Small firms - under the radar?
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Stephen Bland, Director of Small Firms, and Retail Intermediaries sector leader, FSA
Financial Adviser Expo. London
22 May 2007
Introduction
Good morning ladies and gentlemen, it gives me great pleasure to be here today. I am grateful to Hal Austin and Financial Adviser for giving me the opportunity to speak at this important annual industry event.
Before I get into the detail of my speech I would like to give you a very brief introduction to my roles at the FSA. I am the Director of Small Firms Division at the FSA. This Division supervises the nearly 18,000 small retail firms for which FSA is responsible. These are principally the financial advisers, the mortgage brokers and the general insurance brokers. I am also the Sector Leader for Retail Intermediaries. As sector leader, I work closely with trade associations and others (and indeed by reading Financial Adviser and other 'pinks'!) so as to try, as early as possible, to identify and assess the major concerns of the sector and the major risks to consumers that might arise in it - thus working for the benefit of the industry and consumers alike. In this role, amongst other things, I am leading on the Retail Distribution Review – a crucial topic in its own right for us all, on which (if you will excuse the plug) you can hear more at our own conference on 27 June.
What is important to you today is that my supervision role and my sector leader role put me in the front line (and on more than one occasion the firing line), of the retail intermediaries market and the firms operating within it. So I am both acutely aware of the challenges that small intermediaries like you face every day and of the challenges that Parliament has set us in seeking to ensure that consumers are appropriately protected in this area of the financial services market.
Background
What I want to talk to you about this morning is the perception in the industry that small retail firms are below the regulatory radar. It is important for everyone in this room to be concerned about this perception becoming enshrined in 'folk lore'. If the perception were true, then rogue firms could choose to run their business without being picked up by the regulator, tarnishing the industry as a whole. And even the perception that it might be true has potential negative impacts on consumer and market confidence. So this topic is not a bit of regulatory navel-gazing but one which should rightly worry us all. My concern is further compounded by commentary in some parts of the market, claiming that it is now more onerous to be monitored by a network than it is to be directly supervised by the FSA, and that this is driving a significant number of Appointed Representatives to move away from networks to direct authorisation.
My speech aims to tackle this Under the Radar perception head-on by demonstrating:
- How our risk-based supervision strategy helps us to supervise a large number of small firms in an effective and proportionate manner.
- That appropriate action is taken against those firms who pose a significant risk to our consumer protection or other objectives.
- How we maximise the effect of our resources to change firms' behaviour by using a range of innovative supervisory tools.
- And by giving you some facts and figures on advisers' choices between joining a Network and direct authorisation.
Risk-based approach
If you have been an IFA for more than 5 years, you more than anyone will know how the regulatory relationship you have with the FSA has changed. In 2000 when the FSA became the single regulator, and new legislation was passed, we introduced a new and totally different risk-based regulatory approach, tailored to help us deliver our four statutory objectives – maintaining market confidence, promoting public awareness, protecting consumers and reducing financial crime – efficiently and effectively. We wanted, and needed, an approach which was proactive and preventative – put in plain English, one which was capable of heading off problems in advance. We also wanted to create an environment which encouraged firms to manage their own risks better and thereby reduce the burden of regulation on them, an emphasis since further strengthened by our move towards Principles-Based Regulation. At the time this new approach was introduced, and on many occasions since, we have been very clear about what this would mean for small firms: a different approach to monitoring – not less monitoring.
And so when the Treasury announced the FSA would take on the regulation of mortgages and general insurance, we knew we had an appropriate risk-based framework to handle the possibility of the regulated population quadrupling overnight. The pure logistics of supervising such large numbers of small firms meant that we had to design and implement an innovative set of systems and business processes which would enable us to deliver our responsibility to supervise those firms in an effective and proportionate manner.
