Friends or Foes?

From conflict to collaboration in UK financial services regulation

Originally published in the February | March 2015 issue

I am delighted to introduce BDO’s expert analysis of our research which gauges industry reactions to the dual activities of the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA). Covering over 250 senior risk and compliance professionals from banking and lending, investment banking, investment management, insurance and retail intermediaries, our survey provides authentic insight on reactions to the regulatory agenda.

The findings highlight some positive feedback, but also raise questions and emphasise areas of concern. These include frustration or confusion within the industry in relation to the pace of change and a lack of clarity regarding the regulators’ priorities.

Another key finding is the feeling of a power struggle between UK and EU regulators, and the effect this is having on perception of the UK as
a global financial centre. The new College of European Commissioners has now taken up office and the portfolio of financial stability, financial services and capital markets union has been allocated to Briton, Lord Jonathan Hill. He has been tasked by the Commission President, Jean Claude Juncker, with bringing about a well-regulated and integrated capital markets union (CMU) encompassing all EU Member States by 2019. It will be interesting to see whether any proposals he brings forward, with CMU in mind, contribute further to or lessen the tensions between the UK and EU especially in this regulatory sphere.

Our report provides food for thought on the complex challenges and opportunities now
facing the financial services industry in the UK and beyond. The findings are timely and offer a
sound contribution to the ongoing debate.

Noel Clehane
Global head of regulatory and public policy affairs
BDO International Executive Office, Brussels


A core purpose of regulation is to set down laws and rules that will achieve consistency in standards and quality. But does that inevitably mean it hinders change? When the FCA and PRA were set up in 2013 their objectives were stated as follows:

Strategic objectives:
• To ensure that the relevant markets function well.
• To support this, three operational objectives:
   – To secure an appropriate degree of protection for consumers.
   – To protect and enhance the integrity of the UK financial system.
   – To promote effective competition in the interests of consumers.

Two statutory objectives
• To promote the safety and soundness of firms.
• Specifically for insurers, to contribute to the securing of an appropriate degree of protection for policyholders.

And: Supporting the Bank of England’s core purpose of protecting and enhancing the stability of the UK financial system.

All of these are important aims, but the huge scale of the resulting remits must be acknowledged. Is it realistic to believe that even with two regulators all of these objectives will be met? By speaking torisk and compliance professionals across the industry our survey has shone a light on how the regulators are faring in achieving these objectives so far and how the industry feels about their methods.

The findings have been very much in line with what we have been seeing in our work with clients and the regulators. Overall, respondents said that the dual regulatory structure has been a positive change, but when looking at specific areas of regulation a more complex picture developed.

Three core themes have emerged:

• The conflict between regulation and competition.
• Concerns regarding the regulators’ commercial understanding of the industry, and therefore frustration at what some feel can be a “one size fits all” approach.
• Fears that the dual impact of UK and EU regulation is harming the desirability of London as a global financial hub.

Looking at the first point, it is a reality that there will always be conflict between regulation and competition. After all, a core purpose of regulation is to set down laws and rules that will achieve consistency in standards and quality, which can hinder the ability to change and deliver innovation. So, there is a fundamental question around whether the FCA should be charged with promoting effective competition in the industry.

Moving on to the concerns regarding the regulators’ commercial understanding of financial services, only half of the respondents in our survey said the regulators have sufficiently deep knowledge across the industry.

The industry has changed significantly since the financial crisis, with numerous new entrants and the advent and development of new business models such as peer-to-peer lending and crowd funding. The regulators have an enormous task on their hands to cover this complexity and achieve all-encompassing knowledge.

On the challenge of UK and EU regulatory demands, it is certainly true that UK financial services firms are faced with a double impact that may make other global locations seem more attractive. The UK financial services market doesn’t believe it has control over its own regulation, and therefore most are considering the merits of operating elsewhere. The challenge is whether the government, regulators, lobby groups and market participants can turn this around.

In our experience of working across the financial services spectrum, we have seen first-hand the huge change in requirements the regulatory agenda has necessitated and the resulting burden placed on those tasked with managing compliance, wider risk and governance for their organisations. However, through our experience of working with the regulators, we also recognise the phenomenal scope of what the regulators have been charged with achieving.

