FCA Assessing adequate financial resources

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The FCA’s “FG 20/1 Our framework: assessing adequate financial resources” was published on 11 June 2020 and will impact in the region of 45,000 FCA regulated firms. The changes represent a radical change in the expectations placed upon firms. The FCA states that their intention is:

To improve the way firms operate so they can take effective steps to prevent harm from occurring, by improving controls and/or reducing the risk in their activities and put things right when they go wrong

The framework provides clarity on three key areas:

  • The role of adequate financial resources in minimising harm;
  • The practices firms can adopt when assessing adequate financial resources; and
  • How the FCA assesses the adequacy of a firm’s financial resources.

The FCA has confirmed that the guidance does not place specific additional requirements on firms because of COVID-19 but emphasises that the crisis underlines the need for all firms to have adequate resources in place and to consider how needs may change in the future.

The guidance has a considerable amount of content and so over the coming weeks, we will focus on a number of specific topics which will be discussed in more depth.

In this article we will look at:

  • What does the FCA mean by “adequate capital resources”? 
  • Assessing adequate resources – what does the FCA expect of firms.  

Adequate capital resources”? 

The assessment of adequate capital resources is based on how much capital the firm needs, compared to how much capital is available.

The FCA expects firms to have an amount of capital which, at all times, is equal to or higher than its assessment of what is necessary. This includes the type and quality of capital and its ability to be used in a going concern or wind-down situation. In addition, the FCA’s view is that firms that have adequate resources will act in the right way, reducing the potential harm to clients.

Firms are required to hold an appropriate level of capital and/or liquid resources to cover potential harm.

Capital includes elements of a firm’s equity and appropriate loss-absorbing debt liabilities which rank behind general creditors, such as share capital and retained earnings, and subordinated debt.

Liquid resources are normally those that firms can convert into ‘cash’ as soon as needed and with minimal loss in value.

What is capital?

From a regulatory perspective, assessing a firm’s available capital requires an understanding of the different definitions of capital.

Capital and its quality are generally defined to include elements of a firm’s equity (such as share capital and retained earnings) and subordinated debt, after deductions for illiquid assets and other items, such as intangibles or investments in subsidiaries.

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.

Need for capital

To assess how much capital is necessary requires a wider assessment of the risks to which firms are exposed. 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 a firm’s financial statements, either 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 haven’t already be accounted for.

Need for liquid resources

Firms need adequate liquid resources to meet their debts as they fall due. Stressed circumstances could result in increased outflows and enhance risks of mismatched cash flows. These include:

  • Payments a firm decides to make to protect its franchise and reputation to stay in business;
  • Debts arising from direct or indirect costs of litigation, redress or fines;
  • Increased margin calls from exchanges, central clearings or clearing members; and
  • Payments regarding off-balance sheet commitment

The FCA expects firms to have adequate capital to:

  • Ensure they are able to incur losses and remain solvent or fail in an orderly way, and
  • Drive the right behaviour

The FCA state that there are a number of reasons they require firms to have adequate resources these includes:

  • Compensation and redress schemes;
  • Enforcement and fines;
  • Direct and indirect litigation costs; and
  • ‘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.

Having adequate financial resources allows firms to operate and provide services through the economic cycle as well as allowing for an orderly wind-down without causing undue economic harm to consumers or to the integrity of the UK financial system.

Assessing Adequate Resources

In the guidance, the FCA refers to a number of things that a firm needs to do to ensure that the potential harm to the markets and clients is reduced.

Systems and controls, governance and culture

An adequate risk management and controls framework needs to be supported by effective governance, leadership and a purpose. These elements should drive a culture that allows firms to identify, assess, manage, monitor and mitigate the risk of harm. They should help firms to anticipate problems and take effective steps to prevent them from occurring or rectify problems when they occur.

Identify and assess the impact of harm

Identifying the potential harm, to consumers and markets, should help a firm understand what can go wrong, so that it can implement controls to minimise the risk of this happening.

Firms should consider ‘what if’ scenarios and estimate the potential impact. This is to determine the amount and type of financial resources needed to put things right when they go wrong.

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

The potential depletion of financial resources, or inability to monetise assets when needed, may impair a firm’s ability to put things right when they go wrong. Firms should identify, understand, and assess all the material risks which can affect the level of financial resources they have available, not just those which cause direct harm to customers and markets. This is important to minimise the risk of a firm not being able to put things right when they go wrong.

Viability and sustainability of the business model and strategy

Understanding a firm’s business model and strategy helps identify the emerging risk of harm and if there is a misalignment between firms’ profit incentive and the interests of consumers and financial markets. The risks of harm may be heightened if firms are under significant pressure for financial performance or on the verge of failure. Understanding a firm’s financial vulnerabilities and proximity to failure is important to minimise its impact.

Wind-down planning

Wind-down planning aims to reduce the impact of a firm’s failure and is highly encouraged. This typically covers: 

  • Scenarios leading a firm to wind-down its business;
  • Potential impact on consumers and financial markets;
  • Operational tasks required and time necessary to execute each task;
  • Capital to absorb winding-down costs and additional losses; and
  • Liquid resources necessary to support cash outflows

Actions for Firms

  1. Firms need to ensure that they have adequate resources at all times, and this should be an agenda item for Board meetings, if it isn’t already
  2. Management Information should be in place to ensure that senior management are fully aware of the firm’s capital position at all times
  3. Risk assessments should be reviewed to ensure that risks have been identified and that there are adequate controls in place to reduce failure and harm to the markets and clients
  4. Ensure that there is a regular review of wind-down planning, ensuring that it is realistic and achievable
  5. Regularly review the firm’s business model and strategy to ensure that is stainable and doesn’t lead to erosion of capital

Help and advice

If you require any assistance with understanding the capital adequacy requirements or require us to carry out a review of your current policies and processes, please do not hesitate to get in touch.