How to Assess Adequate Financial Resources

By Simon Hill | Uncategorized | 0 Comments

Introduction

Following the consultation on its guidance in June 2019, in June 2020 the Financial Conduct Authority (FCA) has published the Finalised Guidance (FG20/1) on a framework for financial services firms ensure they have adequate financial resources. The guidance applies to all FCA-solo-regulated firms. We summarised the key information to take away from this guidance for you below.

The content of the document focuses on the FCA’s expectations of how firms determine they have adequate financial resources: the regulator expects firms to assess their financial resources in proportion to the risk of potential harm to consumers and the complexity of their business. This starts with considering whether they have enough assets to cover their debts and liabilities.

The framework document also explains the purpose of, and the FCA’s approach to the assessment of the adequacy of financial resources by providing further guidance on the meaning of ‘adequate financial resources’. The guidance can be split into three parts, as it sets out:

• the role of assessing adequate financial resources in minimising harm
• what the FCA looks for from firms when assessing adequate financial resources
• FCA’s expectations as to the practices firms should adopt in their assessment of the adequacy of the financial resources

Purpose of this guidance

Adequacy of financial resources is designed to:

• enable firms to remain financially viable and to provide services through the economic cycle
• enable an orderly wind-down without causing undue economic harm to consumers or to the integrity of the UK financial system

Every firm authorised under the Financial Services and Markets Act 2000 (FSMA) must meet threshold conditions, meaning that firms must have appropriate resources relative to the regulated activities in which they carry on or seek to carry on. The assessment of appropriate resources under threshold conditions considers:

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

To assess if a firm has adequate financial resources, the FCA will consider if a firm can meet its debts when they fall due.

For firms, other than those with limited consumer credit permissions, FCA also considers if a firm has:

• taken reasonable steps to identify and measure its risks
• appropriate systems and controls and human resources to measure risks prudently at all times
• access to adequate capital to support the business, and that client money and custody assets are not placed at risk
• resources which are commensurate with the likely risks it faces

How is your firm affected?

Firms should consider the approach set out in the framework document in a way that is proportionate to the nature, scale and complexity of their own activities. The FCA would expect to see documented evidence of such review available upon request. We would advise firms:

1. Review their current procedures to identify any gaps between the procedures already employed and FCA’s guidance. We can help you review your systems and controls, please get in touch with our consultants for more information.
2. Take action to improve the adequacy of your internal controls, if the need for such action has been identified during the review.
3. Document the results of the review and the actions taken for audit trail purposes.

Firms with a limited consumer credit permission who are subject to a simplified threshold condition of adequate financial resources, are reminded that they are required to meet debts as they fall due. These firms, and any other firms which are not subjected to detailed prudential standards, should focus on what the FCA looks for from firms. The framework document will also give information to aide firms in performing their own assessments.

For firms subject to detailed prudential standards, this document should be considered alongside existing requirements.

FCA’s expectations around the assessment of the adequacy

Firms are required to assess the risks inherent to their business model, the potential harm that can be caused and have a plan to wind down the business in an orderly way.

According to the FCA, the assessment should:

• consider a forward-looking approach to risks and how these evolve throughout the economic cycle
• reflect the risks to which the firm is exposed and the amount of risk it poses
• be proportionate to the likelihood of the risks occurring
• ensure they are financially sound while avoiding excessive costs, which could hinder firms from carrying out their business in a viable way
• happen at least annually, reflecting the fact that the business environment is dynamic so the assessments of risk and harm should be dynamic too

Understand business model & strategy – Firms are expected to understand and articulate how changes in operational and economic circumstances can affect the risks to which they are exposed and their ability to generate acceptable returns.

Prevent harm – Firms are expected to understand the risks associated with the activities they engage in, in order to enable them to detect, identify and remedy problems themselves by ensuring that their systems and controls, governance and culture enable them to take effective steps to prevent harm.

Right the wrongs – The assessment of adequate financial resources should identify sources of potential harm, to consumers and markets, and should also estimate their impact. To put things right when they go wrong may require adequate financial resources. Risks that may stop a firm putting things right should be considered, as well as assessing the circumstances leading to financial stress and the potential depletion of financial resources.

Minimise harm in failure –When a firm fails there can be serious harm for consumers and the financial markets, therefore, the FCA expects firms to consider the scenarios leading to financial stress, explore recovery options and, as a last resort, wind down its business orderly so that the impact of its failure can be minimal.

