IFPR: Preparing ahead of FCA's ICARA reviews

Stock-Take

For investment firms in scope of the Investment Firms Prudential Regime (IFPR), compliance with (and demonstrability of) the Financial Conduct Authority’s (FCA) financial resources requirements, is essential to ensure the ability to reduce harm in case of crystallised risks. The specific requirements and expectations are captured in the IFPR as set out within the MIFIDPRU Sourcebook.

While implementation of the IFPR is now ‘old news’ it is worth noting, in the FCA’s latest Business Plan, the emphasis placed on financial resilience and effective wind-down planning (WDP), which remain high on the FCA’s supervisory agenda.

As we are now at the two-year mark since the introduction of the IFPR in January 2022, the FCA expects in-scope firms to have fully implemented all relevant requirements. Importantly, in-scope Investment Firms should by now be able to demonstrate compliance with and effective implementation of all applicable IFPR requirements, through the Internal Capital Adequacy and Risk Assessment (ICARA).

In this article, we share our insights and lessons learned from supporting a wide range of clients and from the feedback provided by the FCA in their thematic reviews.

FCA’s findings and expectations

Maintaining an effective and fit-for-purpose ICARA is essential for Investment Firms to both understand the nature of risks and harms inherent in their business as well as to remain IFPR-compliant.

The FCA continues to carry out a program of Supervisory Review and Evaluation Process (SREP) reviews to assess firms’ ICARAs, while also undertaking thematic reviews to gauge the progress made with the implementation of the MIFIDPRU prudential framework. The feedback provided by the FCA in their reports published first in February and then in November last year, shows that some firms have:

• Misinterpreted the ICARA approach in a group and show an insufficient assessment of risk of harms of individual firms
• Developed insufficient liquidity stress testing processes
• Determined internal intervention points that would not allow timely remedial action
• Understated wind-down costs and neglected to consider group implications in wind-down scenarios
• Applied inadequate capital models for the assessment of operational risk
• Submitted incorrect or inconsistent data in their MIF returns.

Therefore, when preparing or updating the ICARA document and the core processes associated with the internal assessment, firms must consider key expectations such as:

• The completeness and proportionality of the ICARA
• The effectiveness of governance and risk management arrangements
• Demonstrability of financial resilience by meeting the own funds and liquid assets requirements
• Reliability and operability of the wind-down plan
• Clarity of group-wide implications arising including prudential consolidation if applicable.

What makes a good ICARA?

The ICARA document and its underlying processes are essential to demonstrate effective identification and management of risk of harm. Similarly, it is also critical to demonstrate a firm’s ability to maintain adequate financial resources throughout the economic cycle and, should it become necessary, effect an orderly wind-down.

The effective assessment of operational risk seems to remain a critical point according to the FCA’s latest feedback. This includes developing a comprehensive scenario analysis, understanding how a single trigger event may impact various operational aspects of a business, developing internal models that are evaluated regularly to identify any limitations and ultimately ensuring that operational risk approaches are usable and not overly complicated.

Of course, for the IFPR requirements to be deemed effectively implemented and fully embedded in the ICARA, the conclusions reached should form the basis of strategic decision-making and have actual ‘use’ by management (ie not be treated like an annual exercise done for regulatory compliance purposes only).

When completing the ICARA document, while recognising it as an internal document, it should be drafted bearing in mind the potentially dual audiences of the Board of Directors as well as the FCA. From our experience where the ICARA document lacks structure and a ‘logical flow’ of key information, it is a less efficient management tool and is more likely to attract negative regulatory commentary in the case of a SREP.

The ICARA also allows a firm to test and monitor its financial resilience in situations of stress, and it is therefore essential to demonstrate a full understanding of the specific and different purpose of key processes such as stress testing, reverse stress scenario, recovery planning and wind-down planning.

Lastly, we note that it is good practice to complete, in support of the ICARA, an obligations map to ensure clarity and demonstrability as to the elements of MIFIDPRU (and other key Sourcebooks such as SYSC) concluded as applicable to the firm (and therefore reflected in the ICARA document).

What makes a ‘good' Wind-down plan?

For firms either creating their first WDP or those revisiting existing plans with a view to ensure effectiveness and regulatory compliance there are several overarching ‘objectives’ to bear in mind:

• The WDP must be ‘operable’, with a clear indication of actions and resources required and realistic in terms of time frames assumed for completing each element
• It must be possible to execute an orderly and solvent wind-down while considering the risks posed to the process
• The WDP must be comprehensive in its coverage and in line with the FCA’s Wind-Down planning guide (WDPG).

Firstly, an operable WDP is critical to the completeness of the ICARA and is an area that the FCA will likely focus on during a SREP review. When appraising existing or creating a new WDP it is necessary to take a step back to first consider the nature of business conducted and the operating model of the firm including any reliance placed on third-party services.

In this context, firms should be clear that ultimately the aim of the WDP is the prevention of harm even in the event of failure. This means that firms must also assess the impact of wind-down on clients, counterparties, stakeholders, external suppliers or the wider market, and link the assessment to their risk management framework.

