IFPRU 2.3 Supervisory review and evaluation process: internal capital adequacy standards

1. (1)

   IFPRU 2.3 sets out guidance on IFPRU 2.2 (Adequacy of financial resources) so far as it applies to an IFPRU investment firm. In particular, guidance on how a firm should carry out its ICAAP, as well as some factors the FCA will take into consideration when undertaking a SREP. The terms ICAAP and SREP are explained in IFPRU 2.3.3 G. IFPRU 2.3.48 G to IFPRU 2.3.52 R are rules that apply to a firm with an IRB permission.

2. (2)

   IFPRU 2.3 is mainly written on the basis that IFPRU 2.2 (Adequacy of financial resources) applies to a firm on an individual1basis. However, it is still relevant when IFPRU 2.2 applies on a consolidated basis. When IFPRU 2.2 applies on a consolidated basis, IFPRU 2.3 should be read with appropriate adjustments.

   1

For the purpose of IFPRU 2.3, "capital" refers to a firm's financial resources, own funds 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 FCA. 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 FCA.

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, own funds and internal capital that it considers adequate to cover the nature and level of the risks to which it is or might be exposed (IFPRU 2.2.1 R to IFPRU 2.2.6 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 if it is a significant IFPRU firm or SYSC 20 (Reverse stress testing) if it is not a significant IFPRU firm) taking into account, for a firm with an IRB permission, the stress test required by the EU CRR;

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 (1IFPRU 2.2.12 R1); and

5. (5)

   document its ICAAP (IFPRU 2.2.43 R to IFPRU 2.2.44 R (Documentation of risk assessments)).

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 (IFPRU 2.2.45 R to IFPRU 2.2.57 G (Application of IFPRU 2.2 on an individual1and consolidated basis)). 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 FCA will review a firm's ICAAP, including the results of the firm's stress tests carried out under IFPRU and the EU CRR, as part of its SREP. Provided that the FCA is satisfied with the appropriateness of a firm's capital assessment, the FCA will take into account that firm's ICAAP and stress tests in its SREP. More material on stress tests for a firm with an IRB permission can be found in IFPRU 2.3.50 R to IFPRU 2.3.54 G.1

The SREP is a process under which the FCA:

1. (1)

   reviews the arrangements, strategies, processes and mechanisms implemented by a firm to comply with IFPRU, SYSC and with requirements imposed by or under the EU CRR and wider 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 in (1).

As part of its SREP, the FCA 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 FCA will ask for additional information on the ICAAP.

As part of its SREP, the FCA will consider whether the amount and quality of capital which a firm should hold to meet its own funds requirements in the EU CRR is sufficient for that firm to comply with the overall financial adequacy rule.

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

As part of its SREP, the FCA will also consider whether a firm should hold a capital planning buffer and the amount and quality of such capital planning buffer. In making these assessments, the FCA will have regard to the nature, scale and complexity of a firm's business and of the major sources of risks relevant to such business as referred to in the general stress and scenario testing rule and SYSC 20 (Reverse stress testing), as applicable. Accordingly, a firm's capital planning buffer should be of sufficient amount and adequate quality to allow the firm to continue to meet the overall financial adequacy rule in the face of adverse circumstances, after allowing for realistic management actions.

After completing a review as part of the SREP, the FCA may notify the firm of the amount and quality of capital which it should hold as a capital planning buffer over and above the level of capital recommended as its ICG. The FCA may set a firm's capital planning buffer either as an amount and quality of capital which it should hold now (ie, at the time of the FCA notification following the firm's SREP) or, in exceptional cases, as a forward-looking target that the firm should build up over time.

Where the amount or quality of capital which the FCA considers a firm should hold to meet the overall financial adequacy rule or as a capital planning buffer is not the same as that which results from a firm's ICAAP, the FCA usually expects to discuss any such difference with the firm. Where necessary, the FCA may consider the use of its powers under section 166 of the Act (Reports by skilled persons) to assist in such circumstances.