Expectations of firms to reduce potential to cause harm

Financial Resources

Adequate capital resources

The assessment of adequacy of the resources is based on how much capital is needed, which is then compared to how much capital is available. One basic principle that applies across prudential regimes is that the assessment of capital adequacy is underpinned by accounting principles. If there are changes to the value of assets or liabilities, which are not otherwise compensated, this affects the accounting value of capital. Any resulting losses are deducted from the retained earnings which are part of a firm’s common equity.

To assess how much capital is needed, firms must conduct a wider assessment of the risks to which they are exposed to. This assessment focuses on potential changes in the book value of assets or liabilities that would result in a loss to the firm or changes in its equity. Expected losses should already be recorded on financial statements through provisions or impairment of assets. Quantifying potential changes in value of assets or liabilities, to determine capital requirements, should be based on adverse circumstances and capture unexpected losses, as well as other potential losses that have not already be accounted for.

The need for adequate capital is to ensure a firm can incur losses and remain solvent or fail in an orderly way and includes:

• compensation and redress schemes – consumers should be compensated for losses incurred as a result of a firm’s misconduct
• enforcement and fines – statutory investigations or enforcement actions by the FCA or other authorities
• direct and indirect litigation fees – firms may have to compensate consumers or other firms through legal action
• ‘skin in the game’ – adequate capital may be required to ensure firms can function in an orderly way and that their incentives align with the best interests of their clients or the wider financial markets. This should capture the level of activity performed and the potential for market disruption.

Adequate Liquid Resources

The quality and availability of liquid resources depends on the ability of a firm to convert different types of available liquid resources into available ‘cash’ to settle debts as they fall due – particularly under stressed conditions. A firm should consider:

• Its ability to monetise liquid assets – factors affecting the ability, timescale and loss of value when converting assets into cash
• Its diversification of liquid assets – diversification could help monetise liquid assets without incurring a significant loss
• Currency convertibility – the currency of liquid resources and its conversion should be assessed as a potential obstacle to meeting stressed liquidity outflows in a specific currency
• Transferability of funds – adequate liquid resources should be maintained on a legal entity specific basis unless they can freely move between entities.

Systems and controls, governance and culture

A sound risk management and controls framework will allow firms and their senior management to identify, understand, manage, monitor and mitigate the risk of potential harm caused to consumers and markets.

The FCA expects the management bodies of firms (boards of directors) to take responsibility for the firm’s strategy and be actively involved in risk management, have a clear communication of strategies and polices to relevant staff, and a risk culture that encourages effective challenge by promoting a range of views in the decision making process. The key word here is “active” risk management, the FCA expects directors and senior managers to be setting the tone for managing of risks from the top. This means being forward looking in the assessment of business risks and clearly communicating with relevant staff to ensure effective operational implementation of the risk management approach.

Firms should have a clear and quantified risk appetite to be followed across the firm. An appropriate risk management and controls framework will consider:

• The risk in the day-to-day activities, including the development of new products and services, taking on new customers, and changes in the firm’s business model
• the management body understands the firm’s activities, how it operates, the risks it faces and the appropriateness of controls
• the policies and procedures to identify, manage or avoid conflicts of interest, including a segregation of duties and consideration of consumer interest
• the risk function is adequately resourced and sufficiently independent to perform its duties
• the impact of the outsourcing on the firm’s business and the risk it faces is considered and reasonable care is taken to supervise the discharge of outsourced functions by its contractors, noting that firms cannot contract out their regulatory obligations.

Identifying and assessing the risk of harm

Causes of harm

Examples of potential causes of harm include:

1. Poor conduct as a result of poor financial management: A firm under pressure for performance or is on the verge of failure may have an enhanced risk of causing harm, in an attempt to improve performance, by actively ‘cutting corners’ to enhance profits.
2. Disruption of markets’ function: Macro-prudential and micro-prudential events may present material risk to firms’ business models. Confidence and participation in financial services markets may be threatened by market abuse, unreliable performance or disorderly failure.
3. Inability to pay redress or to transfer or return client money and assets, i.e. compensate consumers, and the transfer of these costs to other market participants via the FSCS levy, is unfair and places an unnecessary burden on other firms.
4. Disruption to continuity of service – Not adequately investing in people, processes, and systems and controls, may increase the risk of disruption to the continuity of service.

