Written by Matt Raver
1. the capacity to recover quickly from difficulties; toughness.
2. the ability of a substance or object to spring back into shape; elasticity.
In January 2022, investment firms shall bid farewell to (for some) a much beloved acronym – ICAAP, or the Internal Capital Adequacy Assessment Process. Its replacement is the ICARA – Internal Capital and Risk Assessment Process. Whilst not technically an acronym (otherwise it would be ICARAP) the ICARA represents an evolution from the ICAAP, including its role in a regulatory drive to improve ‘resilience’ at financial institutions.
The introduction of the ICARA is part of a wider initiative to update and consolidate the current prudential frameworks for investment firms and certain fund managers. Known as the ‘Investment Firms Prudential Regime’ (‘IFPR’) and taking effect in the UK in January 2022, various aspects of a firm’s regulatory requirements are affected. These include: regulatory capital and the regulatory capital requirement; liquidity; concentration risk; consolidation; governance; remuneration; disclosures; and regulatory reporting.
The ICAAP was introduced over 15 years’ ago. Part of the ‘Pillar 2’ process, it is a mechanism for firms to identify and manage major sources of risk, including the impact of such risks on the firm’s financial resources. Where the financial resources, as determined by prescriptive calculations as part of the ‘Pillar 1’ process are insufficient to cover such risks, a firm is required to increase its financial resources.
The ICAAP applies to a wide range of financial institutions, including credit institutions (banks, building societies and credit unions), investment banks, market makers, brokers and asset managers. Conversely, it does not apply to certain investment firms to which IFPR applies, including certain firms currently classified as ‘Exempt CAD’ firms (broadly, firms whose activities are limited to investment advice and arranging deals).
Whilst conceptually, and in application, the ICAAP and ICARA share certain characteristics, under the FCA’s proposals for the ICARA, set out in a recent Consultation Paper, there are some fundamental differences between the respective frameworks.
A key change is a focus on ‘harms’ as opposed to ‘risks’.
Under the ICAAP, a firm is obliged to consider its risks (for instance, business risks, operational risks, credit risks, market risks and liquidity risks) and consider how best to manage these. Conversely, the ICARA will require firms to address any material harms that may result from its ongoing activities. These harms might be with respect to the firm itself, to its clients and counterparties or to the wider marketplace.
Hence, ‘harms’ is more outward-looking compared to ‘risks’.
As a consequence, firms currently subject to the ICAAP might find that under the new regime the process for identifying and managing ‘harms’ will not be as rigid as the current process regarding ‘risks’.
A key aspect of the ICARA framework is the application of proportionality. Whilst the requirements apply to all firms subject to the IFPR, the regulatory expectation is that smaller firms carrying on simpler activities can take a less detailed approach to the monitoring and management of a smaller range of harms.
However, there are some additional requirements for firms of all sizes. For some firms, there will invariably be some challenges and pitfalls:
- The ICAAP requires firms to consider whether the Pillar 1 regulatory capital amount is sufficient, or should be increased, in response to the risk mitigation exercise. Whereas the ICARA in addition requires firms to consider its liquid assets, as well as its regulatory capital, in the context of harms. This is in-line with the introduction of a quantitative liquid assets requirement for investment firms, typically equal to 1 month of fixed expenses.
- There is an increased emphasis on the viability of a firm throughout the economic cycle, and ensuring that its wind-down is orderly and minimises harm.
- Consequently, the wind-down plan will need to be more detailed than historically. The plan should reconcile wind-down resource needs to regulatory capital and liquid assets requirements. It plan should include qualitative – in addition to quantitative – elements to ensure that the wind-down is as orderly as possible so to minimise harms. In 2020, the FCA published guidance on wind-down planning (as part of wider guidance on assessing adequate financial resources). The ICARA’s outcomes are compatible with this guidance.
- Some additional metrics are introduced including ‘wind-down triggers’, which apply to financial resources and liquid assets. Where a ‘wind-down trigger’ is reached, the FCA expectation is that a firm commences wind-down unless the firm’s governing body has concluded that there is an imminent and credible likelihood of recovery.
- There will be a requirement to notify the FCA where the regulatory capital or the liquid assets requirement (as determined either by the prescriptive calculations or via the ICARA process) or the wind-down trigger has been breached. There is also a requirement to notify the FCA at the ‘early warning indicator’ point which is usually where regulatory capital falls to 110% of the regulatory capital requirement. With respect to each notifiable event, the FCA sets out its expectations from the perspective of the firm and the regulator (regarding potential supervisory actions).
Similar to the ICAAP, the ICARA process must be reviewed at least once every 12 months. There will be an associated FCA return – the ‘MIF007’ (ICARA assessment questionnaire). This is submitted to the FCA after each review. The FCA has indicated that the MIF007 will be more straightforward than the current ICAAP-related return.
The ICARA has its origins in the EU’s reforms of its prudential regime for investment firms, which is a long-standing initiative. Conceptually, the intended outcomes of the ICARA framework are also compatible with the increased focus on resilience, which is in part influenced by the challenges faced by market participants during the pandemic. An operational resilience regulatory framework is being introduced for more systemically important firms, including credit institutions and insurers and certain significant investment firms. For other investment firms, the ICARA recognises that potential harms could have an impact that goes beyond the firm itself, and that is notwithstanding the firm’s size, nature and characteristics. The ICARA process also provides an opportunity for firms to consolidate its processes for identifying harms, considering its resilience to events such as economic downturns and a wind-down, and putting in place credible solutions to address these.