The Financial Conduct Authority (FCA) has told intermediaries to up their game when stress testing their organisations as it uncovers evidence of high debt levels and short-term refinancing strategies at groups hitting the acquisition trail.
The regulator’s multi-firm review of consolidation in the financial advice and wealth management sector identified a split between well resourced organisations with clear structures, strong governance, risk management processes and those lacking in these areas.
Emphasising its concerns, the regulator said it was not setting any new expectations of intermediaries when undergoing consolidation processes.
Practices which could increase harm
In identifying practices which could increase harm to customers, the regulator pointed to groups which are not prudentially consolidated.
It added this can lead to a difficulty recognising, measuring or mitigating risk and may also limit regulatory oversight of group debt, goodwill and associated risks.
It also pointed to group debt arrangements which were weakening the resilience of regulated entities.
This included regulated entities transferring cash to unregulated parent companies, known as upstreaming, via intra-group loans or guaranteeing the holding company’s debt, exposing them to the group’s financial and operational risks.
And the FCA highlighted concerns with groups which fail to grow their compliance and governance infrastructure to keep pace with their rapid growth.
Resource, resilience and clear structures
When identifying areas of good practice, the regulator pointed to a number of key characteristics.
This included highlighting that groups with a clear structure, strong governance and risk management processes were likely better placed to achieve sustainable growth and deliver good outcomes for clients, staff and shareholders.
Groups which ensured regulated entities were well resourced and resilient despite debt levels elsewhere in the group were also highlighted.
So too were groups that considered risks across all entities, capturing capital and liquidity needs created by these risks.
Stress testing and short-term debt financing
In terms of where firms can improve, the regulator highlighted group-level financial resilience and solvency.
It maintained top-level consolidated financial statements often showed net liabilities or relied on intangible assets, such as goodwill, for balance sheet solvency, while the regulator revealed it also found some evidence of high debt levels, limited stress testing, and short-term refinancing strategies.
It further found that in some cases, debt was secured on regulated entities’ assets and some regulated entities guaranteed a holding company’s debt.
This exposed firms to the credit and operational risks of the group and could reduce the assets available for other potential creditors, including clients, in the event of insolvency elsewhere in the group.
Other areas of concern highlighted included a reliance at group-level on short-term borrowing which can create fast-growing future obligations and heightened refinancing risk where guarantor arrangements existed.
The regulator added it saw heavy reliance on cash generation from regulated entities to service group debt. And while some groups had contingency plans in case cash was not available, some did not.
This risk was often unrecognised and not effectively stress tested. While some firms transfered cash via dividends, many were found to have built up intra-group receivables which may not be realisable in a stress environment.
Group debt management
Turning to debt management, the regulator revealed top-level consolidated financial statements often showed net liabilities or relied on intangible assets, such as goodwill, for balance sheet solvency.
It added it found some evidence of high debt levels, limited stress testing, and short-term refinancing strategies.
And in some cases, debt was secured on regulated entities’ assets and some regulated entities guaranteed a holding company’s debt. This exposed firms to the credit and operational risks of the group and could reduce the assets available for other potential creditors (including clients) in the event of insolvency elsewhere in the group.
Concerns were also raised reliance at group-level on short-term borrowing. This can create fast-growing future obligations and heightened refinancing risk where guarantor arrangements existed.
But the regulator also saw a heavy reliance on cash generation from regulated entities to service group debt.
Some groups had contingency plans in case cash was not available, but some did not. This risk was often unrecognised and not effectively stress tested. While some firms transfer cash via dividends, many were found to have built up intra-group receivables which may not be realisable in a stress.
Group risk management and structure
On group risk management, the regulator praised firms for having explicit consideration of risks across all group entities, including those outside of any investment firm group (IFG), capturing capital and liquidity needs created by these risks, for example in the ICARA.
Groups were also found to have managed their growing complexity by promptly deauthorising dormant firms, ensuring future liabilities were retained within the group and prioritised client interests.
However, some groups were found to have not considered group risk and may have underestimated interconnected risks and resource needs.
Firms were also praised for including entities within an IFG which supported effective governance and oversight at group level enabling effective regulatory supervision.
However, where goodwill was held outside the IFG, the regulator added this meant that the inherent uncertainty of value was not recognised in the assessment of adequate financial resources.
Some groups were also found to have used dual-parent structures, often with one or more offshore, meaning they limited prudential consolidation.
These practices may undermine the financial resilience of regulated entities, making effective regulatory oversight harder and increasing the risk of harm to clients and markets, the FCA said.
Acquisition and integration approaches
The regulator pointed out well managed acquisition and integration can create real value for clients, employees, buyers and sellers of regulated entities.
However, some firms needed to improve due diligence, monitoring and resourcing of the process, and ensure they had an ability to adapt processes to the client or staff profile of the acquiring firm.
Some groups’ due diligence did not review basic compliance and some due diligence exercises appeared to be ‘tick box’ in nature, it warned.
Some groups acknowledged that risk and compliance frameworks needed improvement pre-acquisition. Where issues were not addressed quickly, substantial further investment of financial and non-financial resources was required.
Governance and resourcing
Where groups seek to grow quickly through acquisition, the regulator pointed out resourcing must keep pace with the increasing scale and complexity of the group.
This means ensuring that compliance and risk management functions are well resourced and that robust systems and controls are in place to make sure management can monitor and act upon emerging risks appropriately.
As groups grow, it added senior management must have the knowledge and experience necessary to manage the increasing size and complexity of the business.
Having independent challenges at committee and board level was normal practice for businesses of reasonable size and scale, it highlighted.
It further pointed out that it is also important for groups to embed knowledgeable staff in the acquisition and integration process and ensure appropriate governance to road-test proposed acquisitions and assess any potential risks.
In this area the regulator found evidence of investment in staff training on migration to new systems. This included product testing and ongoing reviews monitored by a robust product governance framework.
However, some groups did not scale systems and controls in line with their growth.
The FCA noted they needed management information to allow for effective governance of multiple entities within the group and infrastructure and this resulted in poorly controlled growth.
The regulator also pointed out that groups needed to ensure leadership had sufficient knowledge and experience to deal with increasingly large and complex issues maintained.
Sometimes, decisions materially affecting regulated firms were made by unregulated boards, without adequate consideration of the impact on the regulated firm’s business.
Some groups did not have independent challenges on boards and others had little independent challenge at important board committees. Such oversight, the regulator added, could offer unbiased scrutiny of management decisions and challenge group assumptions.
Conflicts management
Some good practices identified when it came to conflict management were incentives not being offered based on the investment decisions made by the client, either through adviser remuneration or via the deal structure.
However, some groups offered explicit or implicit incentives to invest in group products or services, including investment products.
While the regulator identified conflicts of interest registers which recognised many of the relevant conflicts at play, consideration of how to mitigate them could be unclear or under-developed.
Ultimately, the FCA was keen to point out that it was “not setting new expectations”.
“Our findings are intended to help firms understand those that already exist,” it continued.
“If you are a firm with this business model, you should factor in the nature, scale and complexity of your business when considering these findings and their underlying principles.
“Compare our findings to your firm or group’s arrangements to see if your arrangements might lead to increased prudential and conduct risks.
“Consider where you may need to reassess your risk management arrangements or group structure to deliver resilient and well-managed growth, in line with the Consumer Duty and in the best interest of market integrity. These attributes are likely to support timely change in control processes.”