Identifying Harm

To help firms identify potential harm, the FCA has topic specific guidance (e.g. operational resilience, client money & assets, remuneration practices, product governance).

In order to identify potential causes, firms should assess how their actions, the actions of others performing outsourced functions, or the failure of systems and controls, might cause harm to consumers or financial markets.

Firms should:

• consider the risks before the controls are considered
• look at each significant risk and assess what controls are in place to remove or reduce that risk
• assess how much risk of harm remains.

This assessment should also inform if the risk is within or outside their risk appetite, and help the firm decide if extra controls are needed.

Risks that can lead to harm or impair the ability to compensate for harm done

The FCA expects firms to look at:

• losses related to changes in book value of assets
• losses arising from failure of clients or counterparties to transactions in financial instruments
• change in value of positions in financial instruments, foreign currencies, and commodities
• obligations to defined benefit pension schemes
• being unable to convert different types of resources into available ‘cash’ to pay for obligations as they fall due.

The FCA detail of how different factors and circumstances can result in a firm being unable to meet its varying obligations. When potential additional risks have not been assessed it can lead to unexpected losses which can impair a company’s ability to put things right when they go wrong.

Viability and Sustainability of the business model and strategy

Business model and strategy analysis simply help to understand how a business generates returns and the vulnerabilities that may affect its ability to do so.

Firms who can identify and understand the existing or new vulnerabilities to which they are exposed to, will be in a better position to:

• understand how vulnerabilities can affect a firm’s ability to generate acceptable returns
• develop a clear risk appetite stating which stress scenarios a firm chooses to survive
• develop a reverse stress test that tests the point of non-viability of a firm’s business model

The FCA expects firms to use forward-looking financial projections and strategic plans to enable it to understand the risks to viability of its business model and the sustainability of its strategy over a period of at least 3 years. We would advise these financial projections are reviewed by the board or the senior management at least annually.

Stress Testing

Firms should provide forward-looking financial projections under severe but plausible adverse circumstances. These scenarios should be considered against a firm’s own risk appetite for survival. The FCA gives good examples of scenario analysis under stressed conditions:

• stress scenarios must be severe but plausible and relevant to the circumstances of a firm, its business model and the market in which it operates, including events that cause reputational damage to the firm
• based on forward-looking hypothetical events
• contain clear assumptions, when compared to business-as-usual projections, which are consistent with the macroeconomic scenarios considered
• scenario analysis and stress testing should be performed on individual business lines and portfolios, if relevant, as well as at a firm-wide level, including sensitivity analysis of material vulnerabilities in generating returns
• cover all material risks and vulnerabilities identified and analyse the impact of events of a varying nature, severity and duration on both financial resources and requirements.
• estimate the effects of the stress scenario on a firm’s profits and losses, and its financial position before and after taking account of realistic management actions

Reverse stress testing

A reverse stress test must result in a firm reaching a point of non-viability and should provide useful information about vulnerabilities in a firm’s business model and strategy. This should help when designing measures to prevent and mitigate the risk of business failure. The point of non-viability can come before a business’ financial resources are exhausted.

Wind-down planning

Wind-down plans need to be credible and have realistic timescales and assessments of how financial and non-financial resources are maintained while the firm exits the market, in order for a firm to reduce the impact of its failure.

A firms’ wind down plan should consider:

• operational tasks required and time necessary to execute each task, including identifying key staff and systems, dependencies from group or other third parties, and client communications
• risks to the continuity of the services provided and its impact on consumers and financial markets, by identifying firms by whom services could be provided or clients’ assets transferred, and the timescales needed to do so
• the provisions in the client assets resolution pack to help speed up the return of client money and assets
• the level of both capital and liquid resources available and required as a stress situation might have depleted resources prior to a decision to wind down being made

Quantitative Investment

The FCA notes that a 9-month estimated wind-down period is a realistic timescale dependant on the firm’s activities, size and sustainability. Firms should produce an accurate estimate of the cost of winding down as well as extra costs such as termination penalties and redundancy costs. A firm should not expect to maintain revenues at a level similar to the normal course of business and in many cases, firms may be unable to maintain a revenue stream at all. The realisable value of certain assets is likely to be considerably lower than their book values, especially in the case of shorter wind-down periods.