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The latest regulatory capital adequacy policies in the UK and EU - a summary

Jonathan Wilson, Ellis Wilson Ltd, Director, London, 21 July 2020


In an ideal world, compliance officers should have nothing to do with capital adequacy; it is officially the job of the finance department. In reality, however, when a new rule emerges, the compliance officer has to jolly the finance department along and ensure that it starts to pay attention. Compliance officers have to monitor the rules and tell other departments about the rules.

Enter FG20/1, issued by the Financial Conduct Authority and entitled Assessing adequate financial resources. This so-called 'framework document' aims to inform people about:

  • the job of adequate financial resources when it comes to minimising 'harm';
  • the steps that firms can take when assessing adequate financial resources; and
  • the way in which the FCA assesses the adequacy of any given firm's financial resources.

The paper sets out the FCA's expectations for all regulated firms, exhorting them to:

  • hold adequate capital, including the capital that it expects to need for compensation and redress schemes, enforcement and fines, including overseas regulators and direct and indirect costs of litigation;
  • establish effective risk management and controls;
  • conduct 'what it' scenarios and stress tests;
  • operate viable and sustainable business models and strategies;
  • plan 'wind-down'; and
  • spot all significant damage related to the activities that they undertake.

This 'final guidance' is consistent with CP19/20 from last year.

Let us be clear. Despite the FCA saying that it does not "seek to impose additional requirements on firms," this all-but-the-kitchen-sink 'guidance' draws on much of the orthodox 'good practice' which the FCA has encouraged since the introduction of ICAAP.

This is an interesting assertion because, out of eight companies listed on the Financial Services Compensation Scheme's website this June as 'failed,' 'under investigation' or 'in administration,' their FCA 'permissions' (licences to do various things) - and prudential categories that they probably occupied because of those 'permissions' - indicate to me that these firms were subject to IFPRU (part of the FCA rulebook that regulates investment firms prudentially), BIPRU (part that regulates portfolio managers prudentially) or IPRU-INV (the part that deals with collective portfolio management firms) detailed prudential requirements. The point is that these detailed rule-based requirements have not been effective in preventing each of these firms' failures. Indeed, one failed less than six months after the FCA approved it. Having said that, our observations may be unrepresentative of the 5,509 firms listed by the Financial Services Compensation Scheme (FSCS) as 'failed' or 'under investigation' over its lifetime.

All firms ought to consider the adequacy of their capital and liquid resources in the context of these guidelines. Firms that are not subject to ICAPP may have further to go than firms that are. Given the clear reference to the FSCS, firms with a retail footprint and/or registered with the FSCS ought to take note. I re-iterate, however, that the guidelines are addressed to all.

Bride of ICAAP

Near the end of last month the Financial Conduct Authority set out the way in which it hopes to implement the European Union's new prudential regime for investment firms (based on the IFD and IFR). It is relevant to investment managers subject to BIPRU and GENPRU or IFPRU, firms exempt from the Capital Adequacy Directive and CPMI firms.

On the credit side, FCA discussion paper 20/02 (on prudential requirements for MiFID investment firms, consultation period closes on 25 September) promises annual regulatory reporting by portfolio managers managing less than €1.2 billion and the likely end of Pillar 3 disclosures whenever these smaller investment managers have simple capital structures. That's it. On the debit side, there is to be an increase in the minimum capital requirement to €75,000, the application of a fixed overhead requirement (FOR) to all investment firms, a requirement to hold one-third of the FOR in liquid assets and new K-Factor capital requirements (KFRs) and quarterly reporting for firms managing more than €1.2 billion.

Rather than simplifying the existing capital adequacy regime for investment managers, these proposals are to increase minimum capital requirements for most and directly or indirectly introduce more complex capital calculations as well as 'Bride of ICAAP' for almost all. Since the FCA is placing responsibility on firms to assess their capital adequacy, the senior manager responsible for capital adequacy in accordance with the Senior Managers and Certification Regime (SM&CR) should take note of these pronouncements and of the FCA's "whack-a-mole tool" to impose additional capital requirements whenever it sees fit.

It is not known how these proposals are going to help the FCA achieve its aim to stop firms from hurting HNW consumers and the markets. The proxies for operational risk embedded in the KFRs for AuM, clients' monies, clients' assets and clients' orders appear arbitrary values at best, while existing prudential and capital-adequacy-related controls have not stopped all firms from failing and/or draining the coffers of the FSCS before.

The FCA also seems to have neglected the job of the external auditors in this paper. The auditor is responsible by law to hand the regulator information that it is reasonable for him to believe to be relevant to this-or-that function of the regulator. This probably includes a risk assessment and its link to capital adequacy.

* Jonathan Wilson can be reached on +44 (0)20 3146 1869 or at jon@elliswilson.co.uk

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