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

If a firm disagrees with the FCA's assessment as to the amount or quality of capital planning buffer that it should hold, it should, consistent with Principle 11 (Relations with regulators), notify the FCA of its disagreement. The FCA may reconsider its initial assessment if, after discussion with the firm, the FCA concludes that the amount or quality of capital that the firm should hold as capital planning buffer is different from the amount or quality initially suggested.

The FCA 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 own funds requirements.

If, after discussion, the FCA and a firm still do not agree on an adequate level of capital, the FCA may consider using its powers under section55L of the Act on its own initiative to require the firm1 to hold capital in line with the FCA's view of the capital necessary to comply with the overall financial adequacy rule. In deciding whether it should use its powers under section 55L,1the FCA will take into account the amount and quality of the capital planning buffer which the firm should hold as referred to in IFPRU 2.3.13 G and IFPRU 2.3.14 G. SUP 7 provides further information about the FCA's powers under section 55L.1

If the FCA gives individual capital guidance to a firm, the FCA will state what amount and quality of capital the FCA 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 own funds of an amount which is at least equal to a specified percentage of that firm's own funds requirements plus one or more static add-ons for specific risks, in line with the overall Pillar 2 rule.

Individual capital guidance may refer to two types of own funds:

1. (1)

   General capital. It refers to total common equity tier 1 capital and additional tier 1 capital after applying deductions and prudential filters under the EU CRR.

2. (2)

   Total capital. It refers to total common equity tier 1 capital, additional tier 1 capital and tier 2 capital after applying deductions and prudential filters under the EU CRR.

Where the FCA notifies a firm that it should hold a capital planning buffer, the notification will state what amount and quality of capital the FCA considers is adequate for the firm to hold. This will normally be notified to the firm, together with its individual capital guidance and expressed as a separate amount of own funds that the firm should hold in excess of the amount of own funds indicated as its individual capital guidance.

For the purposes of IFPRU 2.3.21 G, 1IFPRU 2.3.20 G1 applies as it applies to individual capital guidance. References in those provisions to individual capital guidance should be read as if they were references to capital planning buffer. In relation toIFPRU 2.2.62 R, where the general stress and scenario testing rule or SYSC 20 (Reverse stress testing), as part of the ICAAP rules, applies to a firm on a consolidated basis, the FCA may notify the firm that it should hold a group capital planning buffer. In these cases, the firm should ensure that the group holds a capital planning buffer of sufficient amount and adequate quality to allow it to continue to meet the overall financial adequacy rule in the face of adverse circumstances, after allowing for realistic management actions.

A firm 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 FCA's supervision of that firm. Therefore, if a firm's own funds 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 FCA 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 own funds or to reduce its risks and hence its own funds 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 in IFPRU 2.3.23 G, the FCA 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 FCA will seek to agree with the firm appropriate timescales and scope for any such additional work, in the light of the circumstances which have arisen.

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

Monitoring the use of a firm's capital planning buffer is also a fundamental part of the FCA's supervision of that firm. A firm should only use its capital planning buffer to absorb losses or meet increased own funds requirements if certain adverse circumstances materialise. These should be circumstances beyond the firm's normal and direct control, whether relating to a deteriorating external environment or periods of stress, such as macroeconomic downturns or financial/market shocks, or firm-specific circumstances.

Consistent with Principle 11 (Relations with regulators), a firm should notify the FCA as early as possible in advance where it has identified that it would need to use its capital planning buffer. The firm's notification should at least state:

1. (1)

   what adverse circumstances are likely to force the firm to draw down its capital planning buffer;

2. (2)

   how the capital planning buffer will be used up in line with the firm's capital planning projections; and

3. (3)

   what plan is in place for the eventual restoration of the capital planning buffer.

