Investment Firms Prudential Regime: Highlights from the FCA’s recent Policy Statements and 3rd Consultation Paper

This blog was published on 02 September 2021.

The FCA continues to deliver on its plans to establish a new prudential regime for UK investment firms from 1st January 2022. In response to their first two IFPR Consultation Papers (CP 20/24 and CP 21/7), the FCA has now published two Policy Statements with accompanying near final rules (PS 21/6 and PS 21/9, hereafter “PS”). A third and final pre-implementation consultation paper (CP 21/26) has also been issued, with a corresponding policy statement expected later this year. The FCA has concluded that the near final rules reflect their previous CP proposals and, in general, they do not expect make any changes to these rules before they are made final.

This note builds on our previous blog on the FCA’s detailed CP proposals, and highlights some of the key additional developments and implications from the FCA’s two policy statements and third consultation paper.

Scope and application

The FCA provided additional clarification for Collective Portfolio Management Investment (CPMI) firms, including confirmation that MIFIDPRU requirements will apply to them.  Whilst the Fixed Overheads Requirement (FOR) will apply to the whole firm, other aspects of MIFIDPRU (e.g. K-factors) will only apply to the MiFID business undertaken by a CPMI.

Other amendments included confirmation that the transitional provisions can also be used by CPMI firms.  The new regime will align the definition of the FOR under both MIFIDPRU and Chapter 11 of IPRU-INV.  The FCA acknowledged that the definitions of liquid assets and own funds do differ across both regimes and indicated that this is something that they will seek to address in the future.

Separately, due to clarifications regarding the K-factors for daily trading flow (K-DTF) and client orders handled (K-COH), there is an addition of two new metrics when considering if a firm is a SNI or not.  The addition reflects that some firms trade in their own name on an agency basis and are not dealing on own account. To be an SNI a firm must have an average daily trading flow for both cash and derivative trades of zero. 

Consolidation 

The policy statements provide clarification on several areas regarding the consolidation scope and own funds requirements.  

• Consolidation will apply to a UK parent and its subsidiaries and connected undertakings (CU) i.e. consolidation will not capture non-UK entities above the UK parent entity (subject to the FCA determining in specific cases that it is appropriate).
• The PS notes that neither the consolidation requirements, nor Group Capital Test (GGT), impose any obligations directly on a non-UK entity. However, the UK parent may incur obligations by reference to the position of a non-UK entity. Consequently, the UK parent may be expected to hold capital for group risk which is not held at the non-UK entities level.
• In respect of CPM/CPMI firms, the PS confirmed that these firms will be included in an investment firm group when they are subsidiaries or connected undertakings and fall under the definition of a financial institution.
• In determining CUs, the FCA is not looking to deviate from the consolidation scope in the UK CRR. The onus will be on the firm/parent to make a determination on consolidation scope and the method. There is clarification that the significant influence indicators are indicative only and their existence is not conclusive. The ultimate test is whether a firm has the power to participate in the financial and operating policy decisions of the other undertaking. The accounting concept of significant influence should also be considered when determining significant influence, alongside all facts and circumstances.
• Credit institutions can be included in an IFPR consolidation scope. This could be UK credit institutions if they are determined to be connected undertakings, and third country banks if they are not included in a consolidation under UK CRR. This can lead to a group having to meet consolidation requirements under both UK CRR and IFPR.
• Clarification that CUs arising from participation in other entities would not necessarily determine the group as ‘too complex’ for the GCT.

Consolidated own funds requirements:

• If third country entities in the consolidation group undertake activities that would be MiFID activities if they were performed in the UK, they will be included in the calculations of K-factors.
• The consolidated FOR will include all expenses from entities in the group whether incurred from MiFID or non-MiFID activities
• However, K-AUM should only include MiFID AUM (or third country equivalent) and not include amounts arising from AIF or UCITS activities.
• The consolidated K-NPR will be an aggregate of the individual firm’s K-NPR i.e. no offsetting of positions within the group is available, unless permission is obtained from the FCA.
• When calculating consolidated K-COH rather than applying an adjustment for double counting to the sum of the individual firm’s K-COH, any transaction will be netted on consolidation and so excluded from any consolidated K-COH calculation

Own Funds 

All FCA investment firms will be subject to the same regime for own funds on an individual basis, even those which are part of a banking group. The FCA also provided a number of additional clarifications about deduction from own funds, including:

