The Financial Conduct Authority’s approach to Regulation

04/07/2011

This paper goes some way towards providing the market with a fuller view of the FCA’s priorities and methods of operation, although it goes little further than what the Government announced in its February paper A New Approach to Financial Regulation.

The FCA will adopt a different tone.

The FCA will develop a new culture. It will adopt a proactive ‘can do’ approach. Having the right powers is crucial for a regulator but perhaps of even greater importance is having a cultural disposition to act and be bold in the use of its powers. (Speech by Margaret Cole 28th June 2011)

What’s new?

The Approach to Regulation sets out four new powers or approaches, although only the fourth is truly new.

  1. The FCA will provide a “new approach to conduct regulation”, although much of what the FCA will do is little different from FSA’s more focused approach adopted during the past three years. Larger firms, and especially banks and insurers, will already be familiar with the more judgemental and interventionist style promised for FCA.
  2. The Government intends that the FCA will have new powers in three areas – product intervention, to amend orwithdraw a misleading financial promotion, and to publicise the issue of a disciplinary Warning Notice. FSA already possesses the first two powers, and has exercised them on a number of occasions; what is significant is that the FCA is being given them as featured powers, which gives off a clear signal that they will be used more often. The power relating to publishing Warning Notices is discussed further on.
  3. The FCA will adopt a “more issues- and sector-based” supervisory approach. This makes sense – the only way that the FCA can maintain grip on the disparate group of 27,000 firms that it regulates is periodically to select an issue or a group of firms of varying sizes and dive into the detail. Even so, it sounds much the same as FSA’s current “thematic” approach which, looking over the past year into client money, with-profits governance and sale of structured products, has resulted in significant enforcement action across a wide range of firms.
  4. The focus on promoting efficiency, choice and competition is significant and is likely to be used by the FCA to seek to reshape aspects of the retail market in particular.

What will the FCA do?

The FCA will have a single strategic objective of protecting and enhancing confidence in the UK financial system plus three operational objectives:


- Securing an appropriate degree of consumer protection

- Promoting efficiency and choice. It must also discharge its general functions of determining policy and making rules so as to promote competition

- Protecting and enhancing the integrity of the UK financial system.

Within these objectives it has the functions, currently discharged by the FSA, of regulating market conduct as well as exchange infrastructure and seeking to minimise the extent that a regulated firm can be used in connection with financial crime. In these areas the FCA is likely to build upon the sound progress already made by FSA in combating market abuse and money laundering.


Most of the FSA’s rules are derived from EU Directives, notably MiFID, and this will be unchanged for the FCA which will remain principally an implementer of EU policy rather than a maker of its own policy. Nonetheless, the FCA will retain some autonomy in determining its policy for authorisation, supervision and enforcement. These are the key interactions of a regulatory relationship and FCA will therefore be able to achieve its objectives through setting a distinctive approach in each of these areas.

How will firms interact with the FCA?

There are three aspects to this.

- For the great majority of firms for whom the FCA will be the prudential and conduct regulator, the authorisations and approvals process will remain similar to present FSA procedures, although some developments are likely. In particular, one assessment criterion for approving a firm’s application for authorisation will be how this would affect competition in the market.

- For a bank or an insurer regulated by both the FCA and the PRA, the effective coordination of regulatory functions will be key. In addition to a weakly-worded statutory duty to coordinate contained in the draft Bill, the paper refers to operational arrangements for coordinating regulatory processes and for consolidated supervision. These are areas that the market will insist are fully developed in order to ensure that the new regulation is seamless and effective. A “clunky”, maladroit or badly coordinated regulatory regime will damage the reputation of the UK as a sound regulatory environment as well as damaging firms and their customers. The steps that are proposed include:

What is the FCA’s supervisory approach?

