Joining the dots: The Essential Role of Forecasting Capital and Liquidity

In the ever-evolving landscape of financial services, MIFIDPRU Investment Firms face a dual challenge: meeting the stringent regulatory capital and liquidity requirements while navigating market uncertainties. Central to this is the implementation of robust forecasting and budgeting, which not only drives strategic decision making but also ensures compliance with the key drivers of the Investment Firms Prudential Regime (IFPR) such as meeting the own funds and liquidity threshold requirements and wind down planning.

Realistic forecasts and budgets are fundamental tools that firms should utilise to maintain sufficient liquid assets at all times and in turn remain an ongoing concern whilst limiting their potential to cause harm to their stakeholders and the wider markets. 

What does this mean at a practical level?

Plan – Firms should plan ahead through forecasting and budgeting and assess their liquidity position for the foreseeable future.

Assess – Firms must assess their liquid resources available and use stress testing to foresee any potential deficiencies in adverse circumstances.

Conserve – Firms need to consider setting aside liquid assets.

Maintain – Ensure that adequate liquidity is maintained and is enough to cover any possible deficit situations going forward.

Update – Firms should revisit and update their forecasts, wind-down plans and ICARAs to ensure that these assessments are relevant to the current market conditions.

Use – The results of accurate forecasting should be fed into various business processes and utilised in a firm’s business strategy. 

What goes into building a realistic and suitable forecast?

To meet the FCA’s requirements and to gain maximum benefit from them, the forecasts should cover a business-as-usual 3-year projection period, taking into account any planned future growth, and also consider relevant severe but plausible stresses that could affect the firm’s business. 

A key part of a forecast is the inclusion of detailed Profit and Loss (P&L), Balance Sheet (BS), and Cash Flow sections. The interaction between these and the Overall Financial Adequacy Rule (OFAR) enables firms to accurately monitor their capital and liquidity throughout the 3-year period and identify any potential future shortfalls. Any additional capital and liquidity calculated through the Assessment from Wind Down (WDP) and Assessment from Ongoing Operations (AoH) calculations should also be included within the forecasted OFAR.

How best to stress test?

Being able to demonstrate that you have adequate capital and liquidity in both business-as-usual and stressed conditions shows strong financial resilience. Forward-looking hypothetical stressed scenarios should reflect a firm’s own risk appetite for survival. Here are some points to consider when applying stressed scenario analysis:

• Choose severe but plausible scenarios that are relevant to the circumstances of your firm.
• Have clear assumptions, when compared to business-as-usual projections, which are consistent with the scenarios considered.
• Perform analysis on individual business lines, if relevant, as well as at a firm-wide level.
• Cover all material risks and harms identified and analyse the effects of the stress scenarios on your firm’s profit and loss, financial position, and in turn the OFAR.
• Consider realistic management actions that can be taken if hypothetical situations do arise. 

What are your liquid resources?

There is often confusion about the difference between the capital in the business and the liquid assets available. The capital and liquidity requirements are two separate thresholds making up the Overall Financial Adequacy Rule (OFAR) that need to be adhered to at all times.

Liquid assets are cash and cash equivalents but cannot be considered capital until specifically designated as ‘regulatory capital’ through a capital injection. In addition, not all current assets can be treated as liquid assets. Liquid assets are split into two categories under the IFPR, core and non-core liquid assets. 

Firms also authorised under AIFMD have a requirement to ensure that their ‘Funds under Management’ requirement can be met through liquid assets, however, the rules around which current assets can be treated as liquid are less stringent under AIFMD.

Firms must hold sufficient core liquid assets on their balance sheet to cover their Basic Liquid Asset Requirement (BLAR) at all times. If a firm identifies that it needs to hold additional liquid assets and in turn has a higher Liquid Asset Threshold Requirement (LATR), then the firm may hold the liquid assets in any combination of both core and non-core liquid assets to comply with this.

In determining the quality of liquid resources, firms should consider: 

• The legal or operational restrictions on the asset that may affect the liquidity.
• Ability, timescale, and loss of value when converting assets into ‘cash’ in a period of stress.
• If denoted in a currency other than GBP then a haircut on the value will apply.
• The transferability of assets – in severely stressed conditions, liquid resources might not be freely transferable between group entities, so adequate liquid resources should be maintained in the regulated entity.

Forecasting is not only essential for strategic decision-making but also for regulatory compliance and risk management for MIFIDPRU investment firms. Accurate and realistic forecasting with the integration of the OFAR, can enhance a firm’s financial resilience, help mitigate regulatory risks, and ensure long-term sustainability. 

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