Introduction

The Financial Services Authority (“FSA) has recently published a Consultation Paper on Individual Capital Adequacy Standards (“CP 136). In this Paper the FSA sets out, and invites comments on, its proposed draft framework for individual capital adequacy standards (“ICAS) for authorised firms. These proposals are particularly relevant to deposit-takers, insurers and investment firms who have permission to take principal positions (i.e., all firms in PRU categories 1,2 or 3).

Purpose of new framework

FSA states that the purpose of the new ICAS framework is to reduce the likelihood of consumers suffering loss, or markets being disrupted, because of prudential failure. The framework seeks to achieve this by ensuring that the amount of capital held by a firm is commensurate with the risk associated with its business profile and its systems and controls environment. Although any rules and guidance derived from the new framework will eventually form part of the ‘Integrated Prudential Sourcebook’ (“PSB) and the ‘Supervision Manual’, the framework is not designed to replace existing rules and guidance within the rest of the PSB but rather, it is intended to add more guidance on how firms may assess what are ‘adequate resources’ and how the FSA may satisfy itself that a firm’s assessment is appropriate.

The proposed ICAS framework is a ‘risk-based’ process (reflecting FSA ‘s new risk assessment methodology) that includes two key elements:

· The Internal Capital Assessment; and

· The Supplementary Capital Assessment.

The Internal Capital Assessment (“ICA)

The ICA, which will apply to all firms in PRU categories 1,2 or 3, will address business and capital systems and controls not adequately captured in the minimum capital requirements in the PSB. These additional capital requirements will be determined on a firm by firm basis. The main process for achieving this will be through self-certification by the firms themselves, in one of two ways:

(i) the firm’s own assessment of its capital needs, based on the rules and guidance to be included in the PSB; or

(ii) if certain pre-conditions are first met, a firm may use an estimate of its capital requirement as determined by its own economic capital model, supplementing it with capital add-ons where the model does not adequately cover the risks identified within this framework.

The overall aim of the ICAS framework is for senior management to determine a minimum level of capital that will be appropriate to the business risks and systems and controls environment of their firm. Firms would be expected to review their internal assessment regularly and to implement policies and procedures to prevent a breach of that minimum level. Senior management would be required to certify that they consider that, on the basis of all information and guidance available to them, the capital their firm holds is sufficient to mitigate the business and control risks that they have identified.

FSA have stated that the draft rules and guidance arising from this new framework will be aligned with the risk-specific chapters in the PSB, namely:

· Capital

· Credit risk

· Market risk

· Operational risk; and

· Insurance risk.

Chapter 4 of CP 136 explains the ICA in more detail, highlighting how it would apply to firms in different sectors.

The Supplementary Capital Assessment (“SCA)

An SCA is intended to be a supervisory tool (which can be either remedial or preventative) designed to address specific concerns regarding a firm’s systems and controls or business risks, where these have not been adequately addressed, where applicable, by the ICA.

Whereas the ICA will apply only to PRU category 1,2 or 3 firms, the SCA will be available for use for all categories of firms, regardless of business type.

FSA are proposing that the SCA may be used as a tool to increase capital requirements where it determines that a firm has systems and controls weaknesses and where the risk arising from these weaknesses can sensibly be mitigated by an increase in the capital held.

FSA does, however, recognise that the requirement for additional capital is not the only tool, or indeed always the most appropriate tool, to deal with systems and controls issues.

FSA will include further detail on the setting of an SCA in the PSB and in the Supervision Manual. However, they have at this stage stated that the appropriate supervisory response to risks identified will depend on, amongst other things, a firm’s specific business profile, organisational structure, size, whether it is the member of a group, and how that group is organised.

Rules and Guidance – Changes to the FSA Handbook

It should be noted that the CP does not include any draft Handbook text. The FSA have stated, however, that as they develop the framework, they will seek to ensure an appropriate balance of rules, evidential provisions and guidance (the latter two categories providing the bulk of the text). New rules (or modifications to existing PSB rules) will, in particular, require firms:

· to undertake their own capital adequacy assessment and to keep this assessment under review;

· to document their assessment in order to support their view;

· to hold capital in accordance with their self-assessment; and

· to certify, on an annual basis, that they have followed this framework and notify FSA of their self-assessment.

The draft text will be included in a later CP.

Relationship of proposals to current international work

It should be borne in mind that the CP has been published against a background of wide-ranging international discussions on prudential standards. The FSA have therefore sought to anticipate, as far as possible, the outcome of these discussions.

Accordingly, as regards credit institutions and investment firms, the ICAS is intended to be the vehicle for implementing both the capital adequacy element of Pillar 2 of the new Basel Capital Accord and the parallel EU directives.

Where the implementation of the new prudential regime for insurance firms is concerned, it is likely that the ICAS framework will result in the UK being ‘superequivalent to’ (i.e., set higher than) the EU’s minimum requirements (which are widely regarded as being inadequate).

Particular proposals affecting insurance

The FSA notes that the EU has been revisiting the existing solvency margin rules for insurance companies. This process has been pursued in two parts. The first part, known as ‘Solvency I’, will slightly change (two directives were passed in February 2002) the solvency margin regime for life and non-life insurers. The second part, known as ‘Solvency II’, is likely to lead to enhanced risk-based capital requirements for insurance firms. Moreover, in the longer term, the International Accounting Standards Board’s (“IASB) international accounting standard for the valuation of assets and liabilities will also have an impact for accounting purposes on the capital adequacy regime for insurers. The FSA believe that it will draw out more clearly how much capital is genuine on a realistic basis and how much is merely a capital ‘buffer’ within the firm’s assets or liability valuations.

The FSA believe that it is too early to indicate the content and timing of the new EU legislation. However, as a result of the Baird report and the Tiner review, the FSA are committed to reviewing the minimum capital requirements for insurance firms ahead of the implementation of the EU’s Solvency II review.

Within the insurance risk module, the FSA are proposing the use of an enhanced framework for firms to determine how much capital they will need to satisfy the requirement to hold adequate financial resources which will consist of three elements:

· an enhanced Pillar 1 requirement (under the new Basel Capital Accord);

· stress and scenarios tests (with the assumptions made and the results of the tests included in the firm’s regulatory reporting); and

· capital add-ons to reflect operational risk and systems and control weaknesses.

The FSA say that they will consult separately on the implementation of any new EU directives at a later date but hope to implement this framework in 2004.

The insurance industry has cautiously welcomed in principle the Consultation Paper, as the proposed changes will provide insurers with the freedom to align actual capital needs with specific risk and represents a move away from the existing “one size fits all policy. However, doubts have been expressed as to how far FSA can go with these proposals until the EU’s Insurance Directive has been agreed and common international accounting standards have been introduced.

Next Steps

FSA have requested that all comments on the consultation reach them by 31 August 2002. They plan to issue a second CP in 2003 that will include draft rules and guidance and further detail on the proposed framework.

To access the FSA discussion document please click here

For further information please contact Nick Paul on +44(0)20 7367 2806 or e-mail [email protected].