FSA mortgage regulation - one year on
Speech by Callum McCarthy, Chairman, FSA
The Council of Mortgage Lenders Annual Conference
6 December 2005
I am grateful to the Council of Mortgage Lenders for the invitation to speak this afternoon. It gives me an opportunity to review what has happened since we took on the responsibilities for regulating mortgage brokers at the end of October 2004: what we set out to do; the approach we have adopted; the results so far; and how we intend to go forward.
The scale of the task
First, let me set out the scale of the challenge. The immediate task was considerable: the authorisation of over 14,000 firms new to regulation, and variation of authorisations for over 4,500 firms already regulated. This was an administrative task of size and complexity, which I think it fair to say was done with efficiency. More fundamental, the advent of so many new firms, overwhelmingly small firms, presented the FSA with substantial policy issues. It significantly altered the demographics of the population of firms regulated by the FSA: more than 90 per cent of the firms we now regulate fall into the category of small firms. It altered profoundly the experience of regulation among the firms we regulated: almost none of the firms brought into regulation had any previous experience of the FSA – and vice versa. It raised issues of how we should apply our risk-based approach to a large number of small firms; how we should communicate with them; more generally, how should we engage with them.
The approach
Our approach has been based on a determination to deal with the very large number of mortgage brokers in a way which recognises the special features of the sector – the large number of firms involved, their size, and their – and our – relative inexperience of dealing with each other. The fact that most mortgage brokers are small means that, applying the FSA's risk-based philosophy of regulation, we will not in the normal course of business expect to visit or inspect them. This places a premium on different methods of exerting influence from those we use with large firms (including many mortgage lenders). In place of the "close and continuous" supervisory relationship which the FSA has with large financial institutions, our relationship with mortgage brokers is based on surveys, sampling and statistical knowledge of the sector which enables us to consider the results of surveys and samples and then publicise good and less good practice found in them to the relevant firms within the sector.
The approach has specifically recognised that we are in new territory. Our risk-based approach means that we do not try to do everything at once, which would indeed be impossible. Instead we concentrate on areas where we see real risks to the objectives that Parliament has set us. We aim to be transparent about where we think these risks lie and so we have from the beginning set out to explain what our priorities would be. Clive Briault set them out at the equivalent conference to this last year. They were:
- making sure that firms carrying on business requiring authorisation are in fact authorised – in the jargon "policing the perimeter". We need to do this for the sake of the overwhelming majority, the compliant firms, by acting against the relatively few non-compliant;
- reviewing a wide variety of financial promotion material and practices;
- reviewing the quality of disclosure documentation for customers; and
- looking at particular high risk mortgage activities, namely the sale of lifetime mortgages and associated investment advice.
In a moment I will describe what we found. But first I want to set out our overall response. It has been based on communication of our results, for educational purposes: to set out findings of what is and is not working; to identify good and not so good practice; and to give warning of where improvement is needed.
Communications with the industry
We have, at all levels, used as many opportunities as we can to communicate with the industry. We hope that this goes some way to help make it easier for firms to do business with us. We have not only been working with lenders and brokers to feedback our findings and to help them to better understand our mortgage requirements, but we have used our web pages, newsletters, roadshows, speaker events and Industry Training workshops not only to deliver our messages but also to listen to the industry's responses to those messages and the things that are concerning them most. We have issued press releases on some of our actions, both as a way of being transparent about what we have done to others and as a way of getting our messages out in the national and trade press. It is also important that we maintain good relationships with trade associations as this has proved to be a beneficial way of reaching firms and receiving feedback. The quarterly forum on lifetime mortgages, of which the Council of Mortgage Lenders is an active member, is a really good example of where we can act in partnership.
Our approach has emphatically not been based on enforcement: our aim is to make sure first that firms understand what is expected of them, and second that they act accordingly; it is not to seek to take enforcement actions in the first instance, unless the offence is egregious – so were we to discover fraud you should expect us (in every sense) to take enforcement action.
This policy of education and communication rather than enforcement has not been without its critics. I am convinced however that it was the right way of introducing the new regime.
What have we found?
