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Speech by Clive Briault, Managing Director, Retail Markets, FSA
AIFA & AMI Belfast Regional Conference – keynote speech
29 September 2005

Good morning and thank you for the invitation to attend your Belfast regional conference. I very much welcome the opportunity to visit Northern Ireland – something I and my colleagues at the FSA are keen to do more often.

Today's programme covers both AIFA and AMI constituencies, so both investments and mortgage intermediation. Given that I have a morning slot, I will focus mainly on the investments side, but since it is nearly lunchtime I hope it is acceptable if I also say a few words about our initial findings nearly a year after our taking on mortgage regulation.

I would like to begin by mentioning the important role that AIFA and AMI play in supporting the investment and mortgage advice industry. We have constructive dialogue with the associations on a range of issues. And I hope that we can continue to build on this for our mutual benefit. In particular, in the context of Treating Customers Fairly, the associations have an opportunity to focus even more on supporting you in increasing further the standards of the industry and the quality of the service you provide to your clients. More on this in a moment.

Objectives: retail market

The FSA's three strategic priorities are: to promote efficient, orderly and fair markets, both retail and wholesale; to help retail consumers to achieve a fair deal; and to improve our business capability and effectiveness.

Within this, our retail agenda focuses on delivering an effective and efficient retail market for financial services and products. This requires:

• Capable and confident consumers.
  
• Clear, simple and understandable information available for, and used by, consumers.
  
• Soundly managed and well capitalised firms who treat their customers fairly.
  
• And risk based regulation.

These components of an effective market apply as much to the market for financial advice as to any other part of the retail financial marketplace.

Our primary objectives for the retail distribution system centre on the quality of advice available to consumers and the fair treatment of consumers by firms.

What do we want the advice market to provide?

Good quality financial advice plays an important role in ensuring that consumers have expert help in making a complex range of choices on important financial decisions. The provision of financial advice is a large industry, and with rising incomes and wealth, and evidence that many individuals are not investing enough for their retirement, there should be plenty of scope for the advice market to expand significantly. The challenge here for you as providers of advice is to demonstrate to more consumers that there is value to them in paying for your services.

At the simplest level, we believe a well performing retail financial advice market should provide good quality, suitable advice to consumers. And consumers should be able to recognise when this is happening, and when it is not, and to respond accordingly.

The advice market as a whole (of which financial advisers are a part, but not all) should be healthy and sustainable, built on viable business models.

As a regulator, we do not want to prescribe how the advice market should be structured. Rather, we want to allow firms to choose what advice they provide, and to allow consumers to choose what advice they want to take and how they pay for it. And we want consumers to be able to understand the different types of advice that are available to them.

We are clear that the retail financial services market is not yet operating in a consistently effective and efficient way. On the mortgages side, our early findings report a mixed picture in terms of standards. On the investments side, the market is in a state of flux. Both product providers and distributors face a range of challenges and issues, including: adapting business strategies to reflect a depolarised world; rebuilding capital and balance sheets; paying the costs of compensation arising from past poor advice; and coping with sluggish demand for investment products in weak markets and where consumers have low levels of confidence in the sector.

Depolarisation – the story so far

After extensive review and consultation over many years, the new 'depolarised' world came fully into force on 1 June this year.

Depolarisation is largely a permissive regime and firms are free to develop their business models in a more tailored way for their customer base, or they can continue trading pretty much as they were before – albeit with improved disclosure and other adjustments such as the requirement for 'independent' firms to offer a fee option.

From what we have seen so far:

• Most small financial advisers have indicated their intention to maintain 'independent' status. In other words they will offer whole-of-market advice as well as giving customers the option of paying by fee for that advice.
  
• Elsewhere in the market a number of previously tied firms have moved toward a multi-tied proposition, by expanding the range of packaged products they offer to their customers. Others have decided to remain single-tied and others again have chosen to gap-fill rather than fully multi-tie. With appropriate disclosure, this all adds up to wider choice for the customer.