The supervisory model requires a new supervisory assessment framework to replace ARROW. This will include both firm-based assessments and comprehensive market, sectoral and product chain analysis. Central to its design however, will be simplicity and a recognition that the approach must be understandable not just to regulatory specialists but to boards as a whole. (Speech by Hector Sants 29th June 2011)

There will be two distinct elements to this. First, at a macro level, the FCA will perform detailed business and market analysis to understand the way that the market or a segment of it is working. The FCA promises a rigorous analysis of how consumers make decisions and how firms compete. It will then diagnose any problem, design and implement the remedy using a risk framework driven by impact and severity and review the result of its work, performing further diagnosis as needed.

The FCA will be forward-looking and preventative; it will move to a more forward-looking assessment of potential detriment to identify problems that need to be tackled. It will design an approach that includes enhanced sector and cross-sector analysis which, combined with firm-specific and thematic work, will help diagnose and treat the root causes of problems, rather than just the symptoms. (Speech by Margaret Cole 28th June 2011)

At a micro, or firm-specific level, firms – especially large and mass-market retail firms – will experience a regulator with lower risk tolerance than the FSA and which has a more intensive supervisory style and a greater willingness to intervene. Elements of this will probably include:

- Increased regulatory contact for all firms, with a reduction in relationship management for mid-sized firms and a concentration of resources on the largest firms

- More forward-looking assessment of potential detriment, with the FCA heading it off before it materialises

- Earlier intervention in the development of new products and distribution paths, with the FCA assessing potential change from a risk perspective

- A more interventionist approach to securing redress than firms currently experience with the FSA

- A focus on culture as a driver of a firm’s conduct, building on FSA’s recent statements on this topic

- And possibly an expectation that instigating disciplinary action where there is material consumer detriment, weak systems or consumers have been exposed to risk will be the norm rather than, as now, the exception.

What will “promoting efficiency and choice” mean?

The paper states that choice and efficiency in financial services markets are often sub-optimal, and that the FCA will focus on market power and seek to promote competitive markets. Where consumers cannot exercise informed choice, the FCA may intervene to promote choice.


The FSA has already shown willing to remodel the marketplace with campaigns such as its Retail Distribution Review and, to a lesser extent, the Mortgage Market Review. The FCA can now go further because, although it has no new competition powers, it has been given a mandate to promote competition. Some of the examples given in the paper, such as helping consumers to make better decisions by requiring the provision of information, are familiar. Other possible applications of this power would be new. The applications suggested in the paper are given in bold; while the example appended to each is
conjectural, it does show how widely the FCA could interpret this power.

- Reducing market power. The FCA could refuse an existing supplier’s plans for acquisition, expansion or new products where it held a dominant position.

- Reducing barriers to entry or exit. The FCA could decide to offer a fast and simplified approvals process for certain firms.

- Introducing stronger competition. The FCA could choose to favour a new market entrant over an existing firm’s plans for expansion.

- Reviewing prices and margins in determining if consumers are being fairly treated. Where the FCA considered that a product was poor value for money, it could require charges to be changed or consumers refunded excess charges.

How will things differ for firms?

General stance


The FCA will take a “differentiated and proportionate approach” to consumer protection so that, as now, a mass-market retail firm will experience the full weight of the FCA’s concerns. It will also engage more with consumers. While the earlier tag of “consumer champion” has been withdrawn, the message remains clear that the FCA will be a regulator focused on combating what is termed “adverse consumer outcomes”.


Intervention

The FCA will be prepared to step in early to prevent consumer detriment. This might mean using its powers to ban products before they reach the market or it might mean banning a firm from selling a widely accepted product if its sales processes are unacceptable. (Speech by Margaret Cole 28th June 2011)

The FCA will be prepared to intervene earlier to tackle risks, especially emerging or potential risks, where it believes that the market for a product or a service is “not operating in the interests of retail customers or the wider economy”. This is a wide, quasi-economic, brief that will enable the FCA to intervene in many situations – in the words of the paper, “successful FCA interventions will necessarily depend on changing the way financial services markets work”.

