GENPRU 1.2 Adequacy of financial resources

The guidance in this section is drafted with respect to a firm to which this section and the other provisions of GENPRU and BIPRU referred to in this section apply in full. The guidance in this section is also applicable to a firm that falls into GENPRU 1.2.2 R. However, the guidance in this section only applies to such a firm in respect of liquidity risk and it should be read accordingly.

In the case of an incoming EEA firm that is a full BCD credit institution and of a third country BIPRU firm that is a bank, this section only applies to its United Kingdom branch. However, as a branch is not itself a legal entity separate from the rest of a firm, his restriction does not mean that the rest of the firm can necessarily be left out of account when considering compliance with this section. For example, the availability of the branch's liquidity resources may be affected by general liquidity problems in the firm. Similarly, there may be liquidity resources elsewhere in the firm that are available to meet liquidity problems in the branch.

One factor that may affect the degree to which it is necessary to take into account the firm as a whole is the extent to which the firm manages the liquidity of the branch on an autonomous basis, or includes the branch within integrated liquidity management of the firm as a whole. In the latter case, the requirement in the general stress and scenario testing rule, insofar as it applies to liquidity, to carry out scenario analyses may be satisfied by the firm meeting similar requirements set by the regulator in its home country in respect of the firm as whole, provided that the firm separately identifies the impacts on the United Kingdom branch of the scenarios analysed. However, in the case of an incoming EEA firm, the application of this section is further restricted by GENPRU 1.2.5 R.

The scope of application of this section is not restricted to insurers that are subject to the relevant EC Directives.

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise and so, except as described in GENPRU 1.2.8 G, this section applies to a firm in relation to the whole of its business. In the case of a UCITS investment firm this means that this section is not limited to designated investment business excluding scheme management activity. It also applies to scheme management activity and to activities that are not designated investment business.

Adequate financial resources and adequate systems and controls are necessary for the effective management of prudential risks. This section therefore has requirements relating to both of these topics.

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources that a firm needs to hold in order to be able to meet its liabilities as they fall due. These resources include both capital and liquidity resources.

In the case of a bank or building society this section implements Article 123 and (in part) Annex XI of the Banking Consolidation Directive. In the case of a BIPRU investment firm this section implements Article 34 of the Capital Adequacy Directive so far as that Article applies Article 123 of the Banking Consolidation Directive.

This section also has rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, how it intends to deal with those risks, and the amount and nature of financial resources that the firm considers necessary. GENPRU 1.2.60 R provides that a firm should document that assessment. The FSA will review that assessment as part of its own assessment of the adequacy of a firm's capital. This review by the FSA forms part of the FSA's ARROW assessment of a firm.

This section also has rules requiring a firm to carry out appropriate stress tests and scenario analyses for the risks it has previously identified and to establish the amount of financial resources needed in each of the circumstances and events considered in carrying out the stress tests and scenario analyses.

The basic requirements in this section are drafted to apply to a firm on a solo basis. This section then goes on to describe when its requirements do and do not apply on a solo basis and on a consolidated basis (see GENPRU 1.2.45 R to GENPRU 1.2.47 R and GENPRU 1.2.57 R to GENPRU 1.2.58 R). It also sets out some details about how the solo requirements are adjusted when they are applied on a consolidated basis (see GENPRU 1.2.48 R to GENPRU 1.2.56 G and GENPRU 1.2.29 G).

GENPRU 2.1 sets out the minimum capital resources requirements for a firm. GENPRU 2.2 sets out how capital resources are defined and measured for the purpose of meeting the requirements of GENPRU 2.1.

1. (1)

   BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment) set out detailed guidance on how a firm should carry out the assessment referred to in GENPRU 1.2.15 G. The more thorough, objective, and prudent a firm's assessment is, and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment.

2. (2)

   BIPRU 2.2 and INSPRU 7.1also have information on how the FSA will review and respond to the assessments referred to in GENPRU 1.2.15 G. In particular they deal with the giving of individual capital guidance to a firm, which is guidance about the amount and quality of capital resources that the FSA thinks a firm should hold under the overall financial adequacy rule as it applies on a solo level and a consolidated level.

SYSC sets out general rules and guidance on the establishment and maintenance of systems and controls.

1. (1)

   SYSC 11 sets out material on systems and controls that apply specifically to liquidity risk.

