IFPRU 2.2 Internal capital adequacy assessment process

BIPRU 12 contains rules and guidance relating to the adequacy of a firm's liquidity resources. In assessing the adequacy of its liquidity resources, a firm should do so by reference to the overall liquidity adequacy rule, rather than the overall financial adequacy rule.

The effective management of prudential risk relies on the adequacy of a firm's financial resources, systems and controls. These need to be assessed in relation to all the activities of the firm and the risks to which they give rise, and so this chapter applies to a firm for the whole of its business. For a collective portfolio management investment firm, this means that this section also applies to its activities in relation to the management of AIFs and/or UCITS.

The liabilities referred to in the overall financial adequacy rule:2

1. (1)

   include:2

   1. (a)

      a firm's contingent and prospective liabilities;2

   2. (b)

      liabilities or costs that arise in scenarios where the firm is a going concern and those where the firm ceases to be a going concern;2

   3. (c)

      claims that could be made against a firm, which ought to be paid in accordance with fair treatment of customers, even if such claims could not be legally enforced; and2

   4. (d)

      claims on insurance that a firm has made or is in the course of making; and2

2. (2)

   exclude liabilities that might arise from transactions that a firm has not entered into and which it could avoid (e.g. by taking realistic management actions such as ceasing to transact new business after a suitable period of time has elapsed).2

In the light of IFPRU 2.2.4 G, a firm should make its assessment of adequate financial resources on realistic valuation bases for assets and liabilities, taking into account the actual amounts and timing of cash flows under realistic adverse projections.

Risks may be addressed through holding capital to absorb losses that unexpectedly materialise. The ability to pay liabilities as they fall due also requires liquidity. Therefore, in assessing the adequacy of a firm's financial resources, both capital and liquidity needs should be considered. A firm should also consider the quality of its financial resources, such as the loss-absorbency of different types of capital and the time required to liquidate different types of asset.

1. (1)

   This paragraph gives guidance on some of the terms used in the overall Pillar 2 rule.

2. (2)

   In a narrow sense, business risk is the risk to a firm that it suffers losses because its income falls or is volatile relative to its fixed cost base. However, in a broader sense, it is exposure to a wide range of macro-economic, geopolitical, industry, regulatory and other external risks that might deflect a firm from its desired strategy and business plan. IFPRU 2.3.47 G to IFPRU 2.3.54 G provides further guidance on business risk.

3. (3)

   Interest-rate risk in the non-trading book is explained in IFPRU 2.3.39 G (Interest rate risk in the non-trading book).

In the overall Pillar 2 rule, internal capital refers to the financial resources of a firm which it treats as being held against the risks listed in the overall Pillar 2 rule. The obligation in that rule to assess the distribution of such capital refers, in relation to a firm making an assessment on an individual1basis, for example, to the need to take account of circumstances where part of a firm's financial resources are held by a branch of that firm which are subject to restrictions on its ability to transfer that capital. An assessment of internal capital distribution might also take account of such of a firm's financial resources as may be ring-fenced in the event of its insolvency.

Certain risks, such as systems and controls weaknesses, may not be adequately addressed by, for example, holding additional capital and a more appropriate response would be to rectify the weakness. In such circumstances, the amount of financial resources required to address these risks might be zero. However, a firm should consider whether holding additional capital might be an appropriate response until the identified weaknesses are rectified. A firm, should, in line with IFPRU 2.2.43 R to IFPRU 2.2.44 R (Documentation of risk assessments), document the approaches taken to manage these risks.

1. (1)

   A firm should:2

   1. (a)

      carry out assessments of the sort described in the overall Pillar 2 rule and IFPRU 2.2.13R on an ongoing basis; and2

   2. (b)

      document the assessments in (a), in line with IFPRU 2.2.43R to IFPRU 2.2.44R (Documentation of risk assessments), at least annually, or more frequently if changes in the business, strategy, nature or scale of its activities or operational environment suggest that the current level of financial resources is no longer adequate.2

2. (2)

   The appropriateness of the internal process, and the degree of involvement of senior management in the process, will be taken into account by the FCA when reviewing a firm's assessment as part of the FCA's own assessment of the adequacy of a firm's financial resources and internal capital. The processes and systems should ensure that the assessment of the adequacy of a firm's financial resources and internal capital is reported to its senior management as often as is necessary.2

To comply with the general stress and scenario testing rule, a firm should undertake a broad range of stress tests which reflect a variety of perspectives, including sensitivity analysis, scenario analysis and stress testing on an individual portfolio, as well as a firm-wide level.

