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The European Banking Authority (EBA) has suggested bringing prudential requirements, such as capital requirements related to credit and liquidity buffers, under rules that ape EU’s banking rules. Experts mull the implications to risk, competition and innovation.
Over the summer, the EBA published its official opinion on how the European Commission could beneficially overhaul the Payment Services Directive (PSD).
The document includes many headline-grabbing ideas, including merging the PSD with its sister regulation, the Electronic Money Directive (EMD).
Yet, the opinion also pushes an idea that has long been desired among European regulators: shifting the payments and e-money industry closer to banking when it comes to prudential compliance requirements.
"The general trend in Europe is towards a level playing field between PIs, EMIs and banks,” said Kjeld Herreman, head of strategic advisory at RedCompass Labs.
Stronger prudential requirements would minimise the risk that counterparties deal with, but also protect consumers, considering that they are not protected by the European Deposit Insurance Scheme.
"When I was at my first EBA payments working group, the first comment from one of the member states was 'what do we do for banks?',” commented James Borley, managing director of payments services at Compliancy.
For Borley, the idea of shifting payments compliance towards a similar regime to banking is a historic view that has now been re-opened by the EBA's feedback to the European Commission.
“Many still think that the risks relating to payment and e-money institutions should be considered on a similar scale to that of banks and mitigated in a similar way,” he said.
“There seems to be some reluctance for payment institutions to be too far from banks in terms of divergence.”
For Herreman, changes to prudential requirements could pave the way for the settlement finality to be extended to payment and e-money institutions.
This was something that was suggested in the European Commission’s Retail Payments Strategy, which stated in the Settlement Finality Directive (SFD) review (launched in Q4 2020) that "the commission will consider extending the scope of the SFD to include e-money and payment institutions, subject to appropriate supervision and risk mitigation”.
“When the Bank of England allowed payments and e-money institutions to open accounts with them in 2018, thereby allowing them to directly settle transactions, they had to deal with fintechs going bust,” said Herreman. “Propping up prudential requirements would minimise the risk the European Central Bank faces in allowing EMIs and PIs to have settlement accounts in TARGET2, drawing upon the UK central bank’s lessons learned.”
Payments institutions themselves have suggested that changes to prudential requirements may be worth regulators considering, suggested Nicolas Kalokyris, Brussels-based lawyer at DLA Piper.
“The market seems to be of the view that PSD2 has contributed to increasing levels of security and innovation in the European payments landscape, encouraging further competition and the development of new products and services.
“However, some of the prudential requirements have been subject to criticism by payment institutions, notably for their ambiguity,” he said.
A lighter regulatory load
"The interesting thing with the Payment Services Directives so far is that there has always been a simplified regulatory capital regime for non-banks,” said Max Savoie, a partner at Sidley Austin. “As a result, some institutions that may look and smell a bit like banks can operate under a lighter regime as long as they don’t accept deposits.”
According to Savoie, there has always been a trade off between having simpler rules for smaller or simpler businesses and a more risk sensitive regulatory framework in place for entities such as banks.
"In terms of what the requirements are for payments institutions in the EU and UK, many activities are able to be carried out with a payments licence that would be defined as traditional banking activities,” agreed Bradley Rice, a partner at Ashurst.
He pointed out that with this licence, however, there are much lower prudential requirements. “If you want a banking licence in comparison, it is an extremely onerous process."
In its opinion, the EBA suggests the introduction for non-bank payment service providers of liquidity risk monitoring and management, which includes the preservation of liquidity buffers.
This would see PSPs operating under requirements that have to date been more typical of banks.
In addition, the Paris-based regulator suggests that capital requirements for payments and e-money institutions should be overhauled.
Here, the EBA suggests including in PSD3 a uniform calculation method to determine own funds requirements for credit risk based on the standard method under the Capital Requirements Regulation, which was introduced in 2013.
This could mean that certain PSPs will need to hold more regulatory capital than is currently required by PSD2/EMD2.
“The involvement of payments institutions and how they are regulated is an issue that has swung back to the early 2000s and the first directive. There were a lot of objections from banks, who didn't want others involved in payments,” pointed out John Burns, a fellow managing director at Compliancy.
According to Burns, the commission pushed hard to enable payment institutions to compete with the banks, in the face of bank opposition. “There are two angles to this now. These are the experience since then, but also, the fact that the market has moved on.”
Technology has advanced, and this has meant that the products being provided are more complex now.
“COVID hasn't helped either and did spur the UK Financial Conduct Authority’s concerns about liquidity," said Burns. "It is a combination of time and experience to try and push back from a light touch approach to now a bank-style approach so that there aren't more high-profile failures, as happened with Wirecard."
Sources have suggested to VIXIO that the fallout from Wirecard may in part be behind these potential reforms, with one saying it “spooked” people and got the conversation started about governance at payments and e-money firms.
“It was one of the biggest payment providers that nobody had heard of but they were involved in lots of payment chains across e-commerce and white label billing.”
Method B
In its opinion, the EU’s banking watchdog also suggests making Method B the default position for PSPs.
“The EBA has suggested that Method B should be the default methodology on the basis it considers that to be a more risk-based approach,” said Savoie. “This takes away some flexibility from the institutions and could result in some firms that use one of the other two methods having to hold additional regulatory capital."
In Article 9 of the PSD2, the EU defines different methods a firm can choose to compute their funding requirements.
Method A relies on the company's overheads; Method B on its payment volume; while Method C focuses on a relevant indicator, comprising the sum of interest income, interest expenses, commissions and fees received, and other operating income.
“The EBA are now suggesting they drop optionality and go with a single model,” said Rice.
If the commission was to take this on, firms currently using Method A or C could be required to change unless the firm is able to convince its regulator that that would not be appropriate.
“The problem is how to draw the line so that payments firms that are big enough and systemically important enough are treated in a way that doesn't cause problems for start-ups,” said Rice.
Burns warned this could have negative consequences. "The suggested change to Method B as default, particularly where there are high transaction values and low margins, may actually cause an issue for some firms.
“In such cases, applicant firms would typically opt for Method A, based on fixed overheads, as the requirements under Method B are likely to be significantly higher."
Such an issue could mean the EU loses innovation through shutting people out, said Rice. “Regulators need to find a balance that enables new entrants and, as they grow, prudential requirements become more stringent."
"Payments and e-money licences do allow innovative services to come to the market without intense requirements,” acknowledged Herreman.
It is a case of balancing consumer protection and allowing innovation, he continued, suggesting that changes could have some negative consequences.
“What could be an adverse result of stricter prudential requirements is concentrating risks on a couple of players,” said Herreman. “More fintechs would end up just being an agent for larger entities such as banking as a service providers, effectively piggy backing off of their licences."
Although the EBA’s report has certainly grabbed the attention of payments stakeholders in Brussels and further afield, it still remains to be seen whether the European Commission will entirely overhaul the directive.
Eric Ducoulombier, the European Commission’s payments chief, did recently caution that “nothing has been decided yet” at an event, meaning that Berlayment will likely take its time establishing what the next steps will be for payments.
However, with suggestions in the Retail Payments Strategy and questions in different jurisdictions about the governance of PSPs, including Lithuania and Belgium, as well as outside the EU in the UK it is something that will be on their radar.