The challenges for firms will include getting to grips with the new disclosures they have to make, in particular the fact that they will be required to provide information about the cost of advice at an earlier stage in the sales process. The menu also provides consumers (for the first time) with comparative information about commissions.

Firms that have previously not offered a fee option will need to consider how to price their services appropriately, in order to remain competitive but also to develop economically sustainable business models. Firms will need to consider their longer term strategies in terms of the needs of their customers and the actions of their competitors.

There is very much a place for independent advice in the depolarised world. However, there is a challenge for these firms in promoting their own services more effectively than may have been the case in the past.

We have already committed to conducting a post-implementation review of depolarisation, looking at its impact on both consumers and the industry. This will take place in a number of stages, looking at the effect of the changes within the appropriate timeframes. It is fair to say that some of the changes that may occur as a result of depolarisation will take longer to materialise than others.

A Day

Another major challenge facing the industry is A day, in other words 6 April 2006, when the new pension tax simplification rules take effect. In a speech last week my colleague Sarah Wilson warned that financial advisers need to make sure they review the business and strategic impact of A-day in order to avoid potential loss to consumers.

The onus is partly on pensions providers to ensure that their systems and controls, including IT and other legacy systems, are adequately updated to cope with the changes, and to enable them to provide accurate pension projections and benefit statements. But you as advisers also need to be aware of the impact of A-day and discuss relevant issues with clients looking for help with their pension choices, including when to retire, changes in regulations on releasing tax-free sums, and the introduction of a lifetime allowance for pension savings. It is also important that advisers receive appropriate training to enable them to give suitable advice.

Following this challenge to you, I was very pleased to see that you had a session on 'Countdown to A-Day' earlier this morning. So I will not go into any more detail today, other than to say that we are currently looking at the state of readiness of a sample of regulated firms, and will use this information in future discussions with the industry.

Quality of advice – what have we seen in the last few months?

I spoke at a conference in May this year about the overall quality of investment advice. I reported a mixed picture.

We do see many examples of well managed firms. When we visit firms we find the majority are making every effort to comply with our rules, and are keen to try to do things properly. We see firms who genuinely believe it is in their business interests to develop effective, long-term relationships with their customers, based on trust and fair treatment.

But our regulatory experience does nevertheless suggest that within some firms there are significant shortfalls against the standards set out in our rules and guidance, and that we would expect all firms to observe.

Our work – whether on individual firms or on projects across the sector as a whole – also suggests that poor advice and mis-selling is by no means a thing of the past. Those past episodes will be familiar to you – the widespread problems with personal pensions, mortgage endowments and precipice bonds. Other examples are more recent.

For example, as (an incidental) part of our research on the filtering/sales process for the Sandler simplified products, we asked consumers not only to follow through a mock Basic Advice interview but also to complete a full financial fact find that was given to a fully qualified adviser. The results from these two processes were then compared with a benchmark derived from a computerised planning tool. Overall, 11% of product recommendations – and 18% of pension recommendations - made by the financial advisers in this sample through the full fact find were deemed to be “bad” outcomes, and this was a significantly higher proportion of such outcomes than were generated from the Basic Advice route. This is worrying, even if the results must be treated with some caution because the research did not seek to capture all the checks and balances that would be present in a real advice process.

An ABI report on commission published earlier this year also found that in a mystery shopping exercise based on a scenario where consumers had credit card debts, and where good advice would include the need to repay these debts, in 22% of cases for commission based IFAs and 15% for tied advisers, the consumers were not advised to pay off these debts as a priority¹. And the reported figures contain no information on how many advisers even considered the possible advantages to consumers of also paying off some of their mortgage.

The quality of advice is difficult to measure, but it is often reasonably clear – and sometimes only too obvious – that a consumer is being advised to make an investment that is unsuitable for him or her, or where an inadequate attempt has been made to assess a consumer’s circumstances and risk appetite or to explain why a particular recommendation is suitable for that consumer.

