What your new regulator expects of you...
OnMonday 25 March, the FCA's Risk Outlook and Business Plan for 2013-14 were published. These documents are important for firms as, together, they provide an indication of where the FCA intends to focus its activities over the coming year.
The Risk Outlook addresses the drivers of conduct risk and identifies five priority risks for the FCA in achieving its consumer protection, market integrity and competition objectives. The Business Plan draws on the Risk Outlook, setting out the activities the FCA intends to take in 2013-14 to meet its objectives and how it plans to use its resources.
The Risk Outlook differs from previous years' Retail Conduct Risk Outlooks (RCRO) in four key areas: (i) it addresses wholesale conduct risks as well; (ii) it is more explicitly linked to the Business Plan and the FCA's objectives, informing the FCA's strategic priorities for the year ahead; (iii) the risks identified are more high-level and forward-looking in focus, with crystallised risks addressed in the Business Plan; and (iv) it sets out key messages for consumer bodies, as well as for firms. We anticipate that the FCA will build on this approach in subsequent years.
In general, the risks identified in the Risk Outlook are in line with previous Financial Services Authority (FSA) communications, with few surprises. However, the paper does highlight a new area of focus related to innovation and new market entrants. In addition to identifying complex products as a risk, the paper identifies a shift towards more innovative, complex or risky funding strategies or structures of firms coming to market, as posing a risk to market integrity and consumer protection. And while the document focuses predominantly on the implications of firms' actions, it also explicitly highlights the growing responsibility of consumers to manage their finances for current and long-term spending needs.
This briefing note will focus mainly on the Risk Outlook, referring to the Business Plan where it discusses specific conduct risks.
Drivers of conduct risk and the evolving risk landscape
Three main drivers of conduct risk have been identified: (i) inherent factors, such as information asymmetries, biases and inadequate financial capability; (ii) structures and behaviours, such as ineffective competition, culture and incentives, and conflicts of interest; and (iii) environmental factors, such as economic, regulatory and technological trends and changes. The paper identifies three broad implications arising from the risk drivers: (i) rising pressure on firms to adjust their strategic business models; (ii) failure to balance prudential soundness and profitability with good consumer outcomes; and (iii) misalignment of market performance expectations and underlying fundamentals. The FCA's Policy Risk and Research Division will continue to monitor and refresh its thinking and so we can expect further information over the coming year on how the FCA will prioritise its activities.
The five priority conduct risks
Page 58 of the Risk Outlook outlines the action the FCA will take in relation to its five priority risks in 2013-14.
- Firms do not design products and services that respond
to real consumer needs or are in consumers' long-term
interests
The FCA will focus on where products are unnecessarily complex, lead to excessive prices or reduced access and where there may be obstacles to consumers being able to exit a product or service.
The FCA intends to carry out thematic reviews in the following areas: product governance processes across retail and wholesale markets; strategies for mortgage arrears and forbearance management; and product design/charging structures in the asset management sector. The FCA also intends to develop its competition expertise, and will carry out market-level studies to analyse competition issues. - Distribution channels do not promote transparency for
consumers on financial products and services
The FCA will focus on transparency, culture and incentives, seeking to identify where firms may exploit information asymmetries or fail to manage conflicts of interest.
The FCA plans to follow up on its thematic reviews into financial incentive schemes and conflicts of interest in the asset management sector and will continue to take action following the Wheatley Review of LIBOR. It will review financial promotions across all sectors and will stand ready to use its new power to ban financial promotions, where appropriate. The FCA will investigate the transparency of custody banks' secondary services and review practices across the transition management industry. Retail Distribution Review (RDR) implementation will continue to be a focus, with the FCA conducting thematic reviews into the retail investment advice market. As part of its wholesale conduct strategy, the FCA will address culture, systems and controls that govern relationships in wholesale markets. - Over-reliance on, and inadequate oversight of, payment
and product technologies
The FCA recognises the risks that may result from poor oversight of technology or from consumers not being adequately informed about how to protect themselves from financial crime or use technology correctly.
The FCA intends to review the risks that price comparison websites present to consumers and their compliance with regulatory requirements. It will also undertake supervisory work to ensure that firms offering new and mobile payment methods are providing sufficient information to consumers. It will implement lessons learned from recent systems failure and undertake supervisory and analytical work to assess the resilience of market infrastructure and risks associated with trading strategies such as algorithmic or high-frequency trading. The Payment Services Directive (PSD) will also be a focus. - Shift towards more innovative, complex or risky funding
strategies or structures that lack adequate oversight, posing risks
to market integrity and consumer protection
Incumbent firms and new entrants may use increasingly innovative, complex and risky funding sources and structures. The FCA will focus on where these funding sources may prove to be unsustainable and may not be compatible with firms' existing governance and oversight arrangements, or expose firms to financial crime. They may also have implications for consumer protection if firms increasingly prioritise funding needs over consumer needs.
The FCA will consult on implementation of the revision to the Capital Requirements Directive (CRD IV), seeking to implement the changes in a proportionate and risk-based manner. - Poor understanding of risk and return, combined with
the search for yield or income, leads consumers to take on more
risk than is appropriate
The FCA recognises that consumers' search for yield may incentivise them to invest in higher yielding products that are inherently more risky or, as credit conditions remain tight, seek out alternative financial service providers or structures. The FCA will focus on low consumer awareness of risks associated with high-yielding products, consumer focus on brand and firms that provide inaccurate or misleading assessments of risk and return to consumers.
The FCA intends to publish results of its thematic review into interest-only mortgages. It will also undertake research and consumer engagement work to devise regulatory interventions and improve understanding of risk and return.
FCA Business Plan - key objectives and other areas of focus
Sections 2.2 to 2.4 of the Business Plan outline some of the key risks already under consideration by the FSA which the FCA will consider as it pursues its objectives, both in the UK and internationally. Many of these are areas on which the FSA has already started work e.g. implementation and review of the Mortgage Market Review (MMR), retail investment advice and the management of client assets in the context of the European Market Infrastructure Regulation (EMIR). In addition the plan provides, in section 2.5 of the Business Plan, a clear view of the supervisory framework which firms can expect to see over the next year.
Other areas of interest include:
- Implementation of the revision of the Markets in Financial Instruments Directive (MIFID II);
- Revisions to UCITS (Directive on Undertakings for Collective Investment in Transferable Securities);
- Research to be commissioned, including on the asset management sector and add-on services in the general insurance market; and
- Work on EU policy initiatives around transparency of fee structures and charges related to bank accounts and current account switching.
The FCA plans to spend £445.7m in 2013-14, with fees payable of £391.5m. Total FCA headcount will be 2,848 (FTE), with just under a quarter of its headcount focused on Supervision and Supervisory Oversight and, overall, 70% of its headcount allocated to front-line divisions.
What should firms be doing?
The Risk Outlook sets out high-level messages to firms and consumer bodies. In light of the conduct risks identified in the report, the supervisor asks that firms assess their business model, strategy and structure, to ensure that that they are putting the consumer and the integrity of markets at the heart of what they do. Firms should ensure that they have a culture that promotes sound conduct outcomes; establish appropriate oversight and governance around the design and innovation of products and services; ensure transparency with consumers; and promote consumer confidence by taking an active role in maintaining the integrity of the financial markets.
Firms may also wish to use the conduct risks identified in the Risk Outlook to shape, inform and influence their conduct risk appetite as well as their oversight activity during 2013-14 to ensure that they are proactively mitigating the relevant risks identified by the FCA within their businesses.
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.