Sea-change for over 45,000 FCA regulated firms as the assessing adequate financial resources framework is introduced

If you haven't heard about the FCA's "FG 20/1 Our framework: assessing adequate financial resources" (the "Framework") published on 11 June 2020, you aren't alone; with Covid-19 related stories dominating the headlines, this FCA guidance has flown under the radar despite taking effect immediately. However, the consequences of the Framework for 45,000+ FCA regulated firms are dramatic as it represents a radical change in the expectations placed upon them.

Quick Read

The vast majority of FCA-regulated firms are currently not subject to either regular supervisory review or an annual capital adequacy assessment. But these 45,000+ firms can now expect greater regulatory supervision from the FCA to ensure that they operate with sufficient financial resources at all times. Burdens for such firms under the Framework have increased which the FCA providing detailed guidance on what is expected from them:

• Regular assessments of a firm's capital resources (including liquid assets) to ensure they are adequate to avoid insolvency / fail in an orderly way and drive good behaviours, such as compensating consumers they have suffered as a result of a firm’s misconduct;
• Identify and understand the risks inherent with their business and ensure an effective risk management and controls framework is in place to mitigate these risks and prevent harm to consumers and markets;
• Identify all significant harms related to the activities a firm undertakes, including evidence they have considered 'what-if' scenarios;
• Have forward-looking financial projections and strategic plans, under both business-as-usual and adverse circumstances, and undertake reverse stress testing; and
• Have a credible wind-down plan that has realistic timescales and assessments of how financial and non-financial resources are maintained while the firm exits the market.

Failure to comply with the new Framework could lead to the FCA issuing fines against firms, making public announcements relating to the breaches and, in serious circumstances, withdrawing a firm's authorisation.

If you need advice to ensure your firm complies with the new Framework, contact us. We can help you assess your capital resources, review your firm's systems, controls, strategy and business models, understand the potential risks and harms inherent with your business and prepare a wind-down plan.

Detail

Who is affected? 

The FCA splits the firms they firms they regulate into 3 'classes':

*(as at July 2019).

Firms in Class 1 and 2 are already subject to high levels of FCA supervision and the Framework probably won't affect them; they likely already comply with the new requirements it imposes.

However, the Framework means the 45,000+ firms in Class 3 face a sea change in what is expected of them and many will need to adapt to ensure they can comply.

What changes can Class 3 firms expect?

Until the Framework was introduced, the FCA's only requirement of Class 3 firms was a nebulous general obligation to operate with "adequate resources". At least once year, the FCA required firms to assess the risks inherent in their business model and the potential harm that could occur. The bottom line to the FCA's amorphous position was that firms needed to have enough capital to remedy mistakes and ensure they were not exposed to a disproportionate amount of risk. 

However, the Framework now sets out detailed requirements for firms:

1. Financial resources

Firms must undertake an assessment of capitals resources there is adequate capital to:

• ensure they are able to incur losses and remain solvent or fail in an orderly way;
• drive the right behaviour (such as compensating consumers they have suffered as a result of a firm’s misconduct, paying FCA fines and pay direct or indirect legal costs).

Firms must have an amount of capital which, at all times, is equal to or higher than its assessment of what is necessary. For firms with limited potential to cause harm, meeting debts as they fall due may be enough to show they have adequate financial resources. For firms with potential to cause significant harm, a more in-depth assessment is likely to be required.

The Framework also states that firms must have adequate liquid resources to meet their debts as they fall due. The risk of mismatched cash flows is enhanced in stressed situations which result in increased outflows, such as:

• 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
• payments regarding off-balance sheet commitment

2. Systems and controls, governance and culture

Firms must identify and understand the risks that arise from their activities and the way they conduct their business. These should be translated into a clear and quantified risk appetite which is communicated, understood and followed across the firm.

The FCA expects firms to have an effective risk management and controls framework that allows risks to be managed and to mitigate the risk of potential harm caused to consumers and markets. Indicative 'good' behaviours and values will be used by the FCA to assess how management are approaching these issues.

3. Identifying and assessing the risk of harm

The FCA expects firms to identify all significant harms related to the activities they undertake and page 18 of the Framework sets outs examples of potential harms caused by the activities of different firms.

The FCA also expects firms to assess how their actions, the actions of others performing outsourced functions, or the failure of systems and controls, might cause harm to consumers or financial markets, including considering ‘what-if’ scenarios for the activities undertaken.

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

Firms are required to consider additional risks that may deplete the level of their available financial resources and cause harm. This includes assessing the:

• book value of assets in different scenarios (e.g. write-downs due to non-recoverability);
• failure of counterparties to settle transactions which might cause loss to firms (e.g. derivative contracts);
• change in value of positions due to movements in market prices or other events (e.g. operational failures);
• pension obligations of the firm;
• potential for a lack of liquid resources resulting from franchise payments, unexpected obligations or funding management.

5. Viability and sustainability of the business model and strategy

Firms are expected to consider forward-looking financial projections and strategic plans, under both business-as-usual and adverse circumstances that are outside their normal and direct control. This helps a firm to understand the risks to viability of its business model and the sustainability of its strategy over a period of at least 3 years.

The FCA also expects firms to undertake reverse stress testing by considering scenarios of adverse circumstances affecting a firm’s business model and strategy, where the ability to generate returns is beyond a firm’s risk appetite to stay in business, or where the firm is unable to meet its legal requirements to remain solvent, determined as the point of non-viability.

6. Wind-down planning 

Firms are expected firms to have a credible wind-down plan that has realistic timescales and assessments of how financial and non-financial resources are maintained while the firm exits the market.

The FCA considers reasons where a firm’s senior management would decide to wind-down its business such as:

• the firm’s risk appetite regarding business model viability and the different scenarios in which it would decide or be forced to wind-down its business;
• how different scenarios would affect financial resources available at the moment a decision is made.

Next steps? 

For many Class 3 firms an overhaul of their governance, accounting and stress-testing structures will be required to ensure they can comply with the Framework. As the FCA increases it scrutiny of these firms they should develop clear strategies to ensure compliance with the Framework and ensure meticulous records are kept.