A firm with an IRB permission which has any material credit exposures excluded from its IRB models should also include these exposures in its stress and scenario testing to meet its obligations under the general stress and scenario testing rule. A firm without IRB permission should conduct analyses to assess risks to the credit quality of its counterparties, including any protection sellers, considering both on and off-balance sheet exposures.

In carrying out the stress tests and scenario analyses under IFPRU 2.2.37 R (1), a firm should also consider any impact of the adverse circumstances on its own funds. In particular, a firm should consider the capital ratios in article 92 of the EU CRR (Own funds requirements) where its common equity tier 1 capital and additional tier 1 capital is eroded by the event.

A firm should assign adequate resources, including IT systems, to stress testing and scenario analysis, taking into account the stress testing techniques used, in order to accommodate different and changing stress tests at an appropriate level of granularity.

For the purpose of IFPRU 2.2.37 R (5), a firm should consider whether the nature of the major sources of risks identified by it, in line with IFPRU 2.2.7 R (2) (Main requirement relating to risk strategies, processes and systems), and their possible impact on its financial resources suggest that such tests and analyses should be carried out more frequently. For instance, a sudden change in the economic outlook may prompt a firm to revise the parameters of some of its stress tests and scenario analyses. Similarly, if a firm has recently become exposed to a particular sectoral concentration, it may wish to add some stress tests and scenario analyses to reflect that concentration.

A firm to which the ICAAP rules apply on a consolidated basis need not prepare a consolidated basis assessment if such an assessment has been prepared by another member of its FCA consolidation group. In such cases, a firm may adopt such an assessment as its own. A firm nevertheless remains responsible for the assessment.

The purpose of IFPRU 2.2.52 R to IFPRU 2.2.55 G is to enable the FCA to assess the extent, if any, to which a firm's assessment, calculated on a consolidated basis, is lower than it would be if each separate legal entity were to assess the amount of capital it would require to mitigate its risks (to the same level of confidence) were it not part of a group subject to consolidated supervision under Part One, Title II, Chapter 2 of the EU CRR (Prudential consolidation). The reason the FCA wishes to make this assessment is so that individual capital guidance which it gives is fair and comparable between different firms and groups. Group diversification benefits which a firm might assert exist can be a material consideration in a capital adequacy assessment. Understanding the methods used to aggregate the different risks (eg, the correlation assumptions) is crucial to a proper evaluation of such benefits.

Whereas a single legal entity can generally use its capital to absorb losses wherever they arise, there are often practical and legal restrictions on the ability of a group to do so. For instance:

1. (1)

   capital which is held by overseas regulated firms may not be capable of being remitted to a firm in the UK which has suffered a loss;

2. (2)

   a firm which is, or likely to become, insolvent may be obliged to look to the interests of its creditors first before transferring capital to other group companies; and

3. (3)

   a parent company may have to balance the interests of its shareholders against the protection of the creditors of a subsidiary which is, or might become, insolvent and may, rationally, conclude that a subsidiary should be allowed to fail rather than provide capital to support it.

The general stress and scenario testing rule requires a firm to carry out stress tests and scenario analyses as part of its obligations under the overall Pillar 2 rule. Both stress tests and scenario analyses are undertaken by a firm to further a better understanding of the vulnerabilities that it faces under adverse conditions. They are based on the analysis of the impact of a range of events of varying nature, severity and duration. These events can be financial, operational or legal or relate to any other risk that might have an economic impact on the firm.

Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm's financial position.

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of adverse events on the firm's financial position, for example, simultaneous movements in a number of risk categories affecting all of a firm's business operations, such as business volumes, investment values and interest rate movements.

