Transcript: Series 2 Episode 7: Re-articulating risk - preparing for the IFPR

Andrew Strange:

Hi everyone, welcome to our latest Risk & Regulation Rundown podcast. I am Andrew Strange, your regular host, and as usual we are recording this remotely, so please note this might impact the quality of sound. Today, we wanted to explore one of the first post-Brexit regulatory initiatives to hit financial services firms: the new prudential regime for asset and wealth managers.

Based on a set of EU rules, the UK now has the freedom to implement this outside of the confines of existing EU legislation, but what does that actually mean for firms? I am joined today by two great guests, who are going to offer some really interesting perspectives.

David Croker is the Partner who leads PwC’s Asset and Wealth Management Regulatory practice, and Jill Townley is a Director in our reward practice, who co-leads our Remuneration Regulatory team.

David, as I said these new rules are UK specific, and not just onshored existing legislation from the EU. Given the new regulatory architecture, and the objective that’s been set by Treasury to address potential harms that firms pose to their clients and markets, and specific vulnerabilities and risks inherent to investment firms, do you think these proposals are actually going to work?

David Croker:

That’s a really good question, Andrew. The new suite of rules on the face of it should achieve what they are designed to. One of the big criticisms that we’ve seen of the rules that are in place for many of the firms captured by this new regime has been that the rules today were designed with banks in mind. As a result, they are focussed on balance sheet risk, they’re focussed on financial risks that these firms are exposed to. Actually, in most cases the thing that would kill an investment firm or knock an investment firm over is more the operational risk. The approach of the regime, certainly through the K factors, to try and develop a suite of what are essentially proxies for the levels of risk, and operational risk particularly that firms pose is really helpful in that regard.

The other interesting component, and this is a UK-specific piece, with the FCA’s proposal to update the ICAAP process with the ICARA, is the expectation that firms take a really holistic view of risk across the organisation. Under the current regime, firms are almost forced down a road of pigeon-holing risk against a series of quite distinct categories. You’ve got the Basel risk categories, of credit risk, operational risk, market risk, etc.

The new broader categories that the FCA has established, the risk to client, risk to firm, risk to market, almost require firms to take that blank sheet of paper approach to risk identification and say given the nature of what it is that we do, the way that we do it, the markets and clients that we transact with, what risks are we exposed to? If firms are doing that properly, you should see a much greater variant in terms of the types of risks that different types of organisations are identifying. Whereas, again a criticism of the existing approach is that most investment firms come up with almost a template suite of risks that you would expect them all to have. On the face of it, it looks positive, but clearly with all these things, the devil is in the detail of how it’s implemented.

Andrew:

Thanks David, so speaking holistically about risk, in the past, regulators have often used pay as a tool to drive sound risk management, is this regime any different Jill?

Jill Townley:

Absolutely, remuneration is a really big part of the new regime, and this time it’s going to really bring in some fundamental changes to how investment firms pay their key people. In the past, it’s fair to say that a lot of these firms have avoided applying some of the more onerous requirements to their key staff, but now, if you like, their luck has run out and they are going to have to make some big changes. Some of the firms, who previously always paid upfront in cash in terms of their bonuses, are going to have to implement significant deferrals over three or even five years, and they are also going to have to pay significant chunks of people’s bonuses in instruments. The other big change that we are going to see is the level of public and media scrutiny on how much people are paid. The new rules require firms to disclose how much they are paying people and the ratio of variable pay to fixed pay, and that could attract some attention.

Andrew:

Yeah, I can definitely see the media attention that would go with that kind of public disclosure, but who is actually going to be impacted by that, does it apply to all staff?

Jill:

It’s not going to apply to all staff. Firms are required to apply specific qualitative and quantitative criteria, which defines which individuals are going to be in scope of the rules. Typically, that’s going to capture their senior management, their control functions, other heads of key functions, like HR and finance, but it’s also going to capture the high earners. That’s the category that’s really caught firms’ attention, because that’s going to capture their portfolio managers, their highly paid sales staff.

