IFPR: The ICARA - Common Challenges and Pitfalls

IFPR: The ICARA - Common Challenges and Pitfalls

The Regulatory Centrepiece - The ICARA

The Internal Capital Adequacy and Risk Assessment (ICARA) represents the new regulatory centrepiece of the prudential regime for investment firms. Read our series of articles designed to help you address key requirements and implementation challenges arising from the Investment Firms Prudential Regime (IFPR).
 

IFPR Introduction

Welcome to the first in our series of thematic publications focusing on the IFPR. In this first article, marking the one-year anniversary of the IFPR going live, we share our views on the practical challenges firms have been facing in implementing the ICARA - the centrepiece of the new prudential regime.

ICARA processes should be fully embedded by now, but many firms are still working on their first ICARA document and are understandably seeking guidance and reassurance that their work meets regulatory standards. Our insights will help identify common pitfalls and better understand FCA’s expectations for firms to meet regulatory requirements and apply good practice in the development of internal processes.

As advisors we have the unique opportunity to work with many different clients from across different segments of the FS Industry. It will not come as a surprise that there are almost as many different approaches to implementation of the ICARA as there are firms - perhaps not quite but there certainly are many variations and individual risk appetites (both corporate and individuals’).

#BDOifprseries

Get a better understanding of key aspects of IFPR implementation, focusing on the following themes: ICARA, Remuneration, IFPR Implementation, Wind down planning and Public Disclosures.

Our IFPR Series (#BDOifprseries) is designed to do just that, a series of articles exploring the key challenges of the new prudential regime in detail, along with practical thoughts and insights of good practice.

Our series will conclude a webinar where we explore what are the key takeaways and what firms should be doing in light of these updates.
 

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Our first article in the series explores the ICARA, including key features and practical challenges.
 

What does the IFPR prescribe?

The IFPR rules sit in the MIFIDPRU sourcebook of the FCA Handbook and cover both capital and liquidity requirements, as well as also recovery planning, governance, remuneration, public disclosures and regulatory reporting. The regime applies to FCA-authorised firms with MiFID permissions (renamed ‘MIFIDPRU investment firms’).

The IFPR prescribes prudential standards that are broadly similar to the previous regime but has also introduced new concepts and methodologies. One major change is the split of firms into two overarching categories: Small Non-Interconnected (SNI) - smaller and less complex vs the larger more complex firms (non-SNI), which are subject to different requirements due to their size and nature of business.

The own funds requirement is based on a permanent minimum amount and fixed overheads for all firms. In addition, non-SNI firms are subject to a component based on ‘k-factors’, a set of coefficients applied to the volume of business activities, aiming to cover the ‘risk of harm’ posed by the firm.

It is worth noting that liquidity is more prominent in the IFPR than under the previous regime as firms must hold a minimum amount of liquid assets and calculate additional resource requirements throughout the economic cycle as well as in wind-down.
 

What are the key features of the ICARA?

The centrepiece of the IFPR is of course the ICARA.

The new assessment process is comprehensive and requires all SNI and non-SNI firms to demonstrate their ability to meet the Overall Financial Adequacy Rule (OFAR). Meeting the OFAR involves firms assessing the amount of Own Funds and Liquid Assets are needed to:

  • Maintain a sustainable business through the economic cycle; and
  • Complete an orderly wind-down.

Of course, the ICARA is not all new and inherited some concepts from the ICAAP framework such as the forward-looking approach, the centrality of a risk management framework, stress testing and recovery planning. It does however also introduce a number of important new additions, perhaps most importantly:

  • Own Funds Threshold Requirement (OFTR);
  • Liquid Assets Threshold Requirement (LATR); and
  • Consideration of wind-down costs in assessing the amounts of financial resources needed.

The OFAR became a regulatory requirement on 1 January 2022. Therefore, all MIFIDPRU investment firms are now expected to develop an effective ‘ICARA process’ sufficient to calculate the OFTR and LATR. Furthermore, all ICARA processes must be embedded in an ‘ICARA document’ with a 2022 reference date, even though the ICARA questionnaire (MIF007) can be submitted up to the end of 2023.
 

How do firms get it right?

As with all new regulation it often takes a little time for practical arrangements to bed in and for regulatory expectations to become fully visible to the industry. Firms must understand the requirements, identify potential challenges and pitfalls and adopt best practice in the development of internal processes. This reflects the reality of what is needed in a regulatory transition and the proportionality of the approach to be taken based on the diversity of firms subject to the IFPR.

The one thing that so far is only just emerging is tangible regulatory views expressed by the Financial Conduct Authority based on their Supervisory Review and Evaluation Process (SREP) which ICARAs are subject to. In the remainder of this article we set out the areas we consider most critical to ‘get right’ and share our views and experiences of what good looks like.

