Investment Firms Prudential Regime:
The FCA have recently published some of their observations from the current state of readiness from the industry and some common themes that they have been seeing through their supervision and discussion with firms in this regard.
The full text can be found here.
This indicates that firms may still have some way to go to fully adopt the new obligations and sufficiently deploy governance, routines, controls & activities, underpinned with rationale and evidence to support their compliance and considerations under the new regime.
Background
Introduced in January 2022, the Investment Firms Prudential Regime (IFPR) is the new prudential regime for MiFID investment firms including, fund managers, asset managers, trading firms, depositaries, and investment platforms. Under this regime the Internal Capital Adequacy and Risk Assessment (“ICARA”) has replaced the previous Internal Capital Adequacy Assessment Process (“ICAAP”).
The IFPR and the corresponding prudential standards under MIFIDPRU introduced a requirement for all firms in scope of the regime to complete the ICARA process.
Through the ICARA process, firms identify the risk of harm in their operations and provide appropriate resources to mitigate such harm, whether as a going concern or when winding down.
ICARA can be applied at a solo entity level, or as part of a consolidated calculation where firms are part of a group structure and when agreed with the FCA ā they can opt to complete a āgroup ICARAā process.
Identifying risks and harms
A risks and harms assessment conducted at a granular firm level and then as appropriate consolidated at the group level, aims to ensure that risks are accurately considered and reflected in the firms ICARA.
Whilst there is no requirement to adopt a different approach to assess risk at group level, when the assessment is allocated to separate entities, senior management of each must demonstrate that they have understood and assessed the impact of risk at group level.
Under MIFIDPRU 7, each MIFIDPRU investment firm in an investment firm group must still carry out its solo ICARA process even if the investment firm group operates a consolidated ICARA process.
Assessments should be vigorous and performed robustly with any observations coherently translated into actionable plans to ensure firms can manage its financial resources and the risk of harm across its operations.
Without an entity-specific assessment, the requirement under MIFIDPRU 7.9.5R(3) for each MIFIDPRU investment firm to comply with the overall financial adequacy rule (OFAR) on an individual basis, has not been fully met.
āGoing and Gone Concernā Approach
Alongside assessments of the prudential requirements for its āgoing concernā activities, firms also need to make assessments on a worst case and insolvency type situation, to ensure wind-down planning is considered, comprehensively planned for and capable of being actioned in a reasonable timeframe, avoiding further harm to the customer, market or market participants and indeed to the wider UK financial system as a whole.
Qualitative and quantitative monitoring of trigger events against pre-determined thresholds, continuous business model assessment, stress testing scenarios and recovery planning require inclusion in the wind down plan. Ā Trigger events must be impact assessed against the potential harm they can cause . An assessment of risk with estimates of own funds and capital thresholds must be quantified and continuously tracked, and should be subject to internal review as well as supervisory and audit assurance reviews.
Under IFPR, firms must hold sufficient financial resources to support on-going activities and wind-down in an orderly manner, as required by the Overall Financial Adequacy Rule (OFAR). Firms are further directed to complete an ICARA process to check whether it complies with the OFAR.
ICARA is structured under measurable criteria called āK-Factorsā, which look to simplify prudential standards and reflect the risk that the new prudential regime intends to address. Firms align capital to adequately cover liquidity and capital adequacy across business models ā this includes areas, such as credit and market risk, which were prescribed under previous prudential regimes but may not have been retained under IFPR.
It remains that, unless business models have changed, firms will continue to be exposed to the same risks and so should be taking account of and documenting all risks they face including those not specifically covered by K-Factor calculations.
Firms should only stop holding capital for risk types which they have been able to mitigate fully or are assessed as immaterial. Such risks should still be captured and explained within the ICARA document.
Monitoring and decision making
Thresholds and trigger points can be useful to ensure recognition and identification of risks materialising.
Governance and warning indicators are critical for firms to make informed decisions and mitigate risks, by taking effective steps to prevent them and rectify problems when they occur.
