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The Financial Conduct Authority’s (FCA) consultation on its approach to assessing the adequacy of financial resources for all 46,000 FCA solo-regulated firms closed on 13 September 2019. This initiative complements its Approach to Supervision document, most recently updated in April 2019. In comparison to the “hard requirements” contained in its prudential rules, this documents sets out the FCA’s “soft requirements” or that is to say its approach and supervisory expectations.

While the FCA is principally a conduct and markets regulator, with the exception of firms that are dual-regulated by the Prudential Regulation Authority, it is also responsible for the prudential supervision of the vast majority of financial services businesses. As this population varies greatly in size, business model and complexity, these firms pose significantly different risks of harm to consumers and market integrity. A calibrated, proportionate and risk-based response is required.

Why this consultation paper is of interest?

The consultation paper is interesting because of the significant detail it contains around the FCA’s expectations on firms’ assessments of their financial resources and the steps that the FCA expects firms’ management to take. These steps (which we summarise below) appear to go beyond those which FCA has previously articulated in respect of firms that are outside the scope of Basel-derived bank capital adequacy rules. The FCA appears to expect firms to have wind-down plans in place, even where they are not formally subject to the “living wills” legislation that applies to banks.

The paper does not seem to have attracted much commentary in the market to date, which is perhaps surprising; this might be because the FCA has very much couched this initiative as a clarification as to existing rules and its current expectations, rather than anything new. As a practical matter many firms’ assessment of their regulatory capital needs, and the way in which firms carry out their capital assessments is often less sophisticated and holistic than the FCA’s expectations appear to be.

Is it relevant to all firms?

The paper states that it is addressed to “all FCA solo-regulated firms subject to threshold conditions and/or the Principles for Businesses and to provide further guidance on the meaning of ‘adequate financial resources’ under these.” This will include payment firms since the extension of the Principles to them from 1 August 2019. The FCA states that firms not subject to “detailed prudential standards,” should focus on chapter 2 and consider the details provided in Chapter 3 as information to help them conduct their own assessments. Otherwise, for firms subject to detailed prudential standards, the document should be considered in conjunction with existing requirements. Prudential standards are said to refer to the FCA handbook or European prudential legislation. Although it is not entirely clear, it is likely this covers not only those firms subject to the prudential sourcebooks in the FCA handbook, but payment firms subject to minimum requirements for initial capital and own funds derived from EU legislation.

The FCA’s approach

At the heart of the FCA’s prudential supervision is the avoidance of disorderly failures and the minimisation of the harm to consumers (or to the integrity of the UK’s financial system). Examples encompass situations where services are not easily replaceable by other providers, or alternatively, a firm is unable to return client money or cannot pay redress. A lack of “financial prudence” can also give rise to various risks including poor financial management leading to poor conduct where, for example, a firm prioritises short-term revenue generation over its customers’ interests.
Specifically, the FCA says it aims to provide more clarity to firms on:

  • the role of adequate financial resources in minimising harm;
  • the practices firms can adopt when assessing adequate financial resources – and what are the FCA’s expectations in this regard; and
  • how it assesses the adequacy of a firm’s financial resources – here the FCA promises to be more transparent.
Will firms need more financial resources?

The FCA says that it does not intend to increase the general levels of financial resources needed but will take a “proportionate and risk-based approach.” However, some sectors that pose the greatest potential to harm consumers or the integrity of the UK financial system may need to increase their financial resources. It refers to the fact that most Financial Services Compensation Scheme payments arise in respect of firms with few detailed prudential standards.

How does this relate to the EU’s new Investment Firms Prudential Framework?

Surprisingly perhaps, the FCA makes no reference to the EU’s new Investment Firms Prudential Framework – although this will not be relevant to all FCA solo-regulated firms. This will replace the existing Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) that are primarily aimed at banks with their focus on credit risk, consequently making them ill-suited for investment firms. It will introduce new tailored classes with increased capital requirements for larger firms with a “lighter toucher” regime for small and non-interconnected firms. Moreover, the framework envisages a shift away from assessing capital requirements based on MiFID activities and services to quantitative indicators reflecting risks to customers, markets and to firms themselves. Its implementation in the UK from 2021 may depend on whether there is a soft-Brexit (with an implementation period) as opposed to a hard-Brexit this October.