Let me turn to the results of our work against the priorities we established. Before I take you through these priorities I should take this opportunity to say that overall most of the mortgage industry has conscientiously tried to deal with the changes regulation has brought. Although we have seen some areas of particular concern, we are more or less where we expected to be one year on from the start of the new regulatory regime. However, we have to be clear that there is still some way to go, for some firms, in some areas. We will continue to work to help both lenders and intermediaries meet our requirements in a way that helps firms continue to do business effectively and competitively but also in a way that ensures that they are treating customers fairly.
Policing the perimeter
I'll start with our 'perimeter' work. We contacted over 600 firms, 450 in the form of visits, and found that the vast majority of mortgage brokers are well informed about the need to be authorised by us to conduct regulated activities. Only 11 mortgage brokers who should have been authorised weren't; seven of these applied for authorisation and the remaining four no longer conduct regulated activities. We were also pleased to see that lenders are refusing to deal with intermediary firms where they are uncertain about their authorisation status.
So, in May this year, we were able to announce that the mortgage perimeter seemed to be 'in good shape', which was very encouraging. And, although our focus shifted to the general insurance sector for the second half of this year, we have continued and will continue to monitor the mortgage market and react to leads from the industry and consumers to prevent firms operating illegally.
Financial promotions
Second, our financial promotions work. Through desk based reviews and visits to a cross-section of firms across the mortgage market we assessed the quality of these firms' financial promotions as well as the adequacy of their senior management arrangements and their systems and controls to comply with our Mortgage: Conduct of Business requirements. Overall, we did not find any significant concerns with the major mortgage lenders, lifetime mortgage providers and the larger intermediaries in the sub-prime market, and in many cases we were pleased with the standards we saw. However, we did have some concerns over newly authorised networks' controls over their appointed representatives and general compliance with our financial promotion rules by smaller firms promoting sub-prime lending on the internet. We have been working with individual firms to communicate our findings and have set remedial action in some cases.
We have just completed some further work looking at small firms using internet promotions for sub-prime lending – an area where consumers are particularly vulnerable – and found that many websites still do not comply with even the basic requirements contained within our mortgage rules for financial promotions. The main problems we've seen include a lack of risk warnings and APRs, or, where this information is included, a failure to give them enough prominence to serve their purpose. We have given the regime a year to bed in. We are now considering taking further action where we continue to see these same issues.
Throughout the year we have used our financial promotions quarterly bulletins on Mortgages and General Insurance and the financial promotions pages of our website to communicate our findings and key messages – a demonstration of our approach via communication rather than enforcement.
Disclosure documentation for consumers
Third, our disclosure concerns: one of the cornerstones of our mortgage regime is disclosure documentation. This documentation seeks to provide the consumer with clear, straightforward and comparable information to help them understand the services and products a firm offers. This will enable them to shop around more easily and so make informed decisions. So, it is no surprise that this was one of our initial priorities.
We sampled a cross-section of mortgage lenders' and intermediaries' Initial Disclosure Documents (IDDs) and Key Facts Illustrations (KFIs) to check whether they were in the right format with the right content. We also commissioned an external agency to conduct a mystery shopping exercise to see whether firms were handing out these documents to consumers at the right time.
The quality of the documents varied, with most firms not producing fully compliant Initial Disclosure Documents and Key Facts Illustrations. For example, we reviewed 280 Key Facts Illustrations and found that around half of them were longer than they needed to be. The position was not as bad as some reports indicated: reports suggesting these documents are '16 pages long' were not found to be the case. We have made it clear that we regard good practice for KFIs as being five pages or fewer and we know that many lenders are now doing this. I would encourage you all to move in that direction. It can be done. There's no reason why it should not be done.
We also found that for both disclosure documents the prescribed format and text laid down by our rules were not being used. We acknowledge that the significance of individual failings may not have been major, but, taken together, the failure was more significant. Departing from this standardised format hinders the consumer's ability to compare mortgages and mortgage services – which should be one of the main advantages of the new regime. We also saw lengthy descriptions of features and charges often scattered with legal language and jargon, when plain English explanations would be clearer.
Much more worrying, the mystery shopping also told us that many firms, 43% of the 82 mystery shopping assessments conducted, are not providing these disclosure documents to customers at all. This is a very real concern.
We have published messages on our disclosure work and the concerns we have with those firms who are not following good practice. We have also provided further detailed feedback for firms to help them to improve the quality of their documentation and published the report highlighting the results of our mystery shopping. All of this information is available on our website.
