From June 2021, adviser/arranger firms will be subject to significant new requirements including increases to capital and liquidity, enhanced governance standards and new disclosure rules. Board members and other senior management of these firms have started to, and should continue to plan and act early to ensure they have adequate financial resources, personnel and systems in place to be ready come 26 June 2021.

The ‘adviser/arranger’ designation has been popular in the UK amongst the private equity, real estate and corporate finance sectors due to the FCA’s adoption of the so-called “Exempt-CAD” regime, specifically because such firms benefit from comparatively low capital requirements and light-touch regulation.

With the new rules applying with parity across all UK investment firms, for those starting from a lower base the resulting changes to their business will be significant.

To help adviser/arranger firms better understand how they will be impacted by these changes, this article focuses on the key changes and the various actions firms should take early to achieve readiness.

What is causing these changes?

The EU’s new prudential rules for investment firms [1] were finalised in December 2019, starting the 18-month countdown. Since this time, the European Banking Authority (EBA) has published technical papers providing the necessary detail to the more complex rules [2]. Further, the Financial Conduct Authority (FCA) has published its discussion paper outlining its implementation plan for UK investment firms. This is becoming known as the Investment Firm Prudential Regime (IFPR).

The FCA’s discussion paper clarifies that, despite Brexit, the UK will press ahead and implement an almost-identical regime. Adviser/Arranger firms can use this paper in conjunction with the EBA’s publications to better understand the impact on their business and act in good time to be ready.

Why do we need the IFPR?

Most investment firms are currently governed by the EU’s prudential capital framework for banking, with the FCA making use of the various derivations and exemptions. It is widely accepted that a banking framework is ill-suited to most investment firms and the disparate application of these rules over time has made it difficult for national regulators to supervise effectively.

Regulators have long wanted to apply more appropriate arrangements for calculating regulatory capital in the sector. The IFPR creates a prudential capital framework that is more tailored to the investment firm industry.

While the changes will be modest for much of the industry, adviser/arranger firms might feel as though the new rules are somewhat less simple and proportionate to them. Compliance with the new regulatory capital requirements could cause changes to the fundamental assumptions of firms’ business models.

IFPR impact on adviser/arranger firms

Under the current requirements, prudential compliance for adviser/arranger firms is a relatively simple process. Firms hold capital in excess of a fixed minimum amount and submit reports to the FCA on a periodic basis. However, under the new framework, the amount of capital they will be required to hold will rise by at least 50% and, in many cases, by significantly more.

In addition, the time required to ensure compliance with more complex and onerous capital, liquidity, reporting, group consolidation, disclosure, remuneration and other governance requirements is sure to create a need for additional resources.

Actions an adviser/arranger firm can take now
As a first step, firms should explore the proposals to see which category they will fall under. Adviser/Arranger firms will need to:

1. Evaluate impact on capital

The new minimum, formula-based, requirements will force most adviser/arranger firms to increase the amount of capital they hold by a significant amount:

The initial capital requirement (ICR) of €50,000 will increase to €75,000;
Firms will also have to contend with a Fixed Overheads Requirement (FOR) for the first time; equivalent to a quarter of annual expenditure.
Larger firms may face additional “K-factor” capital requirements, calculated with reference to the type and volume of business they conduct.
A silver lining to these increases is the transitional provision meaning that, for most adviser/arranger firms, the capital requirement will be limited to no more than €100,000 for a period of five years, after which the full requirement will apply.

2. Implement internal risk-based assessment

Every adviser/arranger firm needs to plan for the increase in capital requirement that will be required to continue doing business after the end of the transitional period.

Firms will need to carry out an assessment of their capital requirements specific to the risks that they are exposed to. The FCA is calling this the Internal Capital Adequacy and Risk Assessment (ICARA) process and will have supervisory powers to review and evaluate a firm’s assessment, imposing capital add-ons in the event of any shortcomings.

This is the first time this requirement applies for adviser/arranger firms and would require a considerable amount of work to implement and operate.

As may be clear, the application of this “Pillar 2” regime could also give rise to the need to hold even more capital – depending on the outcome of the firm’s or the regulator’s assessment.

3. Assess group status

One area in which the European authorities could not agree on simplification is the rules governing consolidated supervision. Consequently, adviser/arranger firms, a category which has not been subject to group supervision rules before now, must consider the impact of their group structure on their prudential supervision.

