Overview of the FCA prudential approach

Update October 2024: Several aspects described in this speech, including some prudential regimes and the prudential categorisation approach, have been replaced and are no longer used by the FCA.

The FCA as a prudential regulator

The Financial Conduct Authority, although it has the word 'conduct' in its name, is also responsible for the prudential regulation of over 24,000 firms in the UK.  We cover a wide range of sectors, many of whom are represented here today – asset managers, investment firms, platforms and a range of infrastructure providers.  This makes us, by number of firms, the largest prudential regulator in Europe.

We supervise firms under more than a dozen prudential regimes - most observers can think of BIPRU and IFPRU, the new regime for CRD IV firms, but there are actually many more prudential regimes covering different types of firms.  

Similar to our approach to conduct supervision, our prudential assessments consider a wide range of factors: they go beyond quantitative analysis of firms’ financial resources and consider systems and controls, governance arrangements, and risk management capabilities including the risk of misconduct - essentially, we assess how well a firm understands the risks that it is running, and how well placed it is to manage those risks, and to avoid large, unexpected costs.

I will introduce some of the key aspects of our approach to prudential supervision at the FCA, the role of the client assets regime (known as ‘CASS’) and areas on which firms should focus.  Many of these themes will be developed further during the day.

Introduction to our approach to Prudential Supervision

In summary, our approach to prudentially regulating 24,000 firms is guided by the FCA’s statutory objectives of consumer protection, market integrity and competition.

Some firms may and do fail - our role is not to prevent firms from failing but to minimise detrimental spill over or ‘domino’ effects on customers, counterparties or market stability. 

In a healthy and competitive market, some firms may and do fail - our role is not to prevent firms from failing but to minimise detrimental spill over or ‘domino’ effects on customers, counterparties or market stability.  Our focus is on mitigating the impact of failure, in the interests of consumers, markets, and competition.  Because of this, we also focus on making sure that client money and assets are protected through the supervision of the CASS regime.

Secondly, we take a risk based approach: we prioritise our attention on firms which would have the greatest impact on consumers and markets if they were to fail – they tend to have relationships with a significant number of customers and market participants, and would cause widespread disruption - these firms fall into our P1 and P2 categories, and those that tend to have a lesser potential impact fall into P3. 

Proactive Supervision

For the P1 and P2 firms, we take a proactive approach to supervision:

• We carry out baseline monitoring of returns to identify rule breaches or proximity to breaches, any emerging risks, and notable changes to the financial position or other signs of strain;
• We perform a Supervisory Review and Examination Process (SREP) on regular cycles to determine the appropriate level of capital and liquidity that the firm should hold, based on the risks posed by its business model – this is a thorough assessment of a firm’s risk management exposures, management capability and controls, starting with an examination of the firm’s written submission (the Internal Capital Adequacy Assessment Process (ICAAP)).  We have found in some cases that firms are not assessing their ICAAPs appropriately – this can result in us requiring significant capital increases – we will be covering this further today;
• Operational risk is high on our agenda, and rightly so since it represents the single largest risk class for most of our solo-regulated firms.  Our assessment of this involves us looking at systems and controls, including IT vulnerabilities such as cyber crime;
• For firms where this is material, we also conduct specialist visits on market and credit counterparty risk controls, and prudent valuation frameworks.  That same team of quantitative specialists also examines the performance and modelling of complex investment and borrowing products, so they play both a prudential and conduct role;
• We place great store in ensuring that firms consider adequate wind-down planning.  We assess plans to ensure that firms have sufficient financial analysis, reverse stress tests, management actions and dispositions in place to ensure that minimal disruption to customers and markets will be caused if it fails.  Some of our crisis management arrangements involve working with our colleagues at the Bank of England’s Resolution Directorate.  You will hear directly from them later today.

The role of data and alerts

Our supervision of P3 firms is reactive. 

For P3s as well as P1 and 2 firms, we react to a range of alerts generated by our systems. These alerts may be triggered by something unusual in the returns or information received from the firm, or from other intelligence received from the firm’s counterparties, the Financial Ombudsman Service, consumers or whistleblowing by the firm’s employees.

You will be aware that firms submit regular returns containing both conduct and prudential information to the FCA.  Firms will need to continue to do so, with increased granularity under CRD IV, where detailed specifications including data taxonomy, validations and filing rules are published and regularly updated by the EBA.  

It is important that data entered is complete and correct – if it is not, we cannot easily compare information and generate alerts, and firms will be asked to resubmit any incorrect returns.  We can also interpret incorrect data as an early warning of financial stress or other issues, and this can trigger a request for an explanation from the firm, and further scrutiny.

By focusing our prudential supervision on identifying early signs of financial strain in firms, we can spot worrying trends early on and respond quickly to deteriorating financial positions.  For example:

• Using a combination of alerts and other intelligence we were able to focus early on an investment firm and ensure as orderly a wind-down as possible through the Special Administration Regime upon insolvency.  By being on the front foot, we were able to manage a crisis in non-panic mode and invoke the regime that provided greater assurance for the return of client assets.
• Through these arrangements, we also identified early several major firms that were for a short period of time in breach of their regulatory obligations, until our intervention prompted their respective parents to remedy the situation.
• Identifying surprising trends helped us to identify early a group of firms that were growing too fast for comfort, and from there we engaged in a useful exploratory discussion with them.  In that particular case, the conversation enabled us to better understand their strategy and their business model, thus furthering our mutual understanding of their prudential and conduct circumstances.

