The implications of the return of prudence: assess your appetite for risk now

Citation

McCaig, M. (2004), "The implications of the return of prudence: assess your appetite for risk now", Balance Sheet, Vol. 12 No. 3. https://doi.org/10.1108/bs.2004.26512cab.001

The implications of the return of prudence: assess your appetite for risk now

Malcolm McCaig is a partner at Deloitte in London.

The new regime

Sometimes, changes appear to be a long way off and then, in spite of all the advance notice and debate, you blink and they are just round the corner. So it would seem with the Integrated Prudential Sourcebook (PSB) that is being introduced by the Financial Services Authority (FSA).

The PSB represents a fundamental change in prudential regulation. It creates a single regime for the whole financial services sector, setting standards that are based on type of risk rather than industry sector. It also makes changes to the way that firms are run, to ensure they are more prudent with their capital and more robust in their control of risk.

The rationale for this integrated approach is to enable the FSA to have a better and more focused oversight of the industry. It is also designed to meet the FSA's objectives of maintaining market confidence, protecting consumers and ensuring the international competitiveness of the UK as a financial sector.

The rules, set to be finalized later this year, apply to all financial services firms regulated by the FSA – although some investment firms are exempt from the changes in financial resource requirements.

The many classes of risk

The PSB concentrates on two key principles: risk management and financial soundness. It divides risk into six classes. These are: market risk, credit risk, operational risk, liquidity risk, insurance risk and group risk.

For each risk class the PSB sets standards for the systems and controls necessary to manage the risk. This is made up of rules and guidance. One of the more difficult aspects of the PSB is its lack of prescription. In many cases, the guidance is open to interpretation, with the responsibility put on the firm to demonstrate that it has identified and adopted an appropriate response.

Firms will also need to show that their systems and controls form an integral part of the operation of the business; they cannot simply sit alongside the business and be visited once a year.

In addition to the systems and controls standards, the PSB also sets financial resource requirements. The FSA has moved away from a deterministic approach, in which capital requirements are based on the application of a formula, to a risk-based approach. The amount of capital that a firm must hold will depend on the particular firm and the class of risk; the greater the risk, the greater the amount of capital that must be held.

The FSA's intention is not to change the total amount of capital in the market, but to change the distribution of capital, determined by the risk profile of each firm. As a result there will be winners and losers; some firms will need to hold more capital, others less.

Sorting out risk appetite

Certain elements of the PSB may require further clarification. The term "risk appetite" is used throughout the PSB, which is not a standard market term and which does not have standard practices for its measurement. The FSA has also introduced a requirement for firms to conduct stress and scenario testing, but has not provided guidance on these areas.

Overall, firms will need to devise their own solutions. The FSA will determine what is best practice through the course of its discovery visits. It is therefore critical that firms keep abreast of what their peers are doing and how market practices are evolving. If not firms could fall short of the FSA's expectations.

The timetable for compliance varies by industry sector. However, the pressure on all firms is mounting, and the challenge facing the insurance industry is particularly great. Not only does the insurance industry have to implement the full PSB regime this year, it also has more work to do to ensure compliance than other sectors. Some of the industry's risk management practices are not as sophisticated as those of others financial services companies. The banking industry, for example, is more advanced in terms of managing operational and credit risk.

Based on a Deloitte survey published last year, many firms indicated that they will attempt implementation using primarily their own resources. Correspondingly, they identified "resource constraints" as one of the biggest challenges facing them.

By this stage, firms should have already performed a business aspect analysis to determine what is required of them by the PSB. Equally, a gap analysis should have been conducted to assess how firms' current approach falls short of regulatory requirements.

Firms should now be taking corrective action to redress any shortfalls in their processes, by designing and building new frameworks to effect the necessary changes. After this it is matter of implementing the changes and undertaking continuous assessment to ensure long-term compliance.

Remember the context

When considering the PSB, it is important that firms look at it in the context of other developing regulatory changes. The Basel Accord, the International Financial Reporting Standards (IFRS) and for US-registered firms the Sarbanes-Oxley legislation impact on firms' management of risk and capital allocation. The Basel Accord and EU risk-based solvency rules drive the capital requirements of the PSB, for instance. As such, the rules cannot be viewed in isolation; firms must take an integrated approach.

Although there are strong regulatory drivers, the PSB should be seen as an opportunity to effect positive business change. If firms do more than the bare minimum to comply, and instead treat the rules as a catalyst for change, then commercial benefits can be gained. Responding to the PSB will enable firms to make optimal use of capital, and they will have better systems and controls that could reduce losses and earnings volatility. It could also create more efficient businesses and improve profitability. It is therefore vital that senior management recognize the importance of the PSB.