We are now embarking on follow-up which will continue into next year to check whether there is a noticeable improvement in the quality of firms' disclosure documentation and the timely provision of them to consumers. We acknowledge the systems changes that some firms need to make following our initial round of work. We will be mindful of this during our second round of work. Where firms have yet to roll-out full changes we will focus on the changes planned to see whether they are going to improve the documentation and comply with our rules. We plan to deliver our messages from the follow-up work in spring 2006. But this is an area where real improvement is needed.
Lifetime Mortgages
The last of our priorities was the specific issue of lifetime mortgages and associated advice. As you know Lifetime Mortgages are higher risk products because of their complexity, lock-ins and the target consumer base. Clearly, provided they are properly sold, they can meet a very real social need, and provide value to consumers. Our concern is that a product which can be of great value is not abused.
We undertook a mystery shopping exercise looking at the sale of lifetime mortgages – to find out how the product is explained to consumers, to get a better understanding of how the advantages and disadvantages of releasing equity are explained, and to gather information on the lifetime mortgage sales process. We also conducted visits to firms and desk-based reviews of firms who give investment advice on the capital released through equity release schemes – checking suitability, whether advisers had taken all the necessary factors into account and had explained the risks of borrowing to invest.
We found significant shortcomings. The mystery shopping revealed that a number of advisers did not gather enough relevant information about their customers to make recommendations suitable to the customer's personal and financial circumstances or to enable them to make informed decisions about whether equity release was right for them. The exercise also revealed that some advisers were not giving customers enough information about equity release products and the way they work. In those circumstances it is hard to see how the customer makes an informed decision.
As well as the mystery shopping, the visits and desk based review work showed that some advisers were failing to explain the link between the two transactions of, first, releasing equity and, second, the subsequent investment. There were also concerns over the quality of advice being given to customers. For example, we were very concerned to see that some advisers were recommending that customers borrow money at 7%, an average lifetime mortgage rate, and invest that in products with a yield of around 3.5% - something which raises obvious prima facie concerns.
I would like to cover this investment advice aspect in a little more detail. The investment advice fell into three main categories: investing for growth; investing for income; and inheritance tax mitigation.
On investing for growth: we found that some advisers were encouraging customers to release more than they required and advising them to reinvest the surplus cash in products such as investment bonds. On investing for income: there are equity release products on the market which allow the consumer to drawdown an income from their lifetime mortgage. However, we saw examples where advisers were recommending customers to release a lump sum and reinvest it in an investment bond and take withdrawals to provide an income. It was difficult to see why the customer was being recommended down this route since it is not only more expensive, but reinvesting capital in equity-backed investments exposes the customer to different risks, which need understanding and justifying. Finally, on inheritance tax mitigation: there is a very fine balance here and we found a number of cases where the lifetime mortgage would leave the customer's estate worse off than if they had done nothing to mitigate their IHT liability.
It is, therefore, not surprising that we are working with individual firms to correct these problems and are taking enforcement action against one firm – an example of the (I am glad to say) relatively rare instance where we consider abuse of mis-selling has been so clear that enforcement action is appropriate. We will also be conducting a further round of visits over the coming months and conducting more mystery shopping.
Electronic Reporting
I explained in describing our approach that we would use statistical and sampling techniques rather than the supervision and regular visitation of individual firms as the basis for our regulatory relationship with the mortgage broking sector. To do this, we need good data – hence our requirements on both intermediaries and lenders.
Our first electronic returns started to come in from August. For mortgage intermediaries this means the Retail Mediation Activities Return (RMAR), which is the basis of their regulatory reporting to the FSA, and the first time that returns have been submitted to us. For lenders this is the Mortgage Lenders and Administrators Return (MLAR) and product sales data which firms should by now have registered and started to submit. I thank both intermediaries and lenders who have submitted their returns already and remind those that need to submit during December to get their returns into the system in plenty of time.
We intend to check on the quality and accuracy of the regulatory returns towards the end of the year and are already using the data provided to identify and act on emerging trends and risks. I hope the method of providing these data will prove useful and efficient to both you and us. It is intended to be so.
