Change is coming - new prudential requirements for personal investment firms

Overview

At the end of November 2023, the FCA published its consultation paper (CP23/23) in respect of proposed new capital deductions for redress aimed at personal investment firms (‘PIFs’). The purpose of these proposals is to ensure that PIFs hold sufficient capital to meet potential redress liabilities with the intention of making individual firms responsible for their mistakes and reducing the financial burden on the Financial Services Compensation Scheme (‘FSCS’).

The impact of these proposals would likely be an increase in the amount of capital PIFs are required to hold, particularly where individual firms have received complaints historically in respect of the advice they have provided. Where firms have insufficient capital to meet their requirements, post any redress liability deductions, they may become subject to asset retention requirements which would limit their ability to conduct transactions outside the ordinary course of business.

The FCA has also included a discussion chapter, setting out high level proposals to enhance the prudential framework for PIFs. These proposals explicitly draw from the Investment Firms Prudential Regime (IFPR) applicable to MiFID investment firms. The impact of the proposals included within the discussion chapter would be a wholesale change to the prudential regime for PIFs – introducing new capital, liquidity, reporting and disclosure requirements, as well as a setting new expectations for governance and risk management.

Redress Liabilities

The proposed rules would require PIFs to consider:

• Unresolved redress liabilities – instances where the firm has received a complaint which is yet to be resolved; and
• Prospective redress liabilities – foreseeable harms that could give rise to redress to a retail customer or recurring or systemic issues, which could give rise to an obligation to provide redress.

Firms would be required to set aside capital against unresolved redress liabilities until they have been resolved and there is no realistic prospect of them being reopened.

For prospective redress liabilities, firms will be required to calculate these liabilities based on the following formula:

I x A x P

Where...

I = 

The estimated number of consumers impacted. The FCA has stated that it estimates the prospective claims to be equal to the total number of complaints received in the preceding six years but have highlighted that firms with even one complaint in the last six years have a significantly higher probability of complaints in the future.

A = 

The estimated redress amount. The FCA has noted that the sector wide averages were £8,933 for investments related complaints and £11,273 for pensions related complaints. Firms will be able to utilise their PII coverage as part of the estimated redress assessment.

P = 

The probability factor used to discount the potential redress liabilities that a firm identifies. This should be a firm-specific ratio of total upheld complaints to total opened complaints. However, the FCA is proposing a default probability factor of 28%. To apply a probability factor discount of more than 28%, a firm must apply for a waiver or modification under SUP 8.

Impact of the new requirements

1. Reporting and Frequency

Where firms identify potential redress liabilities these will be treated as an additional deduction from the firm’s capital resources and will need to be reported in the firm’s RMA-D1 return.

Typically, a firm will be expected to recalculate its redress liabilities as part of its regular financial accounting cycle. However, where a firm becomes aware of new information which indicates a material change in the firm’s potential redress liabilities, or where there are changes to its PII arrangements, the firm should update its assessment.

2. Asset Retention

Where the deduction of redress liabilities results in the firm having insufficient financial resources to meet its capital requirements, the firm will be subject to an asset retention requirement.

This requirement is designed to ensure that firms retain sufficient resources within their business by halting transactions which are deemed to be outside of the ordinary course of business. These rules will effectively stop firms from diminishing the value of their assets until they are able to meet their requirements post the deduction of potential redress liabilities.

Firms subject to asset retention requirements will be required to supply the FCA with a remediation plan explaining how the firm intends to remediate the breach of its capital resources requirement.

3. Exclusions

Firms which are part of groups operating in group level processes that are deemed to achieve the same objectives as these proposals can, following notification to the FCA, be excluded from these new rules. This will include firms which are part of MIFIDPRU investment firm groups, CRR and Solvency II groups.

Discussion Chapter – New prudential Requirements for PIFs

The proposals discussed by the FCA in the discussion chapter would represent a wholesale change in the financial resources requirements for PIFs.

Whilst specific rules are yet to be put forward the proposals include:

• Increased minimum capital requirements – potentially to £55,000;
• New activity-based capital requirements;
• The imposition of liquidity requirements for PIFs for the first time – including both formulaic ‘basic’ requirements and activity-based liquidity requirements;
• Increased expectations in respect of risk management including firm specific assessments and quantifications of the amount of harm PIFs may pose – similar to the Internal Capital Adequacy and Risk Assessment (‘ICARA’) process for MIFIDPRU investment firms;
• More focus on wind-down planning – potentially ‘right sizing’ existing wind-down planning requirements for PIFs; and,
• New rules and guidance in respect of PII cover to give firms a clear benefit for more comprehensive PII in terms of reducing financial resource requirements.

Next Steps

Whilst the proposals are currently only being consulted on, it is our expectation that a move towards more comprehensive financial resource requirements for PIFs are likely to be implemented. The approach taken by the FCA in these proposals are aligned to those put forward for other sectors; namely an ongoing alignment to the principles and rules implemented for MiFID investment firms in 2022.

Redress Liabilities

The proposals in respect of redress liabilities certainly seem more imminent for firms. We recommend that firms review these proposals carefully and begin to assess the impact of these new requirements on their financial resources. If necessary, firms should look to take advanced action to ensure they will remain adequately capitalised once these proposals go live.

New Prudential Requirements for PIFs

The FCA’s proposals set out within the discussion chapter, whilst subject to change prior to consultation, are clearly at an early stage but do indicate a direction of travel for PIFs.

In our view the prudential requirements for PIFs will be subject to major overhauls in the next 12 to 24 months and it is vitally important that firms are conscious of these new requirements when undertaking forward looking business planning. Further, as with any regulatory change, the new requirements will need to be incorporated into existing regulatory reporting and capital monitoring processes and board members may need to seek training on these new requirements to ensure they are providing effective oversight.

The consultation closes on 20 March 2024. We urge all firms which may be impacted by these proposals to review the Consultation Paper and provide feedback to the FCA.