 44.a of the BRRD which will be introduced, effective as of December 28, 2020, by the BRRD2.

The Q&As raise a number of issues from the standpoint of both the conceptual structure backing the BRRD and the MiFID, on one hand, and the implications of the new provisions for the design of business models, on the other.

This is Sound and Prudent’s sweet spot, so I hope you will bear with me for a tale of investors, mis-selling, and policy-making.

Once upon a time there was MiFID.

The Flow of The Air (Massimo Catalani)

The directive introduced a “suitability” test and an “appropriateness” test, which apply in different circumstances, depending on the type of investment service provided to the investors. Most notably, if investment advice is provided, then the suitability test shall apply. Which of the two tests applies matters a lot, because the suitability test is meant to be “blocking”. That is, if the instrument is not suitable for the investor, the latter should not be allowed to purchase it (but see below why I wrote “should”…). To the contrary, if the transaction is subject to the appropriateness test and the financial instrument is not appropriate, the investor can still decide to purchase it.

At the time the directive was issued in 2004, nobody would doubt that it was legally possible for financial institutions to structure business models which did not entail the provision of investment advice (and therefore did not entail the suitability test).

As the MiFID was transferred from the books into the reality of supervision, however, the space for such business models started to erode slowly but relentlessly.

In 2007, at the time of the implementation in Italy, Consob made clear that the sale of certain products (e.g. class III insurance products) de facto ordinarily implies the provision of investment advice, thus triggering the obligation to run the suitability test.

In 2008 it was the time of OTC derivatives: Structuring such financial instruments — Consob argued — equals to investment advice and necessarily requires a suitability assessment.

Came two rounds of inspections by Consob in the early years after MiFID was implemented, as a result of which intermediaries were induced en masse to structure business models which include the provision of investment advice. As a result, the most institutions adopted business models centered on the provision of investment advice.

Yet, a number of those institutions continued to take a somewhat liberal — to put it mildly — approach to these issues. In fact, a cottage industry of crude but effective suitability-avoidance technologies flourished.

Assume Bank Alfa wants to raise subordinated own funds and proposes an investment in such funds to Mr. Rossi, one of its clients. Unfortunately the investment is “unsuitable” for Mr. Rossi (for example, he has responded to the MiFID questionnaire that he has never seen a subordinated bond before).

Mr. Rossi, however, is not discouraged so easily by the bureaucratic rules set out by MiFID…

After having failed the suitability test, Mr. Rossi may spontaneously (?) reiterate to Bank Alfa a request to purchase the bonds upon his own initiative (?), without the need of any advice and without the need to run the suitability test.

Alternatively, Mr. Rossi may fill in again the MiFID questionnaire. Mr. Rossi may thus rapidly, almost miraculously, become an expert in subordinated bonds and reply to the questionnaire accordingly. Sometimes one might find that the questionnaire is submitted to Mr. Rossi several times, in rapid sequence, with more answers being changed each time, until the result of the questionnaire becomes that Mr. Rossi is indeed perfectly equipped to understand what subordinated bonds are (Mr. Rossi must be a real genius, he learns new stuff every few minutes, as the questionnaire is repeatedly submitted to him!).

Meanwhile, in a galaxy far, far away within the financial regulations universe, the BRRD framework was introduced. One of the cornerstones of the bank resolution framework is the idea that investors must bear the risks embedded into their investments in banks. This is the essence of the so called “bail-in” and all the related panoply of resolution authorities’ powers.

This sounds as — and most likely is — an excellent idea, especially if one considers that the typical alternative to the “bail-in” is not some form of “bail-nowhere”, i.e. the disappearance, as if by magic, of losses generated by the failure of banks, but the “bail-out” by the State.

There is only one small detail, for the impeccable logic behind the “bail-in” principles to work: Investors must properly understand what they are buying.

The trajectories of the BRRD and the MiFID thus naturally crossed, as it turned out that in many cases investors had been sold instruments issued by failing banks without fully appreciating the risks embedded in the investment.

And this is where art. 44.a of the BRRD2 enters the stage, by setting stringent rules for the sale of subordinated banking liabilities to retail clients.

