BIPRU 2.2 Internal capital adequacy standards

BIPRU 2.2 applies to a BIPRU firm.

1. (1)

   BIPRU 2.2 sets out guidance on GENPRU 1.2 (Adequacy of financial resources) so far as it applies to a BIPRU firm. In particular it sets out guidance on how a firm should carry out its ICAAP, as well as some factors the FSA will take into consideration when undertaking a SREP. The terms ICAAP and SREP are explained in BIPRU 2.2.4 G. BIPRU 2.2.41 R-BIPRU 2.2.43 R are rules that apply to a firm with an IRB permission.

2. (2)

   BIPRU 2.2 is for the most part written on the basis that GENPRU 1.2 (Adequacy of financial resources) applies to a firm on a solo basis. However it is still relevant when GENPRU 1.2 applies on a consolidated basis. When GENPRU 1.2 applies on a consolidated basis, BIPRU 2.2 should be read with appropriate adjustments.

For the purpose of BIPRU 2.2, "capital" refers to a firm's financial resources, capital resources and internal capital, all as referred to in the overall Pillar 2 rule.

The adequacy of a firm's capital needs to be assessed both by a firm and the FSA. This process involves:

1. (1)

   an internal capital adequacy assessment process (ICAAP), which a firm is obliged to carry out in accordance with the ICAAP rules; and

2. (2)

   a supervisory review and evaluation process (SREP), which is conducted by the FSA.

The obligation to conduct an ICAAP, includes requirements on a firm to:

1. (1)

   carry out regularly assessments of the amounts, types and distribution of financial resources, capital resources and internal capital that it considers adequate to cover the nature and level of the risks to which it is or might be exposed (GENPRU 1.2.30 R to GENPRU 1.2.41 G (the overall Pillar 2 rule and related rules);

2. (2)

   identify the major sources of risk to its ability to meet its liabilities as they fall due (the overall Pillar 2 rule);

3. (3)

   conduct stress and scenario tests (the general stress and scenario testing rule), taking into account, in the case of a firm with an IRB permission, the stress test required by BIPRU 4.3.39 R to BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy for a firm with an IRB permission);

4. (4)

   ensure that the processes, strategies and systems required by the overall Pillar 2 rule and used in its ICAAP, are both comprehensive and proportionate to the nature, scale and complexity of that firm's activities (GENPRU 1.2.35 R); and

5. (5)

   document its ICAAP (GENPRU 1.2.60 R).

Where a firm is a member of a group, it should base its ICAAP on the consolidated financial position of the group. The group assessment should include information on diversification benefits and transferability of resources between members of the group and an apportionment of the capital required by the group as a whole to the firm (GENPRU 1.2.44 G to GENPRU 1.2.56 G (Application of GENPRU 1.2 on a solo and consolidated basis: Processes and tests)). A firm may, instead of preparing the ICAAP itself, adopt as its ICAAP an assessment prepared by other group members.

A firm should ensure that its ICAAP is:

1. (1)

   the responsibility of the firm's governing body;

2. (2)

   reported to the firm's governing body; and

3. (3)

   forms an integral part of the firm's management process and decision-making culture.

The FSA will review an ICAAP and, if the firm has an IRB permission, the result of the firm's stress test carried out under BIPRU 4.3.39 R to BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy for a firm with an IRB permission), as part of its SREP. Provided that the FSA is satisfied with the appropriateness of a firm's capital assessment, the FSA will take into account that firm's ICAAP and stress test in its SREP. More material on stress tests for a firm with an IRB permission can be found in BIPRU 2.2.41 R to BIPRU 2.2.45 G.

The SREP is a process under which the FSA:

1. (1)

   reviews the arrangements, strategies, processes and mechanisms implemented by a firm to comply with GENPRU, BIPRU and SYSC and with requirements imposed by or under the regulatory system and evaluates the risks to which the firm is or might be exposed;

2. (2)

   determines whether the arrangements, strategies, processes and mechanisms implemented by the firm and the capital held by the firm ensures a sound management and coverage of the risks in (1); and

3. (3)

   (if necessary) requires the firm to take the necessary actions or steps at an early stage to address any failure to meet the requirements referred to in (1).