2. (2)

   Chapters LM and LS of IPRU(BANK) contain guidance on the overall financial adequacy rule so far as it relates to adequate liquidity for banks and the firms to which GENPRU 1.2.2 R (Application of this section to certain non-EEA firms) applies.

3. (3)

   Chapter 5 of volume 1 of IPRU(BSOC) contains guidance and an evidential provision on the overall financial adequacy rule so far as it relates to adequate liquidity for a building society.

4. (4)

   SYSC 11.1.21 E is an evidential provision relating to the general stress and scenario testing rule concerning stress testing and scenario analyses. SYSC 11.1.24 E is evidential provision relating to the overall Pillar 2 rule about contingency funding plans.

5. (5)

   GENPRU 2.2 (Adequacy of financial resources) requires certain BIPRU investment firms to deduct illiquid assets when calculating their capital resources.

BIPRU 2.3 contains rules and guidance on interest rate risk in the non-trading book. That material elaborates on the general obligation in the overall Pillar 2 rule.

For a BIPRU firm using a VaR model BIPRU 7.10.72 R (Risk management standards: Stress testing) sets out certain stress tests that the firm should carry out.

BIPRU 10.6.22 R (Stress testing of credit risk concentrations) sets out further stress tests that a firm should carry out if it uses certain approaches to collateral for the purposes of the rules about concentration risk.

For a BIPRU firm using the IRB approach BIPRU 4.3.39 R to BIPRU 4.3.40 R set out a recession credit rating migration stress test that the firm should carry out. Further rules and guidance on such stress tests are set out in BIPRU 2.2 (Internal capital adequacy standards).

The liabilities referred to in the overall financial adequacy rule include a firm's contingent and prospective liabilities. It excludes liabilities that might arise from transactions that a firm has not entered into and which it could avoid, for example, by ceasing to trade. It includesliabilities or costs that arise as a consequence of strategies other than continuing asa going concern. Italso includesclaims that could be made against a firm, which ought to be paid in accordance with fair treatment of customers, even if such claims could not be legally enforced.

A firm should therefore make its assessment of adequate financial resources on realistic valuation bases for assets and liabilities taking into account the actual amounts and timing of cash flows under realistic adverse projections.

Risks may be addressed through holding capital to absorb losses that unexpectedly materialise. The ability to pay liabilities as they fall due also requires liquidity. Therefore, in assessing the adequacy of a firm's financial resources, both capital and liquidity needs should be considered. A firm should also consider the quality of its financial resources such as the loss-absorbency of different types of capital and the time required to liquidate different types of asset. SYSC 11.1.24 E is an evidential provision relating to the overall financial adequacy rule concerning contingency funding plans.

1. (1)

   This paragraph gives guidance on some of the terms used in the overall Pillar 2 rule.

2. (2)

   Insurance risk refers to the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

3. (3)

   Interest rate risk in the non-trading book is explained in BIPRU 2.3 (Interest rate risk in the non-trading book).

4. (4)

   In a narrow sense, business risk is the risk to a firm that it suffers losses because its income falls or is volatile relative to its fixed cost base. However, in a broader sense, it is exposure to a wide range of macro-economic, geopolitical, industry, regulatory and other external risks that might deflect a firm from its desired strategy and business plan. GENPRU 1.2.73 G provides further guidance on business risk.

5. (5)

   Further material on pension obligation risk can be found in GENPRU 1.2.79 G – GENPRU 1.2.86 G.

In the overall Pillar 2 rule , internal capital refers to the financial resources of a firm which it treats as being held against the risks listed in the overall Pillar 2 rule. The obligation in that rule to assess the distribution of such capital refers, in relation to a firm making an assessment on a solo basis, for example, to the need to take account of circumstances where part of a firm's financial resources are held by a branch of that firm which are subject to restrictions on its ability to transfer that capital. An assessment of internal capital distribution might also take account of such of a firm's financial resources as may be ring-fenced in the event of its insolvency.

Certain risks such as systems and controls weaknesses may not be adequately addressed by, for example, holding additional capital and a more appropriate response would be to rectify the weakness. In such circumstances, the amount of financial resources required to address these risks might be zero. However, a firm should consider whether holding additional capital might be an appropriate response until the identified weaknesses are rectified. A firm, should, in accordance with GENPRU 1.2.60 R (Documentation of risk assessments), document the approaches taken to manage these risks.