Having said that, there is a process that where individuals are captured on the basis of earnings alone, you can engage with the FCA to get those individuals excluded, if you can make a good argument as to why that’s appropriate. That, however, is going to be bring some difficulties in itself, because a lot of these firms really haven’t had to talk to the FCA about remuneration in the past. They are now going to have to interact with the regulator a lot more than they are perhaps used to and attract more regulatory scrutiny on how they pay people.

Andrew:

Thanks Jill.

David, we started this by talking about the fact that this was not an onshored piece of EU legislation, but a UK-specific initiative. Also, I’ve seen lots of EBA publications and quite a lot of EU concepts, Jill was talking about material risk takers, and things like that. But in a post-Brexit world, how different is the UK regime going to be from the EU regime?

David:

It varies depending on the topic that the regime covers. There are some areas where the UK has diverged quite strongly from the European approach, which is interesting if we think about where this was born. This was a piece of regulation that was largely driven by the UK in terms of the policy development within the European process to agree it for member states. The UK has diverged, obviously the timeline is the big one. We are seeing the UK delay implementation until January 2022 to allow firms more time to be ready. The other key area where the UK has diverged is on reporting. The European approach has developed some quite granular reporting templates and the UK has proposed a far more simple reporting template with far less detail needed each quarter.

The piece that will be more challenging for firms is some of the nuances, so some of the interpretations of things like the definition of assets under management and how that’s calculated, where the European text is slightly different to the way that the UK is proposing to implement. And there will be more of those I think as we work our way through the FCA consultation paper, where there will be nuances and divergence between the regimes. The other really interesting piece, and this is less EU versus UK, but actually different member states taking slightly different interpretations of the European text. We’ve already seen some of our clients challenged by the German regulator potentially taking a slightly different approach to the calculation of AUM than other European regulators. This is going to be one that is really important for investment firms to keep an eye on as we move from now to June for European implementation and then again as we work towards the January 2022 implementation date in the UK.

Jill:

It’s a similar story for remuneration as well. The FCA was very involved in the development of this regime at EU level. On the face of things, they are bringing in a broadly consistent regime and we would expect all of the headlines in the UK to be the same as those in the EU. Having said that, the difference is really going to come in the detail. Although we haven’t had full clarity from the FCA yet on the detail of the remuneration implementation, there are already some divergences in what’s coming out of Europe compared to what the FCA has said so far. For example, the EBA has said that they are going to apply 12-month holding periods on anything that is paid in instruments. They are going to restrict bonus payments to annually. Any quarterly commission, for example, would not be compliant anymore. They are also bringing in a restriction on being able to pay dividends on bonuses that are paid in shares. All of these things, if the FCA take a different approach, and it does sound like they are going to do that on some of these areas, that just creates complexity for those firms that have UK operations and EU operations. That complexity then extends to the implementation deadlines, because in Europe, we’ve got this coming in at the end of June 2021, but it’s not coming in in the UK until the 1st of January 2022.

In particular for firms that have performance years that start in between those two dates, they are going to have a situation where these rules come into effect for individuals in their EU territories, a whole year potentially, before it comes into effect for their UK staff, and that’s going to make things difficult as well.

Andrew:

Yeah, its really interesting when you think about the potential impact, as you said, of deadlines that fall between those two dates, and annual pay rounds and things like that, that’s a really good point.

David, based on that, in the summer when we looked at the FCA’s discussion paper, one of things that both you and I were very taken with was the new ICARA process, which we felt was going to be quite a big deal for firms. That hasn’t formed part of the first consultation from the FCA at Christmas. So, is this still important or have they deferred it because they think it’s comparatively easy for firms to do? What’s your take on that?

David:

My sense on ICARA is actually this is going to be, probably the single biggest impact on firms that are in scope of this. Clearly, there will be some firms that have never done an ICAAP before, for which this will be a brand-new process. Even those that need to convert from ICAAP to this ICARA process will have an awful lot of work to do, not just in the document itself, but in some of the changes to the underlying processes. The key wording in the FCA’s discussion paper that caught our attention in the summer was that reference to ICARA looking superficially similar to ICAAP, but there being key differences.