As part of its SREP, the FSA may ask a firm to provide it with the results of that firm's ICAAP, together with an explanation of the process used. Where appropriate, the FSA will ask for additional information on the ICAAP.

As part of its SREP, the FSA will consider whether the amount of capital which a firm should hold to meet its CRR in GENPRU 2.1 (Calculation of capital resources requirements) is sufficient for that firm to comply with the overall financial adequacy rule. Where the amount of capital which the FSA considers a firm should hold is not the same as that which results from a firm's ICAAP, the FSA expects to discuss any such difference with that firm. Where necessary, the FSA may consider the use of its powers under section 166 of the Act (reports by skilled persons) to assist in such circumstances.

After completing a review as part of the SREP, the FSA will normally give that firm individual guidance (individual capital guidance), advising it of the amount of capital which it should hold to meet the overall financial adequacy rule.

If a firm considers that ICG given to it is inappropriate to its circumstances it should, consistent with Principle 11 (relations with regulators), inform the FSA that it disagrees with that guidance. The FSA may reissue individual capital guidance if after discussion with the firm the FSA concludes that the amount of capital that the firm should hold to meet the overall financial adequacy rule is different from the amount initially suggested by the FSA.

The FSA will not give individual capital guidance to the effect that the amount of capital advised in that guidance is lower than the amount of capital which a firm should hold to meet its CRR.

If, after discussion, the FSA and a firm still do not agree on an adequate level of capital, the FSA may consider using its powers under section 45 of the Act to vary on its own initiative a firm's Part IV permission so as to require it to hold capital in accordance with the FSA's view of the capital necessary to comply with the overall financial adequacy rule. SUP 7 provides further information about the FSA's powers under section 45.

If the FSA gives individual capital guidance to a firm, the FSA will state what amount and quality of capital the FSA considers the firm needs to hold in order to comply with the overall financial adequacy rule. It will generally do so by saying that the firm should hold capital resources of an amount which is 3at least equal to a specified percentage of that firm's capital resources requirement. Such amount should be sufficient to enable the firm to continue to meet the overall financial adequacy rule in the face of the adverse circumstances and events to which GENPRU 1.2.42 R (2) refers, taking account of any risk mitigation available to the firm.3

1. (1)

   Individual capital guidance may refer to two types of capital resources.

2. (2)

   The first type is referred to as general capital. It refers to total tier one capital resources and tier two capital resources after deductions.

3. (3)

   The second type is referred to as total capital. It refers to total tier one capital resources, tier two capital resources and tier three capital resources after deductions.

1. (1)

   In both of the cases in BIPRU 2.2.17 G capital resources should be calculated in the same way as they are in GENPRU 2.2 (Capital resources). This includes the rules limiting the amount of capital that can be included in the various tiers of capital when capital resources are being calculated.

2. (2)

   GENPRU 2.2.42 R does not allow innovative tier one capital to count as tier one capital resources for certain purposes. This restriction does not apply for the purposes in BIPRU 2.2.17 G.

1. (1)

   Individual capital guidance may also be given with respect to group capital resources. This paragraph explains how such guidance should be interpreted unless the individual capital guidance specifies another interpretation.

2. (2)

   If BIPRU 8.2.1 R (General consolidation rule for a UK consolidation group) applies to the firm the guidance relates to its UK consolidation group. If BIPRU 8.3.1 R (General consolidation rule for a non-EEA sub-group) applies to the firm the guidance relates to its non-EEA sub-group. If both apply to the firm the guidance relates to its UK consolidation group and to its non-EEA sub-group.

3. (3)

   The guidance will be on the overall financial adequacy rule as it applies on a consolidated basis under GENPRU 1.2.59 R (Application of GENPRU 1.2 on a solo and consolidated basis: Adequacy of resources) and insofar as it refers to capital resources.