There are three broad purposes of stress testing and scenario analysis:

1. (1)

   it can be used as a means of quantifying how much capital might be absorbed if an adverse event or events occurs (ie, a simple 'what if' approach to estimating exposure to risks), this might be a proportionate approach to risk management for an unsophisticated business;

2. (2)

   it can be used to provide a check on the outputs and accuracy of risk models, particularly in identifying non-linear effects when aggregating risks; and

3. (3)

   it can be used to explore the sensitivities in longer term business plans and how capital needs might change over time

One of the main purposes of stress tests and scenario analyses under the general stress and scenario testing rule is to test the adequacy of overall financial resources. Scenarios need only be identified, and their impact assessed, in so far as this facilitates that purpose. In particular, the nature, depth and detail of the analysis depend, in part, upon the firm's capital strength and the robustness of its risk prevention and risk mitigation measures.

Both stress testing and scenario analyses are forward-looking analysis techniques which seek to anticipate possible losses that might occur if an identified risk crystallises. In applying them, a firm should decide how far forward to look. This should depend upon:

1. (1)

   how quickly it would be able to identify events or changes in circumstances that might lead to a risk crystallising resulting in a loss; and

2. (2)

   after it has identified the event or circumstance, how quickly and effectively it could act to prevent or mitigate any loss resulting from the risk crystallising and to reduce exposure to any further adverse event or change in circumstance.

Where a firm is exposed to market risk, the time horizon over which stress tests and scenario analyses should be carried out will depend on, among other things, the maturity and liquidity of the positions stressed. For example, for the market risk arising from the holding of investments, this will depend upon:

1. (1)

   the extent to which there is a regular, open and transparent market in those assets, which would allow fluctuations in the value of the investment to be more readily and quickly identified; and

2. (2)

   the extent to which the market in those assets is sufficiently liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) to allow the firm, if needed, to sell, hedge or otherwise mitigate the risks relating to its holding so as to prevent or reduce exposure to future price fluctuations. In devising stress tests and scenario analyses for market risk, a firm should also take into account the following:

   1. (a)

      the general stress and scenario testing rule should include a regular programme of stress testing and scenario analysis of its trading book positions, both at the trading desk level and on a firm-wide basis, with the results of these tests being reviewed by senior management and reflected in the policies and limits the firm sets;

   2. (b)

      the firm's stress testing programme should be comprehensive in both risk and firm coverage, and appropriate to the size and complexity of trading book positions held;

   3. (c)

      for the purpose IFPRU 2.2.37 R (5)(b), the frequency of stress testing of trading book positions should be determined by the nature of the positions;

   4. (d)

      the stress testing should include shocks which reflect the nature of the portfolio and the time it could take to hedge out or manage risks under severe market conditions;

   5. (e)

      the firm should have procedures in place to assess and respond to the results of the stress testing programme, in particular, stress testing should be used to evaluate the firm's capacity to absorb losses or to identify steps to be taken by the firm to reduce risk;

   6. (f)

      as part of its stress testing programme, the firm should consider how prudent valuation requirements in article 105 of the EU CRR will be met in a stressed scenario.

In identifying scenarios and assessing their impact, a firm should take into account, where material, how changes in circumstances might impact upon:

1. (1)

   the nature, scale and mix of its future activities; and

2. (2)

   the behaviour of counterparties, and of the firm itself, including the exercise of choices (eg, options embedded in financial instruments or contracts of insurance).

In determining whether it would have adequate financial resources in the event of each identified realistic adverse scenario, a firm should:

1. (1)

   only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and

2. (2)

   take account of any legal or other restriction on the use of financial resources.

1. (1)

   In identifying an appropriate range of adverse circumstances and events in accordance with IFPRU 2.2.37 R (2):

   1. (a)

      a firm will need to consider the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries;

   2. (b)

      for the purposes of IFPRU 2.2.37 R (2)(a), the amplitude and duration of the relevant cycle should include a severe downturn scenario based on forward-looking hypothetical events, calibrated against the most adverse movements in individual risk drivers experienced over a long historical period;

   3. (c)

      the adverse scenarios considered should in general be acyclical and, accordingly, the scenario should not become more severe during a downturn and less severe during an upturn. However, the FCA does expect scenarios to be updated with relevant new economic data on a pragmatic basis to ensure that the scenario continues to be relevant; and

   4. (d)

      the adverse scenarios considered should reflect a firm's risk tolerance of the adverse conditions through which it expects to remain a going concern.

