Broking Business – Winter 2019/20
In June 2019, the FCA published its consultation paper CP19/20 ‘Assessing Adequate Financial Resources’. It explains the importance of financial resources In helping firms to minimise harm and risk, how to assess these internally and what to expect from the FCA’s assessment. Paul Goldwin reports.
The FCA has emphasised that this is not merely an attempt on their part to get firms to overload on financial resources. Rather, it is taking a proportionate and risk-based approach to the supervision of firms.
It expects firms to assess what they perceive to be their adequate financial resources commensurate to the risk of harm to consumers and the complexity of their business. Firms should start with the premise that there must always be enough assets to cover their debts and liabilities. This is based on the Insolvency Act 1986 guideline to ‘have sufficient cash-flow to meet liabilities as they fall due’ and the balance sheet test of having ‘sufficient assets to cover liabilities’.
What is the role of adequate financial resources?
Firms were already required to consider their level of financial resources through two other sets of guidelines: COND 2.4 Appropriate Resources and PRIN 2.1.1 Principle 4 – Financial Prudence. But this new FCA paper is more succinct and provides a steer for the whole life of an organisation.
Why are adequate financial resources so vital? Because they mean firms are not only financially viable, but can also carry out an orderly wind-down, without causing undue harm to consumers or to the integrity of the UK financial system.
The FCA expects a firm to conduct its own assessment and may ask that it is submitted for review to see where it fits in the market.
How should firms go about the assessment?
Firms are expected to assess the risks inherent in their business models and hold financial resources proportionate to the nature, scale and complexity of their activities. They must also understand how changes in operational and economic circumstances might affect these risks.
Sometimes things do go wrong, often through factors outside of the control of the firm. So they must identify the potential sources of harm to consumers and markets, and ensure they have adequate resources to estimate its impact and deal with it.
Similarly, firms should consider the risks that may stop them from putting things right. This means assessing the circumstances leading to financial stress, the potential depletion of financial resources and the inability to convert assets into cash in time to pay for obligations as they fall due.
In order to reduce the impact of failure, firms must also explore recovery options and, if unsuccessful, consider their wind-down choices and how to maintain resources during this process so that they exit the market in an orderly manner.
How does the FCA assess the adequacy of a firm’s resources?
In simple terms, the assessment of adequate resources is based on determining how much capital is needed against how much capital is available. The FCA expects firms at all times to have capital which is equal to or higher than its assessment of what is required.
In assessing adequate financial resources, the FCA distinguishes between ‘capital’ and ‘liquid’ resources:
- Capital refers to the elements of a firm’s equity and consists of such items as share capital, retained earnings, subordinated debt less deductions for items such as intangibles, investments in subsidiaries. The value of such items is underpinned by accounting principles.
- Liquidity, on the other hand, is less defined by accounting principles. It depends on the ability of the firm to convert different types of available liquid resources into ‘cash’ to settle debts as they fall due.
To assess how much capital a firm needs to carry requires an overall assessment of the risks to which the firm is exposed.
Expected losses should already be accounted for through provision or impairment of assets. Potential losses depend on the probability of adverse circumstances that will affect the values of the assets and liabilities the firm carries on its balance sheet. The FCA expects firms to have adequate capital to be able to incur losses yet still remain solvent.
How much liquid resources should a firm hold? Enough to be readily convertible into available ‘cash’ to settle debts on time. But having particular regard to: the ability to monetise liquid assets; having diversified liquid assets; the ability to convert cash to the required currency and having free transferability of funds among entities in order to make these readily available.
How should firms manage risk?
In the FCA’s view, a sound risk management framework should help firms to identify, monitor and mitigate potential harm to consumers and markets.
A firm’s risk appetite is the maximum level of risk it is willing to take on to generate acceptable returns from its business activities. The FCA expects firms to measure these risks, and ensure they are understood and communicated across the firm.
Firms must have a clear organisational structure and, as part of their controls framework, should consider risk in their day to day activities. They must also have procedures to manage conflicts of interest and a risk function that is adequately resourced and independent. Although business processes can be outsourced to third parties, firms are responsible for any harm caused by the management of outsourced activities.
“Firms should have a clear and viable business model and strategy to understand how they generate returns and the factors that may affect their ability to continue generating acceptable and sustainable profits”
What causes ‘harm’ and how can it be prevented?
Harm can be caused by many factors. These include: poor conduct as a result of poor financial management; disruption of markets’ proper functioning; disruption to continuity of service; an inability to pay redress or to transfer or return client money and assets.
The regulator requires firms to consider ‘what if’ scenarios for the activities that they undertake, taking into account that all events may not take place at the same time and that some will be covered by insurance.
Part of this is determining whether the risk undertaken is within or outside their risk appetite and therefore deciding if extra controls are required.
How can the business model help?
Firms should have a clear and viable business model and strategy to understand how they generate returns and the factors that may affect their ability to continue generating acceptable and sustainable profits.
The FCA expects firms to look at:
- ‘business as usual’ financial projections
- projections under severe but plausible adverse circumstances
- reverse stress testing.
What if a wind-down is needed?
Finally, the regulator requires all firms to have a ‘wind-down plan’. This aims to reduce the impact of a firm’s closure on the market. It should ensure that they have sufficient resources to pay redress if needed, avoid consumer loss, and have prepared plans for continuity of service.
A wind-down plan must be credible, include realistic timetables and assessments of how financial and non-financial resources are maintained while the firm exits the market.
Firms should undertake both a qualitative and quantitative assessment of their wind-down plan:
- Qualitative assessment should consider: operational tasks required; risks to continuity of service; the provisions of the client asset resolution pack where client money/assets need to be returned; the level of capital and liquid resources available to carry out the wind-down, mindful that these might have depleted through the actions that led to the firm’s failure or closure.
- Quantitative assessment should determine the likely wind-down period (often 3-9 months) and the run-off or closure cost financial provision needed for the exercise. Experience shows that although firms may have sufficient capital to be able to carry out the wind-down, often there is a lack of liquid assets for them to operate the wind-down effectively and avoid harm to consumers.
Does your firm have ‘adequate financial resources’ to meet the FCA’s expectations?
