Last week we published a blog on the FCA’s expectations for how firms should go about safeguarding their customers' funds, as set out in proposed temporary guidance for payment firms.

In this blog, we discuss another topic covered by the guidance, no less vital to protecting customer funds – prudential risk. Given the sector’s rapid growth, the issue of payment firms’ financial resilience has been scaling the regulatory agenda for some time. Last year, the FCA brought payment firms into the scope of its Principles for Business requirements - including Financial Prudence. The move ensured that payment firms are in scope of the FCA’s Framework for Assessing Adequate Financial Resources

The FCA also conducted a cross-firm review exploring payment firms’ awareness and management of prudential risk which resulted in remediation plans for many payment firms and detailed financial adequacy reviews for the most significant. Then in May of this year, just one month after it identified payments as a sector priority for supervision and intervention in its Business Plan, the FCA proposed this temporary guidance.

What did the temporary guidance say?

We consider three distinct but highly interlinked aspects of the guidance in turn.

1. Risk Management, Governance and Controls

The guidance reminds payment firms that robust governance arrangements, effective procedures, and adequate internal control mechanisms are a condition of authorisation. It places responsibility for reviewing these arrangements with Senior Management and sets an expectation they should be tailored to firms’ business models, growth and risks. Coming after the FCA’s review, this suggests the regulator is not yet satisfied that this condition is being met – and expects Senior Managers to act.

The guidance emphasises the importance of stress testing to assess the impact of severe business disruption and to ensure the firm is meeting its conditions for authorisation. The FCA adds that stress testing should be done using internal and / or external data and scenario analysis which is then used to identify any changes or improvements to required systems and controls.

2. Capital and Liquidity

The guidance describes the accurate reporting of capital positions as ‘essential’ and stresses the need for senior management to review capital resources regularly, as part of ongoing capital planning. The FCA also sets out its view that it is best practice for firms to deduct any assets representing intra-group receivables from their own funds. This is to reflect the risk the credit risk of other group entities and ensure the UK regulated entity has sufficient capital – an important consideration given the prudential regime for payment firms does not currently include provisions for prudential consolidation.

To inform decisions on capital and liquidity adequacy and to ensure that firms continue to meet their own funds requirements, the FCA again recommends the use of stress testing. The reference to ‘adequacy’ rather than regulatory requirements indicates that compliance with capital requirements is no longer considered enough. Instead firms should be assessing what financial resources they would need in a stress. Also, while the prudential regimes for payment firms make no reference to liquidity, it is clear the FCA considers it to be a key aspect of financial prudence and a highly relevant risk for the sector.

The FCA says it expects firms to consider whether their liquid resources and available funding options for meeting liabilities as they fall due are sufficient and whether they need access to committed credit lines to manage their exposures. It considers it best practice for firms not to include any uncommitted intra-group liquidity facilities when performing the assessment.

3. Wind-down plans

The FCA has clarified that it regards wind-down plans as a condition for authorisation and that it expects payment firms to evidence how they could wind down the business in both a solvent or insolvent scenario. The guidance sets out how the FCA’s Wind-down Planning Guide applies to payment firms and covers the following areas:

  • Funding: as part of their risk management, firms need to calculate the capital and liquidity they require to pay for the costs of the wind-down and returning customer funds. This requires the production of a detailed model of wind-down, incorporating all the envisaged costs on a monthly basis in both a solvent and insolvent scenario, taking into account operational requirements. The total net costs provide the firm and regulator with information that could inform the capital and liquidity adequacy assessment described above.
  • Triggers: firms need to implement a robust indicator and trigger framework that helps management and the board decide when to formally consider entering into wind-down or even entering insolvency. The indicators should cover a wide range of scenarios and risks and the triggers should be calibrated to levels where there would be serious doubts about the firm’s ongoing viability.
  • Counterparties: certain clients and counterparties may be reliant upon a payment firm’s services and to minimise any secondary impact of wind-down, they must be given sufficient time to identify alternative suppliers. Where possible, firms should plan to support the transfer of business to the alternative provider.
  • Information: the wind-down plan should provide sufficient information to allow the administrator to identify client funds and return them. The underlying data should be stored in a format that can be easily understood and used by a third party as part of wind-down. Any additional information that would be helpful to the administrator (e.g. systems, key supplier contracts) should also be made easily-available.

What should payment firms do now?

  1. Undertake a robust assessment of whether their existing risk management and governance arrangements are likely to meet the FCA’s expectations as set out in the guidance and in the FCA’s Framework for Assessing Adequate Financial Resources. These arrangements should be tailored to the regulated entity, its specific business model and risks, and updated to reflect the firm’s growth (actual or planned);
  2. Perform a line by line review of their capital returns;
  3. Build up their risk management framework by creating a stress testing programme. The FCA is clear that it expects stress testing to sit at the heart of firm's risk management. Senior Management supported by the Risk function should consider stress testing scenarios, how to operationalise stress testing and extract the maximum value from it. For example using stress testing to identify risks, inform risk appetite statements, refresh policies, update controls and create wind down scenarios by performing reverse stress testing;
  4. Ensure that wind-down plans, liquidity and funding risk, capital and liquidity planning and (where applicable) intra-group risk are fundamental pillars of a firm’s prudential risk management; and
  5. Review governance arrangements against best practice and with a view to ensuring that the risk management framework is embedded.

Given these changes may be significant for many firms, require additional resources and take time to implement and embed, we suggest firms start to review their current arrangements and implement the required changes as soon as their circumstances permit.