Those firms operating within a group which falls within scope of consolidation supervision rules, will need to assess the impact of the new capital rules and ICARA process requirements on a group basis as well as an individual one. This should not present a problem for groups which are suitably capitalised, but those which implement debt as part of their financing within the group structure might need to consider revisiting to ensure the group can comply with the new rules.

4. Hold liquidity resources

Adviser/Arranger firms will need to implement internal policies and procedures that allow them to monitor, measure and manage liquidity resources. Firms will have to hold one-third of their FOR as liquidity, as a base-line requirement. Larger firms will have to implement additional liquidity calculations and potentially will need to hold higher levels of liquidity.

5. Review remuneration practices and formalise policy

The Remuneration Code is a long established principle for many UK investment firms which, for personnel whose actions affect the risk profile of an investment firm, is designed to align risk with reward, mitigate conflicts of interest and dis-incentivise adverse investment decision-making behaviours.

This will, however, be a new concept for adviser/arranger firms and, whilst many will have aligned to industry best-practice, such firms will need to review their current practices in line with the new requirements and formalise those in a Remuneration Policy.

6. Prepare for disclosure

Adviser/Arranger firms have previously had no requirements to make public disclosures. The IFPR will mandate that all UK investment firms will, as a minimum, be required to disclose information on risk management objectives and policies as well as capital resources and requirements. Many firms will, in addition, be required to disclose information on governance, ESG and remuneration policies and practices.

Aside from the administrative tasks of drafting the disclosures in compliance with the required standards, much of the initial hurdle will be dealing with the cultural shift of having to disclosure potentially sensitive information in the public domain. Adviser/Arranger firms should begin now to understand the required content of the disclosure to ensure there are no last-minute surprises when the new rules become effective.

What is next?

Before the implementation date of 26 June 2021 there a still a few major milestones to watch out for. The FCA will finalise its implementation approach based on feedback received on its discussion paper. Further, the EBA will continue to issue further rounds of consultation papers in the planned phases for addressing the required technical standards intended to add clarity to the IFR and IFD.

Firms should keep abreast of these developments, particularly if there is a specific area of focus or concern to be covered by one of the aforementioned future publications. Wheelhouse Advisors will continue to provide updates in the event of key developments as these publications emerge.

In conclusion

The IFPR creates both risk and opportunity for adviser/arranger firms. Firms need to ensure their business strategies can support the additional investment in people and resources that are necessary to fulfil the enhanced obligations applicable to them.

For a small number of firms operating at the margin today, the answer may be that they cannot support the additional costs and capital needs with their current business model.

For others, this will represent a potential business opportunity. The categorisation changes could provoke a strategic shift. Firms could decide to enter new types of business previously avoided because of the consequential increase in regulatory requirements. Under the new regime, firms would already be fulfilling the same requirements for prudential capital so can try out a fuller scope of activity.

In short, adviser/arranger firms face a sea change in the prudential requirements that they operate within. These rules have the capacity for substantial positive and negative consequences. What is clear is that firms should begin to review how the required increase in capital and governance expectation will impact their operations as soon as possible.

Wheelhouse Advisors will continue to monitor the progress of the IFPR through the FCA and EU systems and provide updates as key developments emerge.

How Wheelhouse Advisors can help

We have a range of solutions designed to help you meet your IFPR obligations. These include:

• Impact assessment – to help you understand how the IFPR impacts your firm. This includes categorisation, capital requirements and resources, liquidity requirement and resources, group consolidation rules, regulatory reporting, ICARA process and public disclosure.
• Regulatory reporting – we can look after your on-going regulatory reporting burden allowing your team to focus on the day-to-day business.
• ICARA process – all firms will be required to annually conduct and document their ICARA process to assess the level of capital that adequately addresses future and current risks in their business. Wheelhouse Advisors assists firms in developing and documenting their ICARA process as well as advising how the key underlying functions can be embedded in day-to-day governance.

Connect with Wheelhouse Advisors to learn how our expertise can deliver a comprehensive and integrated approach to prudential governance across your firm. Call our prudential experts at +44 (0)20 3404 0440 or email at info@wheelhouse-advisors.com.

[1] Investment Firm Regulation (IFR) and Investment Firm Directive (IFD)

[2] EBA has published several consultation papers for technical standards and has further phases planned for publication before the end of the year