2. (2)

   In making the estimate required by IFPRU 2.2.37 R (3), a firm should project its own funds and required own funds over a time horizon of three to five years, taking account of its business plan and the impact of relevant adverse scenarios. In making the estimate, the firm should consider both the own funds required to meet its own funds requirements and the own funds needed to meet the overall financial adequacy rule. Those projections should be made in a manner consistent with its risk management processes and systems in IFPRU 2.2.7R.

3. (3)

   In projecting its financial position over the relevant time horizon, the firm should:

   1. (a)

      reflect how its business plan would "flex" in response to the adverse events being considered, taking into account factors such as changing consumer demand and changes to new business assumptions;

   2. (b)

      consider the potential impact on its stress testing of dynamic feedback effects and second order effects of the major sources of risk identified in accordance with IFPRU 2.2.7 R (2);

   3. (c)

      estimate the effects on the firm's financial position of the adverse event without adjusting for management actions;

   4. (d)

      separately, identify any realistic management actions that the firm could, and would, take to mitigate the adverse effects of the stress scenario; and

   5. (e)

      estimate the effects of the stress scenario on the firm's financial position after taking account of realistic management actions.

4. (4)

   A firm should identify any realistic management actions intended to maintain or restore its capital adequacy. These could include ceasing to transact new business after a suitable period, balance sheet shrinkage, restricting distribution of profits or raising additional capital. A firm should reflect management actions in its projections only where it could, and would, take such actions, taking account of factors such as market conditions in the stress scenario and its effects upon the firm's reputation with its counterparties and investors. The combined effect on capital and retained earnings should be estimated. To assess whether prospective management actions in a stress scenario would be realistic and to determine which actions the firm would and could take, the firm should take into account any pre-conditions that might affect the value of management actions as risk mitigants and analyse the difference between the estimates in (3)(c) and (3)(e) in sufficient detail to understand the implications of taking different management actions at different times, particularly where they represent a significant divergence from the firm's business plan.

5. (5)

   The firm should document its stress testing and scenario analysis policies and procedures, as well as the results of its tests in accordance with IFPRU 2.2.43 R to IFPRU 2.2.44 R (Documentation of risk assessments). These records should be included within the firm's ICAAP submission document.

6. (6)

   The FCA will review the firm's records in (5) as part of its SREP. The purpose of examining these is to enable the FCA to judge whether a firm will be able to continue to meet its own funds requirements and the overall financial adequacy rule throughout the projection period.

7. (7)

   If, after taking account of realistic management actions, a firm's stress-testing management plan shows that the firm's projected own funds are less than those required to continue to meet its EU CRR or needed to continue to meet the overall financial adequacy rule over the projection period, the FCA may require the firm to set out additional countervailing measures and off-setting actions to reduce such difference or to restore the firm's capital adequacy after the stress event.

8. (8)

   The firm's senior management or governing body should be actively involved and engaged in all relevant stages of the firm's stress testing and scenario analysis programme. This would include establishing an appropriate stress testing programme, reviewing the programme's implementation (including the design of scenarios) and challenging, approving and actioning the results of the stress tests.

The FCA may formulate macroeconomic and financial market scenarios which a firm may use as an additional input to its ICAAP submission. In addition, the FCA may also ask a firm to apply specific scenarios directly in its ICAAP submission.

A firm may consider scenarios in which expected future profits will provide capital reserves against future risks. However, it would only be appropriate to take into account profits that can be foreseen with a reasonable degree of certainty as arising before the risk against which they are being held could possibly arise. In estimating future reserves, a firm should deduct future dividend payment estimates or other forms of profits distribution2 from projections of future profits.

1. (1)

   Stress and scenario analyses should, in the first instance, be aligned with the risk appetite of the firm, as well as the nature, scale and complexity of its business and of the risks that it bears. The calibration of the stress and scenario analyses should be reconciled to a clear statement setting out the premise upon which the firm's internal capital assessment under the overall Pillar 2 rule is based.