4. (4)

   BIPRU 2.2.16 G to BIPRU 2.2.18 G apply for the purpose of this paragraph as they apply to guidance given on a solo basis. References to capital resources should be read as being to consolidated capital resources.

A firm's continuing to hold capital in accordance with its individual capital guidance and its ability to carry on doing so is a fundamental part of the FSA's supervision of that firm. Therefore if a firm's capital resources have fallen, or are expected to fall, below the level advised in individual capital guidance, then, consistent with Principle 11 (Relations with regulators), a firm should inform the FSA of this fact as soon as practicable, explaining why this has happened or is expected to happen and:

1. (1)

   what action the firm intends to take to increase its capital resources or to reduce its risks and hence its capital requirements; or

2. (2)

   what modification the firm considers should be made to the individual capital guidance which it has been given.

In the circumstance set out in BIPRU 2.2.20 G, the FSA may ask a firm for alternative or more detailed proposals and plans or further assessments and analyses of capital adequacy and risks faced by the firm. The FSA will seek to agree with the firm appropriate timescales and scope for any such additional work, in light of the circumstances which have arisen.

If a firm has not accepted individual capital guidance given by the FSA it should, nevertheless, inform the FSA as soon as practicable if its capital resources have fallen, or are expected to fall, below the level suggested by that individual capital guidance.

BIPRU 2.2.20 G - BIPRU 2.2.22 G also apply to individual capital guidance given on a consolidated basis as referred to in BIPRU 2.2.19 G.

BIPRU 2.2.25 G to BIPRU 2.2.27 G set out what the FSA considers to be a proportional approach to preparing an ICAAP as referred to in GENPRU 1.2.35 R (The processes, strategies and systems required by the overall Pillar 2 rule should be comprehensive and proportionate), according to the relative degree of complexity of a firm's activities. If a firm adopts the appropriate approach, it may enable the FSA more easily to review a firm's ICAAP when the FSA undertakes its SREP. The FSA is also likely to place more reliance on an ICAAP which takes the appropriate form described in BIPRU 2.2.25 G to BIPRU 2.2.27 G than would otherwise be the case although there may also be circumstances in which the FSA will be able to rely on an ICAAP that is not drawn up in that form.

1. (1)

   This paragraph applies to a small3 firm whose activities are simple and primarily not credit-related.3

2. (2)

   In carrying out its ICAAP it could:

   1. (a)

      identify and consider that firm's largest losses over the last 3 to 5 years and whether those losses are likely to recur;

   2. (b)

      prepare a short list of the most significant risks to which that firm is exposed;

   3. (c)

      consider how that firm would act, and the amount of capital that would be absorbed, in the event that each of the risks identified were to materialise;

   4. (d)

      consider how that firm's CRR might alter under the scenarios in (c) and how its CRR might alter in line with its business plans for the next 3 to 5 years;

   5. (e)

      consider whether any of the risks in the overall Pillar 2 rule is applicable to the firm (it is unlikely that any of those risks not already identified in (a) or (b) will apply to a firm whose activities are simple);

   6. (f)

      document the ranges of capital required in the scenarios identified and form an overall view on the amount and quality of capital which that firm should hold, ensuring that its senior management is involved in arriving at that view; and

   7. (g)

      (in order to determine the amount of capital that would be absorbed in the circumstances detailed in (c)) carry out simple sensitivity tests where the firm analyses the impact of a shift in the key risk parameters identified in (b) on the earnings of the firm.

3. (3)

   A firm is also expected to form a view on the consolidated amount of capital it should hold as well as the capital required to be held in respect of each of the individual risks identified under the overall Pillar 2 rule. For that purpose, it may conservatively sum the results of the individual tests performed in (2)(c). If the firm chooses however to reduce that sum on the understanding that not all risks will materialise at the same time, then the firm should perform scenario tests that demonstrate that a reduction in capital is legitimate.

