The Investment Firms Prudential Regime (“IFPR”) entered into force in the UK on 1st January 2022. On 27th February 2023 the Financial Conduct Authority (“FCA”) published its initial observations into investment firms’ efforts to implement the new internal capital adequacy and risk assessment (“ICARA”) process and undertake related reporting. The purpose of this article is to summarise the key takeaways from these ICARA process observations.
The FCA’s observations are based on findings from a multi-firm review into the largest investment firms’ ICARA processes. The review involved reviewing firms’ ICARA process documentation and holding bi-lateral discussions with senior managers.
In general, the FCA reported that most firms had “engaged well” with the ICARA process. Most firms had made progress in: (a) understanding the requirements; and (b) implementing improvements. Even so, the FCA highlighted some areas requiring improvement.
(1) Group ICARA processes insufficiently consider the idiosyncratic risks faced by individual firms
- Most investment firm groups opted to complete a “group” ICARA pursuant to MiFIDPRU 7.9.5R.
- The FCA found that, with some exceptions, this had led to groups producing a single set of documents that did not adequately consider the risk of specific harms inherent in, or posed to, the business models of the individual investment firms in the group.
- Where this occurred this meant that the individual firms had not adequately assessed their Financial Resource Requirements (“FRR”).
- The FCA stated that it would not recognise an attempt at prudential consolidation taken at firms’ own initiative unless the imposition of voluntary requirements (a “VREQ”) had been agreed with the FCA beforehand.
(2) Some ICARA processes reviewed lacked cohesion
- It is critical that the ICARA process is fully integrated into a firm’s broader approach to identifying and mitigating the risks to which it is exposed. Nevertheless, the FCA found that this is not happening consistently enough, with many firms failing to use their ICARA related assessments to inform their:
- risk appetite statements;
- risk indicator triggers;
- early warning indicators;
- stress and reverse stress testing; and
- estimates of own funds and liquid assets required.
- Some firms had made significant reductions in their regulatory capital as a result of performing their ICARA processes for the first time. This was particularly the case where a risk that continues to exist in a firm’s business model is not covered by a specific K-Factor. Some firms had interpreted the absence of a dedicated K-Factor for such risks as meaning that they are no longer required to allocate capital to address them. The FCA stressed that this interpretation was wrong. Firms must account for all material risks in their business models, whether these:
- are covered by specific K-Factors or not; or
- derive from the conduct of regulated or unregulated activities.
- The FCA made clear that it only expects a firm to stop holding regulatory capital for a specific risk type if that firm can explain why that risk no longer exists in its business model. This explanation should be provided in the ICARA process document.
- In addition to the above, the FCA found that some firms had not set comprehensive own funds and liquid assets triggers. Instead, many firms had just used the default levels / triggers in MiFIDPRU without seeking to properly understand the unique risks inherent in, or threatening their own business models.
- Similarly, the FCA found that many firms had not clarified the steps they would take to intervene in the event of a own funds and/or liquid assets trigger breach, for example whether these would involve discussions, the taking of specific actions or immediate wind down. Moreover, many firms had not tested their planned interventions.
- In short, the FCA found that previous feedback that it had issued in this area had not been considered and/or adequately acted upon. The FCA confirmed that previous feedback issued prior to the implementation of the IFPR remained relevant and should still be considered by firms when undertaking their ICARA processes.
(3) Wind down planning is still receiving insufficient attention
- The FCA stated that, in the main, firms’ wind down planning (“WDP”) efforts remained weak.
- Particular problems identified included:
- unrealistic assumptions. In particular, firms sometimes fail to consider the impact of stress on their assumptions and plans. For example: the reaction of clients, counterparties and the providers of key providers of outsourced services upon becoming aware that the firm is seeking to wind down its operations;
- insufficiently detailed modeling;
- estimates of resources required to wind down that were lacking in justification and, therefore, potentially inadequate to ensure as orderly a wind down as possible;
- incomplete analysis:
- lack of consideration of group interconnection, particularly concerning critical dependencies or a possible need to provide a group service company with additional financial support;
- absence of a clearly articulated risk appetite for group dependencies during wind down, followed by an impact assessment and mitigating controls where potential harms exceeding this risk appetite have been identified; and
- to assess the risks posed by, or to, processes, operations and/or products that are unique to a firm
- Again, the FCA reiterated guidance offered in previous publications, particularly Finalised Guidance 20/1.
(4) Lack of board and executive involvement in the ICARA process
- The FCA said that some directors had a detailed understanding of their firm’s ICARA processes and were able to articulate the challenge they had offered to key assumptions and risks.
- However, the FCA found that other directors could not provide evidence that they had provided sufficient oversight of, and challenge to, the ICARA process. Accordingly, in cases where directors had been less proactive, the FCA stated that it was unable to obtain confidence that a firm’s risks had been adequately identified and addressed.
- The FCA observed best practice where senior executives and board members had been provided with in depth training on the fundamentals of the IFPR. This equipped senior managers and directors with a level of knowledge required to provide robust challenge to a firm’s ICARA processes.
- Senior managers and directors were reminded by the FCA that it views the effective governance of a firm’s ICARA process through the prism of the obligations enshrined in the Senior Managers and Certification Regime (“SMCR”).
(5) Some firms are still submitting inconsistent and inaccurate Reg Data filings
- When the FCA receives inconsistent and inaccurate RegData filings these are perceived as potential indicators of weaknesses in a firm’s systems and controls.
- The FCA referred firms to previous “Dear CEO” letters that it had published on this topic. Furthermore, the FCA asserted that the submission of flawed RegData returns may constitute a breach of the Senior Managers Regime.
Looking for help with your ICARA process?
C&G’s consultants have gained frontline experience of implementing prudential regulations from serving as compliance officers in major investment firms. To date, C&G has assisted several investment firms in designing and implementing their ICARA processes. This has included:
- designing and providing training to directors and senior management on the IFPR and ICARA process;
- providing ICARA framework documentation; and
- helping firms identify and assess the risks in their business models to tailor that documentation.
Please contact us if you have any questions or would like any additional information.
2023. IFPR implementation observations: quantifying threshold requirements and managing financial resources. Financial Conduct Authority, available at: https://www.fca.org.uk/publications/multi-firm-reviews/ifpr-implementation-observations (last accessed 6th March 2023).
2020. Our framework: assessing adequate financial resources. Financial Conduct Authority, available at: https://www.fca.org.uk/publication/finalised-guidance/fg20-1.pdf (last accessed 6th March 2023).
2018. Quality of Prudential Regulatory Returns. Financial Conduct Authority, available at: https://www.fca.org.uk/publication/correspondence/dear-ceo-quality-of-returns.pdf (last accessed 6th March 2023).