In broad terms, such rules state that:

1. subordinated banking instruments cannot be sold to retail clients without a suitability assessment having been performed (and note that Member State can broaden the scope of such provisions to all other types of own funds);

2. quantitative limitations apply to the maximum exposure of investors towards such securities. In particular, retail investors whose financial instruments portfolio does not exceed 500,000 euro, cannot invest more than 10% in subordinated bonds.

Rule no. 1) ushers a remarkable change from a systematic point of view, a true paradigm shift. Whether or not a suitability assessment was required or not was a consequence of the service model adopted by the financial institutions: If the bank offered investment advice (or managed accounts), then suitability was required. Under the new BRRD2 framework, instead, the suitability test becomes a structural feature of transactions involving a given financial instrument, regardless of the service model adopted.

I have no knowledge (from the seller’s side) of the legal rules governing the sale of pharmaceutical products or of weapons (and I wish to make clear that my experience on the buy side is limited to the purchase of medicines), but art. 44.a stimulates analogies with what I suspect to be the rules that apply to the sale of “dangerous” goods.

Quite coherently, then, ESMA has clarified that the suitability assessment shall be carried out even in case of a “reverse inquiry”, that is, in case of an unsolicited request by the investor. This is a consequential statement by ESMA, no doubts. Again, though, this is a somewhat revolutionary statement.

The reverse inquiry is the Holy Grail of financial regulations: Few, if any, have seen it and yet they are the solution to all problems. This is not the case here, again, as even reverse inquiries will not help.

Furthermore, grey areas still remain.

Here is one which has been pointed to me by Jasmine Mazza (good catch Jas, as usual). The Q&As clearly imply that if Mr. Rossi approaches ItaBank Alfa S.p.A. and asks to invest into subordinated bonds issued by the bank, the suitability test will have to be performed. But does the Q&A also imply that such rules apply also if Mr. Rossi approaches USBank Beta Corp. in the US?

I must resist the temptation to answer “obviously not”! Maybe the answer must be more articulated. After all, the idea behind art. 44.a seems to be that such type of bonds simply cannot be sold to investors in the absence of a suitability assessment. Do they apply to bonds sold by non-EU banks? It will have to be seen, but recall the analogy with the sale of weapons: I doubt I can legitimately buy from a buyer abroad, on a reverse inquiry basis, an AR-15 or a good old AK 47.

Rule no 2) is probably conceptually less intriguing, but potentially disruptive for existing operational models. Let’s have a look at one of the Q&As: In responding to the question “what information must firms collect from clients?”, ESMA stated that firms’ policies and procedures shall enable them to collect from the retail client and assess the information on the retail client’s financial instruments portfolio including any investments in subordinated bonds “held with other firms”.

Virtually all institutions providing investment advice and portfolio management services rely on a “portfolio approach” to the assessment of the suitability of the instrument, for a number of reasons (the most important one being that a portfolio approach allows the sale of financial instruments to clients who would otherwise fall outside the “target market” of the security). In short, institutions assess whether Financial Instrument “x” is suitable for client “y” not in isolation, by looking at the instrument in itself, but by looking at how that instrument fit within the aggregate portfolio of assets held by that client with that institution.

Art. 44.a would have a significant impact on this model. Assume Bank Beta has received by the client all information on her entire portfolio, including the assets sitting with other banks (oh, by the way… what level of due diligence will be expected from Bank Beta in verifying the completeness and truthfulness of the information provided by the client?).

On the basis of such information, Bank Beta will have to make a suitability assessment which will take into account the exposure limits set out under art. 44.a. However, this will by definition make the IT suitability engine ordinarily used by the bank useless, as it only assesses the impact of the investment on the portfolio held by the client with Bank Beta. Conceptually this is not necessarily difficult. Yet “banks are run by the IT”, as a friend of mine, a GC at a private bank, once told me: I may be wrong, but changing the suitability engine to accommodate for this occurrence does not necessarily sound as being easy to do.

I suspect that this requirement will create great hurdles to the sale of such instruments, possibly to the point of effectively killing the sale of these instruments to retail clients.

But maybe this is an intended, albeit undeclared, consequence of the new rules.