Implementing the IFPR: key lessons for firms from the FCA’s review

The ICARA process mandates firms to provide a reasonable estimate of necessary liquid assets to support ongoing operations, including in stressed conditions or an orderly wind-down.

The FCA observed shortcomings in how some firms approached the assessment of liquid assets. In particular:

• Inadequate consideration of liquidity stress testing, as required by MIFIDPRU 7.7.3.

• The application of stresses is not closely aligned with the nature of a firm’s cashflows, drivers of liquidity risk, business model or the features of the markets in which they operate in.
• Failure to distinguish the analysis of liquid assets from the analysis of own funds leading to an inadequate assessment of liquid asset resources required.

Liquidity requirements are a relatively new set of requirements for most firms in the scope of the IFPR. The FCA’s findings highlight that some firms still have a long way to go to embed robust liquidity risk management practices. The FCA is concerned that inadequate assessments of liquid assets can lead to an inability to meet obligations under stress, thereby harming stakeholders and clients, and potentially affecting markets.

Firms that weren’t subject to the FCA examination should be reviewing whether they are conducting forward-looking assessments of liquid assets through liquidity stress tests and whether their stress scenarios reflect the features and drivers of the firm’s business model that may cause liquidity strain. Examples are conducting monthly and quarterly analyses of stressed cashflows when the firm is subject to significant intra-day funding gaps, assessing the impact of potential unexpected margin calls or not assessing the failure of multiple market participants where counterparty credit risk is a key concern.

Firms should also be embracing the practice of conducting regular reviews of their stress assessments to ensure they remain relevant as market conditions and the firms’ activities evolve.

The FCA clarified that the liquidity side of the analysis should focus on the impacts of cash or sources of cash. On the own funds side, the analysis should centre on the impact of the value of the firm’s assets, liabilities, and capital accounts without necessarily increasing or reducing cash or its sources.

The FCA observed that the early warning indicator values and triggers for intervention that some firms were setting would not enable firms to take timely action to mitigate harm. The FCA provided examples:

• The point at which some firms planned to consider activating the wind-down plan is when their own funds and/or liquid asset resources have already fallen below the levels needed to support an orderly wind-down.
• Some firms did not consider the interaction of internal intervention points (like when to activate the recovery plan or wind-down plan) with their threshold requirements such that there is a risk that relatively mild stress may quickly force the firm to wind down.
• Only a few firms made effective use of stress testing to identify by how much resources should exceed threshold requirements in unstressed conditions or to test the appropriateness of the setting of levels of resources in their risk appetite framework.

The FCA expects firms’ risk management processes to anticipate problems, take effective steps to prevent them and rectify problems when they occur. Early warning indicators and triggers for action are essential components of the risk management toolkit to help firms identify when problems may be emerging and interventions are required. The indicators and triggers need to be set at levels which allow the firm sufficient time for assessment, decision making and implementation of the necessary recovery or wind-down actions.

The FCA observed that own funds and liquid asset thresholds were often aligned with MIFIDPRU-specified levels without a connection to the firm's business model and risks. Firms are reminded to adopt indicators and triggers for action based on a deep understanding of the business.

Equally, the FCA has reiterated that they expect firms to set early warning indicators and triggers above regulatory levels, derived from the ICARA process and, in particular, stress testing exercise. The linkage between harms assessment, stress testing, reverse stress testing, and early warning indicators and triggers for action should be transparently traced back to the firm’s risk appetite and the limit framework.

The FCA’s wind-down plans observations focussed on two themes.

First, how firms overlook some core operational and business model aspects when creating wind-down plans. Examples are:

• Assuming that wind-down would take place under normal, instead of stressed, conditions. Consequently, firms were not contemplating the possibility that liquid assets and own funds have been depleted by prior stresses when wind-down commences.
• The financial impacts of wind-down did not consider how stress conditions cause the fire sale of assets, the acceleration of liability payments or clients transferring businesses away from the firm at a faster rate.
• Failing to thoroughly reflect the firm’s operations, including products, geographies, activities, and obligations in the plan.
• Solely having wind-down triggers based on own funds and liquidity, and overlooking non-financial triggers, for instance, on reputational risk or key client concentration.

The second wind-down theme was firms failing to consider the potential harms arising from inter-firm relationships within the wider group during the ICARA process. In particular, the FCA noted:

• A lack of consideration of the role of group relationships leading to inadequate assessments of resources to support orderly wind-down.
• A lack of consideration of how the wind-down may be caused by other entities in the group failing. Furthermore, what role may group governance have in the wind-down process.
• Insufficient consideration of group-wide risk appetite statements and wind-down plans may lead to incomplete assessments of harms that should be mitigated.

