Managing Capital Adequacy and Liquidity: Adapting to COVID-19 Pressures

3 April 2020 | Michael Chambers

We are only just beginning to observe the impact of the COVID-19 pandemic on the world and there is little doubt that it will have a meaningful and lasting impact all over the globe. In the meantime, businesses will be weathering the storm whilst looking for ways to maintain solvency and liquidity until some degree of normality is restored.

FCA-regulated firms are no exception and with capital adequacy and liquidity rules to abide by, it is ever more pressing that such firms have a firm grasp of their ongoing and future ability to meet capital requirement and settle debts as they fall due.

Last week the FCA published its expectations on financial resilience in which it states that firms are expected to have planned appropriately for such trying times and can make use of capital and liquidity buffers. Should firms believe they are, or soon will be, in breach of any prudential rules they are encouraged to contact the FCA with a plan for the immediate future ahead.

Given the unprecedented situation we find ourselves in, we have given some thought to the ways in which the investment firms and fund managers in our client base, as well as firms like them, can assess their capital adequacy and liquidity. Below I have highlighted a few areas of focus, to help firms ensure they are best prepared to remain on the right side of the rules and make it through to the other side unscathed.

Fixed overheads requirement (“FOR”)

The default approach for the FOR is to use last year’s audited expenditure as the starting point and then adjust for certain defined items before calculating a quarter of the adjusted total. For firms that have only recently become FCA-authorised and some firms, which have been through a recent variation of permissions (VoP) process, projected annual expenditure replaces prior year audited expenditure.

But, what if you have had to make some significant changes to your business because of the impact of coronavirus? Perhaps your revised expectation for 2020 expenditure is materially lower than 2019 or your original expectations for 2020. In such scenarios, and where the FOR is the highest Pillar 1 capital requirement (i.e. higher than the sum of credit risk and foreign exchange risk requirements), there is likely to be scope to ease the strain on capital resources by adjusting the FOR.

We recommend that firms identify whether a revised FOR based on robust forecasts would be materially lower than their current FOR and, if so, take the necessary steps to benefit from a reduction going forward. Approaches vary depending on prudential category; BIPRU firms can simply make the change, always remembering to thoroughly document the supporting rationale for posterity and in case of regulator enquiry; IFPRU firms and AIFMs need FCA approval, and similar documentation should be prepared before requesting that the regulator approves a proposed change to a lower amount.

This will help with freeing up some buffer or headroom of capital resources over a new, lower FOR, which might be much needed in tough times to come.

As a secondary concern, with an eye on FOR calculations that will apply in financial years after the current one, firms that have incurred significant expense as a direct consequence of their response to the pandemic, such as acquiring additional equipment to ensure employees can work safely and effectively from home, should consider whether those costs can be excluded from the future iterations of the FOR calculation.

Of course, all firms that are required to carry out and document and Internal Capital Adequacy Assessment Process (ICAAP) should consider Pillar 2 impacts on their surplus in conjunction with their FOR review work.

Liquidity

Many firms will experience knock-on effects of any liquidity difficulties faced by their clients and customers. Last week my colleague, Matthew Crisp, spoke to the government measures available to businesses in his article. Firms should consider these provisions alongside other sources of contingency funding available to them, in the round, to ensure they have the best possible chance of being able to continue to meet liabilities as they fall due.

Other risk requirements

Liquidity strains for clients and customers resulting from the COVID-19 situation may mean that some take longer than usual to settle fees. This will result in firms holding increased receivables on their balance sheets, attracting a credit risk requirement.

Where fees are denominated in foreign currencies (whether settled in Sterling or not), not only will any increase in ‘debtor days’ result in increased volatility of foreign exchange gains or capital-eroding losses for firms, but such balances – if unhedged – will attract a foreign exchange risk requirement.

The combined effect of these increases may be such that the FOR is no longer, at least at some points in time, the highest requirement affecting the firm’s capital requirement. Steps can be taken to reduce the impact however; particularly firms that have not hitherto hedged against the impact of foreign exchange fluctuations on receivables. Firms should monitor balances due from customers regularly to consider if the benefits now outweigh the costs, bearing in mind the impact on capital requirements as well as the pure economics of the situation.

Monitoring and forecasting

These are just a few examples of how COVID-19 pressures could affect the capital adequacy and liquidity of investment firms and fund managers, along with some of the key areas where relief may be available. Close monitoring of their capital and liquidity requirements and resources is always advisable and this is more pertinent than ever in the current economic climate. The firms that regularly forecast based on up-to-date information and reasonably foreseeable events will be the best prepared to deal with the future, whatever it may hold.

Our Prudential Advisory team are able to assist: Please contact me: mchambers@wheelhouse-advisors.com

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