A firm should carry out assessments of the sort described in the overall Pillar 2 rule and GENPRU 1.2.39 R at least annually, or more frequently if changes in the business, strategy, nature or scale of its activities or operational environment suggest that the current level of financial resources is no longer adequate. The appropriateness of the internal process, and the degree of involvement of senior management in the process, will be taken into account by the FSA when reviewing a firm's assessment as part of the FSA's own assessment of the adequacy of a firm's financial resources. The processes and systems should ensure that the assessment of the adequacy of a firm's financial resources is reported to its senior management as often as is necessary.

The assessments undertaken by firms in run-off may not need to be as comprehensive or frequent compared to a firm not in run off since this may better reflect the reduced nature and complexity of its business and reduced access to new capital. Whilst a firm in run-off will still need to carefully monitor the progress of the run off, a more comprehensive assessment may only be appropriate on commencement of the run off or when considering a reduction in capital through the payment of a dividend or other capital distribution or if the firm's circumstances change materially.

Stress tests and scenario analyses should be carried out at least annually. A firm should, however, consider whether the nature of the major sources of risks identified by it in accordance with GENPRU 1.2.30R (2) (Main requirement relating to risk processes, strategies and systems) and their possible impact on its financial resources suggest that such tests and analyses should be carried out more frequently. For instance, a sudden change in the economic outlook may prompt a firm to revise the parameters of some of its stress tests and scenario analyses. Similarly, if a firm has recently become exposed to a particular sectoral concentration, it may wish to add some stress tests and scenario analyses in order to reflect that concentration. SYSC 11.1.21 E is an evidential provision relating to the general stress and scenario testing rule concerning scenario analysis in relation to liquidity risk.

1. (1)

   GENPRU 1.2.45 R – GENPRU 1.2.56 G explain when the ICAAP rules apply on a solo basis and when they apply on a consolidated basis. This material also explains how the ICAAP rules are adjusted to apply on a consolidated basis.

2. (2)

   GENPRU 1.2.57 R – GENPRU 1.2.59 R provide that the overall financial adequacy rule always applies on a solo basis. They also explain when and how it applies on a consolidated basis.

GENPRU 1.2.49 R means that non-financial members of the firm's group are excluded from the group assessment. Notwithstanding the scope of GENPRU 1.2.49 R, a firm should nevertheless take account of risks arising from the activities of those excluded members in its overall assessment of risk.

A firm to which the ICAAP rules apply on a consolidated basis need not prepare a consolidated basis assessment if such an assessment has been prepared by another member of its group. Where that is the case, a firm may adopt such an assessment as its own. A firm nevertheless remains responsible for the assessment.

The purpose of GENPRU 1.2.51 R – GENPRU 1.2.53 R is to enable the FSA to assess the extent, if any, to which a firm's assessment, calculated on a consolidated basis, is lower than it would be if each separate legal entity were to assess the amount of capital it would require to mitigate its risks (to the same level of confidence) were it not part of a group subject to consolidated supervision under BIPRU 8 (Group risk - consolidation) or INSPRU 6.1 (Group risk: Insurance groups). The reason the FSA wishes to make this assessment is so that individual capital guidance which it gives is fair and comparable as between different firms and groups. Group diversification benefits which a firm might assert exist can be a material consideration in a capital adequacy assessment. Understanding the methods used to aggregate the different risks (for example, the correlation assumptions) is crucial to a proper evaluation of such benefits.

Whereas a single legal entity can generally use its capital to absorb losses wherever they arise, there are often practical and legal restrictions on the ability of a group to do so. For instance:

1. (1)

   capital which is held by overseas regulated firms may not be capable of being remitted to a firm in the UK which has suffered a loss;

2. (2)

   a firm which is insolvent or likely to become so may be obliged to look to the interests of its creditors first before transferring capital to other group companies; and

3. (3)

   a parent company may have to balance the interests of its shareholders against the protection of the creditors of a subsidiary undertaking which is or might become insolvent and may, rationally, conclude that a subsidiary undertaking should be allowed to fail rather than provide capital to support it.

Where a firm assesses the adequacy of its CRR in its particular circumstances in accordance with BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment) as a basis for deciding what financial resources are adequate, it should include this in the documentation produced in accordance with GENPRU 1.2.60 R.

