The Investment Firms Prudential Regime (IFPR) began on 1 January 2022. We publish initial observations on how firms are implementing requirements on the internal capital adequacy and risk assessment (ICARA) process and reporting under the IFPR. Firms should consider these and how they can strengthen their processes.
1. Who will this interest
This multi-firm review will be of interest to all firms, and to the UK parent entities of investment firm groups, in scope of the IFPR.
2. What you need to do
This publication includes our initial observations on how firms are implementing the IFPR in relation to the ICARA process and reporting. None of the following constitutes a change in FCA policy. Firms should refer to our rules and guidance on assessing adequate financial resources under the Prudential sourcebook for MiFID Investment Firms (MIFIDPRU) and review these observations to help them understand our existing policy. They should consider whether to apply any of these observations to their processes.
The Investment Firms Prudential Regime (IFPR) is the new prudential regime for MiFID investment firms which includes, but is not limited to, fund managers, asset managers, trading firms, depositaries, and investment platforms.1 The IFPR and the corresponding prudential standards under MIFIDPRU began on 1 January 2022. The IFPR introduced a requirement for all firms in scope of the regime to complete an internal capital adequacy and risk assessment (ICARA) process. Through the ICARA process, firms identify the risk of harm in their operations and provide appropriate resources to mitigate harm, whether as a going concern or when winding down.
To support firms as they adapt to the new prudential standards, we held various briefings and discussion forums. We are also carrying out a multi-firm review. This review aims to assess the progress of firms in adopting the new regime, including the conduct of their ICARA processes. The review supports our commitment within our 3-year strategy to help reduce and prevent serious harm. We provide initial observations from the first part of this review to assist firms in understanding and meeting the requirements and enhancing their processes.
Our review is focused on capital adequacy, liquidity adequacy and wind-down planning under the ICARA process, as well as regulatory reporting. Most firms engaged well in our review and progress has been made in understanding the requirements. While firms have applied the relevant MIFIDPRU provisions, our review highlighted the following areas for firms to improve on. These are discussed in full in Section 5:
- For firms which are part of investment firm groups, most opted to complete a ‘group ICARA’ process. However, for most of these, there was insufficient consideration of firm-specific risk and harms in the assessment of threshold requirements of individual firms required by MIFIDPRU.
- Among investment firm groups who completed an ICARA process on a ‘consolidated basis’, we observed that only a few of them also operated solo ICARA processes by independently assessing the financial resource requirements of individual firms in the group, as required by MIFIDPRU.
- The assessments made as part of the ICARA process should be cohesive. They should also be fully integrated in the firm’s approach to managing financial resources to mitigate the risk and harms from its operations. This is not happening consistently within the initial group of firms reviewed.
- Wind-down planning assessments remain weak in terms of scope and quantification. This reflects an incomplete understanding of the purpose of the exercise and of guidance previously provided.
- We have seen inconsistent and inaccurate data submitted in regulatory reports. Firms should ensure that all data submitted is accurate and of high quality.
4. What we did
4.1. General context
The IFPR aims to streamline and simplify the prudential requirements for MiFID investment firms that are prudentially regulated by the FCA in the UK – known as MIFIDPRU investment firms. It refocuses prudential requirements and expectations beyond the risks the firm faces, to also consider and look to manage the potential harm the firm itself can pose to consumers and markets.
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.
The ICARA process brings together our requirements for business model analysis, stress-testing, recovery planning and actions, and wind-down planning. Through the ICARA process, firms assess their risk of harm and produce reasonable estimates of own funds and liquid assets threshold requirements to mitigate harm. Firms must hold financial resources to meet these requirements at any given time, to comply with the OFAR. The ICARA process may be assessed by our supervisory review evaluation process.
Under MIFIDPRU, we also set out new guidance on intervention points, the actions we expect of firms in certain situations and what they can expect from us.
The MIFIDPRU requirements and guidance provided should be read alongside the requirements in other sections of the FCA Handbook and other publications, such as our previous guidance on wind-down planning, guidance on assessing adequate financial resources, and observations on wind-down planning.
4.2. Our review approach
Our review is focused on capital adequacy, liquidity adequacy and wind-down planning. This included reviewing how firms assessed their threshold requirements through their ICARA process and what framework they had adopted to manage financial resources. If these are appropriately considered, managed, and structured, customers and financial markets can have greater confidence that firms can address harms from their operations, mitigate them and reduce harm from firm failure.
We selected a sample of investment firms and investment firm groups covering various business models for inclusion in the review. Included were some of the largest and best-resourced investment firms or firm groups. The review included:
- Bilateral discussions with firms, including with senior members of the Board and management teams, on their approach to assessing risks and harms, quantifying own funds and liquid assets threshold requirements and the framework applied to managing own funds and liquid asset resources.
