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Does advice firms’ capital adequacy go far enough?

Fears mount over ability of buffers to protect clients from setbacks

Compliance experts are debating whether, despite heightened requirements, the amount advice firms are expected to hold in reserve is sufficient should they suffer a major setback.

In 2015, the FCA increased its calculation of how much advice firms need to have set aside for a rainy day. It raised the minimum requirement of capital adequacy for directly authorised firms with 25 or fewer employees to £20,000, or 5 per cent of a firm’s turnover, whichever is higher.

The previous requirement was £10,000, which was subsequently raised to £15,000 during a transition period so firms could adjust to the new limit.

Advice leaders are still conflicted over whether the watchdog’s rules and expectations for the prudential regime are appropriate, however.

Softening the blow

The capital reserve requirement for firms that oversee clients’ investments aims to ensure that if a business gets into trouble and clients risk losing their holdings, it has enough resources to soften the blow.

If a personal investment firm fails and leaves legacy redress that it cannot pay, this is passed on to the Financial Services Compensation Scheme.

The FCA has noted on a number of occasions that “these levies are often seen as unfair to personal investment firms that have not failed and have not caused consumer detriment”. At the time of introducing the raised limit, the FCA estimated that if everyone met the capital adequacy requirement, this would relieve the FSCS levy burden by £4m over seven years.

Arguably, this is not a particularly significant amount, given the annual adviser bill for the FSCS is around £147m, and the average FSCS redress claim relating to pensions or investments is £11,000. Tenet Group regulatory director Caroline Bradley believes the required amount of capital adequacy is insufficient, and the network responded to the FCA’s consultation on the measures by saying at least £20,000 would be needed.

Bradley says: “If the adviser had a number of claims, that [£20,000] would actually barely cover two policy excesses, so we responded to the consultation and felt that it should have been higher.”

She adds: “Effectively, the FCA was talking about £20,000 because of barriers to entry [into financial advice], but if you think about running a business that could advise somebody on a multi-million-pound pension transfer, shouldn’t they have a bit more substance behind them than £20,000?”

The FCA’s uphill fight to end phoenixing

The regulator said at the time that to reduce the FSCS levy in a meaningful way, the capital resource requirement would need to be much higher, but it felt this would be prohibitive to some smaller firms.

Unlike directly authorised firms, most advisers operating under networks are not required to hold the capital reserve, as the network will typically do so on their behalf.

Coming up with the capital reserve monies is therefore one of the expenses advisers who are part of a network and decide to go direct have to keep in mind as part of their bill in making the transition.

When Red Circle Financial Planning’s Darren Cooke first moved to direct authorisation, the old rules applied and the new limit only transitioned in over the next couple of years. Cooke says: “If you go directly authorised now from a network, £20,000 is quite a big leap. Maybe there should be a way of requiring a lower sum initially and then the firms can work up to £20,000, rather than having it on day one.”

A system such as this, which would allow firms to gradually build up funds, could be a solution to the FCA’s barrier-to-entry argument. But would the £20,000 base level still hold up under pressure?

Brexit unknowns

Apart from complaints from clients, there are a host of unforeseen reasons a firm could run into trouble, from key employees or accounts leaving, to steep falls in markets reducing the charges taken from portfolios.

While there are countless potential “unknown unknowns”, the consequences of which could hit firms out of the blue and are unpredictable, one in particular has been looming over companies for a while: Brexit.

Management consultancy KPMG has been surveying asset management firms about their capital reserves and found that “companies were increasingly thinking about Brexit-related relocation scenarios”.

A 2017 report found that 40 per cent of companies were thinking about partial relocation and how Brexit-related contingency plans could impact their capital reserves.

Co-author of the survey, KPMG partner David Yim, says: “I think it is fair to say that any costs the firms have had to bear in terms of Brexit, and are planning to bear, have been funded through their capital reserves.”

Asset manager Rathbones announced late last month changes to its Luxembourg-domiciled fund range, which would enable it to continue with its investment strategy in the case of a no-deal Brexit.

All legal, administrative and transaction costs associated with the conversion were said to be borne by the company.

Rathbones did not provide a comment on whether it financed the move from its capital reserves.

Expert view

Rule quirks can be ironed out

Capital adequacy requirements have increased very slightly over the years, going from £10,000 to £20,000, so for most firms, I don’t think it’s massively prohibitive from that point of view. Where it can be more problematic is if you’re looking to take on debt in a firm, for example; there are some quirks in the rules.

When you want to borrow some money to buy another client bank, if you’re buying assets in the business as opposed to buying the business itself and the equity in it, it’s treated as a deficit for the purpose of calculating capital adequacy. But if you go and use that debt and buy equity in a business, that’s treated as a positive value. The result is non-regulated holding companies get created. It kind of works; it just seems an awful lot of effort goes into structuring these kinds of things for arguably not a great deal of benefit.