Key to an operable wind-down plan are clear governance and decision-making arrangements. Senior management must be directly involved in a decision to wind-down, but also manage relevant processes such as setting Early Warning Indicators (EWI), agreeing an internal wind-down trigger, as well as considering predefined actions such as the allocation of key operational tasks, the ring-fencing of financial resources needed to cover the additional wind-down costs or arranging the transfer of the business to a third party.

For this purpose, a clear operational analysis must be presented as an executable step-by-step action plan, including a list of the persons responsible and a realistic timeframe to completion for each component part.

As to the second point, risks that could hinder the wind-down process must be considered, as the closure of a business represents a stress scenario where things may not always go according to plan.

For this reason, an assessment of the financial and operational risks posed to the completion of the process in an orderly fashion is also important.

A wind-down timeline may change due to unforeseen circumstances and some required activities such as conversion/liquidation of assets or business transfer may not materialise exactly as expected. Other aspects to consider include the completion of a CASS resolution plan, unexpected funding gaps and cash outflows, legal issues from lawsuits or unbreakable long-term contracts, practical challenges to the execution of operational actions and also the time needed for the FCA to grant de-registration.

The third point to consider is completeness of the WDP, in terms of the breadth and depth of analysis as well as its consistency with the WDPG structure recommended by the FCA. Key constituent parts include:

• Governance: clear description of decision-making arrangements during wind-down
• Wind-down Scenarios: consider multiple assumptions leading to wind-down, which may include either financial or strategic failure but also external events or group-wide causes
• Operational analysis: as mentioned above this should be a step-by-step action plan with tasks scheduled in logical order and persons responsible and timeframe
• Impact assessment: an assessment of impact of wind-down on clients, counterparties, stakeholders or the group. This must be consistent with the main harm-led assessment
• Assessment of risks posed to an effective wind-down: events that could affect the timeline or prevent an orderly completion
• Resource assessment: identify essential human and financial resources needed. This should include a detailed cashflow analysis of initial and total wind down costs, while considering financial stress, exceptional costs, reduced revenue streams and limited liquid assets available
• Communications plan: list of actions to inform staff, clients, counterparties and notify the FCA.

An effective WDP should not be an isolated process and must be joined up with all the other constituent parts making up the ICARA overall. Further insight and detailed comments can also be found in our October Investment and Wealth Management monthly issue.

Group considerations

Prudential consolidation is an area that the FCA is looking into to better understand how firms in a group have interpreted the requirements. Firms that are part of wider groups, whether included in an IFG under prudential consolidation or not, must consider group-wide relationships, dependencies and risks when preparing both the ICARA generally and the WDP specifically.

ICARA

Where an IFG exists, the ICARA may be completed on a ‘solo’, ‘consolidated’ or ‘group’ basis. It is important to note that the ICARA can only be on a consolidated basis once express permission has been granted by the FCA.

We are aware of examples of SREP feedback highlighting that firms had misinterpreted the MIFIDPRU rules and guidance on ICARA processes in a consolidated situation. To ensure additional clarity in this space, at the end of September, the FCA issued further guidance in MIFIDPRU 7.9.4 and 7.9.5 in respect of the conditions to a ‘consolidated ICARA’ versus a ‘group ICARA’. In either case, individual MIFIDPRU firms in an IFG must demonstrate and document how they meet the OFAR on an individual basis.

Unless a consolidated ICARA process is requested by the FCA, an IFG may opt to operate a "group ICARA" which may be a more practical and less burdensome process when compared to the consolidated approach, as it combines together the financial adequacy and risk assessment of multiple entities into one document, yet allowing full visibility of the results of OFAR compliance for each individual firm.

Wind Down Planning

In group-wide WDPs the FCA expects IFGs to consider intra-group operational and financial dependencies, loans/liabilities, outsourcing arrangements and shared governance processes between entities.

Wind-down scenarios should include assumptions of single firm failure and its impact on the rest of the group, including any contagion effect and potential for survival of other group members.

Conversely, wind-down assumptions may also include group/parent failure, in which case the wind-down analysis must assess the impact and repercussions on the MIFIDPRU firms in an IFG of critical stress events materialising elsewhere in the group.

Overall, the priority should be to ensure that the financial resources available to the parent entity and group members are sufficient to complete an orderly wind-down process.

Conclusions

The FCA is committed to increasing the use of the SREP monitoring process, so all investment firms, particularly newly authorised and high-risk or high-growth firms, should expect to have their ICARA reviewed by the FCA at some point.

Being ready ahead of an FCA assessment is crucial. A SREP process typically requires the submission of the full suite of ICARA documentation, including all constituent parts and supporting calculations, which need to be accurate and consistent.

The FCA may in some instances ask to meet with senior management to discuss the ICARA in more detail. In all instances it is important to make sure that the key individuals have a clear understanding of all underlying processes and retain full ownership of the prescribed methodologies, the rationale behind conclusions, final assessments and overall results.

It is imperative to not underestimate the time and effort required to complete a SREP, so focusing on the areas mentioned in this article will help align with FCA’s expectations and can make the whole SREP experience more manageable.