PRU 1.2 1Adequacy of financial resources

The guidance in PRU 1.2 is drafted with respect to a firm to which PRU 1.2 and the other provisions of PRU referred to in PRU 1.2 apply in full. The guidance in PRU 1.2 is also applicable to a firm that falls into PRU 1.2.2 R. However the guidance in PRU 1.2, as it applies to such a firm, should be read accordingly. In particular, the guidance in PRU 1.2 only applies to such a firm in respect of liquidity risk.

In the case of an incoming EEA firm that is a full BCD credit institution and of an overseas firm that is a lead-regulated firm, PRU 1.2 only applies to its United Kingdom branch. However, as a branch is not itself a legal entity separate from the rest of a firm, this restriction does not mean that the rest of the firm can necessarily be left out of account when considering compliance with PRU 1.2. For example, the availability of the branch's liquidity resources may be affected by general liquidity problems in the firm. Likewise, there may be liquidity resources elsewhere in the firm that are available to meet liquidity problems in the branch.

One factor that may affect the degree to which it is necessary to take into account the firm as a whole is the extent to which the firm manages the liquidity of the branch on an autonomous basis, or includes the branch within integrated liquidity management of the firm as a whole. In the latter case, for instance, the requirement in PRU 1.2.35 R to carry out scenario analyses may be satisfied by the firm meeting similar requirements set by the regulator in its home country in respect of the firm as whole, provided that the firm separately identifies the impacts on the United Kingdom branch of the scenarios analysed. However, in the case of a full BCD credit institution, the application of PRU 1.2 is further restricted by PRU 1.2.5 R.

The scope of application of PRU 1.2 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

The requirements in PRU 1.2 apply to a firm on a solo basis.

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources which a firm needs to hold in order to be able to meet its liabilities as they fall due. These resources include both capital and liquidity resources. PRU 2 sets out provisions relating to the adequacy of capital resources. PRU 5 contains provisions relating to liquidity.

This section therefore introduces rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, how it intends to deal with those risks, and the amount and nature of financial resources the firm considers necessary. These assessments should be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of capital resources.

This section also introduces 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 needed in each of the circumstances and events considered in carrying out the stress tests and scenario analyses.

The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. This is done, by the FSA, through comparing the firm's capital resource requirements with its capital resources and by review of a firm's processes and systems for assessing capital needs, the results of the firm's assessments, and other information available to the FSA on the risks faced by the firm.

PRU 2.1 sets out the minimum capital resources requirements for a firm. PRU 2.2 sets out how capital resources are defined and measured for the purpose of meeting the requirements of PRU 2.1.

PRU 2.3 sets out detailed guidance on how firms could assess the adequacy of their capital resources both to comply with the rules set out in this section and to enable the FSA to assess better whether the minimum capital resources requirements of PRU 2.1 are appropriate. The more thorough, objective, and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

PRU 5.1 sets out general systems and controls provisions for liquidity risk.

PRU 1.4 sets out rules and guidance on the establishment and maintenance of systems and controls.

The liabilities referred to in PRU 1.2.22 R include contingent and prospective liabilities that a firm has potentially incurred. It therefore excludes liabilities that might arise from transactions that a firm has not entered into and which it could avoid, for example, by ceasing to trade. It includes liabilities or costs that arise as a consequence of strategies other than continuing as a going concern. It also includes 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.

A firm should therefore 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. This does not require a firm to hold financial resources sufficient to ensure that any particular margin of financial resources is maintained under such 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. PRU 5.1.86 E is an evidential provision relating to PRU 1.2.22 R concerning contingency funding plans. 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.

PRU 1.2.27 R amplifies the requirement in SYSC 3.2.6 R.

The processes and systems are required for a firm's internal assessment of the adequacy of its financial resources. The appropriateness of the internal process, and the degree of involvement of senior management in the process, will be taken into account by the FSA when reviewing a firm's assessment as part of the FSA's own assessment of the adequacy of a firm's financial resources. The processes and systems should ensure that the assessment of the adequacy of a firm's financial resources is reported to its senior management as often as is necessary. In addition, a firm would be expected to reassess the adequacy of its financial resources should the firm experience some material change to the nature or scale of its activities.