Following discussions with the firm on the items listed in IFPRU 2.3.27 G, the FCA may put in place additional reporting arrangements to monitor the firm's use of its capital planning buffer in accordance with the plan referred to in IFPRU 2.3.27 G (3). The FCA may also identify specific trigger points as the capital planning buffer is being used up by the firm, which could lead to additional supervisory actions.

Where a firm's capital planning buffer is being drawn down due to circumstances other than those in IFPRU 2.3.26 G, such as poor planning or mismanagement, the FCA may ask the firm for more detailed plans for it to restore its capital planning buffer. In the light of the relevant circumstances, the FCA may consider taking other remedial actions, which may include using its powers under section 55L of the Act on its own initiative, to impose a requirement on a firm.

A firm should inform the FCA where its capital planning buffer is likely to start being drawn down, even if it has not accepted the FCA's assessment as to the amount or quality of its capital planning buffer.

Where a firm has started to use its capital planning buffer in circumstances where it was not possible to notify in advance, it should notify the FCA and provide the information referred to in IFPRU 2.3.27 G as soon as practicable afterwards.

IFPRU 2.3.23 G to IFPRU 2.3.31 G also apply to individual capital guidance and to capital planning buffer on a consolidated basis.

IFPRU 2.3.34 G to IFPRU 2.3.36G set out what the FCA considers to be a proportional approach to preparing an ICAAP as referred to in IFPRU 2.2.12 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 FCA more easily to review a firm's ICAAP when the FCA undertakes its SREP. The FCA is also likely to place more reliance on an ICAAP which takes the appropriate form described in IFPRU 2.3.34 G to IFPRU 2.3.36 G than would otherwise be the case, although there may also be circumstances in which the FCA will be able to rely on an ICAAP that is not drawn up in that form.

1. (1)

   This paragraph applies to a firm that is not a significant IFPRU firm (see IFPRU 1.2.3 R) whose activities are simple and primarily not credit-related.

2. (2)

   In carrying out its ICAAP it could:

   1. (a)

      identify and consider that firm's largest losses over the last three to five 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 own funds requirements might alter under the scenarios in (c) and how its own funds requirements might alter in line with its business plans for the next three to five 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)

      (to determine the amount of capital that would be absorbed in the circumstances 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 for 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). However, if the firm chooses 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 SYSC 20 (Reverse stress testing) to assess how that firm's capital and own funds requirements 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 consider the impact of a severe economic or industry downturn on its future earnings, own funds and own funds requirements, 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.

For a firm that is a significant IFPRU firm (see IFPRU 1.2.3 R1) and whose activities are moderately complex, in carrying out its ICAAP, IFPRU 2.3.34 G (2) to IFPRU 2.3.34 G (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 own funds requirements adequately captures the risks identified in (1) and (2);

4. (4)

   for areas in which the own funds requirements 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 three to five years and estimate how that firm's capital and own funds requirements 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 own funds requirements would alter and what that firm's reaction to a range of adverse economic scenarios might be (see IFPRU 2.2.7 R to IFPRU 2.2.44 R (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 conditions;

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 that is a significant IFPRU firm (see IFPRU 1.2.3 R) whose activities are complex.

2. (2)

   A proportional approach to that firm's ICAAP should cover the matters identified in IFPRU 2.3.34 G and IFPRU 2.3.35 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 kind referred to in (2) may be linked 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 Part Three, Title IV, Chapter 5 of the EU CRR (Use of internal models to calculate own funds requirements for market risk)), advanced modelling approaches for credit risk (see Part Three, Title II, Chapter 3 of the EU CRR (Internal Ratings Based Approach)) and, possibly, advanced measurement approaches for operational risk (see Part Three, Title III, Chapter 4 of the EU CRR (Advanced measurement approaches)). 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 FCA 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 reflects the amount of capital needed for regulatory purposes. Where they are not equal, the FCA will expect a firm to explain any differences. However, it may prove difficult to reconcile the outcome of a firm's modelling with the FCA's own assessment of the adequacy of that firm's capital. For example, when matters of judgment are involved in arriving at a firm's capital assessment or the FCA relies on information which cannot be fully disclosed to the firm (eg, 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 FCA 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 carried out under the general stress and scenario testing rule 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 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.