In July we published finding of our work on equity release, which identified problems with the suitability of advice in this area. We carried out 42 mystery shops – covering product providers, Financial Advisers and mortgage brokers – to assess advice standards within the lifetime mortgage market. A second piece of work, involving visits to firms and desk-based research, looked closely at subsequent investment advice provided to customers.

The results of the mystery shopping revealed that more than 70 per cent of advisers in these firms did not gather enough relevant information about their customers to assess their suitability for the product, and more than 60 per cent of the mystery shoppers reported that their adviser had not explained the downsides of equity release.

We were also concerned about the quality of the subsequent advice. In all of the seven firms looked at, advisers failed to explain the link between this type of borrowing and subsequent investments. We found examples of advisers encouraging customers to release more than they required and to reinvest the surplus cash in products such as investment bonds; recommending that consumers release a lump sum and reinvest it in, for example, an investment bond to provide a regular income stream. But as well as being more expensive for the consumer, reinvesting capital in equity-backed investments unnecessarily exposes the consumer to risk.

Although the sample was small, this remains very disappointing, particuarly given that these consumers tend to be elderly and vulnerable people who can ill-afford to be unnecessarily exposed to risk.We will be carrying out further work in this area, including a second mystery shopping exercise early next year, and we expect senior management to ensure that their advisers are giving appropriate advice, and to deal with the concerns that we have identified.

There have also been many other “mystery shopping” exercises undertaken by consumer organisations and the media, which have found worryingly large incidences of poor advice. These all tend to be based on very small samples, but the similarity of the results each time cannot easily be explained away.

We are absolutely not saying here that all financial advisers have been giving poor advice. And we have been encouraged by finding some potentially-higher risk products (for example property funds) on which standards of advice and understanding seem good. But it is certainly interesting to observe that in each episode of mis-selling we see a polarised situation in which some advisers are pushing complex and risky products strongly while others are closer to the “I would not touch this with a bargepole” position.

We also see some examples of poorly managed and operated firms. This includes inappropriate governance structures; a lack of strategic direction; an absence of management information to support decision making; and poor systems and controls. A recent set of visits to 25 small firms in one area of the country revealed that almost all the firms had issues, for example in relation to record-keeping, provision of suitability letters and the charging of fees or commission. In four of these firms we judged that the failings in relation to the operation of their business put customers at serious risk. We see firms with weak financial positions and inadequate capital resources, often because the directors have removed capital from the firm in the form of remuneration. This means there is little money in the pot for when things go wrong.

We need to see a more robust approach to the provision of capital across the sector. Again, much of the solution lies in your own hands, by ensuring that sufficient capital is kept in the business to enable a reasonable amount of claims against your firms to be met if the need should arise. Our own capital requirements are not risk-sensitive in this way, but clearly one option would be for us to develop a back-book related capital charge.

As a result of these various fundamental weaknesses we regularly see firms failing, or having to be supported by loans from product providers. And with the increasing numbers of failing firms come greater calls on the Financial Services Compensation Scheme and higher levies. This has an adverse knock-on impact on those among you who are doing the right thing.

Mortgage regulation update

I promised to update you on progress with our early work on mortgage regulation.

Using our risk based approach we identified a number of priority areas for action.

First, we focused on enforcing the perimeter to check whether firms are undertaking regulated activities without being authorised to do so. We discovered that the vast majority of mortgage brokers are well informed about the need for them to be authorised by the FSA if they undertake regulated activities. Although we have now shifted the focus of our perimeter work to general insurance, we continue to monitor the mortgage market and to react, as appropriate, to leads from consumers and the industry.

Second, we looked at a cross-section of firms across the mortgage market to assess the quality of their financial promotions, and the adequacy of their senior management arrangements and of their systems and controls to comply with our Mortgage Conduct of Business rules. Overall, we found no major concerns. However, we did have some concerns over newly authorised networks' controls over their Appointed Representatives; and over the non-compliance with our financial promotion rules by some smaller firms promoting sub-prime lending on the internet. We will continue to work with the industry to address the issues we have identified, and we will undertake some further supervision work.