There is still a view across the industry that potentially all ICARA means is rebadging your existing document and just tweaking some of the language around how you categorise risks. But for me, more fundamentally actually, in order to fully embed the new ICARA process, and in order to embed that approach of risk to client, risk to firm, risk to markets, risk management, you need to change your whole narrative around how you manage risk through the organisation.

When you think about the consequences of some of that, you get to a place where you need to think about your risk appetite statements, and are those aligned with risk to client, risk to firm, risk to market. In most cases, people have aligned their risk appetite statements with the existing Basel risk categories, there will then be knock on impacts for risk control self-assessments, risk technologies, risk identification and management processes, flowing right the way through to MI and reporting that’s produced internally across the organisation.

My sense is that ICARA hasn’t formed part of that first FCA consultation, because there is a slightly longer burn on it, because you don’t need to have a fully fledged ICARA to go live on the 1st of January 2022. Actually, you give firms a bit more time to process that, but certainly we are already starting to see investment managers and other investment firms thinking about what they can do to start that transition from ICAAP to ICARA even this year before it’s required, to help almost avoid that big bang of ICAAP to ICARA and to enable them to take their senior management teams on the journey with them in terms of what will need to be there.

As I said, for me that’s going to have the single biggest impact for the work that firms are going to need to do, and they should be prepared to do that work from April onwards.

Andrew:

Well certainly rearticulating risk is a big challenge for firms, but those two deadlines are fundamentally pretty challenge too, June this year is barely five months away, January is less than a year. What other things should firms be doing now aside from beginning to prepare for that ICARA transition?

David:

I will perhaps answer it in two parts. There is the UK piece where you’ve got that slightly longer timeframe, and in the UK, you’ve been helped to a certain extent by the FCA almost breaking this up into manageable chunks for the industry to start focussing on. But at an absolute minimum, you would expect that by now firms have done some sort of impact analysis to identify which parts of this new regime, given its breadth, are applicable to their business, given the activities that they undertake. If I was a UK investment firm, I would then be thinking about addressing each of the requirements in that first FCA consultation paper that we’ve had, ahead of the second consultation that’s due in April landing. So actually focussing on getting your capital resources right, focussing on thinking through the regulatory consolidation questions, thinking about the K factors, where we’ve got the right information starting to prepare for some of that reporting. That would then set you up nicely when we hit April and the delivery of that second consultation paper, which as I said, will include the ICARA, which I think is the biggest single effort here. Actually, that gives firms the bandwidth to be able to focus on the information that comes in the second consultation.

Interestingly, the second consultation contains a lot of the information that we haven’t had much visibility of to date from the FCA, the first consultation focusses on almost the known parts of the regime. Clearly with any of this, an effective implementation plan needs to be put in place. The regulator at the moment is extremely focussed on change management capabilities, putting an effective project management process around all of this, to make sure that any changes you make to address the requirements of consultation one, are actually then sensible in the context of whatever changes you might need to make to processes and activities as part of consultation two.

From the European standpoint, given we’ve got less clarity around what the local nuances might look like in terms of local implementation, because the regulators have been largely silent in terms of their local implementations. My sense is that organisations should be focussing on what they can do and what they do know, so actually the regulation is quite clear around, for example, the K factors, it’s quite clear around what qualifies as regulatory capital. The focus for a European investment firm or a UK investment firm with a presence in Europe, will be to ensure that they are as well positioned as they can be for that first reporting period that will fall at the end of September of this year, to make sure that you can submit timely and accurate initial regulatory reporting to the local regulators.

Andrew:

Thanks David, and Jill, what should firms be doing on the remuneration side?

Jill:

The key thing for firms at the moment is really understanding how big is the problem for them based on their characteristics, and which of the rules are going to apply to them. And really start managing staff’s expectations about how they are going to be paid in the future. If you think about it, if you are an individual who is used to receiving a bonus, which is the same size as your salary, and now you are only going to receive a third of that, and you are going to have to wait for two or three years for the rest of it, that’s going to have a significant impact on cashflow, and firms are going to have to really think about how they manage that.