IFPRU 2.3.37 G to IFPRU 2.3.47 G set out guidance on some of the sources of risk identified in the overall Pillar 2 rule.IFPRU 2.3.50 R to IFPRU 2.3.54 G1 contain 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 FCA, between capital it holds to comply with the overall financial adequacy rule, capital it holds as a capital planning buffer and capital held for other purposes.

2. (2)

   The calibration of the own funds requirements 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 own funds requirements to arrive at an adequate level of own funds.

A firm should assess its exposure to changes in interest rates, particularly risks arising from the effect of interest-rate changes on non-trading book activities that are not captured by the own funds requirements. 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 own funds requirements 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 FCA 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 own funds requirements.

Under 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 own funds requirements, being risk-sensitive, may vary as business cycles and economic conditions fluctuate over time. 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 planning 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 regarding 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 own funds requirements 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 IFPRU 2.2.73 G (Capital planning).

If a firm's current available own funds are less than the own funds requirements indicated by the stress test, that does not necessarily mean there is a breach of IFPRU 2.3.50 R. The firm may wish to set out any countervailing effects and off-setting actions that can be demonstrated to the satisfaction of the FCA as being likely to reduce that difference. The FCA 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 IFPRU 2.2.73 G (Capital planning) and include a plan of the type referred to in 1IFPRU 2.2.73 G (7)1 that 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 IFPRU 2.3.53 G include, but are not limited to, projected balance sheet shrinkage, growth in own funds 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 own funds requirements, a firm should be able to demonstrate to the FCA that all the issues identified in SYSC have been considered and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

1. (1)

   IFPRU 2.3.58 G to IFPRU 2.3.67 G set out guidance for:

   1. (a)

      an asset management firm; and

   2. (b)

      a securities firm;

2. (2)

   IFPRU 2.3.58 G to IFPRU 2.3.67 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 FCA would expect an asset manager to have adequate controls in place to mitigate that risk, it may also like to consider the potential cost to it if 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 three to five years.

In relation to the issues identified in IFPRU 2.3.60 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 it for failing to advise correctly on a certain type of product, the relevance of which 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 FCA expects an asset manager to consider the impact of economic factors on its ability to meet its liabilities as they fall due. Therefore, an asset manager should develop scenarios which relate to its strategic and business plan. An asset manager might consider:

1. (1)

   the effect of a market downturn that affects 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 (eg, 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 following situations 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 (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. Therefore, it may like to assess the impact of losses arising from a failure to place the securities successfully.

Where a securities firm deals in illiquid securities (eg, 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. Therefore, a securities firm may consider the impact of liquidity risk on its exposure to:

1. (1)

   credit risk; and

2. (2)

   market risk.

Counterparty risk requirements 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 facilities; and

3. (3)

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

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 following factors:

1. (1)

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

2. (2)

   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;

3. (3)

   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;

4. (4)

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

5. (5)

   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;

6. (6)

   whether it anticipates expanding its activities (eg, 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 IFPRU 2.3.36 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 FCA to accept as adequate any particular model that it develops, or automatically to reflect the results from the model in any individual capital guidance or capital planning buffer. However, the FCA will take into account the results of a sound and prudent model when giving individual capital guidance or when dealing with the firm in relation to its capital planning buffer.

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 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 IFPRU 2.3.36 G), the FCA 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 own funds requirements before aggregation with the corresponding components of the own funds requirements calculation; and

2. (2)

   evidence that the guidance inIFPRU 2.3.68 G to IFPRU 2.3.75 G1 has been followed.

   1

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. For a firm which is a member of a group, IFPRU 2.2.54 R (Application of IFPRU 2.2 on an individual basis and consolidated basis) 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 diversification benefits between business types, the firm should be able to explain to the FCA, 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.