• There is no credible evidence presented that software assets are readily realisable or have recoverable value during a period of stress or in liquidation and so should be deducted from common equity tier 1 (CET 1) in full.
• The uncertainty and significant judgement involved in determining deferred tax assets creates concerns that these assets are not readily realisable, and nor can their value be reliably measured ahead of time when there is a period of stress. Therefore, the FCA does not intend to amend the full deduction from CET 1 of deferred tax assets that rely on future profitability.
• In line with the EU’s IFR arrangements, the FCA also believes that firms should not be permitted to use defined pension fund assets as their own assets and so will not allow any CET1 offset.
• Regulatory permission will be required to include interim profits as part of own funds.
• FCA investment firms that are limited companies can deduct interim dividends from interim profits without attracting a corresponding deduction from own funds as long as the dividend is less than the interim profit.
• Only a small number of firms make use of Tier 3 to support their regulatory capital positions. Given its lower quality, the FCA concluded that it would not be appropriate to allow its use under IFPR.

Own Funds Requirements

Fixed Overhead Requirements 

The FCA has amended some of the MIFIDPRU rules on FOR deductions, including the following:

• Clarification that “relevant expenditure” is calculated before, and not after distribution of profits. This means any payments related to contract-based profit and loss transfer agreements from total expenditure will not impact relevant expenditure, unless payments are made from residual profits to third country entities which are included within the prudential consolidation scope.
• Similar to the existing treatment for ordinary and limited partnership, limited liability partnership members’ shares in profits can also be deducted from total expenditure, (if included and fully discretionary).
• The FCA agreed to a new provision to allow for the deduction of 80% of the annual value of relevant fees, brokerage and other charges when executing, registering and clearing transactions from relevant expenditure, where the FCA investment firm is dealing on own account (even without customers).
• In addition to expenses reflecting the amortisation of prudently valued software assets, firms may also deduct other intangible assets from relevant expenditure, where the value has already been deducted from own funds.

K-Factor Requirements

The PS provides clarity around certain K- factors as per the table below.

Liquidity Requirements

The PS included clarifications on liquidity including the following:

• Pound sterling deposits held at a non-UK credit institution will not form part of the core liquid assets of the firm. This is because stressed market conditions, coupled with potential localised difficulties that may occur in the relevant jurisdiction, could hinder the ability to readily return these liquid assets to the FCA investment firm.
• A transitional provision has been provided in MIFIDPRU TP 2 to allow exempt-CAD firms to be able to benefit from transitional relief with respect to the basic liquid assets requirement where they are able to apply the alternative requirement for their FOR.

Internal Capital Adequacy and Risk Assessment (ICARA) process

The PS essentially confirmed most of the risk management, ICARA and SREP arrangements that were proposed in CP21/7.  However, the FCA chose not to provide more prescriptive guidance at this time (e.g. on harm assessment or stress testing).  Instead, firms are expected to apply the published principles, rules and guidelines in a manner that is proportionate to the nature and complexity of each firm’s business or operating model.  

• The ICARA process should be used to assess where additional financial resources may be required to mitigate material potential harms that cannot be adequately reduced by non-financial measures alone (e.g. internal systems and controls).  Firms will need to have clear and effective risk appetite, risk management and governance arrangements to support their IFPR process design and application decisions.
• The quantification of the additional resources that may be required to mitigate a given harm is not prescribed and could be based, for example, on a standalone assessment of a specific K-factor or (upward) recalibration of multiple K-factors to capture different sources of harm from a single activity.  Firms can also use models to facilitate their harm assessment, provided standard embedding, governance and validation principles are followed. 
• The FCA has indicated that it will adopt a risk-based approach to supervising firms’ prudential adequacy and potential for harm in the interim and may provide additional firm-specific and general direction over the next 12-36 months, where appropriate.

Firms may choose to conduct a group ICARA process where this is deemed to be better aligned to their business model and operational arrangements.  However, all firms will still be required to comply with the OFAR and wind-down planning requirement on a solo basis.  The FCA may additionally use its consolidation powers to require an investment firm group to also undertake a consolidated ICARA process.  This could include, for example, a requirement to include non-MIFID entities in the group ICARA where material concerns are identified. 

In line with the OFAR requirements, the FCA will not allow any transition provisions or delays to the general implementation of the ICARA process.  However, firms will have the flexibility to choose their MIF007 (ICARA return) submission date and will be asked to provide an indication of their expected initial submission date via an ICARA questionnaire that has been sent to all MIFIDPRU firms.  By default, firms will only be required to review their process and update their ICARA document and return once a year, (unless there are material business model changes). 