CASS

Also linked to 'pure' prudential issues is CASS, the regime that protects client monies and assets.

There is a risk that, when firms run a little short of cash, they might be tempted to dip into client monies: that is of course a breach of our rules, which we regard with the utmost seriousness.  But it does sometimes happen, and when it does, it creates a hole in the CASS accounts that are meant to secure customers.  

It can go undetected for a little while, but if there is a ‘prudential event’ - if a firm is going to enter into serious financial difficulty - or indeed at any time, any incoming fresh cash must first be allocated to making good any shortfall in the CASS account.  

This means that what might look like a picture of reasonable prudential health in a firm could be masking a big, and priority, CASS 'hole'.  So it is vital for firms to have a good handle on their compliance with the CASS rules, their prudential health and any conduct risks, as the three interact.  

For our part, we have a CASS specialist department that monitors firms that hold client money, and swiftly intervene where necessary.

A good example of this is the impact of the recent, unexpected, Swiss Franc movement on firms holding client money.  For those firms that had a good understanding of their prudential position and held enough capital, they felt the hit, and continued to trade.  However for a few others, this was not possible.

As this event was unexpected, we had to react swiftly: we identified the firms that did this type of business and focussed on those whose prudential position made them more likely not to be able to absorb the financial impact.  

These firms were prioritised for emergency visits so that we could make sure that the client money was protected.  We worked closely with the most challenged firms to assess the implications for them, and, if it were the only option, to go into administration in as orderly way as possible.  

In a space of less than a week, we visited and reviewed nearly 30 affected firms holding nearly £1bn in client money, three of which went into administration under the Special Administration Regime.

The link between conduct and prudential issues

I have spoken about prudential regulation per se, but of course prudential issues affect conduct of a firm, and conduct issues can affect the prudential health of a firm. 

For example, how does a firm experiencing financial stress react?

Logically, it tries to sort out its finances by trying to raise fresh money, but that is not always possible. It may also attempt a strategic shift to launch more profitable products: that can work but only if it isn’t too late.

Often, it is too late, and firms may try to generate needed short-term profitability by cutting corners.  One of those corners is treating customers and counterparties fairly – for example, over-charging their customers, or over-selling the benefits of their products. 

And what is at stake for a firm if it engages in misconduct?

Apart from public censure and reputational damage, there are three sets of financial costs that further impact on the firm’s prudential position:

• The first cost is the cost of redress; on the surface of it, that’s simply returning to consumers amounts they should have never paid; but since the redress payments often take place years after the original misselling or other misdeed, they go straight out of profit and reserves and with interest.  The prudential impact can be significant.  If we look at PPI misselling, the total redress costs to date exceed £12 billion for the top 4 sellers of PPI (and over £18 billion in total); the interest rate hedging products redress bill is nearly £2 billion; misselling of card protection insurance cost the firms involved nearly £500m; the misselling of a structured product cost the product provider and the building society that distributed it over £100m in redress.
  • Whilst many of the firms involved in this are not prudentially regulated by the FCA, it is worth noting that these redress payments represent a sizeable fraction of the high street banking sector’s total regulatory capital requirements.
• The second big cost is enforcement fines.  These are on the increase and amounts in the 7 figures are no longer rare – the recent fine on a custody bank for CASS failings was 9 figures, at £126M.  Although most affect a firm, some also attach directly to specific individuals.
• And of course there are also the significant costs to firms of investigation, both monetary and in senior management time.

So whilst prudential impacts can affect conduct, poor conduct can also have prudential consequences - the amount of redress and fines reduce firms’ retained profits, and thus their capital at hand, and the operational risk scenarios these firms have to run to calculate their operational capital in the future may have to consider the possibility of similar events reoccurring. 

Prudential supervision is not just about the financials – as with conduct supervision, it is about assessing how well a firm understands the risks that it is running, and how well placed it is to manage those risks, and to avoid large, unexpected costs. 

Conclusions – focus for firms

So to conclude, from your perspective, what are the areas that your firms should be focussing on?

As I said earlier, prudential supervision is not just about the financials – as with conduct supervision, it is about assessing how well a firm understands the risks that it is running, and how well placed it is to manage those risks, and to avoid large, unexpected costs. 

So you should focus on ensuring you have a methodical yet 'blue sky thinking' approach to assessing the risks you are exposed to, and translating your findings into a robust capital and liquidity assessment that the whole firm buys into and runs with – not just the Finance Director, but all levels of the business, from the Board downwards.  

We have seen instances where this is not done, to the cost of the firm. - you will hear more today about these, and some of the common errors that can attract unwanted capital increases.

We welcome the opportunity today to discuss with you some of the key aspects of prudential regulation.  I hope that you will take the opportunity to engage with us on these issues, and to ask us questions – we look forward to hearing your views.