FSA publishes its observations on Limited Licence Firms ICAAPs

The FSA recently published its observations on the Internal Capital Adequacy Assessment Process (ICAAP) [1] submissions it has received from Limited Licence Investment Firms, such as asset managers and matched principal brokers. Please click here for the FSA's paper. The paper provides the latest benchmark firms can use to evaluate the quality of their ICAAP documentation.

The publication follows a recent stream of policy statements and consultation raising the profile of senior management’s responsibilities for capital adequacy and liquidity – in stress and scenario testing [PS09/20], Capital Planning Buffers [CP09/30] (both December 2009] and systems and control obligations over liquidity management [PS09/16].  The regularity of these publications may feel overwhelming and burdensome for many limited licence firms, yet there can be little to argue against the basic tenets of the Pillar 2 regime - proper financial planning, prudent capital and liquidity management and planning of a few downbeat scenarios; so where does the FSA believe that firms are falling short?

Approaches to ICAAP

According to the FSA, firms appear to be ineffective at demonstrating the method behind their Pillar 2 estimates. The FSA’s expectations here seem fairly benign – “ICAAP submissions that were comprehensive and well-structured often presented background information about the firm including its business model and group and external relationships. This helped to illustrate more clearly how the key risks facing the firm had been addressed through the ICAAP.”

Orderly Wind Down estimates

Limited Licence firms appear to be failing to consider the one critical regulatory risk they all face; that of planning for an orderly wind down. FSA would recommend a ‘structured approach’ for firms to consider and present

(i) the likely period to wind-down its regulated activities;

(ii) the likely costs incurred by the business during this period;

(iii) realistic cash and fund in-flows and out-flows over this period

Group Risk

Firms are failing to consider risks outside the regulated entity. particularly where they are part of a group where costs are re-charged internally and expenses may be underestimated. Too many firms appear to be relying on parental guarantees which the FSA is prepared to accept “only in exceptional circumstances”.

Risk Appetite

Risk appetite continues to be poorly articulated with phrases like risk-averse’, ‘conservative’ and ‘low’ littering those ICAAPs the FSA rated below-standard. Quantitative measures (like tolerable operational losses) should be included alongside qualitative statements, apportioned across business lines and risk types.

Operational Risk

As regards operational risk, FSA observes a failure to provide a granular quantification of risk exposures and insufficient or inappropriate use of historical loss data. FSA recognises that a lack of independent historic loss information can make the process somewhat subjective. However, what seems surprising, given that many of the firms sampled by the FSA will have been large retail and institutional asset managers, is that these firms do not appear to have used their own extensive history of operational loss information as evidence to support the ICAAP development and conclusions. Most firms should maintain operational risk logs, breaches registers or compensation payment records, so hopefully the FSA’s criticism simply reflects a failure to integrate already existing management information into the ICAAP development.

Stress and Scenario testing

Firms have not been sufficiently hard on themselves. Stress and scenario tests were not severe enough and many base case capital forecasts appeared overly optimistic. FSA sees scope for more imagination and thought in stress and scenario testing design and to more closely embed this in integrated senior-management decision-making. FSA believes that its recent Policy Statement on stress testing makes its expectations clearer, particularly on the appropriate severity of Pillar 2 stress tests. This creates a potential conundrum for Limited Licence firms, particularly asset managers, since regardless of how imaginative the firm may be, most scenarios crystallise in a fall in assets under management, the impact of which is relatively easy to model.

Pillar 3 Disclosure

Finally, FSA believes that some firms are not playing straight with the Pillar 3 disclosures. The FSA considers that making the disclosure available “on request’ does not fulfil the spirit of making the information publically available. Firms should consider using third-party websites to host disclosures. Please click here for details of IMS’ Pillar 3 disclosure website.

Conclusion

It’s clear the FSA considers there is still more to do. February is the deadline for many firm’s second FSA019 Pillar 2 return, the main method by which firms provide the regulator with assurance of their compliance with the ICAAP framework. The FSA’s report and recent consultation highlight the importance of senior management engagement in the business planning process and how important it is that this is reflected in the ICAAP. IMS has assisted many firms develop their ICAAP and we encourage the full engagement of senior management in this process.

If you would like IMS to benchmark, review or help you update your ICAAP, taking into account the latest observations from the FSA, contact Jon Wilson, Peter Moore or your usual IMS contact

8 February 2010

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