Third, we looked at disclosure. The key facts documents - Initial Disclosure Documents and Key Fact Illustrations - are designed to give customers clear, straightforward information on the services and products they are being offered to enable them to make informed decisions and to shop around. It is extremely important for all firms to provide these.

We carried out some work to look at the content of both lenders' and intemediaries' mortgage disclosure documents. The review found that although there were some good examples, the quality of documents varied and many needed improvement. We found cases where documents were not in line with the format and content required by our rules or were too long and written in overly-legalistic language. Some Key Facts documents do not contain all the required information, and some include more information than the rules require, making them longer than necessary.

We also carried out a separate mystery shopping exercise on mortgage lenders and brokers to establish whether firms were providing the Initial Disclosure Document and the Key Facts Illustration. We found that firms were non-compliant in more than half of the cases, either because they failed to provide one or both of the documents, or provided them at the wrong time.

These were disappointing findings. We have been working with firms on the quality of these documents and will continue to monitor closely firms' distribution of them through further supervision work. We have also published a Factsheet for intermediaries to help with this.

I have already mentioned the concerns that arose from our work on advice on equity release products.

We have also looked at some of the higher risk areas emerging from our continuing supervision. This includes work on responsible lending; self-certified mortgages; and sub-prime lending.

The work on sub-prime lending looked at compliance by small mortgage brokers with requirements on selling and advising in this market. We visited 31 small brokers active in the sub-prime market and looked in detail at 210 case files.

It did reveal some good practices. We saw some examples of firms going beyond the letter of what our rules require, for example 65% said their practice was to issue suitability letters outlining the reasons for a recommendation.

But there were too many cases where firms were unable to show that they had followed the required procedures relating to suitability when advising on these mortgage contracts. For example, we found that in 80% of cases, there was lack of evidence to show how the recommended sub-prime product met the customer's needs and circumstances. And in 67% of cases which involved debt consolidation, firms could not demonstrate that they had taken account of the additional requirements related to debt consolidation mortgages and thus it was unclear whether the recommendation was appropriate.

This is clearly worrying and, overall, our asssessment of the mortage market is a mixed picture.

So what are we, the FSA, doing about this?

We know it is important to provide feedback on the progress of our work and to help raise industry standards. We meet regularly with a number of trade associations and consumer bodies to keep them informed of our work. And we provide regular feedback on specific projects and themes through our newsletters and we will continue to take up further opportunities to communicate with the industry.

We understand that adapting to regulation takes time. So in our mortgage work (as well as more generally) we are taking a graduated approach. Where our initial work identifies problems, we will work with the industry to tackle these issues. We only take enforcement action at this stage in the most serious cases.

The next step will be follow up work to check that our messages have been received and acted upon. Where at this second stage we find problems that have still not been tackled, we will not hesitate to intervene, including taking enforcement action if necessary.

On the investments side, regulation is not so new, and we already use the full range of regulatory tools to tackle the issues we find in the market.

First, we set and make clear our regulatory standards, using a range of communications and other tools. We have work in hand to simplify the Conduct of Business Sourcebook, we have produced a tailored Handbook and a guide to the Handbook for retail intermediaries, and we are doing work to understand more accurately the cost of regulation. Here we are actively looking to involve small firms, where costs are a particular concern.

We have a dedicated Retail Intermediaries sector team for the investments side, and this has now been extended to cover mortgage and general insurance. Stephen Bland, recently confirmed as Director of our Small Firms Division, will become Sector Leader.

We also provide extensive industry training and support, including workshops on topical issues such as depolarisation and sector newsletters.

Second, we monitor the sector actively – through firm-specific and thematic work. We adopt a risk-based approach to supervision – focusing our resources on the higher risk firms and activities while minimising the regulatory burden for the lower-risk firms. A good example is the issue of Client Money where we have identified a problem, developed a pragmatic solution, and will be working with the industry over the coming months to find practical solutions and new ways of working that will keep firms outside the scope of the Markets in Financial Instruments Directive.

