UK: FSA Business Plan and Risk Outlooks 2011/12

Last Updated: 13 April 2011
Article by Chris Brennan, Dianne Bell and Stuart Maleno

Last month, the Financial Services Authority (FSA) published its Business Plan 2011/12, Retail Conduct Risk Outlook 2011 and Prudential Risk Outlook 2011.

The two risk outlook documents together previously formed the FSA's Financial Risk Outlook. The FSA has split the old Financial Risk Outlook into two parts to reflect the structural changes that are to be made to the UK's financial supervision system during 2012. The Retail Conduct Risk Outlook focuses on risks created by firms' conduct and which may impact upon consumer protection. The production of this document will in future fall under the ambit of the Financial Conduct Authority. The Prudential Risk Outlook addresses financial and macro-economic trends. It will in future form part of the Bank of England's Financial Stability Report. Finally, the Business Plan sets out how the FSA intends to address the risks it has identified.

The Retail Conduct Risk Outlook

The Retail Conduct Risk Outlook (RCRO) is a key component in the FSA's stated strategy of identifying risks to consumers earlier and also intervening earlier in the product chain.

The RCRO will be used to inform the FSA's retail supervisory focus and it acts as a useful routemap for firms when assessing which risks they are most likely to be exposed to.

The RCRO divides risks into three categories:

  • "current issues" – risks that are already apparent from the poor conduct of firms and which may have already resulted in consumer detriment;
  • "emerging risks" – risks in relation to which there is evidence of poor firm conduct, but little or no evidence of widespread consumer detriment as a result of such conduct, although such detriment may arise in the future; and
  • "potential concerns" – risks that may arise in the future.

Clearly, current issues are of interest to firms, although firms should already be aware of these issues. The area that should be of most interest to firms when considering the detail of the RCRO is "emerging risks". The RCRO explains that these risks will and already do require attention from firms and supervisors. Consequently, firms should be on notice as to which areas the FSA is likely to focus on and the message from the FSA is that firms should be proactive in addressing those issues before they escalate into greater concerns.

Although the RCRO is a lengthy document, firms should devote time to considering its contents properly in order to anticipate where their potential exposure rests before the FSA identifies it through one of its supervisory tools. A few examples of areas that the FSA identifies as emerging risks are:

  • implementation of the Retail Distribution Review;
  • remuneration; and
  • product innovation in respect of Traded Life Policy Investments and SIPPs.

The Prudential Risk Outlook

As mentioned above, under the new structure that will soon be in place, the Prudential Risk Outlook (PRO) will in future form part of the Bank of England's Financial Stability Report, so this is a one-off publication. Two of the FSA's statutory objectives (maintaining confidence in the UK financial system, and the protection/enhancement of its stability) are primarily met through micro-prudential regulation and supervision activities. The PRO provides the FSA with an understanding of the overall macroeconomic and financial trends so that it can place its work towards these statutory objectives in context.

The PRO 2011, in general, reaches the conclusion that UK banks' capital and liquidity positions have improved, which has increased their ability to handle surprises. However, there remain risks to financial stability, the most important of which are divided into four areas:

  • The macroeconomic context – this section sets out the FSA's base economic outlook and some alternative scenarios that firms should be considering when assessing potential risks. There are various important messages for firms, an example of which is that when conducting stress tests, firms should prepare for a range of more adverse macroeconomic scenarios (for example, those in section A of the PRO).
  • The UK financial sector – this section considers risks applicable to banks and also risks specific to insurers. One of the messages to banks is that they should continue to dispose of non-core, risky assets as and when market conditions allow. As regards the FSA's messages to insurers, these include highlighting the importance of operating robust strategic planning and having in place appropriate risk management processes to allow firms to react to change. Insurers are also warned that prospective lower investment returns in the current low interest rate environment increase the need for prudent underwriting and reserving. Insurers also need to continue to prepare for the implementation of Solvency II. Of interest to both banks and insurers are the FSA's comments in respect of the risk transfer between banks, insurers and the shadow banking system. The FSA highlights that a key question in this area is to what extent other parts of the financial system (besides banks) take on risks that are transferred away from banks by regulators in the latter's attempts to control risk-taking. In answering this question, the FSA considers that some of the areas to monitor are UK insurance companies, shadow banking (defined as the sub-set of non-bank credit intermediation) and hedge funds.
  • Credit risks – this section focuses on asset quality being a driver for financial stability.
  • The low interest rate environment – this section considers the risks created by a low interest rate environment, as well as those that will be created when the interest rate environment returns to more normal levels.

Regulated firms need to take account of the context set out in the PRO when conducting their own assessment and management of risks. The FSA will be using the macroeconomic parameters in this report when conducting its supervisory stress tests of major banks during 2011.

The Business Plan

Overall, the FSA's Business Plan does not introduce anything new to what the FSA has said and done over the last year. It does, however, reinforce certain important messages. One of these is that the FSA intends to continue with its more aggressive and intrusive supervision style, even with the change of regulatory structure.