Risk vs Harm

The risk assessment underpinning the assessment no longer considers just ‘risk’ but must be a ‘harms-led’ assessment aimed at identifying (and where possible quantifying), the harms that a firm poses to its clients, the market and the firm itself. Some harms deriving from activities such as portfolio management, safeguarding of assets and dealing activities are covered by k-factors to some extent, but firms must assess the financial impact of any residual risk exposures to determine how much capital and liquid assets they should hold.

As a starting point mapping risk taxonomies carefully to harms will help ensure clarity and alignment. It also has the benefit of highlighting if the previous risk universe had gaps relative to the business conducted.

The concept of harm represents a more tangible measure of the financial or operational detriment that may derive from a firm’s activities, which is a step forward when compared with the risk assessment process of identifying the potential impact and probability of trigger events.

Harms to k-factor mapping

Also, it is critical to carefully consider k-factor coverage and to identify residual harms to determine whether it is necessary to hold additional financial resources (i.e. to ensure compliance with the OFAR).

As we know, K-factors are designed to apply to specific Regulated Activities, but the full rationale of the relevant metrics and the actual ‘coverage’ leaves room for interpretation. Firms must take accountability for considering this of course but must take care not to replace proper analysis with poorly explained conservatism in Own funds held as this potentially detriment the understanding of harms arising.

It may therefore not always be easy for firms to ensure that k-factors are mapped consistently to their internal risk taxonomy, in alignment with the harm to client, to the market and to the firm, which poses the risk of potentially underestimating the amounts of additional resources needed.

Liquidity

Liquidity is another area where some firms have found implementation challenging. All firms are subject to the overarching liquidity requirement to meet liabilities as they fall due at all times. In addition, firms are required to hold liquid assets that are sufficient to remain solvent throughout the economic cycle and be able to commence an orderly wind-down.

In practical terms this means that firms must ensure that the LATR calculation includes both a risk-based component and an assessment of the cost of the initial stages of a wind-down process. By doing so it is possible to demonstrate clearly whether the Basic Liquid Asset Requirement (BLAR) is sufficient or instead additional liquid assets may be required.

From our experience some firms may still find it difficult to quantify their liquid assets requirement (i.e. granular cashflow analysis). Breaking the process into its component parts is one approach we have adopted successfully. However, in doing so it is critical to not lose sight of the interaction between components such as the assessment of liquidity risk overall including under stress scenarios; the detailed breakdown of wind-down inflows and outflows as well as consideration of the availability of any realisable assets under recovery or contingency funding. In addition, firms operating within groups must also assess the impact of intra-group connectivity and financial dependencies.

Wind-down planning

The final area of the ICARA where implementation has proven less than straightforward is in terms of Wind-Down Plans (WDP). These constitute an extremely important part of the new prudential framework. Previously, not all firms were required by the FCA to maintain formal WDPs although many did to a lesser or greater degree. For most firms, ensuring a natural and logical link between capital and liquidity risk management and the WDPs, in particular in terms of stress testing was always overarching objectives. However, with IFPR this has now all been formally linked and included as part of the requirements under the new regime.

In a recent thematic review¹, the FCA confirmed that WDPs must be designed according to their guidance and standards, be risk-based, focus on cashflow management and consider group-wide implications such as operational dependencies, intra-group exposures, debt guarantees or group pension liabilities.

The Wind Down Planning Guide (WDPG)²  sourcebook provides clear guidance on the structure and contents of a good wind-down plan. In addition, firms must ensure there is consistency between wind-down planning and the risk management framework and identify the cost of the initial stages of wind-down which is essential for the calculation of the LATR.
 

What is the FCA doing to test the ICARA?

The ICARA is clearly regarded by the FCA as the regulatory centrepiece of investment firms, which is also confirmed by the early SREP reviews that the regulator has started. ICARA processes should be fully embedded by now, but many firms are still working on their first ICARA document and are understandably seeking guidance and reassurance that their work meets regulatory standards./p>

Firms have also started submitting their first ICARA questionnaire (MIF007) which will give the FCA an opportunity to verify how different firms in industry have implemented the ICARA and are complying with the threshold requirements.

Any feedback from the initial MIF007 reviews and SREP work will provide further insight of FCA’s expectations.
 

How we can help

We have a dedicated team of regulatory specialists and prudential experts helping firms with their ICARA and overall IFPR implementation. To find out how we can help you on your journey to overcome challenges and avoid any pitfalls get in touch today with Mads Hannibal, Giovanni Giro or Osita Egbubine.

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