Applying our risk-based philosophy of regulation, means that we do not systematically visit or inspect all small retail firms, clearly this would not be a proportionate, risk-based strategy. Indeed to do so on the same basis as the previous statutory regime for IFAs would have meant that we took on about four hundred extra staff, all of whom would be paid for out of the annual fees levied on the retail intermediaries themselves. A better approach is to concentrate on giving help to firms who want to run their businesses profitably and sustainably in compliance with our requirements, and bearing down on those firms who are not interested in meeting our standards. We use Business Intelligence and other tools to help us identify the firms in the latter category, and the Retail Mediation Activities Return that most of you fill in is crucial in allowing us to do that. Our focus is thus on changing firms' behaviour to benefit consumers by: identifying and prioritising risks to our statutory objectives which arise in individual firms; and in new and emerging cross-industry risks. We then mitigate those risks by taking specific action against those individual firms who have come to our attention or by conducting an industry-wide sampling exercise to look at specific issues and to communicate the results to benefit the market as a whole.
However, this approach places more importance on different methods of exerting influence within small retail firms rather than using one method for all. In this, visits to firms play a relatively smaller part than in a less risk-based world. The important point is not that on average small retail firms get fewer visits (though of course there is always sampling going on) but that the visits are concentrated on those firms which are not trying to comply with our requirements; for such firms, the very clear message is that they could be visited at any time.
Individual Firms
Turning first to individual firms. It is imperative to have at our fingertips a high level, up to date picture of each firm, and a good understanding of the business being written by each firm.
As you are aware, retail intermediary firms are required to submit twice yearly electronic returns. We recognise that this information is a firm's self-assessment and if inclined, there is scope for a firm to provide incorrect, even fraudulent, information perhaps deliberately to distort the picture. Our initial emphasis was to get returns submitted on time; now 90% are doing so – compared with around 40% under previous regimes. Our drive this year is on accuracy. You will not be surprised to know that we do spot checks on accuracy of the return, and are indeed planning to step those up; to date, the results have been re-assuring. Furthermore, this information isn’t the only source of data we have about the firm. What brings the picture into sharper focus is when we overlay the firm specific information with a range of other data, and intelligence - sometimes with very interesting results!
Let me give you a quick canter through of the kinds of other data we receive, if only to give you an idea of how illuminating it can be when considered alongside that submitted by the firm. We regularly receive information such as product sales data from product providers – this covers products they have sold, the intermediary involved, and the method of selling and some customer information.
Other information comes from the Police, Customs and Excise, The Department of Trade and Industry and other law enforcement agencies. Also, the Financial Ombudsman Service, Office of Fair Trading, and other regulators, home and abroad. Highly valuable intelligence comes from internal sources such as the firm contact centre and consumer contact centre. Individual whistleblowers are also becoming an ever increasing source of useful tip offs. And let's not forget all the information and knowledge we pick up about individual firms as part of our project work including the results of mystery shopping.
We have also made no secret of our philosophy of allowing the market to police the market. For some time we have been alerted by providers about financial advisers from which they are having difficulty getting clawback amounts; we take that into account when supervising those firms. Last year we worked with the Council of Mortgage Lenders to introduce a whistle blowing scheme for mortgage lenders and brokers which has produced good results – to date we have pursued 136 cases following information from 25 lenders; and this has led to 34 referrals to our Enforcement colleagues. And we have this year introduced a similar scheme in the general insurance market. We proactively encourage firms to participate in this scheme and help us beat criminal financial activity in their industry. We want to know when a firm has suspicion or evidence of malpractice so that we can act on it where appropriate. We hope that by sharing intelligence in this way, we can work together to reduce financial crime.
Once all this information is assembled together, we analyse and interrogate it to identify and prioritise the outliers – for example those firms who pose the greatest risk to our statutory objectives for example through not meeting one or more of our threshold conditions for being authorised or where there is risk of consumer detriment.
