In July 2010, HM Treasury published its first consultation paper1 setting out plans for the reform of financial services regulation in the UK. The main proposal was to move away from a single integrated regulator towards a tripartite structure in which responsibility for conduct of business (and some prudential) supervision sits with a separate regulatory body. This body, the Financial Conduct Authority (FCA), will carry out prudential and conduct of business regulation for approximately 25,000 firms and conduct regulation for over 2,000 firms prudentially regulated by the Prudential Regulation Authority (PRA).
Since July 2010, HM Treasury and the Financial Services Authority (FSA) have set out various proposals concerning their continued supervisory approach and how this will be taken forward by the FCA. These proposals are, at a basic level, underpinned by the belief that the last 20 years have seen an unacceptable level of customer detriment and, as such, the FCA needs to have a lower risk tolerance than its predecessor, the FSA. The concern with FSA supervision is that it has been too reactive and often relied on enforcement and customer redress after the event. Regulators have focused on high-profile episodes of customer detriment, such as payment protection insurance (PPI), mis-selling, and shortcomings in the marketing and distribution of structured investment products (e.g., Lehman-backed products against which the FSA took action in 2009), and reached the view that the FCA must be a more intrusive regulator, delivering "a forward-looking, judgement-based approach to regulation, at the core of which will be early intervention both in respect of products and selling processes."2
The move to a judgement-based approach is ambitious. To make it work, the FCA will need to carry out effective, up-to-date analysis on a wide variety of products, firms and markets, and have the confidence and ability to make regulatory decisions on that basis. In this article, we look at certain key features of judgement-based supervision, focusing on the FCA's proposed product intervention powers, and consider how the approach will work in practice.
HM Treasury and FSA publications on the FCA highlight the importance of business and market analysis in shaping regulatory action. In June 2011, an FSA paper on the FCA stated that a new business and markets analysis team will take the lead, providing high-quality analysis to determine how markets function and interact with customer behaviour.3 This work will, for example, inform product intervention by flagging particular factors that present a risk of customer detriment. At present, the FSA does not have an equivalent team and the intention is to hire "senior level, high quality" staff with the knowledge and skill to carry out the analysis."4
The key question is whether the FCA can attract and retain personnel with sufficient expertise, particularly in relation to business and market modelling, and product design. If the FCA cannot, there is a clear risk that it will not be able to deliver its intended supervisory approach. Much will depend on whether the FCA can commit enough funds to deliver judgement-led supervision, both in terms of remuneration levels and, if required, increases to staff numbers. One point in the FCA's favour is that the current plan to reduce levels of firm relationship management should free up resources. The FCA will, in particular, expand upon the FSA's existing small firms approach, concentrating on sector profiling and thematic reviews rather than committing personnel to firm management. Internal restructuring will not, of course, guarantee quality of personnel, which is perhaps the key issue in delivering judgement-led supervision.
It is also worth bearing in mind that the FCA will need to apply a judgement-led approach to prudential supervision as well as to conduct of business supervision. The PRA will take over the prudential supervision of banks, building societies, credit unions, and investment firms, leaving the FCA with fewer supervisory responsibilities than the FSA. That said, the dual burden of prudential and conduct of business supervision could challenge the FCA's ability to meet its objectives in relation to judgement-led supervision. The FSA's recent report5 on the failure of the Royal Bank of Scotland (RBS) identifies, among several key reasons for the bank's part-nationalisation in 2008, ineffective prudential supervision. In particular, the report points out that supervision teams responsible for conduct and prudential issues tended to focus on conduct, such as the "Treating Customer Fairly" (TCF) initiative, and risked paying inadequate attention to prudential matters.
RBS and other major firms will, of course, be among firms prudentially supervised by the PRA. Also, from 2008, higher standards have been introduced internationally for key areas relating to the prudential supervision of such firms, in particular capital and liquidity requirements. The FCA will, however, need to take a proactive approach, challenging "management assumptions and judgements" and addressing prudential failings identified in the RBS report, such as in relation to the analysis of balance sheet composition and asset quality.6 Again, this will require high-quality personnel with a deep understanding of supervisory issues stretching across wide-ranging market sectors.
Judgement-led Supervision in Practice: Product Intervention
Product intervention is a central part of the FCA's proposed supervisory approach, with the FSA publishing a dedicated discussion paper and feedback statement in the first half of 2011.7 The basic idea is to move the focus of regulation away from the point-of-sale to coverage of the entire life cycle of products, paying more attention, in particular, to the product design phase. In the FSA's view, the traditional focus on point-of-sale (especially marketing, information disclosure and the provision of advice to customers) prevented regulators from recognising basic problems in product design and distribution, and led to a reliance on enforcement and compensation after customers had already suffered detriment.