The assessments undertaken by firms in run-off may not need to be as comprehensive or frequent compared to a firm not in run off since this may better reflect the reduced nature and complexity of its business and reduced access to new capital. Whilst a firm in run-off will still need to carefully monitor the progress of the run off, a more comprehensive assessment may only be appropriate on commencement of the run off or when considering a reduction in capital through the payment of a dividend or other capital distribution or if the firm's circumstances change materially.

In PRU 1.2.31 R:

1. (1)

   operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events; and

2. (2)

   insurance risk refers to the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

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, which may not be adequately addressed by holding additional capital, will be zero. However, a firm must, in accordance with PRU 1.2.37 R, document the approaches taken to manage these risks.

Stress tests and scenario analyses should be carried out at least annually. A firm should, however, consider whether the nature of the major sources of risks identified by it in accordance with PRU 1.2.31 R 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 in order to reflect that concentration. PRU 5.1.61 E is an evidential provision relating to PRU 1.2.35 R concerning scenario analysis in relation to liquidity risk.

Where a firm follows the guidance set out in PRU 2.3.35 G to PRU 2.3.48 G and assesses the adequacy of the capital resources requirement (CRR) in its particular circumstances as a basis for deciding what financial resources are adequate, it should include this in the documentation produced in accordance with PRU 1.2.37 R.

A large part of the process of managing a firm is based on an understanding of the expected outcomes of its business operations and outside events and the normal variation about these expected outcomes. To gain a comprehensive view of the risks being run by a firm, an analysis of extreme events is also needed. Such analysis may take the form of stress tests and scenario analyses. For example, a firm may normally expect interest rates to increase or decrease by 1 or 2 percentage points due to normal variations in economic conditions. However, in some extreme circumstances, interest rates may change by a much greater amount. The use of stress tests and scenario analyses can give a firm's management a better understanding of the firm's true exposure in extreme circumstances.

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 business.

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of catastrophic 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.

Scenarios generally could also be considered under three broad categories. For example, changes to the business plan, scenarios that involve changes in business cycles and those relating to extreme events. The scenarios can be derived in a variety of ways including stochastic models, analysis of historic experience or a repetition of an historical event. Scenarios can be developed with varying degrees of precision and depth.

Both stress tests and scenario analyses can be undertaken by firms to further a better understanding of the vulnerabilities that they face under extreme conditions. They are based on the analysis of the impact of unlikely, but not impossible, events. These events can be financial, operational, legal or relate to any other risk that might have an economic impact on the firm.

PRU 1.2.35 R requires a firm, as part of carrying out stress tests and scenario analyses, to take reasonable steps to identify an appropriate range of realistic circumstances and events in which a risk would crystallise. In particular:

1. (1)

   a firm need only carry out stress tests and scenario analyses in so far as the circumstances or events are reasonably foreseeable, that is to say, their occurrence is not too remote a possibility; and

2. (2)

   a firm should also take into account the relative costs and benefits of carrying out the stress tests and scenario analyses in respect of the circumstances and events identified.

The purpose of stress tests and scenario analyses 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 prospective analysis techniques, which seek to anticipate possible losses that might occur if an identified risk crystallises. In applying them, a firm needs to 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.

The time horizon over which stress tests and scenario analysis would need to be carried out for the market risk arising from the holding of investments, for example, should 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 liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) which would allow the firm, if needed, to sell its holding so as to prevent or reduce exposure to future price fluctuations.

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 (for example, 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 purposes for which financial resources may be used.

A firm should consider conducting stress tests and scenario analyses which enable it to assess its exposure not only in its current position in the economic and business cycles, but also the possible changes in the cycles which might be expected over, say, the next three to five years.

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 some 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 from projections of future profits.

A firm may substitute for traditional stress tests and scenario analyses more sophisticated modelling techniques and this approach is acceptable providing major risks are identified and the modelling has the effect of calculating the effect on a firm's financial position where the risks crystallise or are assumed to crystallise with a particular probability.

Additional guidance on stress tests and scenario analyses for the assessment of capital resources is available in PRU 2.3.

Additional guidance in relation to stress tests and scenario analysis for liquidity risk is available in PRU 5.1.58 G to PRU 5.1.62 G.