Own Funds

Own funds is the term used in European Union and United Kingdom financial regulation for the capital resources of a regulated firm: the money belonging to its owners, as opposed to money owed to customers or lenders, that is available to absorb losses. The rules define which items count, set a minimum amount for each type of firm and require the firm to stay above that minimum at all times.

The concept comes from banking law, where own funds is the legal name for regulatory capital, and it was carried over into the regimes for payment and electronic money firms. For those firms it is one of two main financial safeguards, the other being safeguarding. The two do different jobs. Safeguarding protects customers' money by keeping it separate; own funds protects the firm's ability to keep operating, and to close down in an orderly way, when it makes losses.

The definition is taken from the Capital Requirements Regulation that applies to banks. Own funds is the sum of Tier 1 and Tier 2 capital. Tier 1 is made up of Common Equity Tier 1, chiefly paid-up ordinary shares, share premium and retained earnings, and Additional Tier 1 instruments. Tier 2 capital consists mainly of qualifying subordinated debt.

Certain items are deducted because they would have little value in a crisis: losses for the current year, intangible assets such as capitalised software and goodwill, and deferred tax assets that depend on future profits. For payment and e-money institutions the mix is also restricted: at least three quarters of Tier 1 must be Common Equity Tier 1, and Tier 2 may not exceed one third of Tier 1. In practice most small firms hold only share capital and reserves.

A firm must hold a minimum amount on the day it is authorised. Under PSD2, the initial capital of a payment institution depends on its services: 20,000 euros if it provides only money remittance, 50,000 euros for payment initiation services, and 125,000 euros for the other payment services, such as operating payment accounts, issuing cards or acquiring. A firm providing only account information services has no capital requirement and carries professional indemnity insurance instead. An electronic money institution needs 350,000 euros.

Small firms registered under national exemptions, such as a small payment institution, may face lower or no capital requirements, depending on the country.

After authorisation, own funds must never fall below the higher of two figures: the initial capital amount, and an amount calculated from the scale of the business. For payment institutions the directive offers three methods, and the regulator decides which applies.

• Method A. Ten percent of the firm's fixed overheads for the preceding year.
• Method B. A percentage of monthly payment volume, taken as one twelfth of the previous year's total. The percentage steps down in bands, from 4 percent on the first 5 million euros to 0.25 percent on volume above 250 million euros. The result is multiplied by a scaling factor that is lower for firms providing only money remittance.
• Method C. A percentage of the firm's income from interest, commissions and fees, again in descending bands and multiplied by the same scaling factor.

For example, a card acquirer processing 24 million euros a year has a monthly volume of 2 million euros. Under Method B its requirement is 4 percent of that, or 80,000 euros, which is below the 125,000 euro floor, so the floor applies. At 240 million euros a year the calculation gives 4 percent of 5 million, 2.5 percent of the next 5 million and 1 percent of the remaining 10 million, a total of 425,000 euros.

Electronic money institutions use a fourth approach, Method D, for their e-money business: two percent of the average outstanding electronic money. If they also provide payment services unrelated to e-money, the requirement for those is added. Regulators may raise or lower a firm's calculated requirement by up to twenty percent on the basis of its risk management and controls.

Firms report their own funds to the regulator at regular intervals and are expected to monitor the position continuously, with a buffer above the minimum. Rapid growth is a common cause of difficulty, since a volume-based requirement rises with the business while a loss-making start-up's capital is shrinking.

A shortfall must be reported and corrected promptly, usually by the shareholders injecting new equity. Persistent breaches can lead to restrictions on the business or withdrawal of authorisation. Supervisors, notably in the United Kingdom, also expect firms to assess whether the formula amount is enough for their actual risks, to hold liquid resources to match, and to maintain a wind-down plan showing that capital would cover the cost of closing.

A bank's capital requirement is set as a percentage of its risk-weighted assets under the Basel III framework, with additional buffers, because banks lend out deposits and bear credit risk. Payment and e-money institutions may not lend customer funds, so their requirement is simpler and far smaller, scaled to volume or cost instead of asset risk. The amounts are modest relative to the sums these firms handle, which is why supervisors place so much weight on safeguarding.