The FCA’s IFPR reviews highlight how wind-down planning and wind-down plans must form part of regular risk management review processes. This is so firms regularly assess their wind-down plans in the context of their business model, market and organisational developments. The FCA found that some wind-down plans had not been updated for years.

Although ICARA’s are completed on an individual firm basis, the FCA is concerned about the harms caused by, and to, regulated firms. This is why the FCA expects firms to consider the intra-group relationships and dependencies as part of the ICARA process including for wind-down planning and plans. To gain a broader perspective firms should also factor in any group-wide resolution plans and wind-down triggers into their own planning when applicable. This approach ensures a more cohesive and thorough evaluation of required resources within the context of group relationships.

The FCA’s Wind-Down Planning Guide should be a go-to document to help embed wind-down planning and wind-down plans into risk management operations.

The FCA saw that many firms assessed operational risk capital using approaches that did not lead to adequate assessments of their own funds required. The weaknesses can be bucketed into three groups:

• The firm did not thoroughly consider the relevant risks.
• Inappropriate use of models (including models designed by other members of the firm’s group).
• The use of complex modelling approaches that were not supported by robust governance and oversight led to approaches that resulted in incorrect or poorly understood results.

The FCA are concerned about poor model risk management and governance. Unless models are used appropriately and the results are clearly understood, the firm does not have assurance that its prudential resource assessment is adequate. Good model risk management practices include a policy of regular independent validation of models and approaches used to assess own funds requirements. This process should include a comprehensive review and challenge of key assumptions in the methodology, ensuring thorough explanations and verifications for each. This helps to identify and rectify any errors early on in the process.

A robust model risk management process should include a relevant staff from across the business to be “critical friends” and contribute their expertise. Subject matter experts can ensure that risks are considered in their totality (for example, cyber risk, is a potential trigger of several “secondary” risks, which should be each individually assessed) and provide insightful loss assessments.

Having robust model risk management practices equally applies to the use of group-level models. The FCA noted how it was prevalent for firms within larger groups to apply group operational risk models in individual ICARA processes without scrutinising their suitability for those individual firms.

Firms should also be mindful not to overestimate diversification benefits and to provide appropriate and sufficient explanations for any diversification benefits recognised in their assessment.

The FCA is looking for the ICARA process to be embedded into the risk management framework so that there is a seamless interaction between the different components. The FCA’s observations around operational risk illustrate that there should be clear linkages between enterprise risk assessment, the risk control self-assessment (RCSA) process, scenario analysis and the operational risk assessment.

The FCA’s report provides a number of good and bad practices regarding firms’ ICARA process which they observed during their reviews. Several of these practices have already been identified in the four themes above. Additional good practices observed are:

• Undertaking a holistic assessment of harms from the firm’s operations. In so doing resources to mitigate harms not covered by K-factors were considered in the assessment of adequate resources.
• ICARA assessments were linked and integrated with each other. For instance, there were clear links between the risks assessed and the risk management process used. This in turn helps to ensure that threshold requirements were based on joined-up assessments with clear consistencies in the analysis of own funds, liquid assets, wind-down planning, and stress testing. 
• For those firms undertaking a Group ICARA process, group-level numbers were adjusted to eliminate the impact of intragroup offsets when allocated to the individual firms. There were also clear explanations as to whether the allocation was appropriate.
• The ICARA document had a clear summary of the drivers of threshold requirements and the stresses used to support the analysis. Furthermore, the reasons for significant changes in own funds and liquid asset resource requirements were discussed.
• There was consistency in the regulatory submissions with the ICARA document, annual reports, and internal management information.

The FCA’s observations reiterate that the ICARA process has to be embedded into the risk management framework so that there is a seamless interaction with the different components of a firm’s risk management processes. Doing so will help firms to ensure that the totality of harms and risks appropriate to the firm’s business model and operations are considered when assessing financial and non-financial resources/actions on an ongoing basis and for wind-down.

Scenario analysis and stress testing (using scenarios associated with a firm’s business model and the markets in which it operates) will provide additional substantive information that contributes to, and informs that assessment. It cannot be overemphasised that the ICARA process should not be viewed in isolation or simply bolted on to the end of existing risk management processes.

The FCA also highlights the importance of providing a clear summary narrative at the beginning of the ICARA document. The summary should be able to bring all of the pieces of the ICARA jigsaw together to explain the outcome of the own funds and liquidity assessments.