In late November the FCA published their IFPR implementation observations concluding report which details the regulator’s findings on how firms are implementing the ICARA under IFPR. This most recent report builds on the FCA’s multi-firm review, which was published in February, and outlines good and poor practices, which should assist firms in identifying where their ICARAs need some work. The FCA encourages regulated firms to “consider whether to apply any of these observations to their own processes.” So, this paper is not regulation, but it is the regulator’s expectations, which amounts to very similar outcomes.
The FCA’s findings have strong echoes from the FSA’s observations on ICAAPs (the ICARA’s predecessor), back in 2010 – namely usability of the ICARA and its integration into management decision making processes, and poor planning and analysis of wind down processes and costs.
The FCA’s observations fall into four headings:
- Liquid asset assessments;
- Early warning indicators, triggers and interventions;
- Wind-down plans; and
- Operation risk capital assessments.
Liquid asset assessments
The FCA note that several firms applied insufficient consideration of cashflows and liquidity stresses, which led to an inadequate assessment of liquid asset requirements. Regulated firms must produce a reasonable estimate of the amount of liquid assets needed to support on-going operations (including in stressed scenarios) or an orderly wind down. Stresses should be relevant, severe (but plausible) and regularly reviewed such that liquid asset levels can be proactively adjusted.
The FCA highlights the recent geopolitical risk and macroeconomic environment which have led to sustained volatility and higher prices in some markets, which can lead to substantial margin calls, higher costs, credit stresses and – potentially – increased counterparty risks.
Some firms evidently also failed to distinguish between liquid assets and own funds when running their analyses, resulting in inadequate assessment of required mitigants. The FCA emphasises that the assessment of liquid assets focuses on which items affect cash or sources of cash, whereas the assessment of own funds reviews impacts on the value of a firm’s assets, liabilities, and capital accounts without necessarily increasing or reducing cash or sources of cash.
Liquid assets analysis should also be sufficiently “time-granular” – i.e., ensuring that analysis is appropriate for the cash flow frequencies of the business.
Actions:
- Review liquid asset assessments to ensure confidence that they are sufficient in both BAU and stressed conditions. The assessment must be forward looking.
- Consider the guidance in MIFIDPRU (MIFIDPRU 7 Annex 1 in particular) so financial/liquid asset stress is appropriately incorporated into the ICARA and to ensure that those stresses are relevant taking into account firms’ own cashflows and liquid assets positions and to regularly review such stresses and liquid asset positions.
- Review ICARA to check it adequately distinguishes between liquid assets and own funds.
Early warning indicators, triggers, and interventions
According to the FCA, most firms did not structure internal intervention points in a way which would ensure actions would be triggered in a timely fashion. The FCA argues that early warning indicators (EWIs) and triggers for action help, firms identify to make interventions.
In addition to the MIFIDPRU prescribed EWIs[1] the FCA states, in what sounds like gold plating, that prudently managed firms will also set internal EWIs and triggers above the level specified for notifying the FCA. In order to manage stress, the FCA explains, firms generally identify two main internal intervention points: 1) the activation of the recovery plan; and 2) the activation of the wind-down plan. Firms should consider the interaction between these two intervention points and use them when deciding how much resource to hold in excess of requirements.
The FCA found in its review that the point at which many firms plan to consider activating the wind-down plan is when their own funds and/or liquid asset resources have already fallen below levels needed to support an orderly wind-down – which the FCA considers is inconsistent with acting with due care and diligence.
Again, the FCA emphasises plausible but severe stress testing so that firms can understand the extent to which own funds and liquid assets can be depleted under stress, and over what period of time, so that a reliable conclusion can be reached as to the resources that need to be held over and above threshold requirements.
Actions:
- Review intervention points for clarity of purpose and appropriateness of the timeframe for triggering. Buffer levels could be used as internal checkpoints and the catalyst for escalation and action. Using informal and non-financial triggers in addition to formulaic ones is good practice e.g., reputational risk or key client concentration.
- Consider using the combined impact of stress on resources available and on resources required. This approach will identify changes in surplus resources and firms could use the largest change in surplus to define a resource buffer to maintain over and above the threshold requirement.
Wind-down plans
The FCA observed that there was little consideration of the role of group relationships which – potentially – leads to inadequate assessment of resources to support an orderly wind down. In addition, firms did not sufficiently consider group-wide wind down plans or recognise that the wind-down may have been caused by, or may cause the wind-down of, other firms in the group. Situations where some or all firms in a group are also winding down can create pressures on shared systems, people, and financial resources, meaning additional resources may be required, having an impact on the cost and timing on individual firms’ wind down plans.
Actions:
- Firms which belong to a group should consider whether also preparing a group-wind down plan would result in a more thorough assessment of required resources and, where there are multiple wind-down plans within a group, they should be consistent with each other. Also, consider items which have cross-applicability (e.g., the wind-down trigger of one group entity may also be a trigger for others) and identify critical dependencies on group entities.
- Make sure wind down plans are current and aligned with cost assumptions – FCA observed some were out of date. The wind down plan must be realistic and not assumed to take place in unstressed conditions.
Operational risk capital assessments
Common failings under this heading included incomplete assessments of risk, inappropriate use of group models and poor governance and oversight around complex modelling approaches, leading to insufficient assessments of own funds. An incomplete assessment of risks means that individual firms will not have enough resources to manage their own risks.
It is in this section that the FCA hammers home the point on good risk governance to ensure that proper models and approaches are used, which should lead to appropriate and well understood results. The FCA further reminds us that MIFIDPRU 7 requires that the management body of firms must ensure that adequate resources are allocated to the management of all material risks.
Actions:
- Management of regulated firms must ensure that there is a clear link between the calculation of the necessary financial resources and the risk management, scenario analysis and operational risk assessments.
- Firms should ensure that appropriate governance arrangements are in place such that all elements of the ICARA process can be appropriately reviewed and challenged, and that such review and challenge is suitably documented.
Concluding thoughts
Whilst this most recent review of the prudential regime is new, many of the concepts outlined in the FCA’s findings are not – as shown by the reference in this article to the FSA’s findings back in 2010 (which share common themes with the most recent review), as well as the FCA’s reference to guidance which is now three years old. As the year draws to a close, regulated firms would be well advised to take the FCA’s good and poor practices into account during their next ICARA review.
December 2023
