Investment firms are woefully under-estimating the level of capital they need to hold in reserve to ensure investor safety should they have to shut up shop, according to accountancy firm KPMG.
Wealth managers and discretionary fund managers are required to set aside a certain portion of their balance sheet as capital in the event the company has to be wound up.
David Yim, a partner at KPMG, said he is concerned about the levels of capital being retained by firms.
He discovered that, of those subject to a Financial Conduct Authority Supervisory Review and Evaluation Process (SREP) in the last four years, the median increase in reserve capital the regulator demanded was 82 per cent per firm, compared with the businesses' own assessments.
Mr Yim said: "This can be seriously disruptive for firms’ plans. It suggests there is work to do if firms’ own assessments of capital requirements are to be aligned with those of the regulator."
He said of the firms he has looked at, most have increased the amount of capital they set aside since 2015.
But the prevalence of firms been forced to significantly increase the volume of capital they hold as a result of FCA action means the capital provisions made by firms are not sufficient.
The amount of reserve capital required, called an ICAAP, is calculated by the company itself, based on what the company believes it would costs to wind up its operations.
KPMG noted the subjective nature of this calculation creates a business risk for wealth managers.
Mr Yim said: "Some firms have had to cut or cancel dividends, or ask parent companies for a capital injection, following these increased capital requirements.
"In several high profile cases, the increased capital requirement impacted on the share price.
"Given the potential damage to business, firms need to bridge the gap between their own assessment and the FCA's expectations.
"And in an increasingly tough regulatory and commercial environment – with the demands of compliance with Mifid II, the Senior Managers and Certification Regime (SM&CR) and General Data Protection Regulation (GDPR) – firms need money to spare for implementing regulations, as well as leaving capital free to invest in growth.
"Having a realistic, defendable capital assessment will enable firms to plan effectively for a fast-changing operating environment.”
He also found that a third of firms he surveyed covered by the regulations have not had a visit from the regulator in the past four years.
Alan Beaney, chief executive of RC Brown, an investment management firm, said companies have an incentive to keep as little capital as possible because it is cash "you can't do anything else with".
He said: "You can’t use it to grow the business, it tends to be held in cash and cash substitutes such as government bonds.”
The Financial Conduct Authority (FCA) guidelines for calculating the ICAAP requirement were included in the organisation’s 2016 handbook.
They required firms to: “Consider scenarios that are severe, relevant to the firm and that may result in the regulated business not being viable.
"Early warning indicators - well-structured management information allows a firm to identify if there are any emerging risks that may make the firm unviable.
"Identify processes for proactively identifying and mitigating any material risks that may arise in the course of wind down.”
Mr Lim said firms have “some way to go” to meet these requirements.
The report was released in October 2017.
The Financial Conduct Authority said it was aware of the KPMG report but chose not to comment on it as it believes it is based on a snapshot in time and on a limited sample of firms in the industry. For this reason, the FCA played down questions about the number of inspections carried out.
The regulator added that as the wealth management industry has grown in recent years it is “natural” that the amount of capital it requires firms to hold would also increase.
The regulator said that on an industry wide basis, firms are holding more capital than they need to, a point also made in the KPMG report.
The concerns expressed in the KPMG report come in light of discretionary fund management (DFM) company Beaufort Securities went bankrupt, with the administrators revealing there is little cash left in the firm and some clients will lose money.
david.thorpe@ft.com