Both stress tests and scenario analyses can beundertaken by a firm to further a better understanding of the vulnerabilities that it faces under extremeconditions. They are based on the analysis of the impact of unlikely, but not impossible, events. These events can be financial, operational or legal or relate to any other risk that might have an economic impact on the firm.

Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm's financial position.

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of adverse events on the firm's financial position, for example, simultaneous movements in a number of risk categories affecting all of a firm's business operations, such as business volumes, investment values and interest rate movements.

There are three broad purposes of stress testing and scenario analysis. Firstly, it can be used as a means of quantifying how much capital might be absorbed if an adverse event or events occurred. As such it represents a simple ‘what if’ approach to estimating exposure to risks. This might be a proportionate approach to risk management for an unsophisticated business. Secondly, it can be used to provide a check on the outputs and accuracy of risk models; particularly, in identifying non-linear effects when aggregating risks. Thirdly, it can be used to explore the sensitivities in longer term business plans and how capital needs might change over time.

The general stress and scenario testing rule requires a firm, as part of carrying out stress tests and scenario analyses, to take reasonable steps to identify an appropriate range of realistic circumstances and events in which a risk would crystallise. In particular:

1. (1)

   a firm need only carry out stress tests and scenario analyses in so far as the circumstances or events are reasonably foreseeable, that is to say, their occurrence is not too remote a possibility; and

2. (2)

   a firm should also take into account the relative costs and benefits of carrying out the stress tests and scenario analyses in respect of the circumstances and events identified.

Subject to GENPRU 1.2.76 G, the purpose of stress tests and scenario analyses under the general stress and scenario testing rule is to test the adequacy of overall financial resources. Scenarios need only be identified, and their impact assessed, in so far as this facilitates that purpose. In particular, the nature, depth and detail of the analysis depend, in part, upon the firm's capital strength and the robustness of its risk prevention and risk mitigation measures.

Both stress testing and scenario analyses are forward-looking analysis techniques, which seek to anticipate possible losses that might occur if an identified risk crystallises. In applying them, a firm should decide how far forward to look. This should depend upon:

1. (1)

   how quickly it would be able to identify events or changes in circumstances that might lead to a risk crystallising resulting in a loss; and

2. (2)

   after it has identified the event or circumstance, how quickly and effectively it could act to prevent or mitigate any loss resulting from the risk crystallising and to reduce exposure to any further adverse event or change in circumstance.

The time horizon over which stress tests and scenario analysisshould be carried out shoulddepend on the maturity and liquidity of the positions stressed. For example, for the market risk arising from the holding of investments, this shoulddepend upon:

1. (1)

   the extent to which there is a regular, open and transparent market in those assets, which would allow fluctuations in the value of the investment to be more readily and quickly identified; and

2. (2)

   the extent to which the market in those assets is sufficiently liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) to allow the firm, if needed, to sell, hedge or otherwise mitigate the risks relating to its holding so as to prevent or reduce exposure to future price fluctuations.

In identifying scenarios, and assessing their impact, a firm should take into account, where material, how changes in circumstances might impact upon:

1. (1)

   the nature, scale and mix of its future activities; and

2. (2)

   the behaviour of counterparties, and of the firm itself, including the exercise of choices (for example, options embedded in financial instruments or contracts of insurance).

In determining whether it would have adequate financial resources in the event of each identified realistic adverse scenario, a firm should:

1. (1)

   only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and

2. (2)

   take account of any legal or other restriction on the use of financial resources.

1. (1)

   A firm should conduct stress tests and scenario analyses which project its financial position (both profitability and balance sheet position) so as to estimate both its capital resources and capital resource requirements throughout an economic or business cycle.

2. (2)

   A firm will need to consider the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries. The length of time over which such projections would be appropriate will therefore vary, but typically might be between three and five years.

3. (3)

   The projections should be based on the firm's business plan, but flexed to incorporate adverse trading conditions and any changes in strategy which the firm could and would take in response to those conditions.

4. (4)

   Changes in strategy might be necessary for instance because capital needed to be able to continue its business at existing volumes is eroded. A firm may also alter its capital management strategy to restrict distributions of profits or to raise additional capital. The combined effect on capital and retained earnings should be estimated. A firm should document how it would react to such economic and business risks.

