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:
Adequacy of financial resources is designed to:
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:
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:
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:
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.
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:
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.
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:
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:
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:
Examples of potential causes of harm include:
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.
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.
The FCA expects firms to look at:
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.
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:
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.
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:
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 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:
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.