On 27th November 2023 the UK Financial Conduct Authority (“FCA”) published its final report outlining how investment firms are engaging with the Internal Capital Adequacy and Risk Assessment (“ICARA”) process introduced by MiFIDPRU on 1st January 2022. The report builds upon the initial feedback provided by the FCA in February. The final report is essential reading for all directors, senior managers, risk and compliance officers at investment firms. The purpose of this note is to summarise key takeaways from the report.
To begin with, the FCA stresses that “most firms reviewed engaged well and showed that they were able to make the transition to the new regulations.” The FCA remarks that it has seen: “a deliberate shift toward considering and seeking to mitigate the harm the firm can pose, particularly to consumers and markets.” Nevertheless, the FCA observes that there are several areas of the ICARA process in which firms can make improvements.
(1) More detailed consideration of cash flow and liquidity stresses
The FCA reminds firms of the need to consider “severe but plausible” stresses to cash flow both in the pursuit of ongoing operations and during wind down. The FCA says that some firms are still not taking account of the extensive guidance it has published on this topic, including that contained in MiFIDPRU 7 Annex 1. Other common problems identified by the FCA include firms:
- applying irrelevant stresses to their business models;
- not stressing their business models on a forward looking basis; and
- not accounting for recent stress and volatility events.
The FCA states that some firms are mixing up their own funds and liquid assets analyses. Accordingly, the FCA provides the following simple definitions to help firms make a distinction between them:
- liquid assets = items which affect cash or sources of cash; and
- own funds = impacts on firm’s assets, liabilities, and capital accounts without necessarily increasing or reducing cash sources.
(2) Proactive assessment of liquid asset requirements
The FCA would like firms to take a more proactive approach to managing their liquid assets requirements. This includes recalibrating them in view of geopolitical developments or periods of extreme volatility which could trigger margin calls, credit stresses, counterparty risk and/or increased costs. In general, the more complex a firm’s business model, the greater the frequency with which senior management should be reviewing that firm’s liquid assets position. However, the FCA states that, currently, few firms are taking a proactive approach to the management of liquid assets:
- many are relying on monthly or quarterly analyses of cash flow. This is unlikely to be sufficiently regular to identify cash flow mismatches, especially where firms have business models with intra-day or inter-day funding gaps;
- some where unaware of what their potential peak cash requirements are during the conduct of ongoing business and a potential wind down scenario;
(3) The setting of realistic internal intervention points which are not tied to the “hard” triggers set in MiFIDPRU which are designed to prompt the FCA to take action
The FCA asserts that most firms reviewed have set deficient internal early warning indicators (“EWIs”) and triggers. Again, these should be informed by severe but plausible stress scenarios that are tailored to a firm’s business model. Otherwise, there is a significant risk that they will not be invoked in time to minimise the harm caused by the firm’s failure. In particular, many firms are falling back on the “hard” thresholds for FCA intervention set in MiFIDPRU as a substitute for determining their own intervention points. For the regulator “A firm acting prudently is likely to set internal EWI and triggers above the level specified for notifying the FCA.” In addition, the FCA cites the ensuing as poor practice:
- planning to activate wind down plans when own funds and/or liquid assets have already been seriously depleted: “We do not consider this to be consistent with acting with due care and diligence”;
- failing to consider how the two intervention points interact (recovery, wind down), meaning that a firm is unsure as to when to intervene;
- uncertainty as to how much resource to hold in excess of the firm’s liquid asset threshold requirement (“LATR”), possibly leading to deficient resources to complete an orderly wind-down if necessary (a bigger issue if wind-down costs drive a firm’s LATR); and
- not employing stress testing in unstressed conditions to help reduce this uncertainty (resources available versus resources required)
The FCA advises that firms use the results of their stress testing to: (a) revise their threshold requirements and (b) set a resource buffer at the level of the largest change in surplus resource.
(4) Ensuring that the application of capital models for operational risk is appropriate
The regulator is critical of firms which utilise models which are inappropriate to their business models, e.g. because they are too complex or built for other entities in their group. This leads to incomplete assessment of risk or results that do not make sense.