5. (5)

   The FSA will take the projections referred to in this paragraph and the plan referred to in (4) into account as part of its SREP. The purpose of examining them is to enable the FSA to judge, at an appropriate level of certainty, whether the firm will be able to meet its obligations throughout a recession.

A firm may consider scenarios in which expected future profits will provide capital reserves against future risks. However, it would only be appropriate to take into account profits that can be foreseen with a reasonable degree of certainty as arising before the risk against which they are being held could possibly arise. In estimating future reserves, a firm should deduct future dividend payment estimates from projections of future profits.

1. (1)

   A firm should assess the nature and severity of the economic recession or business cycle changes which are relevant to it given the nature and scale of its business. When projecting its capital resources and CRR a firm should consider a range of stresses and scenarios both in nature and severity.

2. (2)

   Stress and scenario analyses should, in the first instance, be aligned with the risk appetite of the firm and the calibration of such stress and scenario analyses should be reconciled backto a clear statement setting out the premise upon which the firm's internal capital assessment under the overall Pillar 2 rule is based.

3. (3)

   A firm with an IRB permission should ensure that the range of stresses and scenarios considered encompasses the severity of recession specified in BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy), which is one that might be expected to occur once in a 25 year period. Other firms may also find that this a useful reference point when discussing their assessments with the FSA.

4. (4)

   A firm may also consider scenarios in which the amount of capital it currently holds would be exhausted. This would provide useful information about the reasonableness or remoteness of such scenarios arising. Where a firm uses capital models as part of its risk management processes, considering the sensitivity of model results to variations around the most likely ruin scenario focuses testing on the most relevant scenarios.

A firm should use the results of its stress testing and scenario analysis not only to assess capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the firm if the risk covered by the stress or scenario test actually materialises. Such measures might be a contingency plan or might be more concrete risk mitigation steps.

Additional guidance on stress tests and scenario analyses for the assessment of capital resources is available in BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment).

Additional guidance in relation to stress tests and scenario analysis for liquidity risk is available in SYSC 11 (Liquidity risk systems and controls).

GENPRU 1.2.80 G – GENPRU 1.2.86 G contain guidance on the assessment required by GENPRU 1.2.30R (2)(k) (Pension risk).

The pension scheme itself (i.e. the scheme's assets and liabilities) is not the focus of the risk assessment; it is the firm's obligations towards the pension scheme which is.

If a firm has a current funding obligation in excess of normal contributions or there is a risk that such a funding obligation will arise then, when calculating available capital resources, it should reverse out any accounting deficit and replace this in its capital adequacy assessment with its best estimate, calculated in discussion with the scheme's actuaries or trustees, of the cash that will need to be paid into the scheme in addition to normal contributions over the foreseeable future. This may differ from the approach taken in assessing pension scheme risks for the purposes of calculating resources to meet the CRR, where a firm may not need to consider funding obligations beyond the next five years.

1A firm should assess the risks that increase its obligations towards the pension scheme that might lead to the firm not being able to pay its other liabilities as they fall due.

A firm may wish to consider the following scenarios:

1. (1)

   one in which the firm gets into difficulties with an effect on its ability to fund the pension scheme; and

2. (2)

   one in which the pension scheme position deteriorates (for example, because investment returns fall below expected returns or because of increases in life expectancy) with an effect on the firm's funding obligations; taking into account the management actions the firm could and would take.

Scenarios in which a firm's employees suffer a loss or members of a pension scheme suffer a loss do not necessarily affect the firm's ability to pay its liabilities as they fall due.

A firm should consider issues such as:

1. (1)

   the extent to which trustees of the pension scheme or a pension regulator (such as the one created under the Pensions Act 2004) can compel a certain level of contributions or a one-off payment in adverse financial situations or in order to meet the minimum legal requirements under the scheme's trust deed and rules or under the applicable laws relating to the pension scheme;

2. (2)

   whether the valuation bases used to set pension scheme contribution rates are consistent with the firm's current business plans and anticipated changes in the workforce; and

3. (3)

   which valuation basis is appropriate given the expected investment return on scheme assets and actions the firm can take if those returns do not materialise.

A firm should carry out analyses only to a degree of sophistication and complexity which is commensurate with the materiality of its pension risks.