- Reviewing ICARA documentation and other relevant information.
We also separately reviewed the quality of data submitted by firms to comply with MIFIDPRU reporting requirements.
5. Key observations
5.1. ICARA process – investment firm groups
Lack of adequate assessments of threshold requirements for individual investment firms within investment firm groups
Under MIFIDPRU, investment firms are ordinarily required to complete an ICARA process individually. This means a firm looks specifically at the harm caused by its activities and risks sustained by its operations, including any impact of its membership in a group of firms.
An investment firm group may alternatively choose to complete a ‘group ICARA process’ subject to the conditions outlined in MIFIDPRU 7.9.5R. This means the analysis of the financial impact of risk is carried out at group level, there is a single process, and the investment firm group likely completes one set of group documents, but the assessment must still consider the risks that each individual firm in the group faces. The assessment of individual firm risks must be adequately captured in the group documentation. This ‘group ICARA process’ must result in each individual firm identifying the relevant threshold requirements, risk appetite and triggers for capital, liquid assets, and wind-down appropriate to its operations. The financial resources needed to mitigate harm from each individual firm’s operations must be held within each individual firm.
Where the investment firm group, and the risks arising from it, are operated and managed as a group, there is no requirement to adopt new approaches to assess the risk at group level. However, when the assessment is allocated to the individual entities, senior management of each individual entity must clearly demonstrate that they have understood and assessed the impact of adjustments considered at group level, such as diversification effects. The resulting threshold requirement and financial resource levels for each firm must remain appropriate for its own risks so that it remains resilient and can be wound down in an orderly way.
We observed that most investment firm groups opted to complete a ‘group ICARA process’. There were challenges, however, with how the individual entity requirements were dealt with. Specifically, we saw the following issues.
- The assessment of threshold requirements of individual firms within the group did not always comprehensively consider the risk and harms sustained by each firm individually. Group level numbers based on a consolidated view, were not adjusted to eliminate the effect of intragroup offsets, after they were allocated to the individual firms.
- A group level assessment of financial resource requirements was, in some cases, allocated to individual firms without clearly considering whether this was appropriate for the individual firm.
- The financial resource requirements to support a group level wind-down were also often allocated without a clear link to the specific actions required to wind-down each individual firm.
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. Senior management of firms, customers and the financial markets will have little confidence that the individual firms are resilient and that the risks of harm they pose have been properly considered and mitigated.
As an additional option, where appropriate, we may invite or require an investment firm group to operate an ICARA process on a ‘consolidated basis’ as indicated in MIFIDPRU 7.9.4G. This is different from the ‘group ICARA process’ as it is based on the ‘consolidated situation’ i.e., as if the entire investment firm group were treated as forming a single hypothetical MIFIDPRU investment firm. This invitation or requirement means that each individual entity undertakes a solo ICARA process. In addition, the consolidated information for the group is used to produce at consolidated level a single set of threshold requirements and triggers. Both consolidated and solo threshold requirements should then be monitored.
If an investment firm group wishes to operate an ICARA process on a ‘consolidated basis’ and to report the outputs to the FCA, it may agree a voluntary requirement (VREQ) with us to operate a consolidated ICARA process. The VREQ will provide clarity on the process, including governance of the ICARA process, how the various threshold requirements apply on a consolidated basis, and reporting requirements.
In some instances, firms purported to complete a ‘consolidated ICARA process’ without a VREQ. Although firms can choose to complete a ‘consolidated ICARA process’ voluntarily, we will not recognise the outcome of the process without a VREQ and encourage firms, who wish to use this option, to voluntarily get one. Otherwise, there will be no clarity on how the process and reporting requirements will operate.
We also observed that, where a consolidated ICARA process was completed, there were only a few cases where solo ICARA processes were also completed for each of the MIFIDPRU investment firms in the same group. 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.
For firms which are part of an investment firm group, an overall group-wide view of risks and harms remains essential in assessing threshold requirements and in managing the financial resources of each individual entity. Without this, the individual entity’s understanding of its risks and the harms from its operation is incomplete.
5.2. ICARA process assessments
Absence of unified and integrated assessments
Assessments made as part of some firms’ ICARA process were not linked and integrated with each other. We also found a mismatch with some firms’ ICARA analysis between the risks assessed and the risk management process used. This will lead to insufficient understanding of harms from the firm’s operations and inappropriate mitigation measures.
Some firms did not adequately assess the risks they face or use these assessments to inform elements of their ICARA process including their risk appetite, risk indicator triggers, early warning indicators, stress testing scenarios, and the estimates of own funds and liquid assets required. Similarly, some firms did not consistently use reverse stress testing to help decide the scenarios they used to trigger and quantify the cost of a wind-down plan.
