Look Into the Future of Twin Peaks Regulation

The journey to the FCA

Originally published in the December 2012/January 2013 issue

The Financial Conduct Authority (FCA) recently released its “Approach document” setting out proposals for regulating the conduct of banks and investment firms. The document provides insight into the priorities and approach of the new regulator and talks of where and how far it has travelled already on the ‘Journey’. The paper contains many references to past successes, changed approaches and models that the regulator considers are already yielding benefits and can be a foundation for the future. Reading the detail of the consultation paper and considering the Financial Services Authority (FSA) has been operating under a Twin Peaks during 2012, it would seem the FCA has perhaps already arrived. So, is this approach document less about the regulator's journey and more about the one the industry is about to take?

Why journey to the FCA?
Leaving aside the political and legislative background to the creation of the FCA, there is a presumption in the document that uncontrolled markets are not the answer. The FCA promises to “make markets work” and provide consumers with “a fair deal”, language that epitomises the wider public’s frustrations with financial services – that the directors and senior managers of FSA regulated firms are working for themselves and not consumers. “Meeting fair and reasonable (consumer) expectations… should be at the centre of how firms operate – firms should see it as their responsibility in the first instance, not the responsibility of the regulator,” the document states.

So, the conduct of regulated firms is at the core of what the FCA will be about and it is conduct that the FCA wants to improve; behaviour, attitudes and motivations as evidenced in the experiences and outcomes consumers receive from regulated firms. This all stems from three operational objectives the FCA will have, each consumer-related, namely; protect consumers, promote competition and enhance market integrity.

The FCA wants consumers to receive financial services and products that meet their needs from firms they can trust. The FCA will look at newly authorised firms’ business models to ensure these meet the needs of consumers and do not place them, or the financial system, at undue risk. Those responsible for managing the affairs of a firm will be expected to act with probity, in order to satisfy the regulator that the firm is fit and proper. A firm’s business model is so central to the FCA that a new threshold condition will exist to reference risks that might be posed to a firm, its customers and the integrity of the UK financial system.

One approach fits all
This focus on consumer protection includes wholesale conduct, not just retail conduct. “Consumers need to be protected against activities which exploit differences in expertise or market power” and the FCA “will not accept that there are some categories of relationship in which (it) should not be interested because the sophistication of the parties enables them to look after their own interests”. “Poor behaviour has a wider impact on trust in the integrity of markets, (such as) where charges and fees within wholesale markets are passed down to retail consumers”. The FCA will take a more assertive and interventionist approach to risks caused by wholesale activities and, if necessary, will act to protect a wider range of client relationships than at present.

Product governance and intervention
One of the primary areas the FCA will look to intervene is “product governance” – how firms design, operate and sell products – and this appears to be where fault-lines appear in the paper, as having identified the wholesale sector as in need of change, the language used is that which is more familiar to retail supervision. For example, whether the target consumers’ needs need to be taken into account in the product design, whether there is sufficient product oversight and monitoring of practical outcomes for consumers and whether the distribution strategies are appropriate. “Provider firms will be expected to have robust procedures to assess their target market, perform adequate stress testing, and manage the product risks for consumers.”

“If necessary, (the FCA) will be ready to intervene directly by making product intervention rules to prevent harm to consumers – for example, by restricting the use of specified product features or the promotion of particular product types to some or all consumers…” something the FSA is already doing with its current consultation to ban the promotion of unregulated collective investment schemes to retail clients. The FCA may ban products after consultation with the market or, where there is a need for prompt intervention, temporarily ban a product for 12 months without consultation.

There is potential risk for regulated wholesale firms by the FCA’s approach. Many professional and eligible counterparty relationships are based on “caveat emptor”; the FCA appears to be saying this can no longer be assumed and that all financial services firms need to operate on a basis of trust and act in the interests of their consumers. Activities that directly or indirectly impact on retail consumers and conduct that challenges the integrity of the financial markets and those working in financial services appear to shape the FCA’s priorities.

Disciplinary action and disclosure
The FCA will still view enforcement as being key to its strategy. It will build on the “progress” already made and is committed to more enforcement, tougher penalties, pursuing more cases against individuals, holding senior management accountable, pursuing criminal prosecutions and getting compensation for consumers.

One important development the industry will need to adapt to, is the promise that the “FCA will publicly announce (when it has) begun disciplinary action against a firm or individual”. ‘Warning notices’ will be published to announce the start of formal enforcement proceedings. This is a development that is likely to be met with some concern in the industry, but if the regulator is going to influence culture and conduct perhaps it needs to be transparent about what it considers are good and poor practices more swiftly than it takes for information about enforcement cases to become publicly available.

Living with the FCA
Firms and individuals who are already regulated by the FSA will not need to reapply to become regulated by the FCA. Firms will be automatically transferred to the FCA from legal cut over (expected to be April 2013).

Once at the FCA, firms will be supervised according to four FCA conduct supervision categories: C1, C2, C3 or C4. Alternative investment managers will most likely fall within C2, C3 or C4 by virtue of their lack of retail customers and client assets; the specific category being determined by the size of their wholesale activities.

Many alternative managers are likely to be “C3 and C4 firms (and) will not be subject to the same form of regular assessment as retail firms. They will be supervised mainly through issues and products work.”

The FCA’s supervision model will be based on three pillars:

• Firm Systematic Framework (FSF): preventative work through structured conduct assessment, business model and strategy analysis and an assessment of how firms embed fair treatment of customers and market integrity through governance and culture, product design, sales or transaction processes and post-sales/services and transaction handling;
• Event-driven work: dealing with problems that are emerging or have happened, and securing customer redress or other remedial work where necessary;
• Issues and products: intensive campaigns on sectors of the market or products within a sector that are putting or may put consumers at risk.

The FCA will expect firms to observe high standards in their operational risk management, having procedures in place to ensure continuity of critical services. Firms will be expected to comply with standards for resilience and recovery set in this area.” This is likely to lead to more independent benchmarking and standard setting.

The FCA also states that it will put responsibility on firms to do their own monitoring on some lower risk areas and to self-attest that they have been addressed. Follow-up work will be undertaken by the firm with the FCA making greater use of section 166 powers.

Recent FSA guidance and consultation such as those covering conflicts of interests, financial crime and marketing of unregulated collective investment schemes shine a light on what is ahead; thematic focus, stricter enforcement of conduct and integrity-based rules and principles, or, as it has been summarised in the much trailed phrase – judgement-led supervision. It may be that it is time for firms to prepare and ensure their current governance and conduct arrangements meet the standards the FSA expects and that the FCA will apply next year.

The journey the FCA speaks of is one that alternative managers must also take. It is also an uncertain journey – amidst all the tough talk about regulating wholesale conduct the examples of poor conduct the FCA provides are predominantly retail and banking-related. A shift in emphasis to wholesale conduct, the threat of a more interventionist strategy, public disclosure of enforcement actions, greater use of enforcement and criminal prosecutions is intoxicating language indicating that the journey could be turbulent for all those that need to follow the path to twin peaks.