FCA proposes new capital requirement for personal investment firms

New proposals from the FCA will put more responsibility on personal investment firms to set aside capital for potential redress liabilities. News of the consultation, which closes at the end of March, was accompanied by a Dear CEO letter to remind these firms of their existing responsibilities. The requirements to quantify the risk of harm and calculate required capital are likely to present significant challenges.

The FCA has been taking various measures to tackle the significant liabilities caused by poor advice since it published its consumer investment strategy in 2021. The latest is perhaps the most significant to date: it is recommending enhancing the prudential requirements for personal investment firms so they hold more capital for potential redress liabilities.

Addressing the drain on FSCS

Adviser firms’ financial resources and professional indemnity insurance have often proved insufficient to pay for redress flowing from their activities. This has led to significant redress liabilities ending up with the Financial Services Compensation Scheme (FSCS). The FCA estimates £760 million has been paid by FSCS for professional investment firms that left the market between 2016 and 2022, with 95% of the redress being caused by 75 firms affecting 20,000 consumers.

Summary of proposals

The Consultation Paper CP23/24: Capital deduction for redress: personal investment firms was published on 29th November. In it, the FCA sets out its proposals to require personal investment firms – or PIFs – to hold more capital for potential redress liabilities at an early stage. There are two key proposals from the FCA:

  1. PIFs will need to quantify their potential redress liabilities. There are two elements to the new calculation:
    – ‘unresolved’ liabilities – quantifying where complaints have been received but not yet resolved
    – ‘prospective’ liabilities – identifying ‘foreseeable harm’, or recurring problems that could give rise to redress
    Both of these amounts will need to be deducted from capital.
  1. PIFs not holding enough capital for potential redress liabilities will be required to comply with an asset retention requirement.

The FCA plans to build the proposed changes on requirements that already exist – for example Consumer Duty. It estimates that roughly one-third of the PIFs will be required to set aside additional capital. The regulator estimates additional annual compliance costs for smaller firms of approximately £1000 a year.

Objectives of the proposed changes

Ultimately the changes are to try and make sure the ‘polluter pays’ (or pays more than they do currently), by putting the burden back onto the firms that are contributing the most redress. This should reduce the costs to the FSCS and the wider industry via the FSCS levy.

The changes should also bring additional benefits in terms of making firms more resilient and better able to deal with redress liabilities from customers. It also provides a greater incentive for PIFs to give suitable advice: the better quality the advice, the less additional capital needed to be held for potential liabilities.

For customers, the new processes adopted by firms should make the delivery of redress more effective, reducing the time taken to pay it out.

What Personal Investment Firms will need to do

Assuming the final rules are in line with the consultation, firms will need to take the following actions:

Establish identification process
An internal process will need to be set up to identify potential redress liabilities, and the FCA expects firms to utilise the Consumer Duty and existing complaints-handling rules already in place.

Quantify liabilities
The potential liabilities will need to be quantified, taking into account a number of factors like expected redress based on previous years, what PII cover is in place and the probability of the redress occurring.

Calculate additional capital required
The firm will then need to set aside capital to pay potential redress by deducting potential redress liabilities from their current capital resources in a new capital deduction

Adjust against asset retention requirement
If it’s then found the firm is undercapitalised after setting aside capital the asset retention requirement applies which has the purpose of increasing the PIF’s capital resources to a level where it is compliant.

This new proposed approach aligns closely to elements of the ‘ICARA’ process where identified risks of harms must be quantified and additional capital may be required. The extension of similar requirements to a wider set of firms has the potential to pose significant challenges for firms who are not used to this process.

The FCA is proposing an extended 16 week consultation period providing ample time for firms to respond. The consultation closes on the 20th March 2024 with the FCA aiming to publish a Policy Statement and their response to feedback in H2 2024. The rules are expected to come into force in H1 2025.

We can help

Firms need to start to quantify any potential additional capital requirement under the new rules and model whether they hold sufficient capital and what is their potential shortfall.

Our prudential specialists have extensive experience helping a variety of firms with their capital requirements and risk frameworks and are always happy to have an initial conversation about what this might mean for you.