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Prudential Regulation: ICAAP & SREP

27th April 2016

FCA Prudential Supervision

The Financial Conduct Authority (FCA) is tasked not only with conduct regulation of all those within the UK financial services industry, but also for the prudential supervision of those that do not fall under the charge of the Prudential Regulation Authority (PRA) – approximately 24,000 firms.

Last May (2015), just after their two year anniversary, the FCA held their first Prudential Supervision Forum that focused upon their role as the prudential supervisor to these firms and how their approach to prudential regulation is underpinned by their statutory objectives – those of consumer protection, market integrity and competition.

Prudential Regimes

At the FCA Prudential Supervision Forum, the keynote speaker, Nausicaa Delfas, Director of Specialist Supervision at the FCA informed that when it comes to prudential supervision they take a similar approach as they do to conduct supervision.

The FCA’s prudential assessments consider a wide scope of factors that go “beyond quantitative analysis of firm’s financial resources and consider systems and controls, governance arrangements and risk management capabilities including the risk of misconduct.”

In essence, the FCA assesses “how well a firm understands the risks that it is running and how well placed it is to manage those risks, and to avoid large, unexpected costs.”

As the FCA advises, they “supervise firms under more than a dozen prudential regimes” each dependent upon the different types of firm, however the best known of these regimes are:

• BIPRU (the Prudential Sourcebook for Banks, Building Societies and Investment Firms); and
• IFPRU (the Prudential Sourcebook for Investment Firms).

Basel II: Liquidity & Capital Resources

Basel II introduced three ‘Pillars’ to the regulator’s prudential framework which underpin the Capital Requirements Regulations, these being:

Supervisory Review and Evaluation Process (SREP)

As informed at the Forum last May, the FCA regularly perform the Supervisory Review and Evaluation Process (SREP) to determine the appropriate level of capital and liquidity a firm should hold based upon the risks posed by the firm’s business model. This is undertaken as part of their prudential assessments.

And from the start of 2016, the FCA’s supervisory approach to CRD IV (comprising the Capital Requirements Directive and the Capital Requirements Regulation) has been in line with the European Banking Authority’s (EBA) SREP Guidelines.

The EBA’s SREP Guidelines were issued in December 2014 as a measure to ensure that competent authorities and institutions take a consistent approach in adopting the Pillar 2 supervisory review and evaluation process.

As a consequence of adopting the SREP Guidelines, the FCA proposed changes to its Handbook rules and guidance, which can be found in the regulator’s Quarterly Consultation Paper CP 15/42 (Chapter 10) issued in December 2015.

Why do changes to SREP matter?

The SREP is a core part of the obligations placed upon the Financial Conduct Authority under CRD IV and requires the regulator to determine the adequacy of an IFPRU firm’s Internal Capital Adequacy Assessment Processes (ICAAP).

Since the EBA’s SREP Guidelines lay out the approach the FCA must take in their prudential assessments, firms will find the details useful in preparing suitable systems and controls, policies and procedures for their ICAAPs.

IFPRU Changes

The sections of the FCA’s IFPRU prudential sourcebook affected by the implementation of the EBA’s SREP Guidelines are IFPRU 2.2 on the Internal Capital Adequacy Assessment Process (ICAAP) and IFPRU 2.3 related to SREP: internal capital adequacy standards.

Whilst making these changes the FCA stressed that all IFPRU firms remain subject to the liquidity provisions within BIPRU 12.

Brief Overview of Liquidity Regime for Investment Firms

The liquidity requirements for investment firms regulated by the FCA are largely set out in chapter 12 of the Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU 12).

There are various liquidity requirements imposed on firms, including: the overall liquidity rule, the systems and controls framework, quantitative standards, the process for modifying liquidity requirements and liquidity reporting requirements.

The following extracts from BIPRU 12 highlight some of the most important requirements that the FCA provided further clarification via presentations at the FCA Prudential Supervision Forum:

“A firm must at all times maintain liquidity resources which  are adequate both as to amount and quality, to  ensure that there is no significant risk that its liabilities cannot be met as  they fall due .” BIPRU 12.2.1R

The FCA clarified that ‘at all times’ included during a period of liquidity stress, thus “liquidity covering only a business as usual assessment is inadequate”.

“A firm must consider alternative scenarios on liquidity positions and on risk mitigants and must review the assumptions underlying decisions concerning the funding position at least annually.” BIPRU 12.4-1R

In this regard, the FCA also clarified in at the Forum that for the purposes of stress testing, “firms are required to develop their own liquidity risk scenarios ranging from mild to “extreme but plausible” in scope and impact.

“A firm must have in place robust strategies, policies, processes and systems that enable it to identify, measure, manage and monitor liquidity risk over an appropriate set of time horizons, including intra-day, so as to ensure that it maintains adequate levels of liquidity” BIPRU 12.3.4R

Here, adequate means the amount of liquidity necessary to maintain overall liquidity within your liquidity risk tolerance – which is determined through the firm’s specific stress testing.

ICAAP & SREP

It is without doubt that a firm’s ICAAP is incredibly important and in performing SREP, the FCA is tasked with undertaking a thorough assessment of a firm’s management capability and controls as well as risk management exposures. Thus when reviewing, the regulator will start with an examination of the firm’s written submission - their Internal Capital Adequacy Assessment Process (ICAAP).

It should be noted that at last year’s Forum the FCA stressed they had found that “firms are not assessing their ICAAPs appropriately” which can result in the FCA “requiring significant capital increases.”

For firms confused over their ICAAP requirements, the FCA took the opportunity to clarify what ICAAP should mean to firms in their last Regulation Roundup of 2015:

“The Internal Capital Adequacy Assessment Process (ICAAP) is the firm's risk management process, not a document. It should be supported by effective policies, procedures, systems and controls and these should be reviewed as to their adequacy at least annually. This review should be documented.”

FCA, Regulation Roundup, December 2015

ICAAP Support Services

Should your firm require ICAAP support services such as assistance in examining your ICAAP to ensure it is appropriately assessed for your current business plan and activities or require assistance in documenting this review, our experienced ICAAP Consultants can help.

Read our latest articles, news and views affecting compliance and regulation in the UK Financial Services Industry.

The minimum capital requirements

• ICAAP (Internal Capital Adequacy Assessment Process)
• SREP (Supervisory Review and Evaluation Process)
• ICG (Individual Capital Guidance)

Complements Pillars 1 and 2 by invoking market discipline via the firm's public disclosure of additional information in order to allow market participants to assess capital adequacy.