There are some adjustments that could make the rules simpler. If the FCA could treat goodwill or assets/the client bank in exactly the same way as buying equity, that would make things simpler.

The capital adequacy positions firms are required to have aren’t there to prop up what would effectively be a failing business. They are there to try to assist with an orderly wind-down.

But the amount of money is not going to do a lot. It’s not going to stop a failing firm from failing; it just buys a little bit of time.

With financial advice firms, the implications of a small company going bust aren’t enormous.

Provided it is not a business that is holding clients’ money, it is not like anyone’s money is actually lost.

Phil Young is managing partner of Zero Support

FCA expectations versus reality

In the case of larger investment firms, the minimum amount required for capital adequacy purposes becomes less straightforward.

Individual firms are expected to think about what could go wrong and then calculate how much it would cost to fix it. Surveyed asset management firms’ ideas of how big their buffer should be undervalued the FCA’s expectations by 82 per cent, according to KPMG.

While in the case of investment advice, the FCA’s prudential approach seems to have possible redress payouts in mind, this is not primarily the purpose with asset management firms. However, if a fund was embezzled, for example, investors could be entitled to claim compensation and this would not necessarily be covered by capital adequacy.

Yim says: “The purpose of capital requirements is to make sure that there are sufficient funds within the business to allow the company to operate for a while, while conducting an orderly wind-down of the business, to pay key staff to maintain the accounts that are being managed, and to make sure that they are in the process of being closed down and the investments are being returned to investors.”

He adds: “[Capital reserve] is not necessarily specifically for paying out to investors who have lost out if there has been a fraud.

“If there has been a fraud, there are a number of different scenarios, where it could be that a manager has been at fault – in which case, some of the capital could be used for that.

“But there are other scenarios, where there has been fraud at the administrator or the custodian, and these are complex issues.”

All firms to which the rules apply are required to hold their respective capital adequacy at all times. In the event a company is unable to hold the required amount, it should notify the FCA immediately to avoid committing a capital adequacy breach. The regulator can then impose individual capital guidance.

When, in August 2017, the FCA notified Hargreaves Lansdown it would reassess the company’s capital reserve, Hargreaves promptly announced that it would not pay special dividends to its shareholders for the first time since it went public in 2007, to be able to raise its capital buffer.

The announcement sent the firm’s share price down by 5 per cent.

Apart from scrapping dividends, firms could seek to meet their capital adequacy needs through a number of other mechanisms.

Yim says: “If they are part of a parent group, they can seek a capital injection from the group, which has happened on a small number of occasions that I have seen with some firms in the marketplace. Finally, they can do a capital raise by launching further issues.”

Should platforms feel pressure?

Altus principal consultant Ben Hammond predicts that the regulator will be keen to put further capital controls on platform providers, as they are now entrenched in the value chain and some are “too big to fail”. In the event of their sudden exit, this could start a domino effect across the chain.

Apart from protecting clients, the regulator is seeking to mitigate the “spill-over effect” of one financial firm’s failure to other institutions and the wider economy.

The FCA did not provide a comment on whether it is currently looking into capital adequacy for technology firms that sit behind the advice and investment sectors.


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There are 4 comments at the moment, we would love to hear your opinion too.

  1. Cap Ad is worthless, you could set it at a million and it still wouldn’t make the slightest bit of difference …..

    In today’s world of big fines, PI not paying out, and S166’s

    The assets and cap ad of the company will be stripped out long before anyone could get near it.

    And as for the “Senior persons regime” (catch me if you can)…what a joke, the fines are a paltry (compared to the crime) and if you pay early you get a massive discount hahahahaha that is of course if the senior person is actually caught and brought to book.

    And …….

    For those who run a good company the cap ad just sits there gathering dust (which is a poor advert for us as financial advisers !)

    • Trevor Harrington 8th March 2019 at 12:20 pm


      I commend you for your plain common sense – as indeed we all tried to point out to the regulator last time they raised the Cap Ad …

      Unless of course the regulator has some ulterior motive … like sending a few more IFAs out of business, which is what happened last time.

  2. It is still way too little. If something goes wrong, £20000 even would soon be absorbed. The concept perhaps is that the more skin-in-the-game the adviser has the less likely things might go wrong for clients I guess… and it doesn’t have to just ‘sit there’ – it can be invested! Anyway advisers, don’t you have confidence in your own business to leave capital in it – you expect your clients to have total trust in you after all…

  3. The capital adequacy rules actually exasperate the problem. If you only have £20K in the business and you have a complaint the £5K excess on your PI puts you in breach and so you cease trading. The costs of running down the business use the next £15K so there is no money left to pay further claims.

    A more sensible approach would be to leave capital adequacy where it is and allow firms to remain authorised if they dip below this level as a result of a complaint. Obviously some extra supervision would be required and a plan to bring the level back to £20K.

    Doing this would not only solve the issue above, but it would have the FCA crawling all over inadequately funded firms that have a complaint, and that could be good for the rest of us levy payers.

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