(5) Strengthening the consideration of implications arising from group membership in firms’ wind down planning
The FCA holds that some firms completing their wind down planning on an individual basis had not given adequate consideration to the implications arising from their membership of a group. For example, the regulator claims that the following factors are often overlooked:
- the level of involvement that group governance may have in the execution of wind down plans, particularly the potential for group management to take control of the UK firm’s wind down and/or override the local management and/or board;
- group-wide attitude to risk, and whether this could delay or accelerate a regulated firm’s plans;
- the fact that the catalyst for the wind down may emanate from elsewhere in the firm’s group;
- dependencies on systems, people, and financial resources that are shared between group entities, and the costs and timings of possibly having to find alternatives to pooled resources during times of stress; and
- whether wind down planning across the group is consistent in terms of risk appetite, triggers and identifying dependencies.
The FCA recommends that firms consider negotiating with their groups to put in place group wind-down plans if this would improve consistency and coordination.
(6) Comprehensive list of good and poor practices
The FCA provides a comprehensive list of good and poor practices in an annex to its final report. This is an excellent reference resource for all firms.
(7) Summary of other observations made in the FCA’s most recent IFPR newsletter
Shortly after publishing its final report, the FCA provided some other feedback on investment firms’ prudential arrangements in its most recent Investment Firms Prudential Regulation (“IFPR”) newsletter. The key points can be summarised as follows:
(i) Investment firm groups
- It is suspected that some firms have not been including all relevant financial undertakings in their investment firm group per MiFIDPRU 2.4.
- Controllers of some MIFIDPRU firms have been seeking to avoid the existence of an investment firm group or the application of MiFIDPRU 2.5. The FCA may use powers afforded to it under section 55L(3) of the Financial Services and Markets Act (“FSMA”) 2000 to require the establishment of a UK based parent entity where it identifies possible avoidance.
(ii) Compliance with requirements for issuing CET1 capital instruments
- The FCA reiterates that firms must seek permission using the form in MIFIDPRU 3 Annex 2R BEFORE counting a new issue as regulatory capital.
- Repeat issuances of a capital instrument must be notified to the FCA using the form in MIFIDPRU 3 Annex 3R but do not need prior approval.
(iii) Deductions from own funds
- “Intangible assets” and other deductibles should be treated prudently in accordance with guidance issued by the FCA. Is it prudent to hold enough capital to offset a full deduction?
(iv) Status of matched principal brokerage (“MPB”) restrictions
- Existing restrictions will remain on a firm’s authorisation unless that firm submits a variation of permission application to remove them. This remains the case even though these restrictions “are no longer needed for prudential purposes under IFPR”.
- FCA has “seen examples of firms with the matched principal broker restriction potentially acting outside their permissions due to failure to comply with what constitutes an MPB” as defined in the FCA’s Glossary. The FCA has stressed that all firms must meet all three conditions in this definition to be in compliance with the MPB restrictions. Consequently, the regulator says: “Firms that carry this limitation may wish to conduct a holistic assessment to ascertain if their business mode/activities meet the relevant conditions.”
(v) Firms dealing on own account: reporting K-Factors on Form MIF001
- Some non-small and non-interconnected (“non-SNI”) firms have been leaving the K-Factor fields blank in MIF001.
- Non-SNI firms should report zeros if necessary, e.g. because a firm is perfectly hedged (K-NPR). Yet, if a firm is continually reporting zeros it should question whether it needs to apply to cancel any permissions that it is not using.
(vi) Cell 6A on Form MIF002 should be populated with the full value of trade receivables BEFORE adjustments
- This is irrespective of whether a firm uses trade receivables to meet its basic liquid assets requirement (“BLAR”).
(vii) Form MIF006: reporting book values of investments in a subsidiary
- If value is greater than zero, but less than £1,000 then enter “1” in cell 6.
We have provided extensive support to firms with their ICARA processes.Given our varied experiences and broad knowledge of different business models, we are well positioned to help firms develop robust systems and controls in this area. For more information, please contact us.
- IFPR implementation observations: quantifying threshold requirements and managing financial resources – concluding report. Financial Conduct Authority, available at:
https://www.fca.org.uk/publications/multi-firm-reviews/ifpr-implementation-observations-concluding-report (last accessed 6th December 2023).
- IFPR Newsletter, 28th November 2023. Financial Conduct Authority.