K-factors and capital calculations: What you need to know

The new investment firms' prudential regime (IFPR) from the Financial Conduct Authority (FCA) came into force on the 1st January 2022. It requires firms to minimise the potential harm posed to their clients and the markets in which they operate by maintaining a certain capital value at all times.

Under IFPR rules, firms must:

• Identify whether they’re categorised as a small and non-interconnected (SNI) firm

• Maintain a permanent minimum requirement (PMR) of capital and liquid assets

• Consider K-factors, requirements that help firms calculate their ongoing capital needs

Firm categorisation under the prudential regime

First, and most importantly, a firm needs to work out whether they’re an SNI firm or a non-SNI.

To be considered an SNI, firms must meet all the threshold conditions below:

• Assets under management (AUM) of under £1.2 billion

• Client cash orders of under £100 million per day

• Client derivative orders of under £1 billion per day

• The firm doesn’t safeguard assets

• The firm doesn’t hold client money

• On- and off-balance sheet total of less than £100 million

• Total annual gross revenue from investment services and activities of less than £30 million.

SNI firms would qualify for certain benefits such as some capital and reporting requirements. For example, an SNI firm wouldn’t have to calculate their capital requirements with regard to the K-factors.

However, the capital requirements for all investment firms will be changing, whether the K-Factors apply or not.

The idea is for the IFPR to include three options for the PMR. A firm will have to determine its requirement based on whichever is the highest out of the PMR, fixed overhead requirement and the K-factor requirements.

What is the permanent minimum requirement?

The permanent minimum capital requirement is the lowest amount of capital and liquid assets an investment firm is required to hold at all times.

Maintaining the firm above this threshold ensures that if it has to wind down, it can do so in an orderly manner.

A firm’s PMR depends on its activity permissions:

This requirement could change with other factors like overheads and K-factors. The overhead requirement is simply 3 months of relevant expenditure.

What are K-factors?

K-factors aim to calculate a firm’s ongoing capital requirements based on several capital factors. They measure the risks posed by a firm to its customers, to the market generally and to the firm itself.

The FCA’s expectation is that all firms will be expected to consider the relevant K-factors as part of their internal and supervisory discussions for monitoring sources of harm. That applies even if firms are categorised as SNI.

The relevance of K-Factors will depend on the firm’s status as an SNI and the activities conducted. That said, SNIs won’t have to deal with K-factors when calculating their capital requirement.

There are several K-factors, and some or all may apply to a non-SNI firm.

Many firms that historically have been classified as a BIPRU firm or an Exempt CAD firm are likely to be subject to one of more of the following K-factors:

• K-AUM requirement (assets under management) – 0.02% of the firm’s average AUM; and

• K-COH requirement (client orders handled) – 0.1% of average cash on hand (COH) attributable to cash trades and 0.01% of average COH attributable to derivatives trades

For reference, here is the full list of K-factors:

How does the new regime impact your investment firm?

Under the IFPR, capital requirements have been intensified and, in most cases, will require a specialist compliance team to deal with it.

It must be noted that K-factors will need to be calculated regardless, but will only be required within capital calculation if it is the highest of the three between PMR, fixed overheads and K-factors.

Confused about K-factors, have questions or need help managing the new IFPR? Then get in touch with our team of experienced financial compliance experts!

FinTech Compliance provides comprehensive compliance consultancy to financial services firms throughout the UK, including those in the growing FinTech sector. We’re available to provide ad-hoc support or to keep your firm compliant with award-winning retainer services starting from just one day a month.