Third, we enforce where necessary.

We have a team dedicated to taking action against firms that do not meet the basic standards needed to carry out the activities for which they have sought authorisation – our so-called "Threshold Conditions". In the last year, 28 firms have had their permission to conduct investment business cancelled, and a further 130 have taken remedial steps to address breaches of the threshold conditions. Some of these breaches related to lack of adequate resources (including PII and financial resources) and failures to comply with Ombudsman awards, non-cooperation with the FSA and non-payment of our fees.

There have been a number of enforcement cases recently relating to financial advisers, whether for mis-selling, misleading financial promotions, or other issues such as inadequate internal systems and controls. We have also taken a decisive approach to tackling the question of phoenix firms, those which seek to disappear and then re-establish themselves without meeting their liabilities to customers from previous enterprises. We have successfully thwarted twelve attempts at phoenixing in the last year.

Fourth, for small firms we have, or are putting in place, a range of initiatives to make us easier to do business with. These include: a major programme of improvements to the small firms section of our website; payment of FSA, FOS and FSCS fees and levies in instalments; a programme of geographical Roadshows around the country – opportunities for us to make you aware of key issues and risks and a chance for you to ask questions; and the firms online system, with the new Integrated Regulatory Reporting system which enables firms to report electronically.

We experienced some teething problems with the first Retail Activities Mediation Returns or RMARs. We apologise for any inconvenience this may have caused you. Problems with new systems are not uncommon and we acted promptly to minimise the impact on industry by extending the deadline for submission. Whilst some system issues remain, we have been encouraged by the submission rates so far. The rollout of the system to capture Product Sales Data (PSD) from October this year is currently well under way. I encourage those firms who have not yet registered for integrated reporting to do so as soon as possible.

Treating Customers Fairly

As well as looking at particular projects, risks, products or themes, a key priority for us in delivering an effective retail market is to embed the fair treatment of customers into the retail investment and mortgage advice market.

Our Treating Customers Fairly (TCF) initiative is one of the four key pillars of our retail agenda.

We expect firms to follow the principle that a firm must pay due regard to the interests of its customers and treat them fairly. Most firms aim to do this – after all, it would not make commercial sense to set out to treat your customers unfairly – but we still see instances where this is not the case.

Our approach places responsibility on firms, and in particular their senior management, to consider themselves how they ought to organise their business to respond to their regulatory obligations. We believe that this is a better course of action for us and for the industry than our continuing to set ever more detailed rules and guidance. In the last eighteen months we have been working with the industry to develop a common understanding of how we can make treating customers fairly a reality. Our latest publication, 'Treating Customers Fairly – building on progress', published in July and available on our website, provides a detailed update on this work, including the progress that firms have made.

We have structured our work around the stages of the product life cycle, including product design, marketing, the sales and advice processes, and complaint handling.

We have done 'cluster work' on a number of these stages, and visited a range of firms to explore in more detail what good and less good practice looks like in these areas. We have published the findings of this work. Case studies have also been developed to bring some practical issues to life and to provide firms with ideas they may use.

We are now looking to firms to undertake a gap analysis to highlight any areas where the firm is not meeting its obligation to treat its customers fairly. Where necessary, firms will need to embark on a programme to address any shortcomings. These firms will need to set clear priorities and targets to determine how progress will be tracked.

Some have questioned the need for our initiative on treating customers fairly. But we have found from our contacts with many firms that having looked at this issue they have discovered that there was more to do than they had initially thought, because the review process had identified things which they themselves recognised needed addressing.

We very much believe that treating customers fairly should be proportionate and appropriate to the circumstances of the firm concerned. So our July publication includes a range of helpful pointers for smaller firms to consider. For example:

• On the sales and advice process, management should ensure that advice is appropriate and timely, that due account has been taken of the customer profile, needs and attitude to risk, and that the firm has disclosed information in ways that comply with our rules and requirements.
  
