1st October 2021
The introduction of the Investment Firms Prudential Regime (IFPR) in January 2022 means that there will be a single prudential regime for all investment firms regulated by the Financial Conduct Authority (FCA). The regime proposes raising the capital requirements for smaller firms. There are also changes in respect of risk management and governance, as well as forecasting and budgeting which will nee to be considered.
With the introduction of the regime quickly approaching, it is important to be proactive and ensure you are ready to successfully meet the new requirements when they come into effect.
Clarification on consolidation rules
Management need to fully understand the implications of IFPR for the firm and the firm’s group structure in order to identify whether the consolidation rules apply. This is relevant for many group structures common in the industry, which ring-fence the regulated entity. The consolidation rules mean the regulated entity, along with the other entities in the consolidation group, will not be treated as a single entity.
The FCA has recently provided further clarification on the consolidation rules, including a better description for defining FCA investment firms and quantitative thresholds for assessing the scale of activities carried out. The FCA has also confirmed that there is no link between the Companies Act consolidation requirements and those of IFPR.
Start-ups need to consider how they will structure potential groups immediately, as restructuring at a later date may be complex and expensive. Similarly, existing groups may find that a restructuring exercise is the best option. This will also be a lengthy process and is therefore worth considering sooner rather than later.
Increased capital requirements
As a result of changes to the consolidation group, firms may be required to maintain higher capital levels due to the costs of the group being aggregated together to identify its capital requirements.
Firms must have good foresight of expected capital requirements and consider where to source funds should they need to recapitalise. Firms are rightly focusing on the amount and timing of capital injections. However, this is likely to be particularly challenging for CAD exempt firms and those with limited regulatory permissions (those previously subject to €50k capital requirements) who may need to be capitalised to a similar level as larger firms, at a quarter of the firm’s fixed annual overheads.
The FCA has clarified aspects of the calculation of the fixed overheads requirement (FOR) in response to queries raised during the consultation phase. It confirmed that relevant expenditure for FOR purposes should be calculated before the distribution of profits, and that the expenditure of the entire firm should be included in the calculation (not just the expenditure related to its regulated activities).
The FOR will fluctuate as the cost base of the consolidation group fluctuates. Therefore, management will need accurate forward-looking data based on a combination of historic actuals and known changes. Firms will also need to consider whether they have the expertise internally to appropriately forecast, monitor and advise on the fluctuating capital requirements. In certain cases there may be a need to either expand the finance team to support the additional monitoring and reporting required, or consider outsourcing this function.
The importance of forecasting
The introduction of ISA 570 Going Concern for audits in 2020 increased the amount of work performed by the auditor, with the standard requiring more rigorous challenge of budgets, forecasts and the assertions made by management in relation to the firm’s ability to continue as a going concern. Auditors have been considering management’s assessment of the impact of IFPR and how any capital deficiencies will be remedied, often probing further to see evidence that there is a viable funding source for any forecast increase in capital.
This added scrutiny has forced firms to focus more resources on the ability to create and manage increasingly detailed and accurate forecasts, and this is set to continue given their ongoing purpose in managing expected liquidity requirements.
Many firms are making use of scenario planning, sensitivity analysis and reverse stress testing, in which they consider the impact on forecasts of a fall in income or an increase in costs. The use of forecasting and budgeting is expected to become an integral part of financial management and firms should ensure that their forecasting skills are up to scratch.
Risk management: ICARA, governance and remuneration
The Internal Capital and Risk Assessment (ICARA) process will be in place from 1 January 2022, replacing the Internal Capital Adequacy Assessment Process (ICAAP), so management should already have a good understanding of the new requirements. While the ICARA is not radically different to the ICAAP, it changes how investment firms should think about and manage risk.
The FCA stated that firms will be required to review their ICARA process regularly and submit a report detailing their findings from the review process. The ICARA should be updated immediately once a material change arises. The regulator does, however, understand that firms will be familiarising themselves with ICARA, and therefore it is understood that the reporting for 2022 will be on a best effort basis.
The FCA recently confirmed plans to create a single remuneration code for all FCA investment firms, including thresholds for determining whether basic, standard or extended remuneration requirements will apply to firms. In a consultation paper, it outlined plans for the largest single and non-interconnected FCA investment (non-SNI) firms to set up risk, remuneration and nomination committees, although a non-SNI firm will be able to rely on group level remuneration committees where the firm is part of an FCA investment firm consolidation group and other criteria is fulfilled.
External advice is critical if the firm has no internal compliance expertise of its own. Firms should be aware it will take a significant amount of time for management to prepare for the new regime and prompt action should be taken if this process is not yet underway.
Please speak to Edward Parkes, Senior Manager, or your usual haysmacintyre contact if you would like to discuss the above further.
For further information on haysmacintyre services for Financial Services businesses please contact Melanie Pittas at firstname.lastname@example.org.