Product intervention will be a key element of judgement-based supervision, with regulators required to make early and potentially far-reaching decisions based on an understanding of whether predicted customer detriment will outweigh benefits. The FSA envisages that the FCA will intervene in a number of ways, including banning products and product features, influencing pricing (including by setting price caps and preventing excessive charging), increasing prudential requirements on a firm, and preventing non-advised sales or sales to particular customer types. There will also be the ability to warn consumers about detrimental practices and products. The FCA will only exercise these powers when it has concerns about serious actual or potential detriment.
Product intervention raises a number of issues for the practical application of judgement-based supervision. One overarching concern is how to strike a balance between the FCA's discretion in making judgements and the need for certainty in the UK market. The FSA expects to produce initial product intervention rules by expanding existing guidance from its TCF initiative,8 and the draft Financial Services Bill allows the FCA to introduce temporary rules without consultation.9 If the FCA produces prescriptive rules and guidance, firms may have greater certainty, but there is a risk of them adopting a compliance culture "tick-box" approach to product design, and of the FCA not having sufficient flexibility to deliver a true judgement-led approach. If, as appears more likely, product intervention rules and guidance are general and outcomes-focused, the FCA is likely to have greater power to intervene early in the product life-cycle.
Greater scope for early intervention fits with the vision of regulatory judgments based on high-quality analysis. There is, however, a real concern that this would make firms increasingly reluctant to introduce new and, in particular, innovative products. Such an outcome may help reduce serious customer detriment, but could narrow customer choice and undermine effective competition in the UK market. The FSA recognises these risks, but has stated that choice and innovation do not always benefit customers (observing, for example, that the result of innovation is often more complex, risky products) and reiterated that the FCA will only use its more drastic powers where there is a risk of widespread and severe detriment.
The FSA also acknowledges the risk that UK firms may be put at a disadvantage if FCA judgement-led supervision is more intrusive than regulatory approaches adopted elsewhere in the European Economic Area (EEA). This discrepancy could lead, for example, to regulatory arbitrage where firms from other EEA Member States passport products into the UK without any scrutiny of the design process. The FSA has, however, argued strongly that product intervention will have positive effects on competition within the UK market. In the FSA's view, there are often "supply side" weaknesses in the market, where customers fail to evaluate products properly, "systematically misjudging value or quality."10 The aim is to improve competition by intervening in product design to remove deficiencies, including by making judgements on price and value. Industry respondents to the FSA's Discussion Paper on product intervention were particularly concerned about the FCA making price decisions, arguing that this would cause significant uncertainty and should be left to market forces.11
There are, therefore, several broad areas of concern about the practical application of judgement-led supervision focused on early intervention. In addition to the specific points highlighted above, the FSA has sought to justify the approach on several broad grounds. First, FCA supervision will be risk-based, focusing on products, firms and sectors where there is a higher risk of widespread and severe customer detriment and involving intervention where anticipated detriment clearly outweighs benefits rather than in more marginal cases. As such, a judgement-led approach should not create unnecessary uncertainty or put UK firms at a competitive disadvantage. Second, the FCA will be a more active regulator than the FSA because it will have a lower appetite for customer detriment. The FSA acknowledges that, given the new approach is more ambitious, there may be mistakes; however, it considers that the increased likelihood of identifying in advance cases of widespread potential detriment (equivalent, for example, to PPI mis-selling) would outweigh any practical downsides.
The abiding concern with these arguments for judgement-led supervision is the assumption that the FCA will be able to perform the high-quality analysis needed to sustain its intended approach. For example, the FSA's view on the effect of product intervention on innovation and competition is underpinned by a belief that the FCA will identify weaknesses in customer preferences and, on customers' behalf, make judgements on the value of products. The FCA will need to develop clear, but not overly prescriptive, rules and guidance, and attract high-calibre personnel capable of exercising its powers judiciously.
(c) 2011 Hogan Lovells LLP
Tom Robinson is an associate in the London office of Hogan Lovells LLP, having recently qualified into the commercial and retail banking team. Tom's experience includes working on the review and consolidation of terms and conditions in a major UK private bank, giving regulatory advice on a range of consumer and commercial banking issues, and the replacement of Banking Code requirements in the new Banking Conduct Regime. Telephone: +44 (0) 20 7296 5662; E-mail: firstname.lastname@example.org.Julie Patient is Of Counsel in the firm's London office. Julie is a member of the firm's Financial Institutions Group working in the Commercial and Retail Banking Group. She has extensive experience of the regulatory regime impacting participants in the UK market. Julie has specialised in this area for more than 15 years and has acted for major international financial services providers. Telephone: +44 (0) 20 7296 5790; E-mail: email@example.com.
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