This chapter implements certain provisions of CRD relating to governance and contains guidance related to Section III of Chapter 2, Title VII of CRD (Supervisory review and evaluation process).

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources that a firm needs to hold in order to meet its liabilities as they fall due. These resources include both capital and liquidity resources.

This section has rules requiring a firm to identify and assess risks to its ability to meet its liabilities as they fall due, how it intends to deal with those risks, and the amount and nature of financial resources that the firm considers necessary. IFPRU 2.2.43 R (Documentation of risk assessment) provides that a firm should document that assessment. The FCA will review that assessment as part of its own assessment of the adequacy of a firm's capital under its supervisory review and evaluation process (SREP). When forming a view of any individual capital guidance to be given to the firm, the FCA will also review the regulator's risk assessment and any other issues arising from day-to-day supervision.

This section has rules requiring a firm to carry out appropriate stress tests and scenario analyses for the risks it has previously identified and to establish the amount of financial resources and internal capital needed in each of the circumstances and events considered in that analyses. The FCA will consider, as part of its SREP, whether the firm should hold a capital planning buffer and the amount and quality of that buffer. The capital planning buffer is an amount separate, though related to, the individual capital guidance in so far as its purpose is to ensure that a firm is able to continue to meet the overall financial adequacy rule throughout the relevant capital planning period in the face of adverse circumstances, after allowing for realistic management actions. Therefore, when forming its view on a firm'scapital planning buffer, the FCA will take into account the assessment made in relation to the firm'sICG.

1This section has rules on the individual, sub-consolidated basis and consolidated basis application of:

1. (1)

   the ICAAP rules in IFPRU 2.2.45R to IFPRU 2.2.49R (Level of application: ICAAP rules);

2. (2)

   the risk control rules in IFPRU 2.2.58R to IFPRU 2.2.60R (Level of application: risk control rules); and

3. (3)

   the overall financial adequacy rule in IFPRU 2.2.61R to IFPRU 2.2.63R (Level of application: overall financial adequacy rule).

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 UK CRR5 (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 ICAAPrules 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 UK CRR5 (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 UK CRR5 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'sICAAP 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 UK CRR5 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'ssenior 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-UK sub-group4 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-UK sub-group4 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-UK sub-group4, 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.

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

2 BIPRU 12 contains rules and guidance relating to the adequacy of a firm’s liquidity resources and its assessment by the firm and the FCA.

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 ICAAPrules; 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, – including SYSC 20 (Reverse stress testing) –2 if it is a significant IFPRU firm;2 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 UK CRR4;

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)).

1. (1)

   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: 2

   1. (a)

      diversification benefits and transferability of resources between members of the group;2

   2. (b)

      the contribution of each member within the group to its overall risk profile; and 2

   3. (c)

      an apportionment of the capital required by the group as a whole to the firm (IFPRU 2.2.45R to IFPRU 2.2.57G (Application of IFPRU 2.2 on an individual and consolidated basis)).2

2. (2)

   A firm may, instead of preparing the ICAAP itself, adopt as its ICAAP an assessment prepared by other group members.2

A firm should ensure that its ICAAP is:

1. (1)

   the responsibility of the firm'sgoverning body;

2. (2)

   reported to the firm'sgoverning body; and

3. (3)

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

The FCA will review a firm'sICAAP, including the results of the firm's stress tests carried out under IFPRU and the UK CRR4, 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'sICAAP 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 UK CRR4 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'sICAAP, 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 UK CRR4 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.

1. (1)

   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. 2

2. (2)

   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), and the extent to which the firm has used any of the capital buffers that are required of it under the UK legislation that implemented3 the CRD, as applicable.2

3. (3)

   Accordingly, a firm'scapital 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.2

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'scapital 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'sSREP) 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'sICAAP, 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'stotal risk exposure amount2 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 UK CRR4.

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 UK CRR4.

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 ICAAPrules, 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'sown 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'scapital 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'scapital 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'sICAAP 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'sown 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'sown 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'ssenior 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'sICAAP 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 UK CRR4 (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 UK CRR4 (Internal Ratings Based Approach)) and, possibly, advanced measurement approaches for operational risk (see Part Three, Title III, Chapter 4 of the UK CRR4 (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'sICAAP.

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'sown 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'ssenior 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'ssenior 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'ssenior 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'sICAAP 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'sICAAP 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.

SYSC 18 (Whistleblowing) contains1 requirements on UK SMCR banking firms3 and certain insurers (see SYSC 18.1.1AR) in relation to the adoption and communication of appropriate internal procedures for handling reportable concerns as part of an effective risk management system. SYSC 18.1.1CG provides that firms not otherwise subject to SYSC 18 may nonetheless wish to adopt the provisions in that chapter as best practice1.