It’s really important for firms to understand which rules are going to apply to them, which individuals are going to be in scope, and then also how they intend to meet some of the more challenging requirements.

The other area that we are seeing firms really focus on at the moment is the instruments piece. If you are a public firm and you’ve got listed equity, then it’s easy, but if you are a private firm, or a partnership, it is more complex. It’s going to take a lot more time to design an instrument or find an instrument that’s going to meet the requirements, so it’s better to start that sooner rather than later.

Andrew:

Thanks Jill, and that particular nuance, for example, around finding the right instruments if you’re in a partnership is clearly quite challenging. David, my experience of implementing regulatory change is that there are often other unintended consequences or nuances, or particular subsets of firms that face some real challenges, what’s your perspective on that for the current rules?

David:

One of the really interesting ones, and it links into your last question around the different deadlines of June and January - it is important to flag that January isn’t the end of this. There are elements of this regime that are going to require changes to be made further down the line. There is an issue there for firms making sure that they don’t hit January 2022 and just think they are done. This will be something they will need to keep an eye on and keep abreast of as we move through 2022, 2023 and beyond. As you said, with all regulatory change there are consequences that extend beyond the intended consequences. One of the big challenges that we’ve seen has been around system adequacy. The new regime requires quite a different set of data than firms have historically used to calculate regulatory capital requirements. What we are seeing is that, under investment in technology across the investment firms base historically has led to a challenge for many firms in terms of extracting the right data and getting the right systems to talk to each other.

Key examples would be actually, in order to calculate some of these new K factor requirements, you need to extract trading data, that needs to loop in with finance data and a lot of the preparatory work we’ve done with clients has actually demonstrated that’s quite challenging for many firms to do. There is going to need to be conversations around system investments and changes that might need to be made there.

The biggest impact I see this having is potential restrictions in the M&A activity, particularly in the UK. The UK has chosen to not implement an equivalent to the existing waivers regime that allowed firms to discount the impact of goodwill where they were highly acquisitive from their regulatory capital calculations for the group. What’s being proposed instead, the group capital test, is designed in a similar way but doesn’t quite have the same benefit for organisations. Regardless of whether you go through full consolidation in the new rules or whether you apply the group capital test, in both those scenarios you need to hold capital equal to the value of the goodwill that gets created through any transactions.

When you take into account some of the multiples that exist in the market at the moment for some of the M&A activity, that comes at a huge capital cost to investment firms that are seeking to grow inorganically. It will be really interesting to see what the impact of that is. There are some solutions and some work arounds, firms can look at potential legal entity restructuring to offset the impact of some of that goodwill and extract themselves from regulatory consolidation requirements. But all of that will require some effort and a fair bit of focus from management teams between now and January to make sure that if they have got a plan to be acquisitive going forward, that they have taken the steps ahead of this new regime coming in to enable them to do that. That is gong to be particularly challenging for some of those IFA consolidators, as an example, where actually we are continuing to see huge amounts of deal activity in that space. Actually, a lot of those haven’t been subject to some of these more onerous requirements, historically these are requirements that would be coming onto a number of those firms for the first time.

Andrew:

Thank you, that M&A type activity really could be quite challenging, you are right. A lot of what you said there also for me screams data in its widest sense. Are you seeing firms looking at using tools and technology as a solution for that?

David:

In part yes - there is an almost a two-tier system in play here. For those organisations that are more simple, that have a limited range of activities, and therefore are in scope of a lesser number of K factors – for some of those, actually they might find that once you get your own systems sorted, some of these calculations are relatively straight forward, they are relatively linear calculations of assets under management, for example, times a two basis point value to come to a number.

If you are exposed to few K factors, most of those organisations at the simpler end are looking at trying to do this in house. Clearly then, as you move up that spectrum of complexity, both in terms of size, products, regulatory permissions and activities, this starts to become a bit more challenging. We’ve certainly seen a number of firms exploring technology options and tools to help them manage this, both through a submission of regulatory reports, but also in terms of how do you keep that ongoing focus on your capital adequacy and your financial resource adequacy going forward. Particularly for those organisations that are operating across jurisdictions, both in the UK and in member states, you are going to see that actually tooling will become quite important, because of the nuances and the differences in the reporting frameworks. Actually to avoid having to create a number of manual processes around this, technology is likely to be the answer that makes that more straightforward.