Governance arrangements
In managing the governance of IFRPR and MIFIDPRU obligations, firms are expected to have a defined organisational structure, transparent lines of responsibility, underpinned by an adequate internal control mechanism alongside administration and accounting procedures.
These enable the identification, management and monitoring and reporting of risks. The arrangements must be proportionate and compatible with the requirements in the FCA handbook.
Whilst the firmās governing body has overall responsibility for risk management, the risk function must be independent from operational areas and have sufficient authority, expertise, and resources to appropriately manage and report against risks identified within the firmās business activities.
Importantly, the risk function must have a holistic view of the firmās risks and be able to raise concerns to ensure management can take intervention steps when required.
A key aspect of the risk function in relation to the Internal Capital Adequacy and Risk Assessment (ICARA) process is to ensure the firm has appropriate systems and controls in place to identify, monitor and reduce potential material harms and hold adequate financial resources for the business it undertakes, to enable it to remain viable, address material and potentially materials harms and if necessary to enable an orderly wind down without threatening the integrity of the market or market participants and wiser UK financial system, whilst also minimising harm to consumers in the process alongside.
The FCA does however, recognise that with the vast array of risk and harms possible, it may not always be possible to mitigate all potential impacts, so they require firms to focus on material harms and adopt a risk based approach, proportionate to the business model and activities.
Firms must maintain financial capital adequacy at all times, with their own funds and liquid assets available, that are adequate to ensure compliance with the overall financial adequacy rule.
Firms should use the ICARA process to ensure that it complies and also show how it complies to the overall capital adequacy rules and obligations associated.
As part of the ongoing process, firms should look at how they can further refine and reduce risk of harm and material risk exposure and impacts through overall strengthening of its process, controls and procedures, alongside any other forms of established and appropriate risk mitigation techniques available that fit within its risk policy, standards and approved mechanisms for this purpose,
In addition to the frequent governance and maturity assessment activity, firms should also deploy relevant and severe but plausible stress testing to consider whether the firm would still have sufficient own funds and liquid assets to meet the overall financial adequacy rule.
In February 2023, the FCA issued further feedback on the implementation observations that they have made in relation to the preparation and implementation activities that they have seen with firms and found a mixed and different level of engagement by the firmās board and delegated committees ā some themes from the report below:
Insufficient governance and Board and Executive involvement in ICARA
- Differing degrees of engagement by the Board and their delegated committees in the ICARA process.
- Varied understanding of the firmās activities, operations, the risks, and the appropriateness of controls.
- Lack of relevant challenges to the assumptions and articulation of risks within the ICARA document.āÆ
- Varied oversight over key elements of the ICARA process,
- Insufficient evidence to ensure confidence that the individual firmās risks are adequately identified or addressed, and therefore whether harm could be caused through the failure of the firm.
Having adequate support and the exercise of appropriate diligence are fundamental requirements under the Senior Management and Certification Regime (SM&CR).
Insufficient attention to wind-down plans
- Effective wind-down plans enable firms to fail or exit the market in an orderly way with limited harm to clients and markets.
- Lack of updated and relevant/comprehensive wind-down plans Varied results from reviews of firms process in assessing the own funds and liquid assets threshold requirements.
- Less robust evidence when compared to the assessment of own funds and liquid assets to support ongoing activities,
- Demonstrable as;
- Unrealistic assumptions,
- Insufficiently detailed modelling, and
- Poorly justified estimates of resources needed to support an orderly wind-down.
- Most of the gaps observed are similar to those cited in previous publications around wind-down planning practices indicating a weak adoption of our guidance.
Data quality: inaccurate or incomplete data submissions
- Inaccurate or incomplete data in their regulatory submissions.
- Poor quality of regulatory data submissions assumed as an indicator of weaknesses in firms’ systems and controls.
- Potential for breach of senior managersā responsibilities under the SM&CR;
- In particular, to ensure that the firm complies with relevant requirements and standards of the regulatory system, and
- To appropriately disclose any information of which the FCA would reasonably expect notice.
The full text can be found here.
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