The Financial Conduct Authority (“FCA”) published its Dear CEO letter to wholesale broking firms on 11 January, highlighting four key areas of focus: financial resilience, remuneration, governance and culture as well as the importance of an adequately resourced risk and control function and robust market abuse and financial crime controls.
Unusually, the FCA states a number of upfront commitments to use regulatory tools where it believes practices fall short of expected standards. It also compares the sector to others where it believes more progress has been made in reducing misconduct. Our view is that these remarks are intended to send a clear and robust message. In response, firms should review all the areas discussed in the letter as soon as practicable, but also ready themselves for questions or visit from the FCA in those areas where the FCA has specifically stated it will undertake further work. We have made some suggestions as to how firms should prepare themselves for this.
Below is a summary the key messages to firms in the letter, including setting out the work the FCA plans to undertake in relation to each of these and potential actions it may take where weaknesses are identified:
Improve financial resilience by assessing the levels of liquidity held under IFPR. The FCA will undertake targeted work here and may take action which includes business restrictions and board effectiveness reviews where weaknesses are found.
Seek to reduce identified vulnerabilities by stress testing in more extreme or reverse stress scenarios.
Ensure that remuneration structures comply with IFPR requirements under the MIFIDPRU Remuneration Code. The FCA will review how practices have changed since its 2019 review and specifically, what boards have done to address the risks. It may use regulatory tools including the imposition of capital requirements where weaknesses are found.
Continue to embed Senior Managers Certification regime (“SMCR”) to promote good decision making and accountability. The FCA will scrutinise decision making and board effectiveness where it uncovers weaknesses in financial resilience or remuneration practices.
Ensure that both the board and Senior Management Functions have the right mix of skills and experience to be able to challenge decision making and instil a healthy and purposeful culture.
Fully take into account regulatory references when hiring new staff in line with the SMCR certification regime.
Adequately resource the Control Function which has the capability to influence decisions at board level and ensure effective compliance with rules, policies and processes.
Focus on financial crime in particular client onboarding controls and market abuse as areas of continued weakness. The FCA will carry out further work into onboarding practices.
Below we elaborate on the key messages in the letter and suggest some actions that firms might take to help meet these expectations:
The FCA has highlighted a particular emphasis of the new requirements under the Investment Firm Prudential Regime (“IFPR”). Firms should therefore consider the extent to which the FCA’s IFPR requirements have been embedded within business practices and document where further enhancements could be made together with timelines for doing so.
The FCA has observed that firms that have held adequate levels of own funds or liquid assets have been less likely to cause market disruption in the event of failure. The Internal Capital Adequacy and Risk Assessment (“ICARA”) requirements that were introduced under IFPR will, therefore, be key for firms in determining their required levels of financial resources to mitigate the risk of harm. As part of this process, firms should also consider the adequacy of their Wind Down Plans and arrangements to mitigate the risk of a disorderly wind down scenario.
With regard to financial resources, the FCA has observed a particular weakness across the sector in liquidity risk management and has indicated that it will carry out targeted work on this subject. The FCA has highlighted clearing brokers, however all firms should consider the robustness and completeness of their processes for liquidity risk identification, assessment, quantification, and management as highlighted in the FCA’s general guidance on financial adequacy (FG20/1). For wholesale brokers and other firms that are subject to IFPR, the assessment and quantification of the Liquid Asset Threshold Requirement (“LATR”) is a key requirement to demonstrate and ensure robust and effective liquidity risk management and governance arrangements. Boards should consider whether they receive the appropriate level of management information that covers liquidity risk exposure against appetite to enable effective challenge of the business. Given the FCA’s comments, boards should also ensure that they have sufficient liquidity knowledge and experience to provide the expected level of oversight.
Stress testing and reverse stress testing are also important parts of the ICARA process. These assessments help to demonstrate that a firm has sufficient resources to meet their requirements at all times, including during periods of stress in the economic cycle. The FCA has noted that firms should ensure that stress tests are sufficiently severe in nature, especially when compared to macroeconomic events over the past 12 months, including consideration of the potential for both systemic and idiosyncratic events as part of this process.
If you would like any further information on IFPR implementation, please see our recent blog: IFPR: Observations and current expectations one year on
In relation to remuneration, the letter picks up on the issues that the FCA highlighted in its 2019 Dear CEO letter to wholesale broker firms, noting, for example, the disproportionate weighting towards cash bonuses seen within some firms, which may lead brokers to focus on achieving short-term financial targets at the expense of clients’ interests and limit the firm’s ability to penalise brokers for misconduct if identified after bonuses have been paid.
The FCA notes that it continues to see brokers receiving lower salaries with large cash bonuses based on the value and volume of trades that they conclude for clients. There is also a reminder for firms that individual performance must take account of both financial and non-financial criteria, of which a substantial part of the non-financial criteria may include metrics on conduct and which could include for example, adherence to risk and compliance programmes, completion of mandatory training or the absence of conduct breaches under SMCR.