What considerations are relevant in determining adequate financial resources?

Adequate financial resources mean that firms should remain financially viable throughout the business cycle and allow for an orderly wind-down without damaging consumers or disruption to the integrity of the UK financial system.

All FSMA authorised firms must satisfy the threshold conditions in the FCA Handbook (see COND) and comply with the Principles for Businesses, which require the maintenance of adequate financial resources. This means that the FCA will consider the following factors for resources (including financial resources):

  • the nature and scale of a firm’s business model;
  • the risks to the continuity of the services provided; and
  • the impact of other members of a firm’s group on the adequacy of its resources

Specifically, for financial resources, the FCA will look to see if a firm:

  • can meet its debts when they fall due (this is the sole criteria for firms with limited consumer credit permissions);
  • has taken reasonable steps to identify and measure its risks;
  • has appropriate systems and controls and human resources to measure risks prudently;
  • has access to adequate capital for the business, and that client assets are not placed at risk; and
  • holds resources which are sufficient in terms of the likely risks it faces.

Besides having adequate capital to ensure firms can incur losses and remain solvent (or fail in an orderly way), sufficient resources are needed to “drive the right behaviours,” for example, to see that incentives align with the best interests of clients or wider financial markets.

How does the FCA approach supervision?

The regulator stresses that it has limited resources and, therefore, it identifies and prioritises those firms most likely to cause “harm.” It does this by using data and intelligence sources, sector and portfolio views, market studies and from looking at individual firms. For higher risk firms (in categories P1 and P2), it carries out pro-active regular reviews of firms’ own assessments. In contrast, for P3 firms its supervision is reactive.

When reviewing firms’ own assessments of their financial resources the FCA will, besides looking for a proportionate and consistent approach, wish to see that they:

  • have robust systems and controls, governance, leadership and a culture that reduces the risk of harm to consumers and markets;
  • hold adequate resources that reflect the harm they may cause to consumers or UK financial markets. By way of example, a corporate finance firm failing to apply appropriate due diligence leading to poor outcomes for issuers and investors;
  • seek to reduce the likelihood that failure would impact consumers and the UK financial system. Firms should undertake “what-if” scenarios for their activities; and
  • look to minimise harm in the event of their failure as they exit the market by holding adequate resources and putting in place effective wind-down arrangements.

The FCA says it highly encourages firms to plan for winding down their business. They should include any scenarios that might cause a firm to wind-down its business, the potential impact on consumers and financial markets and the amount of capital needed to absorb winding-down costs, as well as liquid resources to support cash outflows.

What is the minimum expected from all firms?

All firms as well as those not subject to detailed prudential rules (e.g. GENPRU, IFPRU etc.) should focus on the following FCA expectations by:

  • assessing their risks, and
  • understanding how changes in their circumstances might affect these risks and their ability to achieve returns.

As a corollary, they must able to “detect, identify, and rectify problems” through systems and controls, governance and their culture to prevent harm from occurring. It is important that when things go wrong, as they invariably do, that they are put right and this will mean having adequate financial resources. Finally, these firms need to minimise harm when failure occurs. This will involve examining scenarios that could give rise to financial stress and exploring recovery options. In the last resort, asking how the business can retain sufficient resources to wind down the business in an orderly way.

For firms subject to detailed prudential rules are there additional regulatory expectations?

These firms are expected to have capital at all times that is equal to or higher than their assessment of what is necessary. This includes the type and quality of capital and its ability to be used in a going concern or wind-down situation. The quality and availability of liquid resources is also important, especially bearing in mind it may be needed under stressed conditions.
Systems and controls, governance and culture play a central role and directly impact risk appetite, namely, the overall level of risk that a firm is willing to take to achieve acceptable returns. These risks must be identified and understood and an appropriate risk management and control framework put in place. The FCA considers drivers of behaviour to include the “attitude, behaviour and competence” of the firm’s leadership. Firms should have sound and clearly stated values.

Firms must be able to identify and assess the potential harm to consumers and markets. An understanding of what can go wrong, whether as a going concern or on winding-up, will help firms assess if they have sufficiently robust controls and sufficient financial resources to minimise the risk of harm. A number of “harms” are listed in the FCA’s recent Dear CEO Letter on Wealth Management and Stockbroking Supervision Strategy, where customers may suffer harm in this sector, for instance, by having reduced levels of savings and investments due to fraud, investment scams and inadequate client money, or assets controls. Such mistakes, misconduct or failure can lead to consumer loss giving rise to the need to pay compensation. Firms are expected, therefore, to identify all significant harms touching on their activities.