2. (2)

   In identifying adverse circumstances and events in line with IFPRU 2.2.37 R (2), a firm should consider the results of any reverse stress testing conducted under SYSC 20. Reverse stress testing may be expected to provide useful information about the firm's vulnerabilities and variations around the most likely ruin scenarios for the purpose of meeting the firm's obligations under IFPRU 2.2.37 R. In addition, such comparison may help a firm to assess the sensitivity of its financial position to different stress calibrations.

A firm should use the results of its stress testing and scenario analysis not only to assess capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the firm if the risk covered by the stress or scenario test actually materialises. Such measures might be a contingency plan or might be more concrete risk mitigation steps.

This section contains guidance on the assessment required by IFPRU 2.2.7 R (2)(k) for a firm exposed to pension obligation risk as defined in IFPRU 2.2.8 R (5).

The focus of the risk assessment is on the firm's funding2 obligations towards the pension scheme, not of the pension scheme’s risks themselves (i.e. the scheme's segregated2 assets and liabilities). A firm should include in its estimate of financial resources both its expected obligations to the pension scheme and any increase in obligations that may arise in a stress scenario.

If a firm has a current funding obligation in excess of normal contributions or there is a risk that such a funding obligation will arise then, when calculating available capital resources, the firm should include these sources of risk as part of its:2

1. (1)

   stress tests and scenario analysis under IFPRU 2.2.37R and considering at least the scenarios in IFPRU 2.2.81G; and2

2. (2)

   capital projections under IFPRU 2.2.73G.2

A firm may wish to consider the following scenarios:

1. (1)

   one in which the firm gets into difficulties with an effect on its ability to fund the pension scheme; and

2. (2)

   one in which the pension scheme position deteriorates (e.g. because either2 investment returns, or interest rate assumptions, or both,2 fall below expected returns or because of increases in life expectancy) with an effect on the firm's funding obligations; taking into account the management actions the firm could and would take.

A firm is expected to determine where the scope of any stress test impacts upon its pension obligation risk and estimate how the relevant measure of pension obligation risk will change in that scenario. For example, in carrying out stress tests under IFPRU 2.2.37 R, a firm must consider how a stress scenario, such as an economic recession, would impact on the firm's current obligations towards its pension scheme and any potential increase in those obligations. Risks such as interest-rate risk or reduced investment returns may have a direct impact on a firm's financial position as well as an indirect impact resulting from an increase in the firm's pension scheme obligations. Both effects should be taken into account in a firm's estimate of financial resources under IFPRU 2.2.7 R (Overall Pillar 2 rule).

A firm should consider issues such as:

1. (1)

   the extent to which trustees of the pension scheme or a pension regulator (such as the one created under the Pensions Act 2004) can compel a certain level of contributions or a one-off payment in adverse financial situations or to meet the minimum legal requirements under the scheme's trust deed and rules or applicable laws relating to the pension scheme;

2. (2)

   whether the valuation bases used to set pension scheme contribution rates are consistent with the firm's current business plans and anticipated changes in the workforce; and

3. (3)

   which valuation basis is appropriate, given the expected investment return on scheme assets and actions the firm can take if those returns do not materialise.

A firm should carry out analyses only to a degree of sophistication and complexity which is commensurate with the materiality of its pension risks.

This section contains additional guidance on the assessment required by IFPRU 2.2.7 R (2)(l) (Group risk).

A firm should include in the written record in IFPRU 2.2.43 R (Documentation of risk assessments) a description of the broad business strategy of the FCA consolidation group or the non-EEA sub-group of which it is a member, the group's view of its principal risks and its approach to measuring, managing and controlling the risks. This description should include the role of stress testing, scenario analysis and contingency planning in managing risk on an individual basis and consolidated basis.

A firm should satisfy itself that the systems (including IT) of the FCA consolidation group or the non-EEA sub-group of which it is a member are sufficiently sound to support the effective management and, where applicable, the quantification of the risks that could affect the FCA consolidation group or the non-EEA sub-group, as the case may be.

In performing stress tests and scenario analyses, a firm should take into account the risk that its group may have to bring back on to its consolidated balance sheet the assets and liabilities of off-balance sheet entities as a result of reputational contagion, notwithstanding the appearance of legal risk transfer.

A firm should carry out stress tests and scenario analyses to a degree of sophistication which is commensurate with the complexity of its group and the nature of its group risk.