• On training, few smaller firms have dedicated training functions, so it is important for management to be satisfied that all staff who may have an impact on whether customers receive fair treatment have the necessary skills and competence. Management should also be realistic about the potential limitations of training offered by product providers.
  
• On record keeping, we know that this is an area that can be challenging for small firms; however it is important that firms maintain adequate records of customer profiles and instructions, and on each stage of the sales process.
  
• Similarly, it is important that customers remain clear about the nature of the services being offered by a firm. Many smaller firms have close and long-standing relationships with their clients; this can have many benefits, but it can also result in less formality and clarity, both at the point of sale and afterwards. Firms need to ensure that they always act with integrity in their dealings with customers, regardless of the length of the relationship.

We are aware that there are commentators, including some consultants, telling firms that treating customers fairly is about setting up costly systems and extensive governance processes. That is not our position at all. Some firms have found it helpful to use consultants to review their business, but that is not something that we require. Indeed, we have focused on producing useful materials, case studies and example of good and bad practice so that firms will have a clear indication of what we want them to achieve without having to follow an overly-defensive approach.

It is also been suggested that we expect firms to gather large volumes of management information to prove that they are delivering on treating customers fairly. That is not the case either. Our concern is to make sure that firms deliver on their regulatory obligations. As a matter of senior management responsibility, management need to be able to know how their business is performing and management information will be an important part of that assessment. We thought it helpful to flag the need for management to think about whether the information they currently have enables them to judge whether they are complying with treating customers fairly. But we do not want firms to collect information that serves them no useful purpose. I would also like to be clear that for smaller firms performance monitoring is likely to be much simpler, so these firms will need to collect much less management information.

As part of the next stage of our work on treating customers fairly we will also be looking at quality of advice. The aim will be to consider how we can measure and improve the overall quality of advice that consumers receive, rather than looking at specific products or examples where the advice process goes wrong. We will test current practices, looking at a range of areas including training and competency; the systems and controls that support good advice; and entry standards for advisers and firms. We will identify examples of good or bad practice, and share this with the industry.

I should say a word at this stage on the balance between the responsibilities of product providers and advisers in ensuring the fair treatment of customers.

Clearly, as advisers it is your responsibility to understand the products on which you are advising.

However, we believe that providers also have a responsibility to consider, when designing their products, which consumers the product is likely to be suitable for, and equally important which consumers it is not likely to be suitable for. And providers should then pass this information on to their distribution channels, as well as explaining clearly to their distributors the risks as well as the opportunities that their products offer. This should help you as advisers to understand these risks and to tailor your advice accordingly.

So the responsibility for delivering fair treatment and a high quality of advice is, in this respect, a shared one.

Another key area for firms to consider as part of their overall approach to treating customers fairly is complaints handling. We recently did some work to look at the handling of complaints, including mortgage endowment complaints, by smaller financial advisers.

The results were quite pleasing. We found no evidence in our project that small financial advisers are 'fobbing off' mortgage endowment complaints or complaints generally. We also found that for complaints that are referred to the Financial Ombudsman Service, the vast majority are not upheld, and so are ruled in favour of the firm.

There were, however, some minor problems about how complaints were being investigated, with some taking too long to deal with and not following our requirements, or even the firm's own complaints procedures. But overall this is a good story.

We continue to have constructive dialogue with the industry on treating customers fairly. AIFA are members of our TCF consultative group, and AMI have issued a briefing note on treating customers fairly. We believe that there is a real opportunity for AIFA/AMI to play an even greater role here and in raising industry standards.

Conclusions

These are exciting and challenging times for the retail distribution system. You play an increasingly important role in the financial health of our society. And there are real opportunities for you to make a difference.

In many aspects of your work we are encouraged by the progress being made. But elsewhere there is more to do, including making the Treating Customer Fairly principle a reality and a core part of all your businesses. We want to support and work with you to further increase standards in the industry. And I am confident that AIFA and the AMI can play a key role in moving towards what I believe are our common goals.

Thank you for your attention.