According to the FCA, firms should also consider risks that may deplete their available financial resources and cause harm. The consultation gives the example of consumers suffering loss due to a firm’s misconduct or failure. The FCA will want to see that firms have adequate resources in such circumstances to provide redress and it expects them to calculate the potential depletion of financial resources or assess their ability to convert assets into cash in a timely manner. For instance, to consider if they hold many illiquid assets and what would happen in the event that a counterparty were to fail, perhaps, in the context of derivative OTC contracts. Firms should therefore stress test their risk frameworks assessing levels of shock relevant to their business. The FCA points to positions in volatile markets or exotic and non-linear derivative portfolios as examples of factors that may increase the risk of potential losses.

The FCA will analyse a firm’s business model and strategy analysis. It will seek to understand how a firm generates its revenue and the vulnerabilities to which its model is subject. These should include:

  • details of business lines and activities, its forecasts and concentrations in revenue streams;
  • external factors that impact the success of the business model and strategy;
  • reliance on a firm’s franchise and reputation; and
  • competitive advantages over its peers (e.g., IT platforms, scale, range of products etc.).

Firms must have both forward-looking financial projections and strategic plans under business-as-usual and adverse circumstances (i.e., outside their normal control). While more commonly associated with the PRA and banks, management should consider using reverse stress testing to identify at what point a business model will become unviable and the scenarios and circumstances when this might happen (e.g. if the market were to lose confidence in a firm leading to a loss of counterparties or clients). The FCA say testing will help design measures to prevent and mitigate risk.

The FCA will look to see that firms have in place winding-down plans that are credible with realistic timescales. These will include assessments of how financial and non-financial resources are maintained as the firm leaves the market, for example, over a nine month period. Although they may have sufficient capital firms often lack the level of liquid assets needed for an orderly wind-down.

As a result of the FCA’s approach to assessing adequate financial resources, firms should:
  • identify and assess the risk of harm: the FCA clarifies its expectations around firms’ assessment of risks that they pose and that could impact on their financial resources. In particular, the FCA expects them to identify “all significant harms” arising from their activities. Firms should then assess the likelihood and the impact of harm actually resulting. The FCA provides various examples of harm across the financial services sector – for example, in respect of payment firms, it identifies the risk of failing to have resilient systems and controls resulting in serious harm to consumers (e.g. from disruption of service continuity). Should those harms crystallise, there is a risk that resources may be depleted by losses resulting, for instance, from litigation or from losing client relationships.
  • estimate the potential impact on their financial resources based on their knowledge and experience (supported by statistical models – with different underlying scenarios/assumptions – where firms’ control frameworks are sufficiently sophisticated). The FCA expects that the risks and any controls to mitigate them are taken into account, with a “pre-control” assessment of risk made and a “post-control” assessment as to any residual risk of harm once controls are taken into account. The FCA expects firms to consider then whether additional controls are needed and, whether those risks are within or outside of their risk appetite.
  • consider additional risks that may deplete financial resources. For example, the potential depletion of financial resources resulting from a need to compensate consumers or being unable to convert assets into cash on a timely basis. The expectation is that firms consider losses that may result from balance sheet risks (e.g. changes in the book value of assets, losses arising from the failure of clients or counter-parties, or changes in value of investment positions or FX/commodity positions, as well as pension obligations). In effect, the FCA expects firms to stress-test their balance sheet to understand the potential impact on their positions of various scenarios and events. Firms should carry out a holistic risk assessment.
  • assess risks to viability of their business model/strategy supported by financial projections and strategic plans over a period of at least three years. This planning should enable firms to understand any vulnerabilities to their ability to generate the returns/profits that they desire (and the impact of a failure to generate such returns/profits on their capital position).

Richard Powell is Lead Knowledge Lawyer for Baker McKenzie's Financial Institutions Industry Group where he is responsible for legal content projects, training and knowledge initiatives. Previously he was a member of the UK Financial Conduct Authority's Enforcement Division where he advised on regulatory cases. He has also been an editor of Bloomberg Law's UK Financial Services Law Journal.