Other issues
As well as the priorities which we established a year ago, we have, as you would expect, reacted to some particular issues which our work has identified: self certification, sub prime market issues, mortgage administration practices and the wider set of issues associated with responsible lending. Let me report on what we have found.
Self-certification
First, self-certification was already a high-profile area prior to mortgage regulation and we wrote to the chief executives of lenders after the work we did last year. Our work at that time showed that lenders generally had appropriate systems and controls for this type of business. This year, we took the opportunity to follow-up this work with a sample of mortgage lenders. We found that these lenders had strengthened their systems and controls leading to increased detection rates of fraudulent applications; improvements in the quality of information transferred to underwriting departments; and better identification of training needs for the self-certification business. Although this is encouraging news, we are seeing greater competition within this market, tighter margins and rising arrears levels. Lenders need to remain vigilant and ensure their systems and controls are regularly reviewed.
Moving onto the intermediary-side of this market, we have also reviewed the sale of, and advice on, self certification mortgages by small mortgage brokers. The work involved both visits to firms and a mystery shopping exercise – you can see from our work on both disclosure documentation and lifetime mortgage work, that mystery shopping used appropriately is becoming a very useful supervisory tool for us.
We found that a small number of firms were prepared to discuss with the customer the possibility of overstating their income in order to obtain a larger mortgage; but it was encouraging to see that there was no evidence to suggest that this practice was widespread. However, where we do find fraud of this nature we will continue to treat it seriously – and we have instituted enforcement action against a number of firms for such practices over the past year – an example of where enforcement is entirely appropriate.
What we did find disappointing, though, was the significant failings relating to affordability and the suitability of advice given to customers. For example, nearly half of the firms sampled were unable to demonstrate that they had appropriately assessed affordability and in around a third of all cases reviewed it was unclear why a self-certification mortgage had been recommended. We have recently communicated our messages on this and published a factsheet highlighting examples of good and bad practice which is available on our website.
Sub-prime
Now I'll turn to a related area of work, the sub-prime market, a growing area of the mortgage market. As well as the work I mentioned earlier on financial promotions we have also reviewed the selling and advising practices of small mortgage brokers. A key part of this was assessing the adequacy of the training and competence of advisers to determine what information is gathered from the customer, what advice is given to the customer, and the fees charged.
We saw examples of good and bad practice. But, overall, we saw some disappointing results. For example, from visits to 31 firms and a review of 210 case files, in 60% of cases insufficient information was gathered from the customer; in 80% of cases, there was a lack of evidence to demonstrate that the recommendation met the customer's circumstances and needs; and in 67% of the cases involving debt consolidation, there was insufficient evidence that the adviser had taken account of the additional requirements related to debt consolidation mortgages so it was unclear whether the recommendation was appropriate.
We have again published, on our website, a good and bad practice guide to help firms raise the standard of sub prime sales. We plan to carry out some further work in this area during the first part of next year.
Mortgage exit administration fees and early redemption charges
Third, work on mortgage administration. This work has also covered consumer protection powers to identify whether we are seeing unfair contract terms both in mortgage exit administration fees and early repayment charges.
As you know, when consumers pay off their mortgage early or switch their mortgage to another lender, lenders charge exit administration fees. As for many other fees and charges for financial services, in most contracts firms state that they can change these charges over time rather than keep them fixed for the life of the contract.
Recently, we have seen some lenders increase their administration fees and some consumers have argued that because firms have done this they have acted unfairly. As you know, we do not set prices for the products we regulate and, therefore, lenders are entitled to vary the amount they charge for their services. However, when a firm changes its charges, the Unfair Terms in Consumer Contracts Regulations requires the firm to act fairly. In our recent Statement of Good Practice we explained that terms which enable firms to change fees unilaterally are more likely to be fair if there is a valid reason for doing so.
We have reviewed a number of mortgage contracts and believe that some lenders are changing their exit administration fees in an unfair way. Therefore, we are working with these lenders to discuss how they can vary their fees in a way which is fair to consumers.
It is useful to highlight, at this point, that over the past couple of years most of complaints we have seen were about early repayment charges. Having now reviewed the vast majority of these cases we have not found widespread malpractice in the mainstream lender market. However, we are concerned that there are different practices in the sub prime market and there may be firms who are including inappropriate costs in their calculation of early repayment charges. We are planning to conduct further discovery work on the sub-prime lenders market to try to identify to what extent this is a concern.