4. (4)

   A firm should conduct stress tests and scenario analyses in accordance with GENPRU 1.2.42 R to assess how that firm's capital and CRR would alter and what that firm's reaction might be to a range of adverse scenarios, including operational and market events. Where relevant, a firm should also 3consider the impact of a severe 3economic or industry downturn on its future earnings, capital resources and capital resources requirement,3 taking into account its business plans. The downturn scenario should be based on forward looking hypothetical events calibrated against the most adverse movements in individual risk drivers experienced over a long historical period.3

   3

In relation to a firm whose activities are moderately complex, in carrying out its ICAAP, BIPRU 2.2.25 G (3) to (4) apply. In addition, it could:

1. (1)

   having consulted the management in each major business line, prepare a comprehensive list of the major risks to which the business is exposed;

2. (2)

   estimate, with the aid of historical data, where available, the range and distribution of possible losses which might arise from each of those risks and consider using shock stress tests to provide risk estimates;

3. (3)

   consider the extent to which that firm's CRR adequately captures the risks identified in (1) and (2);

4. (4)

   for areas in which the CRR is either inadequate or does not address a risk, estimate the additional capital (if any) needed to protect that firm and its customers, in addition to any other risk mitigation action that firm plans to take;

5. (5)

   consider the risk that that firm's own analyses of capital adequacy may be inaccurate and that it may suffer from management weaknesses, which affect the effectiveness of its risk management and mitigation;

6. (6)

   project that firm's business activities forward in detail for one year and in less detail for the next 3 to 5 years and estimate how that firm's capital and CRR would alter, assuming that business develops as expected;

7. (7)

   assume that business does not develop as expected and consider how that firm's capital and CRR would alter and what that firm's reaction to a range of adverse economic scenarios might be (see GENPRU 1.2.30 R to GENPRU 1.2.43 G (the overall Pillar 2 rule and related rules and guidance)). Where appropriate, the adverse scenarios should consider the impact of market events that are instantaneous or occur over an extended period of time but which are nevertheless still co-dependent on movements in economic conditions3;

8. (8)

   document the results obtained from the analyses in (2), (4), (6), and (7) in a detailed report for that firm's senior management, and, where relevant, its governing body; and

9. (9)

   ensure that systems and processes are in place to review against performance the accuracy of the estimates made in (2), (4), (6) and (7).

1. (1)

   This paragraph applies to a proportional ICAAP in the case of a firm whose activities are complex.

2. (2)

   A proportional approach to that firm's ICAAP should cover the matters identified in BIPRU 2.2.26 G, but is likely also to involve the use of models, most of which will be integrated into its day-to-day management and operation.

3. (3)

   Models of the sort referred to in (2) may be linked so as to generate an overall estimate of the amount of capital that a firm considers appropriate to hold for its business needs. For example, a firm is likely to use value at risk models for market risk (see BIPRU 7.10), advanced modelling approaches for credit risk (see BIPRU 4) and, possibly, advanced measurement approaches for operational risk (see BIPRU 6.5). A firm might also use economic scenario generators to model stochastically its business forecasts and risks. A firm may also link such models to generate information on the economic capital desirable for that firm. A model which a firm uses to generate its target amount of economic capital is known as an economic capital model (ECM). Economic capital is the target amount of capital which maximises the return for a firm's stakeholders for a desired level of risk.

4. (4)

   A firm is also likely to be part of a group and to be operating internationally. There is likely to be centralised control over the models used throughout the group, the assumptions made and their overall calibration.