Noting the provisions introduced under the new MIFIDPRU Remuneration Code, which were designed to support prudential soundness and risk management by promoting accountability, discouraging poor conduct and prioritising positive outcomes by helping to instil a healthy firm culture, the FCA notes that it expects boards and CEOs to ensure that their firms’ remuneration structures comply with these new requirements.
The FCA also notes that where firms have failed to evidence that they have taken appropriate steps to implement the applicable MIFIDPRU remuneration requirements, it will consider using its range of regulatory tools, including its ability to impose additional capital requirements to account for the increased risk that weak incentives can drive.
The FCA has highlighted the need for adequately resourced risk management and control functions that can have influence at board level. Tensions between regulatory expectations around resourcing in this area and possible cost pressures at firms are well versed. As a potential way of addressing these, and some in this sector may already be considering - or have even implemented - an alignment of their risk and compliance functions in order to optimise cost efficiencies, possibly together with the utilisation of new technologies. Where such a material change is being considered that could impact the quality of the control environment, firms should be able to evidence detailed analysis and with robust governance which would include board level sign-off on the changes. Where no such large operational change is underway, a detailed gap-analysis against an up-to-date risk appetite with prioritised actions over a reasonable timescale to address resourcing gaps would be good place for firms to start.
The FCA also highlights financial crime and market abuse as areas where control weaknesses continue to be found. Specifically mentioned as sources of concern are market abuse surveillance and weak Personal Account dealing controls (with clear direction for firms to review practices against relevant Market Watch articles) and secondly, deficiencies in client onboarding processes, where the FCA sets out its intention to undertake further work. Firms may want to prepare themselves for questions or a visit from the FCA by undertaking a proactive review of their onboarding processes. Such a review would include a number of clear use cases of where documented processes have been closely followed including requirements for internal escalation and audit trails.
Governance and Culture
The letter recognises that firms have experienced periods of sustained volatility and has placed the onus on boards and senior management to navigate firms through these unprecedented times. The letter focuses board and senior management decision-making, accountability, and risk culture as the key indicators of good governance and culture. To make progress and succeed in these areas, the letter highlights the importance of challenge in the boardroom, as well as senior management governance committee meetings, and application of SMCR.
The board’s ability to provide impactful challenge and hold executives to account is highly correlated with its composition. Whilst not specifically mentioned in this letter, diversity – and specifically diversity of thought – has a significant role in this respect which is why the FCA published its Policy Statement PS22/3: Diversity and Inclusion on Company Boards and Executive Management in April 2022. Individuals with different skills, experiences, and from different backgrounds are known to consider issues, opportunities, and decisions from a unique perspective and challenge each other as with regards to the interests of different parties and prevent groupthink. In several instances the letter points to a review of the effectiveness of the board as a measure that the FCA would utilise. In our own experience of conducting board effectiveness reviews, we would be likely to consider the board’s composition, evidence of challenge and decision-making, demonstration of appropriate behaviours during and outside of board meetings, as well as the quality and timeless of board papers and processes.
The effectiveness of the board is also linked to the SMCR in terms of performance of directors and discharge of their responsibilities. The application of SMCR extends into the depths of the organisation and the letter specifically states that junior employees: “…can expose broking firms to significant risk of harm to the firm, their clients and the market more broadly”. Senior management teams, as well as boards, should therefore get a deeper understanding of the impact (e.g. on risk appetite) and consequences (e.g. market integrity offences) of hiring individuals who have previously been disciplined elsewhere. The FCA uses robust language in the letter in relation to this and firms’ inability to adequately consider regulatory references or establish risk mitigation approaches when hiring individuals who have areas of concern in their regulatory references. High performing boards, senior management at firms will spend appropriate time on, and have the adequate mechanisms to gain an understanding of the current organisational culture and importantly, mapping how they will achieve their target state.
Incidents and breaches may on the face of it may be a credit risk issue, operational loss event, or as a result of individual misconduct. However, the underlying cause or what prevented its detection earlier or stopped it from continuing to occur, can usually be attributed to poor governance. All three of the other areas of the letter, financial resilience, remuneration, and adequately resourced control functions, are underpinned by robust and effective governance and culture, reflecting the high-level of importance the FCA has placed on this topic in the letter.
In conclusion, we note the FCA’s repeated desire to see board input and influence in all the above areas. Its sentiment may in turn have been driven by the recent challenging market conditions, the FCA’s view that the sector is behind others in preventing poor conduct and culture and the repetition of a number of themes from its 2019 letter where it believes sufficient improvements have yet to be made. We believe firms in this sector should therefore consider themselves to be ‘on notice’ for further FCA interventions in these areas. Firms should therefore think about how they will demonstrate the changes that the FCA wants to see and in particular, that both senior management and the board have been involved in both the design and implementation of them.
If you would like to discuss any matters in this blog further please contact Carolyn Hodder at firstname.lastname@example.org