Funds

The FCA has issued a Consultation Paper (CP19/20) entitled “Our Framework- Assessing Adequate Financial Resources”.  This addresses how regulated firms should approach maintaining “adequate financial resources”. In essence, the Paper takes  the form of Guidance, providing clarity on:-

  • The role of financial resources in minimising harm;
  • The practices firms should adopt when assessing adequate financial resources;
  • The FCA’s own approach to assessment of adequacy.

Purpose

The ultimate aim of the Paper is to encourage better management of risk and resources by firms. The intention is that this in turn will result in less harm being caused to consumers. However if matters do go wrong, better management of resources  means that greater resources will be available to manage the resulting fallout. Of equal importance, it will help reduce the burden on the Financial Services Compensation Scheme. The Paper notes that between 2013 and 2017, the FSCS paid out  £846 million in compensation for FCA firms.

The Paper highlights the requirement under the Financial Services and Markets Act for all regulated firms to meet certain threshold conditions. These conditions include the requirement on a firm to ensure it has adequate resources as embodied in COND 2.4.  The FCA further recognises the importance of this requirement in its Principles for Business. Principle 4  provides that a firm must  maintain adequate financial resources.

The FCA notes that a significant proportion of the firms that it supervises already comply with detailed prudential requirements under EU legislation or FCA rules. For these firms, the contents of the Paper should be considered in conjunction with existing standards. Other firms should use the Paper to help in their own assessments as to whether they have adequate financial resources.

FCA Expectations

Chapter 2 of the Paper sets out the expectations of the FCA. These expectations include:-

  • Firms should develop  financial resources proportionate to the nature, scale and complexity of their activities;
  • An important part of this exercise, is to assess the risks inherent in a business model and potential harms that may arise;
  • Firms need to understand their own business models. This includes  existing and emerging risks and vulnerabilities from changes in operational and economic circumstances;
  • Firms must ensure that their systems and controls, governance and culture enable them to prevent harm occurring;
  • Adequate capital means having sufficient capital available to rectify mistakes when these occur. A firm needs to make a realistic assessment as to where potential harm may occur and the exposure which a firm may have.

In order to meet these expectations, the FCA comments on several key areas that firms should focus on:-

Financial Resources

A firm needs to ensure that it has sufficient permanent capital in the business. This may be equity capital, retained earnings or the like. However, it is equally important to make a realistic assessment of losses and quantify changes in the value of assets and the impact of liabilities on a firm’s capital.

As part of the assessment of the availability of capital, firms need to ensure that there is sufficient capital in liquid form. Firms must meet debts as they fall due.  Capital  also has to be available in cash or readily convertible into cash in certain stressed conditions. Firms need  to be thinking about the extent of liquid resources and the ease with which these may be converted into cash with minimum loss in value. Firms need to plan ahead and in particular for the contingencies when additional cash demands may be made on the business.

Systems and Controls, Governance and Culture

An important feature of any FCA Consultation since the financial crisis 10 years ago, is the culture of a business. “Firm culture shapes the outcomes for consumers and financial markets”. The FCA wants to encourage behaviour and values that drive good outcomes.

One aspect of proper governance is the need to assess and make proper provision for risk appetite. The risk appetite should be communicated, understood and followed across the firm with the risk control framework to manage risks. Management needs to understand a firm’s activities and risks.

Risk of Harm

The FCA considers that identifying and assessing the potential harm to consumers and markets is a fundamental part of assessing adequate financial resources. This is in many ways a corollary of having good governance and risk management systems in place. The assessment of what can go wrong enables a firm to consider if its control mechanisms and financial resources are enough to minimise the risk of harm.

Poor outcomes can lead to customer harm and potential redress. As the FCA sees matters, by considering the likelihood and impact of things if they go wrong, a firm should be able to have in place adequate financial resources.

This involves an element of horizon scanning. The FCA wants firms to consider what additional risks may lead to a depletion of financial resources and plan for this.

Viability of Business Model

The FCA wants firms to focus on how a business generates its returns and the vulnerabilities that may affect its ability to trade profitably. Failure to trade profitably will have a knock on effect on a firm’s ability to generate additional capital to support its activities. Firms should understand their vulnerabilities and develop a risk appetite for dealing with these. They should be looking forward and scenario testing. It is important to consider the effect that  different scenarios will have on the business and plan accordingly.

Wind Down Planning

Firms should have plans as to how to exit the market and how financial and non- financial resources are maintained during a wind down phase.

 

Responses to the Paper are required by 13 September. Fundamentally the only questions posed, are whether the Paper details the correct approach to assessing adequate financial resources.

Frank Doran

Consultant at Brodies LLP
Frank has for many years specialised in the financial regulation and investment fund sectors and regularly advises clients such as banks, asset managers and insurers on compliance with existing legislation and preparing for future developments. His area of expertise includes compliance with the FCA and PRA Rulebooks and legislation that affects companies in the sector such as FSMA, AIFMD, MiFID and EMIR.
Frank Doran