In the ever-evolving landscape of financial regulations, the European Parliament introduced a new regulatory framework for investment firms, consisting of the Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR). The IFD and IFR came into effect on June 26, 2021, at the EU-wide level, triggering subsequent transpositions into national laws.

In the wake of this new prudential regulatory framework, investment firms face a pivotal transition. They are mandated to retire their existing Internal Capital Adequacy Assessment Process (ICAAP) and adopt the new Internal Capital Adequacy and Risk Assessment (ICARA) process. The ICARA journey necessitates the development of fresh assessments regarding liquidity adequacy, the formulation of updated financial projections and stress tests to align with the new K-Factors requirement, and the creation of comprehensive reports that fully adhere to the new regulatory provisions.

As per Law 165(I)/2021, investment firms must establish robust, effective, and all-encompassing arrangements, strategies, and processes to consistently evaluate and maintain the requisite amount, types, and distribution of internal capital and liquid assets. These resources must be deemed adequate to cover the nature and extent of risks that may pose a threat to others and to which the investment firms are exposed or may potentially be exposed. These arrangements, strategies, and processes must be suitable and proportionate in relation to the nature, scale, and complexity of the investment firm’s activities, and they should undergo regular internal reviews.

The ICARA process comprises two pivotal components: the Liquidity Adequacy Assessment and the Contingent Funding Plan. Within this process, the Internal Liquidity Adequacy Assessment Process (ILAAP) and its associated facets, encompassing a detailed analysis of liquidity risks relevant to the firm and liquidity stress testing, play a crucial role. The ILAAP requirement is conceptually akin to the ICAAP and the ILAAP mandated by the CRR/CRD framework.

Furthermore, the ICARA process encompasses a wide range of activities, including business model assessment, forecasting, stress testing, recovery planning, wind-down planning, and the novel concept of calculating additional capital and liquidity requirements (thresholds). It delves deep into the firm’s exposure to various risks and assesses its ability to mitigate these risks through policies and risk management tools.

ICARA serves as the cornerstone of an investment firm’s operations, comprising the following elements:

  1. The Corporate Governance Framework, which encompasses the Board of Directors, Senior Management, and a clearly defined and updated organizational structure.
  2. Internal Control systems.
  3. Risk Management systems.
  4. The formulation of the financial budget and corporate strategy, ensuring alignment with the available capital and risk exposure.

ICARA represents the nucleus of a company’s risk management practices, forming a continuous process through which firms:

  • Identify and Monitor Harms: By implementing systems and controls, firms diligently identify and monitor all material potential harm.
  • Undertake Harm Mitigation: Appropriate financial and non-financial mitigants are put in place to minimize the likelihood of harm crystallization and its potential impact.
  • Undertake Business Model Assessment, Planning, and Forecasting: This involves forecasting capital and liquidity needs, both on an ongoing basis and in the event of a wind-down, encompassing both expected and stressed scenarios.
  • Undertake Recovery Action Planning: Firms determine credible recovery actions to reinstate their own funds or liquid resources in case there’s a risk of breaching threshold requirements.
  • Undertake Wind-Down Planning: Firms meticulously outline credible wind-down plans at the entity level, specifying timelines for the execution of these plans.
  • Assess the Adequacy of Own Funds and Liquidity Requirements: If risks remain inadequately mitigated through systems and controls, investment firms assess the need for additional own funds and liquid assets to cover potential risks.

The ICARA process is a multifaceted and dynamic framework that empowers investment firms to navigate the complex regulatory landscape. It serves as a critical tool for assessing, managing, and mitigating risks, thereby ensuring the stability and resilience of investment firms in an ever-changing financial environment. As the investment landscape continues to evolve, staying abreast of regulatory changes and adhering to the principles of ICARA is paramount to success in this highly regulated sector.