5. (5)

   The more a firm integrates into its business such economic capital modelling, the more it is likely to focus on managing risks for the benefit of its stakeholders. Consequently, ECMs may produce capital estimates that differ from the amount of capital needed for regulatory purposes. For the FSA to rely on the results of a firm's models, including ECMs, a firm should be able to explain the basis and results of its models and how the amount of capital produced by its models reflects the amount of capital needed for regulatory purposes. It may be that those amounts are not equal. Where they are not equal, the FSA will expect a firm to discuss any differences with the FSA. However, it may prove difficult to reconcile the outcome of a firm's modelling with the FSA's own assessment of the adequacy of that firm's capital. This may be the case when, for instance, matters of judgment are involved in arriving at a firm's capital assessment, or the FSA relies on information which cannot be fully disclosed to the firm (for example comparisons with the firm's peers). Nevertheless, a firm whose ECM produces a different amount of capital to that required for regulatory purposes is still obliged to comply with the overall Pillar 2 rule. A firm should therefore be able to explain to the FSA how the outcome of its ECM is adjusted so that it complies with the overall financial adequacy rule and the overall Pillar 2 rule.

6. (6)

   Stress testing should provide senior management with a consolidated view of the amount of risk the firm is or might be exposed to under the chosen stress events. Senior management should therefore be presented with information that considers the possibility of the risks materialising simultaneously in various proportions. For instance, it would be misrepresentative to simulate market risk stressed events without considering that, in those circumstances, market counterparties may be more likely to default. Accordingly, a firm could:

   1. (a)

      carry out combined stress tests where assets and liabilities are individually subjected to simultaneous changes in two or more risk drivers; for instance, the change in value of each loan made by a firm may be estimated using simultaneous changes to both interest rates and stock market or property values;

   2. (b)

      integrate the results of market and credit risk models rather than aggregating the results of each model separately; and

   3. (c)

      consider scenarios which include systemic effects on the firm of wider failures in the firm's market or systems upon which the firm depends and also any possible systemic effects caused by the firm itself suffering losses which affect other market participants which in turn exacerbate the firm's position.

7. (7)

   Furthermore, if a complex firm uses an ECM it should validate the assumptions of the model through a comprehensive stress testing programme. In particular this validation should:

   1. (a)

      test correlation assumptions (where risks are aggregated in this way) using combined stresses and scenario analyses;

   2. (b)

      use stress tests to identify the extent to which the firm's risk models omit non-linear effects, for instance the behaviour of derivatives in market risk models; and

   3. (c)

      consider not just the effect of parallel shifts in interest rate curves, but also the effect of curves becoming steeper or flatter.

BIPRU 2.2.30 G to BIPRU 2.2.40 G set out guidance on some of the sources of risk identified in the overall Pillar 2 rule. BIPRU 2.2.41 R to BIPRU 2.2.45 G have material relating to a firm with an IRB permission.

1. (1)

   A firm may take into account factors other than those identified in the overall Pillar 2 rule when it assesses the level of capital it wishes to hold. These factors might include external rating goals, market reputation and its strategic goals. However, a firm should be able to distinguish, for the purpose of its dialogue with the FSA, between capital it holds in order to comply with the overall financial adequacy rule and to meet the risks set out in the overall Pillar 2 rule and that capital held for other purposes.

2. (2)

   The calibration of the CRR assumes that a firm's business is well-diversified, well-managed with assets matching its liabilities and good controls, and stable with no large, unusual or high risk transactions. A firm may find it helpful to assess the extent to which its business in fact differs from these assumptions and therefore what adjustments it might be reasonable for it to make to the CRR to arrive at an adequate level of capital resources.

A firm should assess its exposure to changes in interest rates, in particular risks arising from the effect of interest rate changes on non-trading book activities that are not captured by the CRR. In doing so, a firm may wish to use stress tests to determine the impact on its balance sheet of a change in market conditions.

A firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. A firm should consider the effect on its financial position of a securitisation arrangement failing to operate as anticipated or of the values and risks transferred not emerging as expected.

A firm should assess its exposure to residual risks that may result from the partial performance or failure of credit risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from, for instance, ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, a firm should assess the appropriateness of its CRR against its assumptions which underlie any risk mitigation measures it may have in place.