There is a really interesting question around which way do you go with this, because you can either fix the underlying systems, and make those all talk to each other and make them work coherently - that’s obviously going to come at a huge cost, when you talk about a full IT transformation programme. Or, do you look at putting some sort of aggregation tool over the top that just takes data feeds from various systems, and then allows you to extract the regulatory capital liquidity and reporting calculations that you might need to do on a periodic basis. But we will certainly see a growing market in terms of providers looking to offer tools to market participants that would be challenged by this.

Andrew:

Thank you David, thank you Jill, I feel that we’ve only really scratched the surface of this, it’s a really interesting, and clearly very detailed and complex subject. Just to end, I am going to ask a final question of each of you, if I can, it’s a different question each.

David, to start with, a very simple one - which is better, the UK regime or the EU regime?

David:

Not wanting to sit on the fence and not commit to an answer, it is hard to say which regime is better. They both share some very similar characteristics. It was a suite of regulation that was designed collaboratively so the UK were largely driving it, but it was done through a European process. Clearly, as we’ve talked about, there are some nuances and the UK is diverging from some of that European text in places. I would almost answer the question through a lens of if I was a firm needing to implement this, which one would I prefer to implement? And I think with all regulatory change and limitation programs, clarity is key.

Actually, the fact that we’ve got the FCA issuing consultation papers, being quite open about its intentions, having that slightly longer timeframe, which suggests that they are more willing to engage with the industry to find something that works. We spoke at the beginning around Treasury’s objectives, and their ongoing focus of making the UK an attractive place for investment firms to establish themselves. It is probably going to be easier for firms to implement the UK version of this than the EU piece, largely because of timeframe, but also because of the level of clarity that we are seeing from the regulator.

Andrew:

Thanks David. Jill, David there talked very briefly about the UK being an attractive place for businesses, but clearly Treasury have a goal around UK competitiveness. Do you think this is going to make the UK a more competitive place compared with the EU, or is this now a debate globally?

Jill:

That’s a really interesting point, and there’s a few lenses that you can consider there. Firstly, if you look at the UK versus Europe, we’ve got some really positive developments in terms of the FCA seems to be more generous in terms of where they are setting thresholds. So potentially, fewer firms will be in scope in the first place in the UK, and also fewer individuals will be caught by the more onerous rules. That’s really positive, but having said that, when we look at a lot of the UK investment management sector, they tend to be global firms. That means they have significant populations in the US, in Asia, and those jurisdictions aren’t subject to these kind of pay regulations. Therefore, that does create competition issues when UK firms have to apply these rules to their entire population, and they are competing against firms who are playing on a different field, if you like.

The final thing to think about is actually competitiveness back here at home in the UK. How the FCA has decided to implement the regime in terms of making a distinction between the smaller firms and the larger firms, with smaller firms not having to implement things such as deferral and payment in instruments. That is actually going to create a sort of two-tier market in the investment sector in the UK. I am certainly aware of a number of larger firms, who have bigger balance sheets and will be subject to all of the rules, looking over their shoulder at some of their smaller competitors, who are going to try and use this as an opportunity to poach some of their key talent and make the most of the fact that they have more flexibility in how they pay people.

Andrew:

Thank you both for your time today and a really fascinating discussion. It is really interesting to hear about both the challenges of the new regime, from data, to consolidation, to remuneration, but also the impact of the new regulatory architecture in the UK, as we begin to see the realities of how broadly consistent regulation actually in some circumstances becomes awkwardly different regulation, and how that impacts firms, both here in the UK, and those firms with a presence in both the UK and Europe.

To our listeners, I hope you’ve found this episode really helpful, please do share this podcast and subscribe to future episodes. I will be back next month with our next episode.