We are also of course able to identify those firms who simply do not submit returns. There are a number of reasons as to why this happen and experience has shown that the reasons are not always sinister. However, we do not tolerate the behaviour of firms who fall at this first hurdle without a good excuse, and in 2006 we withdrew 98 firms' authorisation purely and simply for non-submission of electronic returns where there were insufficient mitigating circumstances and we had given ample warnings.
The use of Enforcement is our most public tool. Last year we withdrew 151 firms' authorisation. But this is only the tip of the iceberg. Around 1,000 firms last year complied with our requirements after we had threatened to send them to Enforcement for breaches of our requirements. And about 1,000 firms per month are contacted by us without any reference to Enforcement because an apparent problem has arisen. For example, about 200 firms last year changed their financial promotions after contact from us. What you see in terms of Enforcement cases really is the tip of the iceberg; to revert to my original metaphor, small retail firms are more on our radar than many think.
Having said all that, firms do of course fail, either financially or by failing to treat their customers fairly. We only have to look at some of the results of our thematic work to illustrate that. As with large firms, we do not aim to operate a zero failure regime, as we believe any such regime would be excessively burdensome for firms and would not accord with the statutory objectives and principles of good regulation, in particular in encouraging innovation by fostering a competitive market. And I am not saying in any way that small retail firms currently have an "acceptable" rate of failure.
Cross-firm Issues
I would like to turn now to how we take action on new and emerging cross-firm issues. I mentioned earlier that we wanted a supervisory approach that was capable of heading off problems in advance. Some risks arise not just in an individual firm but across particular market sectors. These are often best dealt with through a thematic project which co-ordinates a range of regulatory activities designed to investigate, understand and address the risk. By examining the issue in a speedy way we can then communicate for the benefit of all firms the good and poor practice we have seen amongst small firms.
We use the firm-specific and industry data to identify cross-firm problems proactively and promptly and take appropriate supervisory action, using a range of innovative tools, to help limit the probability and impact of potential consumer detriment. A number of you here today may have been visited or telephoned as part our project last year to assess the extent to which investment firms' processes allow them to treat their customers fairly when giving investment advice. If you weren't contacted as part of this, be prepared – as we are doing follow up work later this year, including carrying out an extensive programme of visits.
Any firm can be asked to participate in a thematic project and we do make sure that we target those firms we think are deliberately taking action to fall under the radar. For example, we recently carried out a project to assess firms who are 'geographically remote' and which have not had a previous regulatory visit. And we always include in our thematic work not only firms which have reached our regulatory radar through an aspect of non-compliance but also firms which do appear to be meeting our minimum standards as far as we can tell from the data we receive.
Take for instance, the 659 telephone assessments we conducted late last year and early this year to assess firms' progress in implementing Treating Customers Fairly - TCF - into a substantial part of their business. This exercise was targeted to include many firms who had not had any contact with us before. It was not a self-assessment by firms but more of a structured test which was supported and followed up by visits to a sample of firms to verify that the assessment we had reached, based on information supplied by the firm, was correct.
Similarly with the 400 firms we contacted following the end of our quality of advice process findings for investment firms, we purposely targeted those firms who had not had contact with us in the previous 12 months.
As mentioned earlier the success of a risk-based approach, where we don't routinely visit small firms, is to leverage the results of our thematic work so that firms are clear: about how we expect behaviour to change to deliver the outcomes we are looking for; and that we will carry out follow up work, including further sampling and visits to test that firms have acted on our communications.
Our recent Client Money project is yet another good demonstration of how all this works in practice. When we took on regulation of general insurance intermediaries we carried out a small number of initial interviews which confirmed our suspicion that client money handling in these firms was generally poor. We produced a Client Money Guide to educate and help firms understand what was required of them and sent this to all general insurance intermediaries with a strong message that we would be following up with a sample of firms to test compliance. We recently completed this programme of follow up work and we were very pleased to see that firms had been able to use the Guide to make big improvements in this area. This is good news. Not only because its reduces the risk to our statutory objective of protecting consumers but it proves, once again, that our risk-based approach works and brings about change within firms.
