Investment firms subject to the new Investment Firm Prudential Regime (IFPR) will have to review their risk assessments when undertaking their Internal Capital Adequacy and Risk Assessment (ICARA) process. The FCA has provided guidance in Discussion Paper 20/2 and Consultation Paper 21/7 on how to perform a risk assessment under the IFPR, how the ICARA differs from the ICAAP, and how to incorporate the risk assessment into the firm’s own funds and liquid assets requirements.
One key difference between the ICAAP and the ICARA is the requirement to identify and manage risks resulting in (i) material harms arising from the ongoing operation of the firm’s business to its clients, the market in which the firm operates, and the firm itself; as well as (ii) harms that might result from winding down the firm’s business.
In identifying those harms, firms should use the FCA’s FG 20/1 as guidance. Firms should first document their business model and the activities they perform to visualise different harmful scenarios that could result from those activities. The probability of occurrence and severity of the impact of the event should be considered, as well as the possibility of more than one event affecting the firm’s business at a time, whilst incorporating economic fluctuations into the assessment.
Firms can calculate harm impact using existing knowledge on the firm and its business, peer analysis, statistical models, and its use of insurance. The FCA provides a non-exhaustive list of different types of harm that might be caused by investment firms depending on their business model. For example, harms that can affect clients or the market include the breach of an investment mandate, trading errors, and system outages, among others. Potential harm to the firm could include the loss of a client or counterparty on which the firm heavily relies for revenue.
The identification of material harms and their impact will allow firms to perform risk mitigation and, where the harm cannot be fully mitigated through appropriate systems and controls, to assess the extent to which the own funds requirement and the basic liquid assets requirement (which cannot be used to cover the firm’s liquidity needs for ongoing operations) are sufficient to cover any residual harm.
Where a firm’s own funds requirement is calculated as the higher of the K-Factor Requirement (KFR), the Fixed Overhead Requirement (FOR) and the Permanent Minimum Requirement (PMR), the additional own funds found necessary will be added onto the respective Requirement, depending on the nature of the harm, to form the Own Funds Threshold Requirement (“OFTR”).
For example, if the harm caused by the activity of portfolio management is not fully covered by the K-AUM, either because it is unusual or particularly severe, the financial resources needed to address the residual harm will be added onto the K-AUM and, eventually, the total KFR. If a firm realises that the process of winding down significantly increases harm to the point of the capital needs not being covered by the FOR, then the excess is added onto the FOR. The total OFTR needed to comply with the Overall Financial Adequacy Rule (OFAR) will be the higher of the PMR, the KFR with any additional resources required, and the FOR with any additional resources required.
The Liquid Assets Threshold Requirement (“LATR”), required to meet the OFAR, is calculated as the sum of the basic liquid assets requirement and the higher of (i) the firm’s estimate of the liquid assets necessary to fund ongoing operations at any point in time and (ii) any additional liquid assets needed for orderly wind-down that are not covered by the basic liquid assets requirement.
What does this mean for investment firms?
Firms that fall within the scope of the new rules will need to review their risk framework immediately. The new risk categorisations and methods of calculating additional capital will require updated assessments and documentation. The ICARA process will be an annual requirement at the very least and it will come into effect from 1 January 2022.