The industry has a responsibility to work with the regulators to facilitate better understanding of their operational realities and commercial pressures. The implementation of a completely new regime was always going to bring some tensions and transitional pain, but from now on the onus is on both sides to build greater engagement and nurture a productive two-way dialogue that cements the UK’s position on the global financial stage.

It continues to be crucial that regulators understand the numerous operational challenges that exist throughout distribution chains across wholesale and retail markets.

In our survey 61% of respondents said they believed the dual regulatory structure has been a positive change, with only 4% saying it has been negative. This is a strong result in favour of the new regime. But what lies underneath that positive reaction? Should we believe that the previous regime was so deeply flawed that anything would be seen as an improvement, or is it a more moderate view that the single regulator system was at breaking point?

We consider that the views expressed point to a general acceptance that there was a need for change, not just in reaction to the financial crisis, but also in relation to the developing complexity of the regulated financial services industry. Many respondents commented on the necessity of avoiding any blanket approach by regulators that today must deal with a much broader range of regulated firms than was ever contemplated in the year 2000. In fact in the last year, with the move of consumer credit regulation from the Office of Fair Trading, the FCA’s remit has grown from around 7,000 firms to over 50,000.

This breadth of coverage means that regulators face a huge challenge in dealing effectively with the various sectors of the industry to ensure they formulate and enforce regulation which is able to manage a diverse range of risks in all areas. Additionally, in relation to ensuring robust governance and healthy competition, it continues to be crucial that regulators understand the numerous operational challenges that exist throughout distribution chains across wholesale and retail markets, to ascertain where change will actually result in better conduct, or deliver tangible benefits for the end consumer. Regarding the focus on culture within financial services, our survey suggests that whilst culture is definitely on the agenda for the industry, views of the key causes vary considerably. Whilst firms may be able to point to more obvious indicators of poor cultural drivers, it appears that most firms will still feel a challenge when asked to produce objective evidence of their individual cultures in operation. Despite some views that the regulatory framework itself will directly drive firms’ cultures, the industry must take the lead in developing more ways to demonstrate that client-centric cultures can drive growth and confidence in a sector which still suffers from associations with all the underlying causes of the recent financial crisis.

When asked to comment on UK and EU regulation the respondents in our survey were negative regarding the UK’s ability to influence – with 70% saying they believed the UK has only marginal influence in the writing of EU regulation. On the dual impact of UK and EU regulation, 64% of respondents stated this, combined with increased client demands and tax concerns, is causing them to consider operating outside of the UK.

Overall, the survey indicated that many in the industry feel frustration that the regulators (as well as the government and consumer groups) want an unachievable utopia. Our feeling is that there is some truth in this, illustrating the political challenge of achieving a balance between idealism and realism. It is undoubtedly essential that our financial services industry has robust risk management and governance procedures in place to ensure that the lessons from the financial crisis are learnt, but there is a need to look at the timescales required to implement this. Material cultural and operational change is not something that can be quickly embedded.

Since the inception of the new regulatory regime there has been an unprecedented focus on conduct and culture, but do we have tangible proof that meaningful change has occurred or is genuinely on its way? Industry confidence in this regard continues to grow, but we must ensure that the volume and pace of the regulatory agenda does not result in a box-ticking compliance culture that is effectively a whitewash, beneath which all the old behaviours and errors of the past still lurk.

Key to fostering an industry that is fit for the future is a shared understanding of the vision for UK financial services. What are the long-term aims? What does success look like?

Only when this has been deliberated and agreed can regulators and firms collaborate to deliver an industry that operates at full commercial capacity while maintaining integrity and the safeguarding of customer interests. What comes across strongly in our survey is that the industry needs regulatory frameworks that are well communicated with clear priorities that allow for change via a realistic road map. Currently there is a feeling that too much is being expected too quickly.

A core objective of the PRA is to give insurance policyholders an appropriate degree of protection. In the survey we would have expected insurance companies to have reported significant interest from the PRA over the past year – certainly higher than the average across the whole financial services sector. But this was not the case. When we asked firms about which regulators had shown an interest in how they manage risk in the last year, 48% of the insurers questioned said that only the FCA had approached them. It appears that insurers received no more than average attention from the PRA, with regard to risk management.