A firm should assess, and monitor, in detail its exposure to sectoral, geographic, liability and asset concentrations. The FSA considers that concentrations in these areas increase a firm's exposure to credit risk. Where a firm identifies such concentrations it should consider the adequacy of its CRR.

In accordance with the overall Pillar 2 rule a firm should consider its exposure to liquidity risk and assess its response should that risk materialise.

When assessing liquidity risk, a firm should consider the extent to which there is a mismatch between assets and liabilities.

A firm should also, when assessing liquidity risk, consider the amount of assets it holds in highly liquid, marketable forms that are available should unexpected cash flows lead to a liquidity problem. The price concession of liquidating assets is of prime concern when assessing such liquidity risk and should therefore be built into a firm's ICAAP.

Some further areas to consider in developing the liquidity risk scenario might include:

1. (1)

   any mismatching between expected asset and liability cash flows;

2. (2)

   the inability to sell assets quickly;

3. (3)

   the extent to which a firm's assets have been pledged; and

4. (4)

   the possible need to reduce large asset positions at different levels of market liquidity and the related potential costs and timing constraints.

A firm's CRR, being risk-sensitive, may vary as business cycles and economic conditions fluctuate over time. A deterioration in business or economic conditions could require a firm to raise capital or, alternatively, to contract its businesses, at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

To reduce the impact of cyclical effects, a firm should aim to maintain an adequate capital buffer during an upturn in business and economic cycles such that it has sufficient capital available to protect itself in unfavourable market conditions.

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth according to a range of assumptions as to the state of the economic or business environment which it faces. For example, an ICAAP should include an analysis of the impact that the actions of a firm's competitors might have on its performance, in order to see what changes in its environment the firm could sustain. Projections over a three to five year period would be appropriate in most circumstances. A firm may then calculate its projected CRR and assess whether it could be met from expected financial resources. Additional guidance on capital planning over an economic and business cycle can be found in GENPRU 1.2.73A G (Capital planning).3

If a firm's current available capital resources are less than the capital resources requirement indicated by the stress test that need not be a breach of BIPRU 2.2.41 R. The firm may wish to set out any countervailing effects and off-setting actions that can be demonstrated to the satisfaction of the FSA as being likely to reduce the difference referred to in the first sentence. The FSA is only likely to consider a demonstration of such actions as credible if those actions are set out in a capital management plan based on the procedures in GENPRU 1.2.73A G (Capital planning) 3and including a plan of the type referred to in 3 GENPRU 1.2.73A G (5) 3that has been approved by the firm's senior management or governing body.

The countervailing factors and off-setting actions that a firm may rely on as referred to in BIPRU 2.2.44 G include, but are not limited to, projected balance sheet shrinkage, growth in capital resources resulting from retained profits between the date of the stress test and the projected start of the economic downturn, the possibility of raising new capital in a downturn, the ability to reduce dividend payments or other distributions, and the ability to allocate capital from other risks which can be shown to be negatively correlated with the firm's credit risk profile.

A firm may decide to hold additional capital to mitigate any weaknesses in its overall control environment. These weaknesses might be indicated by the following:

1. (1)

   a failure by a firm to complete an assessment of its systems and controls to establish whether they comply with SYSC; or

2. (2)

   a failure by a firm's senior management to approve its financial results; or

3. (3)

   a failure by a firm to consider an analysis of relevant internal and external information on its business and control environment.

In considering if there are any systems and control weaknesses and their effect on the adequacy of the CRR, a firm should be able to demonstrate to the FSA that all the issues identified in SYSC1 have been considered and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

1. (1)

   BIPRU 2.2.49 G to BIPRU 2.2.70 G set out guidance for:

   1. (a)

      a bank or building society;

   2. (b)

      an asset management firm; and

   3. (c)

      a securities firm;

   whose activities are either simple or moderately complex.

2. (2)

   BIPRU 2.2.49 G to BIPRU 2.2.70 G provide examples of the sorts of risks which such a firm might typically face and of stress tests or scenario analyses which it might carry out as part of its ICAAP.

