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Capital Stress Testing

[fa icon="calendar"] 19-Mar-2020 12:50:37 / by Colin Sloan

Colin Sloan

AdobeStock_320385354 Capital Stress Testing-1I delivered a training session on capital adequacy last week. The irony of delivering the session on the cusp of such a capital-stressful situation was clear to all in the room and many subsequent conversations focused on the steps that these payment and e-money institutions were, and would be, taking to deal with the crisis.

In a blog last week, our Managing Director, Jamie Cooke, commented on the business continuity measures that firms should take in light of the pandemic. In this post, I will set out what payment and e-money institutions are doing (and should be doing) as they brace for the pandemic.

 

Capital Requirements

It’s a condition of authorisation for nearly every regulated financial services business to hold a specified amount of capital. Indeed, the extension of the Principles for Businesses to payment and e-money institutions in August 2019 means they too are now caught by Principle 4, which requires firms to maintain ‘adequate financial resources’, which entails more than simply capital but also liquid assets.

What then are firms doing, in the context of severely reduced income, are in danger of breaching their capital requirements? I lay out six steps below.

  1. Monitor your capital resources

For payment institutions, capital requirements can fluctuate annually, while for e-money institutions this can happen every month.[1] However capital resources may vary constantly. Firms should therefore monitor their capital resources regularly to ensure the requirements continue to be met. This is vital as losses for the current financial year must be deducted from a firm’s CET1 capital.[2] Furthermore for investment firms, capital requirements are based on firms’ risk exposures, meaning that both capital requirements and resources may vary constantly

Therefore, I recommend that our clients monitor their capital adequacy on at least a monthly basis. For firms sailing close to the wind, daily monitoring will be necessary. You can download our capital adequacy monitoring tool here.

Download our Capital Adequacy Monitoring Tool here!

  1. Stress testing

The duration of the present crisis is uncertain. [3] Firms are therefore stress testing for the worst possible outcomes, considering the impact on revenues for the coming year. Obviously firms are also considering cost cutting. However, even given such measures will your firm continue meeting its capital requirements, or will additional capital injections be necessary?

 

  1. Seeking additional investment

Following the monitoring and stress testing outlined above, your firm may conclude that additional capital is required. Firms may need to approach existing and/or new investors requesting capital injections.

If additional investment is not forthcoming, your firm may consider additional borrowing. To note, under the CRR, there are strict conditions on the type of loan that may be taken out to meet the firm’s capital requirements.

Firstly, it must be a subordinated loan. This means that in the event of the firm’s liquidation, all other creditors would have priority over the holders of the subordinated loan.

Secondly, subordinated loan must have a maturity date of at least 5 years, meaning that the creditor does not have to be paid back prior to this date.

Thirdly, subordinated loans of this nature are classified as Tier 2 instruments under the CRR, meaning that they can only contribute a maximum of one third of Tier 1 capital towards a firm’s capital requirements. This means that overall, the subordinated loan can only consist of a maximum of one quarter of the firm’s capital requirement.[4]

 

  1. Borrowing

Even if the capital requirements will continue to be met, what about your firm’s cash flow? Will there be a need to set aside additional liquid assets in order to service necessary expenditure in the context of reduced revenue? Indeed, at present liquidity is a more pressing concern for many firms than capital.

In addition to the scope that subordinated loans have to contribute towards meeting capital requirements, firms may need to consider additional borrowing to meet cash flow needs.

At the time of writing, the Chancellor of the Exchequer has just announced £330 billion of government backed loans and guarantees to tackle the “economic emergency” caused by the virus.[5] While more detail is to be confirmed, it is possible that smaller financial institutions may benefit from this. It will also be interesting to see the nature of these loans and guarantees, and whether they will fall under any of the applicable categories of qualifying items under the CRR.

 

  1. FCA discretion

The FCA has discretion to reduce the capital requirement of payment and e-money institutions by up to 20%.[1] While it is almost unimaginable that the FCA would grant such a reduction, the power is there.

Given that the capital requirement for payment institutions under Methods B and C is based respectively on income and payment volume, both of which are likely to fall during the crisis, it could make sense for such a reduction to be granted for firms exceeding their initial capital requirement under these methods. Otherwise the capital requirement for some payment institutions will be based on prior year figures which do not correspond at all to current economic reality. Also, firms using Method A (based on fixed overheads) could potentially argue for a reduction where they have slashed overheads in response to the crisis.

For e-money firms, the capital requirement under Method D based on a six-monthly average of outstanding e-money, so the ongoing capital requirement is likely to come down sooner than for payment institutions. Nonetheless, there may be scope to argue for a reduction where the amount of outstanding e-money has reduced significantly.

Notably, the FCA have said that they expect firms to manage their financial resilience and actively manage their liquidity, reporting immediately if they believe they will be in difficulty. It may make sense for payment and e-money institutions on the brink to ask for regulatory forbearance in this matter.

  1. Orderly wind down

Alas, not all firms are destined to survive this crisis. Indeed, the capital requirements regime is not intended to create fail proof firms. In the coming weeks and months, the financial impact of the crisis will be clearer, enabling more accurate stress testing of the future impact.

There may come a point that on the basis of both the current impact and future forecasting that you determine that your business is not a viable concern. In order to prepare for this eventuality, your firm should have credible wind down plans based on the projected costs of an orderly wind down.

Notably, in a consultation paper published in June 2019 on capital adequacy[7], the FCA stated that “in most cases, we note a period of at least 9 months” to wind down is appropriate. At a bare minimum, payment and e-money institutions should seek a two-month wind down period for the termination of contracts.[8]

 

Conclusion

The FCA’s direction of travel, particularly in last year’s consultation paper, is to move more firms, including payment and e-money institutions, towards linking capital resourcing to risk exposure. Indeed, investment firms are already required to consider the financial exposure of firms to “sudden and severe events”.[9].

However, as the impact of the current crisis becomes clearer, firms should urgently review their capital and liquid resources, acknowledging that any assumptions they have previously made in relation to sudden and severe shocks are likely to be inadequate given the severity of the current situation.

If you require any assistance or advice with your firm’s capital adequacy monitoring at this stage, please do not hesitate to contact me or one of my colleagues.

[1] E.g. Under Methods A, B and C, payment institutions calculate their ongoing capital requirement that will apply for the forthcoming year. Under Method D, e-money institutions calculate their ongoing capital requirement for the forthcoming month.

[2] See Article 36 of the CRR.

[3] The Guardian, 15/03/2020, https://www.theguardian.com/world/2020/mar/15/uk-coronavirus-crisis-to-last-until-spring-2021-and-could-see-79m-hospitalised

[4] See regulation 22(3) of the PSRs, paragraph 9 of Schedule 2 to the EMRs and Article 92 of the CRR

[5] https://www.bbc.co.uk/news/live/world-51921683

[6] See Paragraph 4 to Schedule 3 of the PSRs and Paragraph 15 to Schedule 2 of the EMRs.

[7] FCA, “Our Framework: Assessing Adequate Financial Resources”, June 2019, https://www.fca.org.uk/publication/consultation/cp19-20.pdf

[8] See regulation 51(4) of the PSRs

[9] IFPRU 2.2.37(2)

This post contains a general summary of advice and is not a complete or definitive statement of the law. Specific advice should be obtained where appropriate.

Topics: Payments sector, E-money sector, Covid 19

Colin Sloan

Written by Colin Sloan