Which sectors of the industry have been a priority for the PRA? The results of our research suggest that investment banks were top of the list, closely followed by investment firms. Clearly, the investment industry is where this regulator has most aimed its sights – perhaps because it fears that risk in this sector has the potential to do the most economic damage. The retail intermediaries interviewed noted a recent sharp increase in interest from the PRA, suggesting the scrutiny on risk management at these firms has the ultimate aim of protecting consumers at the point of sale. Above all, the regulators want to avoid another financial crisis and both the PRA and FCA have shown more interest in risk management – demonstrated across all financial services. But when the survey drilled down to question which areas of risk the regulators had been targeting, such as credit risk or systemic risk, the results produced no clear picture of priorities.

As expected, there were variations between the different sectors, and some areas emerged as apparently more important to one regulator than the other. However, when the findings are considered all together, no clear pattern emerges. All areas of risk have apparently been given the same amount of attention, more or less regardless of the sector involved.

This could be seen in an optimistic light: the regulators are being thorough and even-handed, and are giving equal attention to all areas. But the alternative interpretation points to firms not being clear about what aspects of risk they should prioritise. It’s a hard fact that few firms have the ability or resources to focus on all aspects of risk at once. Firms could end up addressing all these areas equally – that is, equally inadequately.

Given that a key output of an effective approach to risk management is the ability to prioritise a firm’s response to the risks that it faces, this would be a fundamental failing. Up to this point in time, there seems to have been little allowance for the great diversity among financial services firms and the very different pressures at play within each sector. If all are being treated with too similar an approach, and one that does not adapt to circumstances, or offer some measure of proportionality, then regulation may end up being unnecessarily restrictive and unrealistic in its expectations. The danger is that firms from across the various sectors will suffer the fall-out from each other’s problems. If the regulators’ approach is not flexible, then some types of firm may waste valuable time and resources addressing issues that are less of a danger in their own line ofbusiness, but more relevant to another sector. It remains to be seen what impact this could have, but the warning signs are there.

At the heart of the competition question we find a troubling contradiction. A central aim of the new regulatory regime is to encourage healthy competition – but could it be having the opposite effect? We asked our respondents if they were clear on how the regulators would address competition concerns, and most replied with a resounding yes. This seems encouraging. But later on in the same survey, this confidence starts to be undermined.

Investment firms declared themselves the most clear on this issue – many told us they have already engaged with the FCA on this matter. However, insurers also said they understood this issue well, even though almost half of them said they had not yet had practical experience of it. This begs the question: are firms taking too much on faith? There could well be a gap between the regulator’s current expressed intent and how things ultimately pan out in practice.

Another complication is that sectors themselves struggle to agree on what being “competitive” really means. Unsurprisingly, when asked, they proposed a wide range of different factors by which the FCA could gauge competitiveness. Investment firms consider product pricing and the number of market participants to be the most important elements, whereas banks strongly favour client research and product diversity. So although broad agreement can be found in many areas, it is clear that the definition of “competitiveness” is not clear across the industry as a whole. This makes it difficult for the FCA to consistently address competition concerns effectively and for firms to have a clear understanding of how it proposes to do this.

The core contradiction is that the FCA (set up with an objective of encouraging competition) is seen by industry as the single biggest obstacle to competition. Banks and lenders are feeling this most severely – 88% told us they saw it as the key barrier, with investment firms and insurers not far behind. Regulation is seen as much more of an issue than taxation, which is remarkable – it appears that most firms would prefer to welcome the tax man than the regulator. Relatively speaking, firms do not see taxation as having such a big influence on competition, though it remains significant.

Coming a close second to regulation and, encouragingly, beating taxation into third place, client demands were noted as having a key impact on competition. Many sectors said the need to respond to all these issues is crucial to competitiveness, and in some cases (namely investment banks and retail intermediaries) it was the most important factor of all. So with demanding clients on one side and equally demanding regulators on the other, firms may feel caught between a rock and a hard place. The burden of regulation may be hampering the ability of financial firms to pursue the innovation and opportunities that previously delivered their competitive edge.