3. (3)

   The material on securities firms is also relevant to a commodities firm.

An asset manager is primarily exposed to operational risk and reputational risk.

When assessing reputational risk an asset manager should consider issues such as:

1. (1)

   how poor performance can affect its ability to generate profits;

2. (2)

   the effect on its financial position should one or more of its key fund managers leave that firm;

3. (3)

   the effect on its financial position should it lose some of its largest customers; and

4. (4)

   how poor customer services can affect its financial position; for example, a firm which has outsourced the management of customer accounts may want to consider the impact on its own reputation of the service provider failing to deliver the service.

As an asset manager's mandates become more complex, the risk of it failing to comply fully with the terms of its contracts increases. In the event of such failure, a firm can be exposed to substantial losses resulting from customers' claims and legal actions. Although the FSA would expect an asset manager to have in place adequate controls to mitigate that risk, it may also like to consider the potential cost to it should customers claim that it has not adhered to mandates. Past claims and compensation may provide a useful benchmark for an asset manager to assess its sensitivity to future legal action. In assessing the adequacy of its capital, an asset manager may therefore consider whether it could absorb the highest operational loss it has suffered over the last 3 to 5 years.

In relation to the issues identified in BIPRU 2.2.63 G, an asset manager should consider, for example:

1. (1)

   the direct cost to it resulting from fraud or theft;

2. (2)

   the direct cost arising from customers' claims and legal action in the future; an asset manager could consider the impact on its financial position if a legal precedent were to encourage its customers to take legal action against that firm for failing to advise correctly on a certain type of product; the relevance of such scenarios is likely to depend on whether the asset manager is acting on a discretionary basis or solely as advisor; and

3. (3)

   where it has obtained professional indemnity insurance, the deductibles and individual or aggregate limits on the sums insured.

The FSA expects an asset manager to consider the impact of economic factors on its ability to meet its liabilities as they fall due. An asset manager should therefore develop scenarios which relate to its strategic and business plan. An asset manager might therefore consider:

1. (1)

   the effect of a market downturn affecting both transaction volumes and the market values of assets in its funds; in assessing the impact of such a scenario, an asset manager may consider the extent to which it can remain profitable (for example, by rapidly scaling down its activities and reducing its costs);

2. (2)

   the impact on current levels of capital if it plans to undertake a significant restructuring; and

3. (3)

   the impact on current levels of capital if it plans to enter a new market or launch a new product; it should assess the amount of capital it needs to hold, when operating for the first time in a market in which it lacks expertise.

1. (1)

   A securities firm may consider the impact of the situations listed in (a) to (c) on its capital levels when assessing its exposure to concentration risk:

   1. (a)

      the potential loss that could arise from large exposures to a single counterparty;

   2. (b)

      the potential loss that could arise from exposures to large transactions or to a product type; and

   3. (c)

      the potential loss resulting from a combination of events such as a sudden increase in volatility leaving a hitherto fully-margined client unable to meet the margin calls due to the large size of the underlying position and the subsequent difficulties involved in liquidating its position.

2. (2)

   An example of the analysis in (1)(b) relates to a securities firm which relies on the income generated by a large, one-off corporate finance transaction. It may want to consider the possibility of legal action arising from that transaction which prevents the payment of its fees. Additionally, an underwriting firm may, as a matter of routine, commit to place a large amount of securities. It may therefore like to assess the impact of losses arising from a failure to place the securities successfully.

Where a securities firm deals in illiquid securities (for example, unlisted securities or securities listed on illiquid markets), or holds illiquid assets, potentially large losses can arise from trades that have failed to settle or because of large unrealised market losses. A securities firm may therefore consider the impact of liquidity risk on its exposure to:

1. (1)

   credit risk; and

2. (2)

   market risk.

