The new Investment Firm Prudential Regime is on its way in January 2022 and firms should start preparing now.

May 28, 2021

An important topic on the UK regulatory horizon is the implementation of the new Investment Firms Prudential Regime (“IFPR”). The new regime is set to come into force on 1 January 2022 and as this date has already been pushed back from the original implementation date of June 2021, there is unlikely to be any further delay and therefore firms should now be considering how the new regime will affect them and act now to incorporate the changes well ahead of the deadline.  

The IFPR has been designed for investment firms regulated by the Financial Conduct Authority (“FCA”) (rather than for example, banks) and represents a significant change to how these firms will be prudentially regulated. The new requirements seek to capture the potential harm posed by firms to their clients and the markets in which they operate. It also considers the amount of capital and liquid assets FCA investment firms should hold so that if the firm does have to wind-down, it can do so in an orderly way.

As part of IFPRU, in April 2021, the FCA published its second Consultation Paper (CP21/7) (the “Consultation Paper”) which provided further details on the changes such as own funds requirements, liquidity requirements, the introduction of the Internal Capital and Risk Assessment (“ICARA”) document and remuneration changes. It is anticipated that the FCA’s third consultation paper will be published in Q3 this year and will cover public disclosure requirements and consequential amendments.

Within the Consultation Paper, the FCA sets out its proposals and asks for views on the areas noted below.

Own funds requirements and K-Factors

Initial capital requirements refer to the absolute amount of capital required at the point of authorisation. The current regime stipulates the initial capital could be €50k, €125k and €730k according to a firm’s activities and therefore permissions held. Under the IFPR the initial capital requirement is referred to as the Permanent Minimum Capital (“PMC”) requirement and the figure will be increased, according to the firm’s activities as outlined below:

PMCInvestment Firm Activity
€750k• Dealing on own account
• Underwriting/placing of financial instruments on a firm commitment basis
• Operation of MTF/OTF
€150kAll other investment firms
€75kNot permitted to hold client money or securities and carry out one or more of the following:
• Receiving and transmitting orders
• Executing orders on behalf of clients
• Portfolio management
• Investment advice
• Placing of financial instruments without a firm commitment

The FCA is also proposing the introduction of a fixed overheads requirement (“FOR”) that will apply to all FCA investment firms and become a required calculation when all investment firms are considering their minimum capital requirements. This calculation will remain the same as the current FOR which is one quarter of the fixed overheads from the preceding year or last audited accounts.

The remaining activity-based capital requirements will be known as “K-factors” and they will also apply to FCA investment firms.

K-Factor Methodology

The K-factor methodology aims to calculate ongoing capital requirements based on a number of capital factors. It aims to measure the risks posed by a firm to its customers, to the market generally and to the firm itself.

K-Factors will be grouped into three categories – Risk to Customers, Risk to Market and Risk to Firm as set out below:

Risk to CustomersRisk to MarketRisk to Firm
K-AUM + K-CMH + K-ASA + K-COH +Higher of: K-NPR or K-CMGK-TCD + K-CON + K-DTF
Risk to Customers K-Factors defined
K-FactorMeaningCapital Requirement Calculation
K-AUMAssets Under Management0.02%
K-CMHClient Money Held0.45%
K-ASAAssets Safeguarded and Administered0.04%
K-COHClients Ordered HandledTrades: 0.01% Derivatives: 0.01%
Risk to Market K-Factors defined
K-FactorMeaningCapital Requirement Calculation
K-NPR Net Position RiskValue of transactions in the trading book
K-CMGClearing Member GuaranteeHighest amount of initial margin posted to clearing member over the preceding three months
Risk to Firm K-factors defined
K-FactorMeaningCapital Requirement Calculation
K-TCDTrading Counterparty Default RiskExposure value x risk factor at 1.6%
K-DTFDaily Trading FlowCash trades 0.01% Derivatives 0.01%
K-CONConcentration RiskSee Article 38 of IFPR for table of thresholds

The FCA’s current expectation is that all firms will be expected to consider the relevant K-factors as part of their internal and supervisory discussions for monitoring sources of harm, even if firms are categorised as a Small and Non-Interconnect Firm (“SNI”) that will not be subject to capital requirements based on the above K-factors.

Liquidity Asset Requirement

Under IFPR, all investment firms will be required to hold a number of liquid assets that are at least equal to the sum of one-third of the amount of its FOR and 1.6% of the total amount of any guarantees provided to clients (if relevant).

The liquid asset requirement aims to ensure that investment firms always have a minimum amount of liquid assets to ensure there is sufficient liquidity to fund the initial stages of a wind-down process should a wind-down become necessary. The liquidity requirements will require firms to make provision either in cash or quickly retrievable assets, likely to be within 24 hours.

This is a significant change and increase to the liquidity requirements within the current prudential regime and one that firms should be ensuring they will be able to meet.

Introduction of the Internal Capital and Risk Assessment (“ICARA”) Document

The Consultation Paper provides further details on FCA proposals to introduce an ICARA process for all FCA investment firms. Through this, firms will be expected to meet an Overall Financial Adequacy Rule (“OFAR”). The OFAR establishes the standard to determine if an FCA investment firm is holding adequate capital. 