Consumer protection

The FSA will therefore, continue with its consumer protection strategy, intervening earlier in the product life cycle and anticipating (and preventing) consumer detriment. The clear position set out in the Business Plan regarding product intervention is that the FSA plans "to pay more attention to products and product design controls at firms".

Two important initiatives in the consumer protection strategy are the Retail Distribution Review (RDR) and the Mortgage Market Review (MMR).

The RDR is on track to introduce the principal changes to adviser remuneration commission structure and training and qualifications from 1 January 2013. The FSA is continuing to work with firms in ensuring that the changes occur smoothly and in particular will continue to assist in firms' developing of a simplified advice service.

In respect of the MMR, the FSA will this summer publish an indicative cost benefit and impact analysis of a full package of proposed rules. This will be followed in early 2012 by the publication of the FSA's final package of rule changes.

The FSA will also continue to tackle boiler room fraud, which is said to cost UK consumers approximately £200 million a year.

Financial crime

Beyond consumer protection, another area that is likely to come under heavy scrutiny from the FSA is the use of the financial services industry to commit financial crime. One way in which the FSA will look to combat this is by continuing its credible deterrence strategy, in particular to ensure that firms improve and maintain their systems and controls – an area in which several fines were levied against firms last year.

European regulatory reform

The FSA has also stated that it will continue to influence the international and European regulatory agenda. The increased role of the European supervisory authorities (the European Banking Authority, the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority) effectively means that regulatory rules will be largely developed at European level. Therefore, the FSA sees as a key priority influencing such rule development and working with the European bodies to ensure that their policy initiatives are aligned with those of the FSA.

Immediate on the FSA's agenda for influencing European regulatory reform in 2011/12, is working with ESMA in three core areas:

  • reforming the over-the-counter (OTC) derivatives market;
  • the MiFID review; and
  • the regulation of commodity derivatives markets.

The legislation the FSA is working on in these areas has the potential, the FSA states, to change the structure of many markets, both in terms of the way trade occurs and in the way the markets are managed.

Also on the European front during the coming year, is the continued implementation of the major European policy initiatives. In particular, this will see the translation into law of the Basel III agreements and the resolution of the remaining issues on Solvency II.

One of the main messages the FSA makes in the Business Plan is that it will continue to improve on its own strengths and systems through its intensive supervision and credible deterrence culture. The FSA is looking to develop its internal operating systems to improve its market surveillance and supervisory analysis. It will also be reviewing its data management and risk management frameworks. There will be, therefore, no letting up by the FSA.

The new UK financial services regulatory structure

All of the above is set against the coming changes to the regulatory structure in the UK. The FSA will commence the process of this change during the coming year. Part of this move can be seen in the division of the old Financial Risk Outlook into two separate documents that reflect the division of responsibilities under the new structure. The next stage effectively starts in April when a move to a new management structure takes place, with the current Risk and Supervision Business Units to be replaced by the Prudential Business Unit and Conduct Business Unit. This is designed to reflect the future structure. The FSA will also be "road testing" certain elements of regulation in a more "twin peaks" style. Again, this is in preparation for how the new structure will operate.

Actions for firms

Although the Risk Outlook and Business Plan documents do not require immediate action from firms, they do require important consideration now and going forward into 2012. The documents identify the areas that the FSA considers a risk and how it will go about the process of addressing those risks. To this end, Appendix 5 of the Business Plan sets out the FSA's milestones for the year into six areas:

  • Delivering regulatory reform – preparing for the new firm-specific financial regulation regime in the UK.
  • Delivering financial stability – contributing to the protection and enhancement of the stability of the financial system.
  • Delivering market confidence – maintaining confidence in financial markets.
  • Delivering consumer protection – securing the appropriate degree of protection for consumers.
  • Delivering a reduction of financial crime – reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime.
  • Delivering the FSA's operational platform.

Firms should identify those risks that apply – and those that may apply – to its business and ensure that it is addressing those issues in a manner that the FSA would expect. Be ready to document and defend your assessment of any relevant situation as well as your decision-making. Although the FSA has stated that it is not planning any major new initiatives over the next year, it is clear that it intends to continue its more aggressive enforcement of current initiatives and risks.

Taking the example of product design risks, the FSA opened debate on this subject with its Discussion Paper in January 2011. In the Business Plan, the FSA indicates it is not only prepared to use its existing powers to prevent detriment, but that it is also looking to take action before there is widescale detriment. "This requires us to make judgements about potential outcomes and to take action on the basis of these judgments. It may result in more challenges to our actions ..." This demonstrates that the FSA seems inclined to start experimenting with the various statutory powers it has at its disposal, and is prepared to stand up to challenge in doing so.

So by ignoring the signposts set out in the FSA's Risk Outlooks and Business Plan, firms run the risk of leaving themselves open to FSA action.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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