Is your stress testing and risk appetite framework adding value to your business? has been saved
Almost 18 months after the implementation of the Investment Firms Prudential Regime (IFPR) by the Financial Conduct Authority (FCA), stress testing arrangements and risk appetite frameworks are key focus areas for the regulator across the market. We will cover some key stress testing and risk appetite considerations below. In addition some general IFPR observations can also be found in our previous Risk Advisory IM&W blog.
Building on previous expectations set out in Finalised Guidance 20/1, under the IFPR the FCA expects investment firms to conduct stress testing to help demonstrate the adequacy of financial resources and to demonstrate ongoing compliance with the Overall Financial Adequacy Rule (OFAR). Stress testing represents a key tool through which firms assess whether they hold sufficient levels of own funds and liquid assets to achieve their planned business strategy, throughout the economic cycle, mitigating harms that could arise under different forms of stress.
We have highlighted below some key weaknesses in stress testing processes which we have identified though engagements with clients, industry interactions and recent FCA feedback:
Effective forward-looking stress testing can provide a useful understanding of areas of vulnerability under stress, during which risks and potential harms may increase. This provides management with critical information on areas in which risk management capabilities and financial resources of the investment firm may no longer be commensurate with the potential harms in a stress event. The stress testing process should therefore be used as a tool, among other things, to:
In the FCA’s recently published IFPR implementation observations, one area that was highlighted is that many firms lack comprehensive processes to determine own funds and liquid assets triggers and limits. Firms have been criticised by the FCA through SREP feedback for the limited ways in which their stress testing outputs are embedded within the wider risk management framework, with internal indicators and limits set at arbitrary levels that do not consider the impact of a stress event on the firm’s capital and/or liquidity adequacy.
Firms should consider whether their risk appetite frameworks require enhancements in order to meet the FCA’s expectations. In particular, below are some of the key issues we have observed:
Stress testing and risk appetite are critical risk management tools, providing firms with a forward-looking view of the potential harms that may arise as a result of their operations, as well as their risk capacity and tolerance. Firms should be challenging themselves to assess whether stress tests are sufficiently severe and have been leveraged when setting risk appetite limits.
In particular, firms should consider whether their processes to set business strategy, identify key risks, select stress scenarios and calibrate risk appetite metrics are joined up consistently (and documented clearly through the ICARA process). Ensuring alignment between these processes will strengthen the effectiveness of the risk management framework, helping to provide sufficient time and information for management to identify and correct adverse trends at an early stage before potential risks crystalise.
Should you have any queries, or would like to attend Deloitte IFPR industry roundtables, please contact any author of this blog.
Manager in Deloitte’s Investment Management & Wealth Prudential practice, with experience of both PRA and FCA prudential handbooks. Current focus areas include ICARA process, prudential consolidation, capital/liquidity assessments, risk management frameworks, wind down planning, stress testing, governance/oversight and prudential due diligence for M&A transactions. Our recommended pages can be found below : Is your stress testing and risk appetite framework adding value to your business? IFPR: Observations and current expectations one year on FCA Dear CEO Letter 2023 to Wholesale Broking Firms
UK Investment & Wealth Management Prudential lead, with extensive experience of working with firms to develop and implement best practice financial resilience, risk governance, risk management frameworks, recovery and wind-down planning arrangements.
Tom is responsible for working with a broad range of credit institutions and investment firms within the Conduct & Prudential team in London. Tom specialises in liquidity and funding risk, and has extensive experience in stress testing, regulatory reporting and overall risk management. He has worked with a broad range of financial institutions on various prudential matters since joining Deloitte, including a number of IFPR investment firms. Prior to joining Deloitte, Tom spent four years at a Global Systemically Important Bank (G-SIB), in a liquidity and funding role within Treasury.
Faiza is a Director within the Prudential Regulation team in Deloitte’s Conduct & Prudential team within Audit & Assurance. Prior to joining Deloitte in November 2017, Faiza spent over seven years with the UK financial regulator (firstly the FSA, then the PRA) as a firm supervisor and latterly as a technical specialist on capital and credit team. Faiza is a capital specialist, with a focus on retail banking credit risk, climate risk integration into ICAAPs and stress testing. Faiza also specialises in the investment firms and payment firms prudential requirements space, helping clients implement regulatory change programs.