For firms that have an existing individual capital or liquidity guidance (ICG / ILG), the FCA has introduced a transitional provision calculation (TP 10) that will serve as an interim minimum floor pending an FCA review of the guidance.  The TP10 requirement will be captured in the MIF007 return, (submission due by 31 March 2023 latest). The FCA will then have six months from receipt of the MIF007 to review the adequacy of the firm’s assessment and, if required, issue a new ICARA based requirement. Under this arrangement, all TP 10 requirements and pre-MIFIDPRU ICGs / ILGs will then cease to be relevant by no later than 30 September 2023.

Finally, in line with its CP proposals, the FCA’s supervisory review and evaluation process (SREP) will utilise a thematic or sectoral approach (rather than place all firms on a fixed review cycle).  The FCA will notify those firms where a regular (individual) SREP cycle will be applied.

Remuneration 

All FCA investment firms would have to make some disclosure on their remuneration policies and practices. In particular, the FCA is proposing that SNI firms disclose a small amount of information on their remuneration policies and outcomes which differs from the EU Investment Firms Directive (IFD) regime, which does not apply any remuneration requirements, including on disclosure, to EU SNI firms.

Investment firms would be required to disclose qualitative and quantitative information on remuneration which is proportionate to the size of the firm. Quantitative disclosures are likely to be more detailed for firms. In particular, non-SNI firms subject to the standard or extended remuneration requirements are likely to have to disclose a greater level of detail than is currently the case for Pillar 3 disclosures under the CRD framework. However, there will be no requirement to disclose the variable to fixed pay ratio(s) that non-SNI firms are required to set for their population of Material Risk Takers (MRTs) under the MIFIDPRU code. This is a point of difference from the EU requirement under Article 51 of the IFR, which mandates the publication of the ratio(s) for EU non-SNI investment firms.

All non-SNI firms will be required to disclose the types of staff they have identified as MRTs. All non-SNI firms would also be required to publish a summary of their policy for promoting diversity on the firm’s management body.

Reporting

In general, the frequency of IFPR reporting for firms will be quarterly, with regulatory returns to be submitted via the FCA’s Regdata system in an xml file format.  The PS also provided a list of returns that they will stop collecting including the existing FSA001 Balance sheet and FSA002 Income Statement returns and existing liquidity returns.

Applications and notifications

The FCA’s gateway for MIFIDPRU applications opened on 26th July 2021.  Initially, only permissions required in advance of January 2022 will be available on Connect. All other notification and application forms will be added in the Autumn.

The FCA also clarified that FCA investment firms and UK parent entities that have not been subject to the UK CRR definition of capital and wish to count their existing instruments as own funds for the purpose of MIFIDPRU 3, will need to notify them under MIFIDPRU TP7.4R. Permission will not be required for pre-existing CET1 instruments as long as conditions are met.

Firms have until 31 January 2022 to apply for permission to use GCT in order to take advantage of the transitional arrangement. This means GCT can be used for up to 2 years while the FCA processes the application. Firms with permission to use the GCT and the transitional arrangement do not have to comply with prudential consolidation.

Disclosure

The FCA published its disclosure requirements in their third consultation (CP 21/26). The areas covered by the disclosure requirements are broadly similar to existing requirements and include risk management, own funds and own funds requirements, governance and remuneration (see above for some details on remuneration requirements). There will also be some new disclosure requirements on investment policy for some larger firms.   The CP sets out the extent to which these disclosure elements will apply to different IFPR firm types, (namely non-SNIs, SNIs with / without additional tier 1 capital and Commodity and emission allowance dealers).

Disclosures will need to be made annually, alongside annual financial statements (and more often where there are significant changes) and will need to be in an easily accessible part of a firm’s website (or via other freely available material if the firm has no website).

The consultation confirmed that the FCA will consult on ESG disclosures separately.

Conclusion 

The FCA has continued to evolve its thinking in several areas including consolidation, own funds and FOR. However, it is also clear that, where required, it expects firms to use sound judgement to interpret the rules to ensure that potential harms to consumers and markets are minimised.

In order to support effective implementation, firms will want to adhere to basic principles of good governance, and risk management and incorporate appropriate behaviours and arrangements to minimise harm.  This will be particularly important in areas where the FCA will not be providing any further prescriptive guidance in advance of the IFPR going into force on 1st January 2022.

If you have queries about any aspect of the incoming IFPR, please do not hesitate to get in touch with any member of our IM Prudential team