For some firms, the wind-down planning process was not integrated in the assessment of own funds and liquid assets and had no clear link to the estimates of threshold requirements. This does not meet the standards set under MIFIDPRU.
Inadequately explained reduction in risk capital
We saw a significant reduction in the capital requirement in several firms, compared to their assessment under the previous regimes, for operational risk, credit risk and market risk. Some firms assessed no capital requirement for certain types of risk, against which capital was previously held. In some cases, these reductions were not adequately explained. Some firms excluded certain types of risk in their assessments simply because the mechanical K-Factor calculations do not include a formula to cover these risks, despite acknowledging that these are risks which the firm continues to face.
Among IFPR’s aims is to simplify prudential standards. This enables firms to apply approaches to estimating capital which are proportionate to their business. Minimum capital requirements for certain types of risk, including those for credit and market risk, which were prescribed under previous prudential regimes have not been retained under IFPR. However, unless business models have changed, firms will continue to be exposed to the same risks. Firms should be taking account of and documenting all material risks they face including those from non-regulated and non-MiFID activities, and risks and harms not specifically covered by K-factor calculations.
We expect firms should only stop holding capital for risk types – which systems and controls alone are unable to mitigate fully or are assessed as immaterial – where those risks genuinely do not flow from the business model. In that circumstance, we would expect such a change be captured and explained within the ICARA document.
Lack of comprehensive own funds and liquid assets triggers and limits framework
Appetite thresholds and trigger points help firms anticipate problems, take effective steps to prevent them and rectify problems when they occur. It is therefore essential that they are aligned to the firm’s own understanding of its risks. Although most firms identified own funds and liquid asset appetite thresholds or triggers, we saw instances where these appetite levels merely used levels and triggers defined within MIFIDPRU without any link to the firm’s understanding of its risk. The firms’ own assessments of resources needed to support an orderly wind-down were often missing from their metrics. Many firms also have not tested the credibility of their intervention points around a wind-down decision – for instance by using a reverse stress scenario.
Wind-down triggers and early warning indicators specified in MIFIDPRU 7.6.11 and MIFIDPRU 7.7.14 may trigger the interventions by the FCA as explained in MIFIDPRU 7.6.15G and MIFIDPRU 7.7.17G. Under MIFIDPRU, firms should define their own internal framework of managing financial resources consistent with their own analysis and assessments from the ICARA process. The ICARA document should explain why these internal frameworks are appropriate for their business model.
Some firms were not clear on whether their interventions points lead to discussions, trigger specific actions, or immediately set in motion tougher measures such as invoking the wind-down plan. Under MIFIDPRU, firms must identify the steps and resources required to ensure an orderly wind-down, so firms should clearly communicate the actions required at each internal intervention point. This enables firms to have working playbooks that help them navigate in a crisis and mitigate harm.
In FG20/1, we stated that we expect firms to consider whether they continue to have adequate capital to ensure they can sustain losses and remain solvent, and to have adequate resources to minimise harm in failure. We observed that in cases where the own funds threshold requirement (OFTR) and/or the liquid assets threshold requirement (LATR) are driven by the level of resources needed to support an orderly wind-down, most firms have not adequately met this expectation. Risk appetite statements and the internal limit frameworks have not been set up to consider that, under these circumstances, once OFTR/LATR is breached, the need to commence a wind-down process becomes urgent. Without this understanding, the firm is unable to define appropriate intervention points which help ensure that it can continue to absorb losses and remain solvent before needing to trigger an adequately resourced orderly wind-down.
In line with MIFIDPRU and FG20/1, we expect firms to consider their on-going stress testing when developing their internal limit framework. Firms should further assess whether the internal limit framework and internal intervention points actions are appropriate. In cases where the threshold requirements are equal to the level of resources needed to support an orderly wind-down, actions must be aligned with there being no room for the firm to absorb any further stress should the level of own funds or liquid assets reach the threshold requirement. We expect to be informed of any breach of these internal intervention points under the firms’ obligation under Principle 11 for Businesses.
Previous FCA feedback not fully acted upon
We observed that several firms have not fully acted on feedback previously provided, particularly around approaches to capital and liquidity. MIFIDRU is a new set of prudential standards, however the risks and processes needed to manage those risks are comparable to previous regimes. Where relevant, previous feedback should still be considered within the ICARA process.
Insufficient governance and Board & Executive involvement in ICARA
We note differing degrees of engagement by the Board and their delegated committees in the ICARA process. Some have a very detailed understanding of the firm’s activities, operations, the risks, and the appropriateness of controls. These have been able to make relevant challenges to the assumptions and articulation of risks within the ICARA document. Others have not provided sufficient challenge and oversight over key elements of the ICARA process, and so approved a process which does not provide confidence that the individual firm’s risks are adequately identified or addressed, and therefore whether harm could be caused through the failure of the firm.