The FCA sets out how it expects investment firms to determine if they have adequate capital through the ICARA process to determine the appropriate amount of own funds and liquid assets requirements that need to be held via a risk assessment, in addition to the base own funds and liquid assets requirements. This includes that they consider harm to consumers and markets – including risks to their ability to engage in an orderly wind-down, as well as those from their ongoing activities. Firms will be required to review their ICARA process annually or when a material change within a firm occurs.

As part of this, the FCA intends to adapt its prudential supervisory approach for FCA investment firms towards an assessment of risk a firm poses and of specific sector supervision for higher risk firms. The FCA will introduce an ICARA questionnaire reporting template to gather this information.

The FCA emphasise that they will hold senior management or the firms’ governing body accountable if they fail to ensure they have appropriate governance and risk management systems and controls. Therefore, the FCA also expects senior managers to have an active role in reviewing and approving the content of the ICARA document.

Exempt CAD firms

Exempt CAD firms are a categorisation of MIFID investment firms that provide investment advisory services and/or receive and transmit orders only. Currently, such firms benefit from simpler prudential requirements ranging from a minimum capital requirement of €50,000 and also not having to undertake an ICAAP or a FOR calculation.

However, the current proposals state that under the new regime, Exempt CAD firms will now be categorised as SNI firms which means the capital requirements will increase to the higher of €75,000 (the new Permanent Minimum Requirement), the FOR, and potentially the “K-factors” calculation (depending on the activities undertaken). In addition, those firms will have to comply with the liquidity, remuneration, and risk assessment requirements that currently do not apply. Therefore, it is likely firms that are currently categorised as exempt CAD will have to increase their capital requirement along with their assessment of risks posed to the firm and should therefore start to plan accordingly for these changes.

Remuneration Code

The FCA proposes that all FCA investment firms must have a clearly documented remuneration policy. Firms that qualify as an SNI will only need to comply with the basic remuneration requirements such as creating a remuneration policy, setting an appropriate balance between the fixed and variable component of total remuneration and establishing certain governance and oversight requirements on variable remuneration levels.

The Consultation Paper proposes that the larger Non-SNI firms will need to implement risk, remuneration and nomination committees if:

  • The value of on‑and off‑balance sheet assets over the preceding 4‑year period is a rolling average of more than £300m; or
  • The value of on‑and off‑balance sheet assets over the preceding 4‑year period is a rolling average of more than £100m but less than £300m and it has trading book business of over £150m and/or derivatives business of over £100m.

A non-SNI below the above thresholds would notbe in scope of these more complex remuneration rules but would instead be subject to the standard remuneration requirements in addition to the basic remuneration requirements. These additional, standard requirements include performance-related variable remuneration of material risk-takers, restrictions on non-performance-related variable remuneration of material risk-takers and setting a ratio between variable and fixed remuneration.

Regulatory Reporting

The Consultation paper proposes to significantly reduce the amount of information that FCA investment firms need to report to the regulator about their remuneration arrangements. For example, the FCA proposes to introduce an ICARA reporting form for FCA investment firms which will replace the current FSA019 return for these firms.

Collective Portfolio Management (“CPM”) and Collective Portfolio Management Investment (“CPMI”) firms.

The Consultation paper also sets out changes to how firms authorised under legislation other than MiFID will relate to the new sourcebook.

CPM and CPMI firms (firms who operate under the Alternative Investment Fund Managers Directive (“AIFMD”) that either fall outside of MiFID or have MiFID “top up” permissions) will have their sourcebook (IPRU(INV) 11) changed to have references altered to refer to the MIFIDPRU sourcebook and no longer to the UK Capital Requirements Regulation. The effect on CPMs should be limited as they remain under the AIFMD, but they will be encouraged to review the basis for calculating their FOR.

However, CPMIs will need to fully implement the IFPR, with regards to its MiFID “top up” business. But it is noted within the Consultation Paper that both the capital and liquid asset requirement calculated under both AIFMD and the IFPR can be met with the same funds. Therefore, the interaction of both sourcebooks does not incur additional capital requirements.

With regards to remuneration, the FCA is suggesting that it will apply the new MIFIDPRU remuneration code to the MiFID business of CPMIs, meaning that such firms will be subject to two remuneration codes.

Conclusion

To conclude, once IFPRU rules are finalised by the FCA, the time firms to have to review and implement the relevant changes will be limited before they come into effect. Effecta therefore recommends firms prioritise the changes during Q2 and Q3 of 2021 and Effecta are available to assist in the ways outlined below.

How Effecta can Help:
  • Undertake an assessment of your current capital requirements against future capital requirements under IFPRU
  • Assist your firm with the implementation of the ICARA document
  • Assist Exempt CAD firms review their new capital requirement and implement the new required compliance documentation
  • Review your firms current Remuneration code against the forthcoming changes
  • Keep your firm up to date on future IFPRU updates such as the third FCA Consultation paper
  • Undertake a full “Healthcheck” assessment of your firms preparation of IFPRU and what steps need to be undertaken prior to the deadline to be compliant with the changes.