Responsible lending
Last, the wider issues of responsible lending – the requirement to assess affordability of a mortgage for the customer. As well as the problems I have already highlighted around affordability in the self-certification and sub prime markets, over the past few months we have dealt with responsible lending issues with individual firms in mainstream mortgage lending. This has ranged from concerns over whether 'higher risk' mortgage products are reaching customers for which they are not suitable, to the way firms are determining affordability. In these cases we have clearly set out our concerns to the senior management of these firms and reminded them of their responsibility to treat their customers fairly, especially where higher risk products are involved. I expect this to be of growing importance as an issue.
Post-authorisation work
Lastly, over the course of this year we have also been dealing with the risks and issues we've identified from the application and variation of permission process. In particular, we have focused on the 'higher risk' small mortgage brokers. We have found issues with non disclosure, the falsifying of client files and a poor understanding of the mortgage regime. As a result, three of the firms we visited have been referred for Enforcement action. However, we must also balance this with the fact that around half of the 'higher risk' broker firms we visited were acting appropriately.
Where do we go next?
Let me deal finally with where we intend to go next. We have just started a review of the effectiveness of the mortgage regime (a similar review is also planned for General Insurance). Effectiveness reviews are our approach to try to ensure that our policy interventions in the market are actually making a difference in practice. The review will assess how far our mortgage conduct of business requirements for mortgage firms are delivering the benefits for consumers intended. We acknowledge that this can't be done over a period of a couple of months so it will be rolling programme which will be completed in stages. Disclosure requirements and advice and selling practices are a couple of areas on the top of our list where we will look to undertake consumer research early on. We will also be using various other regulatory tools to test the effectiveness of the regime ranging from analysis of statistical information to conducting mystery shopping.
At the beginning of next year we will be undertaking a study looking at the changes in consumer attitudes and behaviour over time. We hope that this research will give us a baseline for the current impact of the mortgage regime on consumers. We then intend to repeat this research periodically so that we can assess any longer term impacts. We plan to feed back our initial findings next summer. If after the first stage rule changes are necessary, we will consult on proposals in the usual way, including full cost benefit analysis. This means that only where a careful and rigourous analysis shows that such a change would be of material benefit should any changes be made. We are mindful of the costs that the industry has already incurred in implementing the existing regime and about which you are understandably concerned.
I am particularly concerned that we should be able to come to judgments about the real effects the new regime is having. Is the information set out in key facts enabling those wanting a mortgage (or to change a mortgage) to make informed decisions? Is switching becoming easier? Are the costs of switching being identified for customers? Is the new requirement on lenders to assess the affordability of a mortgage for their customers being met? Those are among the questions we will wish to answer.
Let me conclude. The first year of the new mortgage regime has been a busy one for all of us. On our side, it has been marked by an approach designed to be proportionate, and based on education and communication rather than enforcement. On your side, it is clear that most firms want to comply with the new mortgage regime. Across the industry there are many examples of good practice, which we both find encouraging and wish to encourage.
But there are also areas – important areas – where practice is not yet good enough, or where good practice is not yet prevalent. We need to see improvements in disclosure, and in the treatment of customers in respect of lifetime mortgages in particular; and we need to improve consideration of customer affordability. All these are central, not peripheral, issues, and you should expect us to treat them accordingly. The graduated and proportionate approach we have adopted in this, the first year, of mortgage regulation will continue. But we expect communication to lead to action: it is not an end in itself. We will therefore be increasingly determined that those issues of concern which we have identified are in fact acted upon; that problems are dealt with; that mispractices cease. You should expect us to act with vigour against those who fail to put their house in order, or who slip from previously good practice. There is obvious benefit for consumers in our doing so. But there is also an important – though perhaps less obvious – benefit for the industry in our doing so. Those with good practices constitute the majority. It is in their interest that the minority who fail to meet standards are penalised for so doing; that good practice is rewarded, just as bad practice carries a cost. So, as we move beyond the introductory year of the new mortgage regime, I look forward to continuing and developing the same co-operation which we have enjoyed, in a context where both you and we have learnt much and therefore can be expected to do better. I am sure we can do this.
Thank you.