Prudential Regulation

Prudential standards seek to ensure that credit institutions and investment firms have adequate resources following the Capital Adequacy Directive and the Capital Requirements Directive. Investment firms are subject to risk-based requirements set out in the General Prudential Sourcebook and the Prudential Sourcebook for Banks, Building Societies, and Investment Firms.

The sourcebook provides guidance on managing credit and counterparty risk, market risk, liquidity risk, operational risk, and concentration risk. It also addresses other risks, including interest rate risk, securitization risk, the risk of excessive leverage, pension obligation risk, group risk, and residual risk.

The purpose of the capital requirements rules is to ensure that firms remain solvent. Firms must maintain financial resources in excess of their financial sources requirement.

Capital resources requirements necessitate a minimum of three months’ annual expenditure. There is a minimum resource flow requirement for all firms, even the smallest personal investment firms. Capital resources must be in a realizable form, such as cash.

Liquidity requirements are crucial as they measure the ability to pay monies or liquid funds when required. Firms must maintain liquidity resources of adequate quantity and quality to ensure that there is no significant risk that liabilities may not be met as they fall due. Emergency liquidity to the central bank is not accounted for.

Foreign funds to a UK branch may only include liquidity resources meeting certain conditions. They must be under the control of senior management in the UK, held by the UK branch, and attributable to its balance sheet.

Firms must carry out an individual liquidity adequacy assessment. This must be based on stress testing and must be conducted at least annually. It may be required more frequently if there is a change in business strategy, the nature of activities, the balance sheet, or if the operational environment suggests that the levels of liquidity held may be inadequate.

The individual liquidity adequacy assessment must inform the board of the assessment of the quantification of liquidity risks and have the firm’s intent to mitigate the risks. It is also used as a means to demonstrate the regulator’s compliance with the internal liquidity adequacy assessment process.

The stress testing must include unforeseen types of stresses in which it is considered by the depositor and market participants that the firm is likely to be unable to meet its liabilities in the short term, and counterparties reduce their credit. Furthermore, an unforeseen market-wide liquidity stress of three months’ duration in which risk aversion in the market from which it derives funds affects the valuation of its assets and the ability to realize certain classes of assets is pertained.

Firms must have robust strategies, policies, processes, and systems that are comprehensive and proportionate to the nature, scale, and complexity of their activities. They must enable firms to identify, measure, manage, and monitor liquidity risk. It must enable them to maintain, assess, and maintain, on a continuous basis, the amounts, types, and distribution of liquidity resources they consider adequate to cover the nature and level of the risk and the risk that the firm cannot meet its liabilities.

Supervision approaches.

The Financial Conduct Authority and the Prudential Regulation Authority take different broad approaches. Prudential supervision focuses on supervising firms. Conduct supervision focuses on thematic work, unless on specific work.

Regulators use a number of tools, including diagnostic tools to identify, assess, and measure risk; monitoring tools to assess the development of risk; preventative rules to reduce and limit identified risks; and remedial rules to address risks that have occurred.

The Financial Conduct Authority has a risk-based framework to support its key activities in supervision, enforcement, and authorization.

The FCA divides firms into different conduct supervision categories. C1 applies to universal banks and investment banks with large trading operations and substantial client assets, banking and insurance groups with a large number of retail assets. C2 comprises large wholesale firms and firms from different sectors with a substantial number of retail customers. C3 covers firms across different sectors with a significant wholesale presence. C4 covers small firms and newly authorized intermediaries.

The FCA concentrates its resources on firms with the greatest potential to cause risk to consumers and market integrity. C1 and C2 firms are subject to the most intensive focus on a two-year regulatory cycle. C3 and C4 firms have their models evaluated on a four-year cycle. Regular baseline monitoring, as well as monitoring of particular activities such as transfers and acquisitions, is conducted.

C4 firms are subject to ongoing sectoral analysis and thematic review. There is occasional four-yearly assessment, which may be a phone or face-to-face interview or combination. The FCA will do specific work on specific risks required to be addressed.

The chief purpose of the business model and strategy analysis risk is to determine whether the firm’s business model exposes it to an unacceptable level of conduct risk. The first pillar is the firm’s systematic framework. It seeks to determine whether the interests of customers and market integrity are at the heart of how the firm is run.

It analyses the firm’s models and strategies with a view to forming a view as to the sustainability of the business and considering what future risks might arise. It is focused on ensuring fair treatment of customers and ensuring market integrity is embedded in the way in which the firm runs its business. This includes cultural matters embedded and tone set from the top.

The assessment is undertaken through four modules. The governance and culture module assesses how effectively the firm identifies and manages risk. The product design module looks at whether the firm’s products or services meet customers’ needs and whether customers are targeted accordingly. The sales process module assesses the firm’s systems and controls. The post-sales handling module looks at how customers are treated after the point of sale, including in particular complaints handling.

The second pillar seeks to deal with the issues that are emerging or have happened or have been unforeseen by their nature. This arises from events that may include mergers and acquisitions, whistleblowing, and sudden increases in complaints.

The last pillar, termed issues and products, arises from analysis made of sectors by the regulatory sector group. They produce sector risk assessments of conduct risk across all sectors. Consideration is given as to whether cross-firm or product issues pose a risk to consumers or endanger market integrity.

The Financial Conduct Authority takes different approaches in its prudential regulation function. In addition to the C1 to the C4 categories, it allocates firms to three prudential categories. The first category is for those whose failures would have a significant impact on the market in which they operate, but where the authority is not confident that an orderly wind-down can be achieved.

These are supervised on an ongoing basis with the view to minimizing the possibility of failure. Firms for which an orderly wind-down can be achieved are categorized as CP2 and supervised on a different basis. Even if their orderly wind-down is likely to have a significant impact, they are categorized as CP3 and are supervised on a reactive and concerned basis. C2 is a proactive and concerned basis.

The PRA uses a judgment-based forward-looking approach to supervision. It uses a range of supervisory tools, including the analysis of public information, firm-provided information, meetings, inspection, onsite testing, stress testing, and liaison with auditors. The degree of activity carried out by the PRA depends on the firm’s category.

The PRA categorizes firms into five categories from high impact to low impact based on their potential impact on the stability of the financial system. The proactive intervention framework seeks to ensure that the authority puts into effect its aim of identifying and responding to emerging risks at an early stage. There are five stages equivalent to the risk of failure as a firm moves to a higher stage. Senior management must take steps to undertake the appropriate remedial action to reduce the risk of failure.

The consumer protection strategy seeks to take a more proactive approach to regulating conduct with retail customers. The strategy seeks to identify whether early intervention is required in the product lifecycle.

The strategy includes more intensive supervision of the conduct of large retail firms, with a focus on product intervention and greater use of enforcement and regulatory tools.

GABRIEL is the Gathering Better Regulatory Information Electronically system. It collects non-licensed information about authorized firms to assist in supervisory activities. This is used to monitor firms, identify risk profiles, and market trend.