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Significant work is needed to ensure that the wind-down planning of firms is credible and operable, the UK’s financial services watchdog has said in a new report.
Firms are failing to prepare to fund the potential winding down of operations, such as when a company goes bust or is dissolved by a parent company, according to the Financial Conduct Authority (FCA).
“We completed a piece of thematic work on wind-down planning across different business models, in light of the ongoing COVID-19 pandemic and the potential harms caused if a wind-down is not orderly,” the regulator said in a statement.
Work conducted by the FCA in preparation for the report focused on liquidity needs during this process, intra-group dependencies and what it calls wind-down triggers.
However, the review does not represent a shift in policy or changing requirements for firms.
Cash flow problems
The FCA has complained that firms are failing to consider their liquidity planning on this issue.
When a firm has to wind down, it is obliged to continue paying its liabilities as they fall due. A failure to do so could push the firm into a disorderly dissolution or an insolvency process.
“We have seen that firms often consider capital needs in their wind-down plans but do not consider liquidity,” the FCA pointed out, adding that firms supervised by the FCA should consider how their cash position may change during the wind-down period, and plan accordingly.
Planning typically includes the cash paid out to complete the process; temporary cash outflows, which can result from an orderly transition, such as trade settlement; and what cash may be received during wind-down, such as residual revenue and from the sale of assets.
When taken collectively, this tells a firm what cash is required to ensure the dissolution process is orderly.
“We expect a firm to consider whether its liquid holdings would be sufficient to fund a wind-down if it were to happen,” the FCA said.
Cashflow mismatches
One of the biggest issues for winding down businesses is cash flow mismatches, such as sudden imbalances between their income and outgoing costs.
The FCA cautions that it expects a firm to have the ability to fund any temporary mismatches that occur during wind-down, some of which can be very significant for certain business models.
“We have observed that even though a firm may be net cash positive over the entire wind-down period, it can experience significant cash timing mismatches during wind-down,” the regulator suggested.
According to the FCA, many firms projected a structurally negative cash flow during this process due to reduced revenue and increased costs. “We saw that firms did not adequately consider that selling assets may take longer than its cash reserves can fund its operations.”
The lack of consideration during planning means firms are often unsighted on any potential cash shortfall at different points in time during the dissolution period, which means that they potentially under-estimate the overall liquidity required.
In addition, funding mismatches can be made more difficult due to the likely withdrawal of overdraft and other financing facilities which the firm would typically have access to in non-stressed environments. “Taken collectively, firms should consider what financial resources may be required to fund these temporary periods.”
Intragroup dependencies
Another shortcoming called out by the FCA was intragroup dependencies.
Intragroup interconnectivity is where the operations or activities of the UK firm involve financial or non-financial resources from other legal entities within the wider group.
For example, this could include having a group human resources function, having intra-group financing arrangements or using a pooled information technology (IT) system, which is hosted and managed by another legal entity.
The FCA called out firms for only looking at the benefits of such an arrangement, rather than focusing on issues such as the stress caused by interconnectivity which can include, for example, parental failure.
“We have seen that this is an area of weakness in firms' wind-down planning, particularly firms with overseas groups, where the UK board may have little to no ability to impact the decision-making of other group entities or its parent,” the FCA said.
Many firms have made little to no consideration of how to manage intragroup dependencies during wind-down, the regulator warned. “This creates significant risks that any scenario involving financial or operational pressure on the group, may result in a disorderly failure of the UK regulated entity.”
However, the FCA did find some examples of good practice among the entities that it supervises.
For example, this could include mapping out the list of existing interconnectivity within the group, then considering the interconnectivity during a wind-down, as well as assessing the impact each point of interconnectivity has on the firm’s ability to dissolve.
Wind-down triggers
Wind-down triggers are deemed an essential part of a firm’s operational resilience, meaning that they have the resources in place to complete an orderly dissolution.
However, the FCA complained that many firms are not putting enough effort into considering an appropriate range of trigger metrics, like capital resources.
“Failure to create adequate wind-down triggers leads to wind-down decisions occurring only late in stress, at the point when financial or non-financial resources may be reduced and time to respond is scarce, limiting the Board’s options,” the regulator cautioned, pointing out that wind-down triggers should be closely linked to the firm’s risk management frameworks and monitored closely, particularly during times of stress.
Senior managers, meanwhile, should have clear lines of responsibility for adequate systems and controls, including wind-down planning. The FCA having observed that shortcomings in triggers sometimes indicated broader issues with a firm’s risk management and risk appetite frameworks.
Of the weaknesses observed in firms, the FCA indicated that some entities had no consideration of an actual wind-down trigger. For example, firms did not consider a quantitative threshold that could trigger such an event, instead relying on qualitative statements.
There is also a disconnect between a firm’s triggers and its risk appetite in a business-as-usual scenario. “Given a wind-down is likely to result from a crystallisation of the firm’s risks, we would typically expect to see a wind-down trigger being a more extreme calibration of the firms existing risk appetite metrics,” the FCA recommended.
Firms further failed to chart the impact of their wind-down scenarios, showing how the risk appetite metrics change over the course of the stress period.
This made it challenging for the board to see whether the triggers would be hit sufficiently early in the stress for it to act, while triggers were also calibrated with no reference to the financial resources required to complete a wind-down.
Therefore, the board had no certainty that wind-down would be triggered early enough in a time of stress that financial resources will still be available for it.
Although there are no changes to the status quo being hinted at by the FCA, it is clear that the regulator does not deem the efforts that its entities are currently doing as adequate.
“Firms may find it helpful to consider our observations when carrying out their own wind-down planning,” the report summarises, adding that all firms are encouraged to read the review.
