The EU Capital Requirements Directive

Compliance, competence and capital adequacy

Robert Kelly, Baronsmead Insurance Brokers

The Financial Services Authority has been, for the most part, entirely reasonable in its approach to the hedge fund industry. To its great credit, it has not responded precipitously to the strident voices calling for harsh regulation of hedge funds, which are based more on prejudice than hard evidence.

So when the regulator invokes the Challenger space shuttle disaster as a warning, it would probably be wise to sit up and pay attention. The somewhat dramatic warning was sounded in relation to the implementation of the European Union’s Capital Requirements Directive and was intended to illustrate the damage that non-compliance could inflict on the financial system. Quoting Richard Feynman, the former American physicist who was one of the architects of the atomic bomb, the FSA’s explanatory notes on the Directive begin: “Relying on simplistic faith in arguably proven risks and formulas is intrinsic incompetence. It is not what we know but what we do not know that we must always address to avoid major failures, catastrophes and panics.”

The message is pretty clear to readers that they should take the requirements of the Directive very seriously.

Sit up and take notice

But the fact is, there is little evidence of many people having taken steps to address the most important part of the Directive, called Pillar 2, which asks firms to list and explain all the risks that are relevant to the business and produce a capital requirement figure. That could well be because implementation of Pillar 2 does not have to take place until January 1, 2008. But it could also be because few firms are sure whether it will apply to them.

The FSA sent out letters at the end of last year to help firms assess to what extent they would need to comply and it is now clear that it will apply to all large financial services institutions. But hedge funds that believe they can produce a capital resource requirement, or minimum capital requirement, calculation as many smaller institutions do today may be wrong. AIMA, which has conducted extensive research into the matter, expects that most FSA regulated hedge fund investment managers will be subject to the new regulatory capital rules.

Only “smaller institutions” that have little complexity in their activities, don’t operate across borders and don’t have an effect on markets (this is always arguable) are likely to be granted a waiver. But they will need to send in a full waiver application rather than just notifying the FSA as in the past and even then they will be expected to make a fuller assessment of the risks to their business under the new rules.

As for everyone else, there is going to be a fair amount of new compliance work to do this year. A lot of detail will need to be provided to satisfy the regulator on Pillar 2 and a fair amount of man-hours required to do so.

It is possible than not too many people will have given much thought to the Internal Capital Adequacy Assessment Process (ICAAP), but by the end of next year many will have spent weeks working on one to send to the FSA for examination. The ICAAP is the firm’s own assessment of how much capital it should hold, bearing in mind its risk management processes.

The ICAAP will need to include a summary of the financial position of the business, including its balance sheet strength and a forecast of future profitability. It needs to describe its capital and dividend plan and what its material risks are. It even needs to comment on why the level of risk it takes is acceptable or, if it is not, what mitigating actions are planned.

The risksthat should be analysed include: credit risk, market risk, operational risk, liquidity risk, insurance risk, concentration risk, securitisation risk, interest rate risk, and business risk.

The firm also needs to say who has carried out the assessment, how the assessment’s assertions have been challenged and revised internally and who within the firm has approved it. In other words, the FSA wants to know it has been taken seriously by senior executives who, one might reasonably imagine, would be held responsible for any mis-statements or omissions.

The onus, says the FSA, is on the firm to explain the assumptions it uses for internal purposes, although on a softer note it does say it is a top-down “reasonableness” test rather than a bottom-up model validation exercise.

Preparing for capital adequacy

If all this seems daunting, unfortunately there is more to it. The FSA is at pains to stress that the ICAAP is just part of the process which leads to a final figure, contained in a document called the Internal Capital Guidance (ICG), for the capital a firm must hold. The ICG is arrived at after a Supervisory, Review and Evaluation Process by the FSA. Following initial testing with a handful of investment management firms, the FSA has said this process would be likely to involve several site visits rather than a single one that lasts for several days. So you may get to know your local FSA representative pretty well.

The FSA finally comes back with its own assessment and capital requirement figure. However, it says it is prepared to listen to firms’ arguments in the meantime, both during the site visits, subsequently and at a later appeal stage.

The point is there is room for negotiation. And since hedge fund firms can send in their ICAAPs any time from now onwards, it probably makes sense to start the process sooner rather than later so that any negotiations can be concluded well before next January.

Firms certainly do not want to end up in a position where measures are taken against them. The most likely measure is they will be asked to increase their capital beyond its current level. The FSA is clear that an adjustment one way or the other is a probable outcome of the process. But firms may also be asked to improve their internal controls or to make specific provisions. At the extreme, they may be asked to restrict their business activities.

Risks and rewards

The one big plus for firms is that in explaining to a demanding regulator what risk systems they have in place and why, they may well improve their business models. And if this is communicated to investors, all those hours of compliance may just prove financially rewarding.

Better risk management systems will also, of course, have the effect of mitigating the capital required. It may lead some firms to consider new ways of reducing their operating risks, such as taking out insurance against events such as trading errors and investor litigation.

Whereas some risk measures are largely subjective, based on modelling to show how sensitive a portfolio or business model is to a certain market event, insurance can be factored into the calculations in a more tangible way.

The Directive says that a firm may recognise the impact of insurance for the purposes of its operational risk measurement system as long as the insurance meets certain requirements and is of sufficient quality.

However, insurance is not a proxy for formal risk management systems and this is made clear in the Directive, which says that the capital alleviation gained from an insurance contract must not exceed 20 per cent of the capital requirement before any risk mitigation measures were put in place.

Just as firms need to start talking to the FSA about how to comply with the Directive, they might want to think about risk reduction and mitigation measures more than a few days before filing their ICAAPs.

It’s not rocket science, but the regulator apparently would like firms to avoid the fate of a certain space vehicle of the 1980s. Their investors probably wouldn’t mind either.

Robert Kelly is managing director of Baronsmead, a specialist hedge fund insurance firm. www.baronsmead.com