Counterparty risk rules only partially capture the risk of settlement failure as the quantification of risk is only based on mark-to-market values and does not take account of the volatility of the securities over the settlement period. A securities firm's assessment of its exposure to counterparty risk should take into account:

1. (1)

   whether it acts as arranger only or whether it also executes trades;

2. (2)

   the types of execution venues which it uses; for example, the London Stock Exchange or a retail service provider (RSP) have more depth than multilateral trading facilities2; and

   2
3. (3)

   whether it offers extended settlements and free delivery compared to delivery versus payment business.

1. (1)

   A securities firm should also consider the impact of external factors on the levels of capital it needs to hold. Scenarios covering such external factors should relate to its strategy and business plan. A securities firm might wish to consider the questions in (2) to (7).

2. (2)

   Whether it plans to participate in a one-off transaction that might strain temporarily or permanently its capital.

3. (3)

   Whether the unevenness of its revenue suggests that it should hold a capital buffer. Such an assessment could be based, for instance, on an analysis of past revenue and the volatility of its capital.

4. (4)

   How its income might alter as interest rates fluctuate where it is obliged to pay interest to its clients in excess of interest it earns on client money deposits.

5. (5)

   How its capital would be affected by a market downturn. For instance, how sensitive that firm is to a sharp reduction of trading volumes.

6. (6)

   How political and economic factors will affect that firm's business. For instance, a commodity firm may wish to consider the impact of a sharp increase in prices on initial margins and, consequently, on its liquidity.

7. (7)

   Whether it anticipates expanding its activities (for example, by offering clearing services), and if so, the impact on its capital.

A securities firm may also want to assess the impact of its internal credit limits on its levels of capital. For instance, a firm whose internal procedures authorise dealing without cash in the account or without pre-set dealing limits might consider more capital is required than if it operated stricter internal credit limits.

A firm may approach its assessment of adequate capital by developing a model, including an ECM (see BIPRU 2.2.27 G), for some or all of its business risks. The assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by a firm's senior management. A firm should also consider whether any relevant risks, including systems and control risks, are not captured by the model.

A firm should not expect the FSA to accept as adequate any particular model that it develops or automatically to reflect the results from the model in any individual capital guidance. However, the FSA will take into account the results of a sound and prudent model when giving individual capital guidance (see GENPRU 1.2.19 G (Outline of provisions related to GENPRU 2.1 (Adequacy of financial resources))).

There is no prescribed approach as to how a firm should develop its internal capital model. However, a firm should be able to demonstrate:

1. (1)

   the confidence levels set and whether these are linked to its corporate strategy;

2. (2)

   the time horizons set for the different types of business that it undertakes;

3. (3)

   the extent of historic data used and back-testing carried out;

4. (4)

   that it has in place a process to verify the correctness of the model's outputs; and

5. (5)

   that it has the skills and resources to operate, maintain and develop the model.

In relation to the use of an ECM (see BIPRU 2.2.27 G), the FSA is likely to place more reliance on a firm's ICAAP if the firm provides the following information:

1. (1)

   a comparison of the amount of capital that the ECM generates in respect of each of the risks captured in the CRR before aggregation with the corresponding components of the CRR calculation; and

2. (2)

   evidence that the guidance in BIPRU 2.2.71 G to BIPRU 2.2.78 G has been followed.

If a firm adopts a top-down approach to developing its internal model, it should be able to allocate the outcome of the internal model to risks it has previously identified in relation to each separate legal entity, business unit or business activity, as appropriate. In relation to a firm which is a member of a group, GENPRU 1.2.53 R (Application of GENPRU 1.2 on a solo and consolidated basis: Processes and tests) sets out how internal capital identified as necessary by that firm's ICAAP should be allocated.

If a firm's internal model makes explicit or implicit assumptions in relation to correlations within or between risk types, or in relation to diversification benefits between business types, the firm should be able to explain to the FSA, with the support of empirical evidence, the basis of those assumptions.

A firm's model should also reflect the past experience of both the firm and the sectors in which it operates.

The values assigned to inputs into a firm's model should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For options or guarantees which change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.