The overall result
If we add up the results of our firm-specific work and our thematic work, you will see that small retail firms are more on our radar than the 'folk lore' would suggest. To use figures relevant to those in this gathering, when we recently looked at the financial advice sector we found that only a third of you had not had individual contact from us in the previous year. And by contact I mean personalised demands for action from us; so this excludes the 170,000 contacts that small firms have with our Firm Contact Centre each year and the 50,000 visits to our small firms' web-pages that you make each month. So this is actually a higher level of contact than previous statutory regulators.
Appointed Representative status versus direct authorisation
Let me move briefly and finally onto the assertion some have made that appointed representatives are choosing to leave networks in the belief that direct authorisation is a lighter touch. In some senses, a Network is bound to do more checking than FSA would; its own senior management need to carry out the responsibilities that we expect the management of any authorised firm to perform. Nevertheless, I am pleased to say that the figures we are seeing simply do not back this assertion up.
Obviously the figures around all this have to be treated with a lot of care. But you would certainly expect some movement towards direct authorisation given the collapse of two large networks in the last year or so and given the rise of competition to traditional Networks from service providers. Indeed in the twelve months from April 2006 to March 2007 the figures for network financial adviser appointed representatives show an overall decrease in numbers of around 19 per month, an annual decrease of about 3%, and these figures include those exiting the market as well as those applying for direct authorisation But, in the first quarter of 2007, appointed representative financial adviser firms actually rose by over 150 firms. No sign there of a steady decline in the network adviser population. What about the financial adviser directly authorised sector? Well, it is true to say that there has been a gradual increase in the number of directly authorised firms – an increase of 29 new firms a month over the April 2006 to March 2007 period, giving an increase of about 7% in the overall number of financial adviser firms. But only about a quarter of new authorisations were identified as network leavers. So this growth is largely driven by healthy growth in the financial advice sector, not by exodus from networks to direct authorisation. The 'folk lore' tale, even given the pressure on and competition for traditional Network models, is simply not true. Please can we not have any more repetition of the 'folk lore'?!
For completeness, I'd note that in the mortgage and general insurance markets, the evidence is even clearer that firms are not seeking direct authorisation as a way of avoiding the compliance burden imposed by networks. What we are seeing here is a gradual decrease in the number of directly authorised firms – by about 9% over the past year - and a rise in the number of appointed representatives of about 11% over the same period. If anything, this could be indicating that many small firms are becoming aware that their processes are indeed subject to FSA scrutiny, and seeking the compliance support that networks (amongst others) can offer.
Summary
I hope I have achieved what I promised to do - that is to explain how we supervise a large number of small retail firms effectively and in a proportinate manner, and how this approach means that small firms are on the radar – even where firms take deliberate action to avoid detection. So the answer to the question posed in the title of my speech 'Small firms – under the regulatory radar?', is "no". Of course there will be a number of exceptions – we do not live in a zero-failure world and you would not want to pay for or experience the supervision that would be necessary to move close to one. And I am conscious that this may come across as defensive – "methinks [he] doth protest too much" – we are always looking to improve our effectiveness and we will continue to assess, and where necessary, revise our approach to make us more efficient and effective. But I think the issue is so important for the health of the market we all care deeply about, and the consumers it serves, that I wanted to put on the record some facts to correct the misperception that has grown up in places.
A final thought for you. In doing this, I hope I have also demonstrated that we do not need to be sitting in firms' offices to have a reasonable understanding and grip on what you are doing. Through a combination of approaches we are able to maintain an accurate and up to date picture of your firm and we use this to target our resources most efficiently. So if you are one of the firms who takes an overly-relaxed attitude to regulatory compliance, don't put us to the test – we might just pass it!,
Thank you for your time and I now open the floor to questions.