Who We Are
Capital Adequacy
Background
Regulation
The Basel 2 Accord requires any firm covered by the 2006 Capital Requirements Directive of the EU to make public isclosures about their risks and risk management processes, the intention being to help ‘stakeholders’ make economic decisions in respect of the firm. This disclosure requirement is called Pillar 3. Pillar 1 is a set of regulations for determining minimum capital to be held by the firm. Pillar 2 is a management process for determining whether the firm’s specific risks call for additional capital to be held.
Who it should interest and why
Fowler Drew is affected by the regulations because it is a discretionary investment management firm as well as a financial adviser. Most of the Basel 2 capital adequacy regime is designed to be applicable to banks, whose stakeholders include depositors and market counterparties as well as shareholders. Our interested stakeholders are primarily our clients.
Our disclosures have been written to address the particular importance to its clients of business risk in a firm of our nature. Because we are not authorised to hold client money, the risks in our business that impact on clients are mainly related to:
- continuity of the business (since most clients appoint us to provide continuing long-term services)
- disputes involving financial compensation
Clients’ first line of defence in the event of a dispute is our Professional Indemnity Insurance cover of £1.3m per claim. The capital we hold under Basel 2 rules therefore serves to prevent risks not covered by insurance from causing the firm to become insolvent or cease voluntarily to trade. In the nature of our business, ceasing voluntarily to trade should not cause actual financial loss to clients, although there may be frictional costs associated with them changing manager or adviser.
Scope
The scope of the disclosures is intended to ensure stakeholders can assess the risks a firm’s capital is exposed to and the firm’s processes for managing those risks. The disclosures have to be reviewed at least annually. These are as at the company’s latest year end, 31st March 2011.
A firm is not required to make disclosures if they are either immaterial or proprietary and confidential.
Pillars 1 and 2
We have assessed the probability-weighted risks under our Pillar 2 stress tests as not requiring any additional capital to our Pillar 1 capital requirement. In our case, the latter is determined as a proportion of our fixed costs, being those that are not contingent on revenues or are contractual in nature.
Our Pillar 1 capital requirement is entirely met by Tier 1 capital (equity and reserves) of £92,382.
Equity capital to finance expansion, in addition to retained earnings, has been provided by the firm’s sole shareholder, Stuart Fowler.
Pillar 3 Disclosures
Liquidity
We hold most of our regulatory capital in liquid form, as cash accounts or debtors. Debtor finance reflects at most quarterly billing frequency.
External working capital needs, whether caused by poor cash flows or decisions about physical expansion, are likely to be met by additions to equity.
Credit risk
This mainly relates to fees due from clients which are paid against invoices, at either monthly or quarterly frequency. Approximately 60% are billed to clients’ pension providers.
Large exposures to debtors, as defined by the FSA, require additional capital provision. We have no large exposures.
We have had no unrecovered debtors to date and a low level of overdue payments at any time. Our clients have a high net worth and we do not expect to encounter problems in the future.
Where commissions are paid by product providers we credit these to clients’ accounts so we have no credit risk exposure to the industry. We take no commissions on an ‘indemnity’ basis so have no liability to providers arising on past business.
Market risk
By charging flat fees we ensure our revenues are not sensitive to the volatility and cyclicality of financial assets.
Client retention rates in investment management are typically sensitive to any mismatch between clients’ expectations about market risk on their portfolios and actual outcomes. Our investment approach, which is heavily reliant on modelling market risk, quantifying it and communicating it regularly, helps to minimise this risk.
Interest rate risk
We have no borrowings. Interest earned fluctuates but is not material to our profitability.
Business risk
As a young business we have experienced high physical rates of growth in client numbers and revenues but this organic growth has not significantly reflected external economic conditions.
Economic conditions affect our clients’ level of wealth but difficult conditions have in the past had the effect of increasing the value of and demand for our services.
The normal link between economic conditions and market risk does not affect our revenues because we charge flat fees.
The main focus of our efforts to secure high rates of retention of existing clients is a high-level of service and good, frequent financial reporting. Our emphasis on goal-focused planning as the basis of most portfolios probably also increases clients’ expectations about the durability of the relationship.
The majority of our income is recurring income from portfolio fees. We rely on consulting and financial review fees for part of our income but this is diminishing steadily as the client base grows.
Operational risk
Both profitability and reputation in an investment business are significantly dependent on the actions and omissions of staff. We manage these risks through a combination of staff operating procedures and IT systems.
There has been a gradual increase in the dependence on customised database-resident systems to perform or monitor processes previously reliant on manual procedures and spreadsheets. This will accelerate as our systems project develops further.
These systems are provided on an arms-length basis under license by a company in which Stuart Fowler is a shareholder, Lambda Investment Technology. Lambda also provides under license the investment modelling capability used in the firm’s investment process.
Human processes will remain a significant source of risk which we see as mainly taking one of two forms:
- bad advice
- dealing errors
As an operational risk, bad advice crystallises as client loss and a possible upheld compensation claim. Compensation is likely to be covered by our Professional Indemnity Insurance unless caused by gross negligence. The best protection against gross negligence is rigorous procedures, rigorously monitored. The quality of our advice is the primary focus of the business and reflects the origins of the firm in seeking to meet customer needs created by weaknesses in the skills and techniques typically applied in retail investment advice and portfolio management.
Our commitment to providing clear and complete information to clients, both to encourage personal responsibility generally and to support specific decision making, is integral to our business format. Providing and recording it make for a strong basis for avoiding misunderstandings and disputes.
The chance of giving bad advice is minimised by ensuring only highly-qualified senior consultants give advice and by a team approach to client relationships, with a small number of clients relative to the size of the team.
Charging flat fees makes us indifferent to the risk levels or other preferences the client decides. This removes a common source of complaint where a firm’s profitability is impacted by the level of the client’s exposure to risks.
We have never had a complaint made against us.
Dealing errors are minimised by using multiple platforms, not grouping client orders and close monitoring, via both manual and systems-based procedures. Fast action in identifying and reversing errors is critical to minimising the size of losses. Errors to date have been insignificant in number and size and affected clients have been fully recompensed at our initiative (without insurance claim).
The overall approach to operating procedures is determined by the Board, delegated to functional staff to implement and monitored by an operations director. For many of the procedures, an overriding responsibility is assigned by the FSA to the firm’s compliance officer.
Our focus on operational procedures goes beyond compliance and risk mitigation to developing a highly systematic business format that could, effectively, be franchised. Apart from meeting a strategic growth objective, the Board sees a franchise model as helping to ensure every facet of the firm’s activities is forced to be consistent with the Fowler Drew brand values.
Pillar 2 stress tests
In determining whether we needed to hold additional capital to our Pillar 1 requirement, we are required to perform stress tests for the business. To be most informative for both clients and shareholders we decided to consider those with a very low probability of arising within a single brief period. This is more rigorous than the regulations require, as it does not benefit from probability weighting.
The extreme scenarios we considered were:
- A single large negligence claim not covered by insurance
- A cluster of dealing errors covered by PII but with excesses on each claim
- Death or incapacity of founder
We quantified the overall risk on the basis each was independent and two would not arise together. The largest financial impact (from 2) was comfortably within our Pillar 1 capital.
Disclosure date
These disclosures were last updated in November 2011.