Culture is another key focus of the regulators. Firms must demonstrate a positive culture; one that safeguards against the unmitigated risk-taking that took place prior to the financial crisis and one that protects consumers. Unfortunately, “culture” is a nebulous concept and it is largely left to firms themselves to offer evidence to support their positive claims. Views vary considerably across the sectors as to what evidence is most appropriate to provide to the regulators. Many cite training and development scheme documentation and also customer data.But generally there is considerable variation among firms, highlighting the diversity of cultural priorities and interpretation of how to measure it.

A significant challenge for all firms remains the need to objectively measure and track culture via appropriate management information and key indicators. Diverse views were offered as to the most useful metrics. Banks (both retail and investment) tend to refer most to product governance, while insurers favour customer treatment committee papers. Investment firms appear to be the most concerned with monitoring their culture, as they call upon the widest variety of management information, including a range of staff metrics.

However, across the board the survey showed that a risk register is not seen as a useful tool to monitor matters that may impact on culture in a negative way; we were surprised by this. We would encourage firms to reconsider how they use their risk register to improve and monitor cultural challenges. Remuneration scheme documentation was also low down on the list. This was unexpected, given that certain pay structures (particularly bonuses) have been widely criticised as driving undesirable behaviour and undermining customer-focused cultures.

When our survey moved on to ask about barriers to nurturing a good and positive culture, a wide variety of areas were raised, some internal and others focused on wider macro issues. A barrier noted across the board was a lack of investment in people and training. This most likely connects to the volume and pace of regulatory requirements in the past 18 months. Could this, to some extent, be blamed for the industry’s inability to make real cultural change? There has been such a focus on compliance and change related to the regulators’ demands that little time has been available for more forward-thinking training and development aimed at financial services employees and the services they deliver to customers. Increased competition from other financial services (which links back to the difficulty of maintaining a competitive edge under the eye of the regulators) was also cited as a barrier to good culture. Is this suggesting that undesirable behaviour is necessary to be competitive?

Turning to banks, 56% of respondents noted a strong concern regarding poor communication from management, along with weak leadership. One reading of this may be that senior management is so focused on responding to regulatory remediation matters and significant regulatory change that they have not been able to focus leadership effort on driving cultural change. Tone at the top and senior leadership buy-in to cultural change are essential to implement the root and branch change that is needed for some institutions to address the behaviours that have been prevalent in the banking sector. There is, however, more and more evidence that culture is high on the agenda, with the majority of large banks and firms now having change programmes in position.

Interestingly, investment banks cited inappropriate remuneration structures as being one of their biggest barriers to a positive culture. This is perhaps unsurprising due to high-profile media scrutiny on investment banking in particular. Does it indicate a greater acceptance of the need for real change, more so than in the other sectors?

If the sectors themselves have different interpretations of culture it points to a lack of clarity from regulators that is a sure recipe for confusion. As with risk management, firms seem to feel unsure as to what they ought to be focusing on. In the long shadow of the financial crisis, the fast pace of regulation has meant huge changes for the industry. If the regulators wish to prevent the destructive patterns of the past, then a set of very clear guidelines and priorities is needed. This will enable companies to foster an enduring culture that is good not just for their employees and customers, but also for investors, shareholders and ultimately for society at large.

Perhaps surprisingly in light of some criticism and apparent uncertainty, a clear majority of respondents considered the dual regulatory system to be an improvement on the previous regime. The onus is now on both the industry and the regulators to explore the many areas where tensions and conflicts remain, and make every attempt to resolve them together. Only then can their interests approach a point of balance, between safeguarding the industry’s stability and integrity on the one hand and its competitiveness on the other.

The irony that emerges from our findings is that many of the goals of the regulators – a competitive industry with a positive culture, better management of risk and a stronger UK industry – are the very things that firms perceive to be under threat from regulation. It’s hard to be competitive and innovative when one is afraid to put a foot wrong, and it’s hard to manage fundamentals like risk and culture without a clear picture of priorities.

The relatively positive response to the new system should be taken by regulators as a constructive sign. There is clearly much work to do and if it is to be done at all, then it needs to be done together. The dissatisfaction of financial services firms is centred largely on regulators’ perceived lack of understanding of their needs. It is up to firms to voice those needs and up to regulators to listen, and it is for them both to attempt to find more common ground.

Perhaps the industry and regulators will never quite be friends, but that could turn out to be ultimately a good thing. If better engagement is achieved and there is open debate regarding the vision for the future, out of their disagreements will come progress.