Possible examples of the exercise of this approach include the following:

- The FCA may examine a firm’s business model and require alterations where it foresees a risk of consumer detriment.

- The FCA may determine that a current widely-sold add-on product – PPI sold on the back of credit cards would be an example – is not in customers’ best interests and require firms to halt sales and recompense customers.

- The FCA may review plans for a new mass-market retail product and, where it has concerns, require that the product launch be halted until changes are made or a different distribution model is adopted.

- The FCA may require a firm to adopt new systems or strengthen its controls where it considers that they are – or may be – inadequate to enable it to identify and manage risks.

- The FCA may review a firm’s retail complaint handling processes and conclude that the fault lies earlier in the chain – root cause analysis – with poor product design generating significant complaints, and require the firm to withdraw the product and offer recompense to purchasers whether or not they have complained.

- The FCA may require a firm to halt all selling activities while undertaking a past business review, rather than allow it to revise its procedures and continue sales.

Each of these examples is, in fact, based on the FSA’s current approach, which illustrates the element of continuity that firms are likely to experience. However, the difference is that the FCA may be prepared to intervene even sooner and on more conjectural grounds than the FSA does at present.


Enforcement

The FCA will be “tougher and bolder” in taking enforcement action, building on FSA’s policy of credible deterrence, and the paper refers to the likelihood of more enforcement cases being brought. Anyone familiar with FSA’s current tough and bold approach to enforcement will recognise this as a further step-change, presaging disciplinary action against both firms and individuals that is more frequent, seeks higher penalties, and – most significantly – is more driven to provide graphic illustrations of failing and punishment to further FCA’s objectives.


Allied to this is the proposal to enable the FCA to announce the fact that it has issued a Warning Notice against a firm or an individual. This is grossly unfair, especially to an individual who is likely to find his or her position within a firm made impossible once the FCA has announced that it is taking disciplinary action against them for alleged misconduct.


Redress

The FCA will be given new powers to require firms to redress affected consumers, although in practice these may only be needed when, exceptionally, a firm’s management is unwilling to compensate on its own initiative.


Senior management responsibility


One of the six regulatory principles to which the FCA must “have regard” is that a firm’s senior management is responsible for his or her firm’s compliance with regulatory requirements. This is a sharpening of the current “principle of good regulation” to which the FSA is subject, and makes it clear that the FCA will go further that the FSA in identifying where a senior manager has responsibility for his or her firm’s failings and in taking individual disciplinary action.


Transparency


The fifth and sixth regulatory principles require the FCA to act openly and transparently. Building on past FSA campaigns for transparency, this is likely to result in the FCA making public additional information about the firms that it regulates, and its dealings with them, or requiring them to publish this information themselves. This is currently happening with complaints data, and may well extend to cover significantly wider areas such as costs and charges, performance and persistency.


Prudential supervision

The FCA will be the prudential supervisor of some 24,500 firms. The FCA’s approach for most of them will be on a “gone concern” basis, in other words ensuring that they have sufficient capital resources and adequate segregation of any client assets held to be wound down in an orderly manner with support from the Compensation Scheme as needed. For firms whose collapse could affect the orderly operation of the market, such as a substantial long-only or alternative asset manager, the FCA will take a more intrusive approach, seeking to ensure that the firm is viable on a “going concern” basis. This will entail reviewing the strength and stress testing of its business model and its finances, and possibly requiring it to have a concrete plan for an orderly wind-down if required.

As regulator of wholesale conduct


The FCA will put greater emphasis on wholesale conduct, including in banking and wholesale insurance, investigating whether they have the potential to damage consumer interests and the wider economy. It will in particular consider the linkages across the value chain where risks are transmitted between wholesale and retail consumers. Possible examples of this might include:

- The production of derivative instruments for incorporation into retail products so that they can offer a guarantee;

- The purchase of interest rate hedges to allow the sale of fixed rate retail products; and

- The use of wholesale market instruments to provide retail products linked to an index.