Firms demonstrating best practices aided their senior executive and boards by providing in-depth training on IFPR. This training set out the fundamentals of the new regime to enable Boards and committees to provide suitable challenge to the ICARA. Having adequate support and the exercise of appropriate diligence are fundamental requirements under the Senior Management & Certification Regime (SM&CR).
5.3. Wind-down plans
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. It is essential that the wind-down plans are updated, relevant and comprehensive. Under MIFIDPRU, firms are required to hold own funds and liquid assets which are adequate to support ongoing activities and an orderly wind-down. Wind-down planning is therefore also an integral part of assessing the own funds and liquid assets threshold requirements.
We found that compared to the assessment of own funds and liquid assets to support ongoing activities, the assessment of resources to support an orderly wind-down is less robust. This is evidenced in unrealistic assumptions, insufficiently detailed modelling, and poorly justified estimates of resources needed to support an orderly wind-down. Common gaps are discussed further below. 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.
Stress backdrop is not always considered
We observed that several firms completed wind-down planning estimates without a starting scenario of stress or a sudden trigger event. Many firms estimated wind-down resources without considering a backdrop of stress, potentially under-estimating resources required.
Wind-down likely occurs following, or during, a significant stress. Recognising a stressed environment materially impacts assumptions around counterparty, outsourcer, and client behaviours. For instance, the timing of cash outflows may change as suppliers become concerned about the firm’s ability to meet obligations, or as clients opt to transfer their business at a faster rate. The amount realised from asset sales will most likely be less than their carrying value in what may be perceived as a distressed sale. Additional liquidity strain may also result from credit clauses being triggered.
Recognising a stressed environment allows the firm to prepare necessary action to manage its impact. The aim is for the firm to have a plan it can operate. Considering a potential stressed chain of events at the start and during the process will make the plan useful, strong, and prudent.
Little consideration of group membership
We observed little consideration of group risk in wind-down plans. Group membership can result in the firm having critical wind-down dependencies on group entities over which they have no control, and which may be susceptible to stress.
For instance, where there is a dependency on a group service company, firms should consider the financial resilience of the service company and the impact of a group wide stress. It may be possible that the firm will be required to provide additional financial support to the service company. Under FCA’s wind-down planning guide, we expect firms to clearly explain their appetite for dependency on group in a wind-down, with a clear assessment of the impact of these dependencies on the plan and the identification of required mitigating actions.
Incomplete analysis of wind-down requirements
We observed instances where the scope of the wind-down plan was not comprehensive with several elements missing in the analysis. Activities or circumstances unique to the firm, such as bespoke processes, obligations, or products, had not been specifically assessed.
We reiterate the expectations outlined in the FCA’s wind-down planning guide and in FG20/1 on the assessment of resources for an orderly wind-down. These include the following areas.
- Key findings of the wind-down plan. Particularly the wind-down strategy, financial and non-financial resources required, and any existing gaps.
- Wind-down actions including triggers points.
- Key underlying assumptions in the wind-down plan, including around the continued survival of specific group entities providing services to the firm.
- Scenario used as the backdrop to identify assumptions and modelling methodology.
- Detailed information on cashflow forecast, capital estimates, future work on the wind-down plan.
- Steps taken to test the credibility of the firms’ wind-down plans, in particular, simulated exercises and validation against a reverse stress test.
5.4. Data Quality
Inaccurate or incomplete data submissions
We observed some firms providing inaccurate or incomplete data in their regulatory submissions. We consider the poor quality of regulatory data submissions to be an indicator of weaknesses in firms' systems and controls. This may also breach senior managers’ 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 we would reasonably expect notice.
Our expectations related to data accuracy have been outlined in previous ‘Dear CEO’ letters on Transforming data collection (February 2021) and Quality of Prudential Regulatory Returns (February 2018).
The transition to IFPR is an opportunity for firms to review their regulatory reporting practices and ensure that all regulatory reporting submissions are accurate. Where relevant, these regulatory submissions should also be consistent with the ICARA, annual accounts and management information. Under the internal governance requirements in MIFIDPRU 7 and SYSC, firms should also consider whether their internal audit functions have adequate oversight of regulatory reporting process and ICARA documents.
6. Next steps for our review
Firms included in this initial part of the multi-firm review have received written feedback letters. We will follow up with them through our usual supervisory activities.
We are continuing with this multi-firm review. We intend to publish a concluding report after completion of the review. We may also publish further interim observations, where appropriate.