The Financial Conduct Authority (FCA) has said there needs to be “significant further work” to ensure the wind down planning of firms is “credible” and operable”.
This comes after the UK regulator examined wind down preparedness of some of the largest firms across several markets, in light of the covid crisis and the stresses this introduced.
Wind down planning is a process in which a regulator identifies the steps and resources a firm needs to wind down its business, especially in a situation where resources are limited; and evaluates the risks and impact of a wind down and considers how to mitigate them.
The objective of wind down planning is to help to reduce the risk of negative effects on consumers and market participants when a firm winds down its regulated business.
The FCA’s investigation involved discussions with firms on their assessment of cashflow needs during wind down, modelling methodology, pre-wind down risks which could reduce the firms starting cash balance and intra-group reliance, as well as reviewing general wind down plan documentation.
It said that the “significant further work” is needed around liquidity and cashflow modelling, intra-group dependency and wind down trigger calibration.
The other key observations of the FCA were:
- Firms should consider the impact liquidity needs in wind down have on their assessment of resource adequacy, their risk appetite and point of non-viability; and
- Testing the outcomes of wind down planning is the best way of showing the firm’s board or governing body, as well as the FCA that the plan and process is credible and operable.
Approach to winding down
The FCA said in the review: “We expect all wind down plans to be credible, operable, and to minimise harm. To achieve this, firms must ensure the availability of sufficient financial and non-financial resources during the wind down process.
“We recognise that part of the purpose of financial resources is to ensure an orderly wind down, and a firm should consider whether its financial resource assessment reflects this.
“Firms should embed wind down planning into their risk management framework, recognising that disorderly wind down is a key driver of harm. Firms are best placed to identify what is required to make their wind down planning credible and operable. We have observed that ‘testing’ of the wind down plan is necessary to show its operability and credibility to the firm’s board.
“Wind down planning should also consider the impact of non-regulated entities, as this may have an impact on the regulated entity. It is up to each firm how they choose to structure their wind down planning documentation, considering the activities, size and complexity of their business.
“We use firm’s wind down planning procedures and documentation as part of assessing whether a firm is holding adequate financial resources. If the wind down planning documentation does not allow us to make that assessment, we may direct a firm to take action to remediate any shortcomings.”
Liquidity and cashflow modelling
Two of the big areas in need of action surrounding wind down were liquidity and cashflow modelling,
The FCA said that it observed that liquidity issues arising during a wind down can be “broadly categorised” in three ways, and all three should be considered when quantifying the liquidity required during wind down.
This includes cashflow timing mismatches, net cash impact of wind down and starting wind down from an already stressed cash position.
In terms of the good practice for firms involving liquidity, the FCA saw:
- Holding ‘ring-fenced’ liquidity explicitly for the purposes of wind down, separate from other existing liquidity requirements;
- Prudently quantifying the liquidity which must be held in non-stress environments to ensure adequate liquidity would be available, should wind down occur;
- Putting controls in-place to ensure funds segregated or ring-fenced for liquidity can only be used following board approval; and
- Ensuring the segregated account is not subject to any right of set-off. A right of set-off may exist if the firm is a recipient of financing from a bank.
The regulator also saw that even though a firm may be net cash positive over the entire wind down period, it can “experience significant cash timing mismatches” during wind down and firms did not “adequately consider that selling assets may take longer than its cash reserves can fund its operations”.
It added: “We have often seen firms misidentify or miscalculate wind down specific costs. This impacts the assessment of the level of liquidity required to meet those costs. We have observed that many firms did not consider the potential impact a wind down scenario may have on their starting cash balance, that is, the cash balance the firm has at the start of wind down.
“Many firms assumed in their wind down plans that they will enter wind down with either their current cash balance and liquidity holdings, or a cash balance broadly in-line with their risk appetite.”
The FCA also looked at the intra-group interconnectivity of firms. This is where the operations or activities of the UK firm involves financial or non-financial resources from other legal entities within a wider group.
“We have seen that this is an area of weakness in firms wind down planning, particularly firms with overseas groups, where the UK board may have little to no ability to impact the decision making of other group entities or its parent,” the watchdog said.
“Many firms have made little to no consideration of how to manage intra-group dependencies during wind down. This creates significant risks that any scenario involving financial or operational pressure on the group, may result in a disorderly failure of the UK regulated entity.
“To mitigate intra-group reliance, some firms considered how interdependencies could be unwound or replaced during a wind down, however we observed that often such measures are not credible.”
Wind down triggers
The last area of importance for the FCA was wind down triggers, which “are an essential part of wind down planning”, the regulator added.
The FCA said they should be designed in a way that the firm enters wind down at a point where it will have sufficient financial and operational resources to complete an orderly wind down.
Wind down triggers “should be considered as an initiation point for the firm to act and consider whether wind down is required”.
The regulator said: “We observed that many firms failed to consider an appropriate range of wind down trigger metrics, such as capital resources, and the calibration of the wind down triggers was not justified. Failure to create adequate wind down triggers lead to wind down decisions occurring only late in a stress, at the point when financial or non-financial resources may be reduced and time to respond is scarce, limiting the board’s options.
“Wind down triggers should be closely linked to the firm’s risk management frameworks and be monitored closely particularly during times of stress. A sound risk management and controls framework should allow firms and their senior management to identify, understand, manage, monitor and mitigate the risk of potential harm caused to consumers and markets.
“Senior managers should have clear lines of responsibility for adequate systems and controls, including wind down planning. We observed that short-comings in wind down triggers sometimes indicated broader issues with firm’s risk management and risk appetite frameworks.”