The Internal Capital Adequacy and Risk Assessment (ICARA) is a cornerstone of the UK’s Investment Firms Prudential Regime (IFPR), introduced to strengthen the financial resilience of investment firms. Designed to ensure firms maintain sufficient financial resources, ICARA plays a crucial role in identifying, managing and mitigating potential risks and it fosters a proactive, forward-looking approach to financial planning and risk management. This article explores the background and rationale behind ICARA’s introduction, its scope of coverage, and how it functions in practice. It also examines its key components, before evaluating whether it is delivering on its intended objectives.

The Background

ICARA was introduced in January 2022 as a fundamental component of the IFPR. This regulatory overhaul was driven by the need for a more tailored prudential framework for investment firms in the post-Brexit financial landscape. Prior to ICARA, firms adhered to the Internal Capital Adequacy Assessment Process (ICAAP), which was largely aligned with banking regulations and often seen as disproportionate to the risks faced by investment firms. ICARA was designed to address these concerns by offering a more proportionate, risk-based approach.

The primary goal of ICARA is to ensure firms have robust processes in place to identify, manage and mitigate financial and operational risks, ultimately enhancing resilience and protecting clients. By introducing a forward-looking, continuous assessment framework, ICARA aims to support market stability and reduce the likelihood of firm failures that could have wider systemic implications. In doing so, it helps investment firms navigate financial challenges while maintaining regulatory compliance.

The Scope of Coverage

ICARA applies to a wide range of investment firms operating under the UK’s IFPR, specifically those authorised under the Markets in Financial Instruments Directive (MiFID). These firms include asset managers, wealth managers and broker-dealers, all of whom must comply with ICARA to ensure they hold adequate financial resources and effectively manage risks.

The framework distinguishes between two categories of firms: Small and Non-Interconnected (SNI) firms and Non-SNI firms. SNI firms, typically smaller in scale with simpler business models, face proportionate requirements, while Non-SNI firms, with greater complexity and risk exposure, are subject to more stringent obligations.

Geographically, ICARA is exclusive to the UK financial sector, introduced to address the regulatory needs of firms post-Brexit. It has replaced EU-based prudential rules with a tailored approach that better reflects the unique operational challenges faced by UK investment firms.

What Does ICARA Do?

At its core, ICARA promotes a forward-looking, risk-based approach to financial planning, encouraging firms to proactively identify potential threats to their business models and take appropriate action. This not only strengthens individual firms but also contributes to broader financial stability within the market.

ICARA’s key focus areas include financial resilience, harm mitigation, and wind-down planning. Firms must maintain adequate capital and liquidity to absorb financial shocks, such as market downturns or operational disruptions.

Harm mitigation is another critical component, requiring firms to evaluate potential risks to clients, counterparties and the financial system. A brokerage firm, for instance, must assess whether its trading practices could expose clients to undue risk and implement controls to prevent such occurrences.

Finally, ICARA mandates firms to develop wind-down plans, ensuring they can exit the market in an orderly manner without causing disruption—critical for maintaining market confidence and protecting clients’ interests.

Key Components

The ICARA process consists of five key components, each designed to ensure that investment firms operate with financial resilience and can navigate potential challenges effectively.

1. Risk Identification and Mitigation

At the heart of ICARA is the need for firms to identify and address risks that could impact their business, clients or the wider market. This involves a thorough assessment of financial, operational, market and conduct risks. Firms must anticipate threats such as market volatility, cyberattacks or regulatory breaches.

Example: A wealth management firm may identify a risk of client data breaches due to cyber threats. To mitigate this, it could implement enhanced cybersecurity measures, conduct regular audits, and train staff on data protection practices.

2. Capital and Liquidity Adequacy

Ensuring that firms have sufficient capital and liquidity to withstand potential financial shocks is crucial under ICARA. Firms must regularly assess their financial position to ensure they have enough resources to cover unexpected events, such as a sudden market downturn or an operational failure.

Example: An investment advisory firm might experience a sharp decline in fee income due to a prolonged bear market. To address this, it should maintain adequate liquidity buffers and diversify revenue streams to remain operational even under stressed conditions.

3. Stress Testing and Scenario Analysis

ICARA requires firms to undertake stress testing and scenario analysis to evaluate how adverse conditions could impact their operations. This involves modelling potential economic downturns, regulatory changes or operational disruptions to understand their financial and operational resilience.

Example: A brokerage firm could simulate a severe market crash to assess the impact on client trading volumes and operational costs. Based on the findings, the firm might develop a contingency plan to reduce discretionary spending and renegotiate supplier contracts.

4. Recovery Planning

If financial difficulties arise, firms must have a clear recovery plan to restore financial strength and continue operations. Recovery plans typically include actions such as raising additional capital, cutting non-essential costs, or restructuring business operations.

Example: A proprietary trading firm facing liquidity shortages might have a recovery plan that includes securing short-term credit facilities or selling non-core assets to stabilise its financial position.

5. Wind-down Planning

ICARA also mandates firms to prepare for an orderly wind-down in the event of business failure, ensuring minimal disruption to clients and the financial system. This involves planning for asset disposal, client fund transfers and regulatory notifications.

Example: An investment platform planning a wind-down would establish clear procedures for informing clients, returning funds and transferring operations to another provider to avoid market disruption.

These components work together to create a comprehensive risk management framework, enabling firms to operate with confidence and resilience in a dynamic financial environment.

Is ICARA Working?

Since its introduction in 2022, ICARA has brought a structured and proactive approach to risk management for investment firms, ensuring they have adequate financial resources and robust planning processes in place. Regulatory bodies such as the FCA have highlighted the framework’s positive impact in fostering greater financial resilience and enhancing firms’ preparedness for market disruptions. However, industry feedback suggests that compliance with ICARA can be resource-intensive, particularly for smaller firms struggling with the administrative burden and complexity of the process.

Looking ahead, ICARA is expected to evolve to address emerging risks, such as those posed by technological advancements and climate change. Regulators may refine the framework to make it more proportionate and adaptable, ensuring it remains relevant in an ever-changing financial landscape. Potential enhancements could include the integration of more dynamic stress testing approaches and greater alignment with global prudential standards.

ICARA clearly plays a vital role in maintaining the financial health of investment firms by promoting proactive risk management and resilience. While challenges remain, its long-term benefits in safeguarding firms and clients alike are undeniable. As the financial sector continues to evolve, so too will regulatory frameworks like ICARA, adapting to new risks and opportunities in the pursuit of market stability.

And what about you…?   

  • How well does your organisation currently assess and mitigate financial risks in line with ICARA’s requirements, and where do you see gaps in your approach?
  • In your opinion, does ICARA provide a practical and proportionate framework for investment firms, or do you believe further regulatory adjustments are needed to better suit your business model?