UK: CRD Pillar 2 Requirements On Investment Firms

The CRD came into force on 1 January 2007. This introduced a risk sensitive approach to the way firms assess, monitor, calculate and disclose the capital needs of their business.

The implementation of these rules into the UK was staggered by the use of certain transitional provisions. Most firms have opted for the transitions provisions as shown below, although they could have adopted the full CRD early.

Pillar 2 establishes a joint supervisory process between the firms and the regulator to ensure they hold sufficient capital in respect of their related risk profile.

Underlying this are two key principles.

1. The overall financial adequacy rule – GENPRU 1.2.26

   "A firm must, at all times, maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due."

2. The overall pillar 2 rule – GENPRU 1.2.30

   "A firm must have in place sound, effective and complete processes, strategies and systems:

   To assess and maintain on an ongoing basis the amounts, types and distribution of financial resources, capital resources and internal capital that it considers adequate to cover:

   1. the nature and level of the risks to which it is or might be exposed
   2. the risk in the overall financial adequacy rule
   3. the risk that the firm might not be able to meet its capital resources requirement in the future; and

   that enable it to identify and manage the major sources of risks."

This is a two-stage process.

Internal Capital Adequacy Assessment Process (ICAAP) is the firm’s own assessment of the internal capital it needs to hold against its risks.

Supervisory Review and Evaluation Process (SREP) is how supervisors (FSA) assess the overall prudential risk of a firm/group, covering inherent business risk, control factors and oversight/internal governance.

BIPRU 2.2 contains the relevant rules and requires firms to carry out regular assessments of the amounts and type of capital it considers adequate to cover the nature and level of risks.

A proportionate approach should be adopted according to the degree of complexity of a firm’s activities. In BIPRU 2.2.25 to BIPRU 2.2.27, the FSA has provided some guidance of the level of detail firms will need to go into, depending on their complexity.

In producing the ICAAP, the firm should:

• identify the major sources of risk to the business, including those risks listed in GENPRU 1.2.30, and previous losses that are likely to recur

• conduct stress and scenario testing that will quantify the potential impact of the major risks, considering in each case what action will be taken if one of the major risks materialises

• consider how the firm’s capital resources requirement may alter under these scenarios

• document and communicate the ICAAP

• ensure that the entire process is an integral part of management, i.e. it forms part of the board agendas.

The lack of specific guidance is likely to pose the biggest challenge as there is no generic calculation that can be applied. Each ICAAP will be specific to the firm and, as a result, there will inevitably be a broad range of approaches, forms of documentation and overall assessment of capital.

Pillar 2 applies from the time that a firm adopts the new approaches to credit risk (under pillar 1). The last possible date for this is 1 January 2008. It is likely to require a significant amount of input from both senior management and compliance staff, so firms should not delay in starting the process.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.