The FSA's retail agenda
Speech by Clive Briault, Managing Director, Retail Markets, FSA
BSA Annual Conference
23 May 2007
Good morning and thank you for your kind invitation to speak to you today.
Within the FSA's overall priorities, our retail agenda focuses on delivering an effective and efficient retail market for financial services and products. We structure our work in the retail area around four pillars:
- 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
- Proportionate, risk-based and more principles-based regulation.
Today I want to focus primarily on the third of these pillars, and in particular on:
- the importance of sound management and adequate capital as safeguards against the risk of less favourable economic conditions; and
- the importance of treating your customers fairly.
In addition, I want to offer some thoughts on the provision of simpler advice on simple products.
But I want to begin by thanking the BSA for its contributions to a number of issues on which you have helped us over the last year. These include:
- Support and contribution towards our Financial Capability agenda. We are working – in partnership with many organisations, including the BSA – to improve levels of financial capability. We want consumers to be capable and confident in dealing with the financial services industry. And we are looking for ways to encourage consumers to engage more actively when dealing with financial products and services, since it is in their own best interests to do so. That is why we are pleased that a number of societies have become involved in our project to deliver education in the workplace.
- Input to the Retail Distribution Review, where building society representatives have participated in two of our industry groups, and BSA staff have acted as observers on all five groups. These groups have played a vital role in considering industry solutions to feed in to our forthcoming Discussion Paper and we have been very pleased by their positive and forward-looking approach. We appreciate in particular the heavy time commitment that this has represented for the BSA.
- Active participation in the consultative group which informs our work on Treating Customers Fairly.
- Representation on our Capital Requirements Directive industry groups, in particular the Pillar 2 Standing Group. The one-day session the BSA provided to the industry on Pillar 2 was a great success.
Market conditions
The UK mortgage market is one of the most dynamic and competitive in the world. It has grown rapidly over the last eight years, at an average annual rate of over 11%, and has more than doubled during this time to the £1.1 trillion of mortgages currently outstanding. The building society sector as a whole has remained competitive throughout this period, keeping up with the overall market. Excluding the impact of de-mutualisations, the sector has maintained its market share of 20-21%. The last quarter in particular stands out as one where building society mortgage lending was strong, with net lending the highest it has been for over three years.
Looking at other products, building societies continue to be a popular choice for those placing cash ISA deposits, with 2007 looking likely to improve on last year, and societies overall having double what you might consider their natural market share, based on the relative size of the sector. Building societies have also been successful in the provision of Child Trust Funds.
Current market conditions are good and the most likely outlook is for these to continue. However, there is always a need to be prepared for the downside. All lenders, including building societies, should ensure they are ready for a possible market downturn. We would be concerned not only with the effect of a downturn on the financial strength of building societies and other market participants, but also with its direct impact on consumers. Recent favourable economic conditions have enabled and encouraged many consumers to take on additional debt, much of it secured against property, but many of them will be unprepared and ill-equipped for a weaker economic environment.
This vulnerability is beginning to show through.
The Bank of England has increased interest rates twice this year. Despite an increasing proportion of people having fixed rate mortgages, the ratio of interest payments to income is creeping up, which in turn increases the vulnerability of both borrowers and those who have lent to them.
The number of personal bankruptcies and Individual Voluntary Agreements, though now levelling off, has risen five-fold since 1998.
Sub-prime mortgage arrears are currently running, even in these relatively benign economic circumstances, at up to 20 times the rate of arrears on prime mortgages.
And even prime mortgage arrears, which came down markedly over the last decade, are beginning to rise.
The last UK housing boom and bust at the end of the 1980s/early 1990s, and the fall-out that we are currently witnessing in the US sub-prime mortgage market, are indications of what could happen.
It is therefore crucially important that all mortgage lenders undertake regular stress testing of their credit risks against shifts in external conditions, including movements in house prices, interest rates, and unemployment. Where lenders have significant exposures against sub-prime, buy-to-let and other specialist sectors of the market they should take account of potential changes in economic conditions specific to these sectors. It is important that building societies know how their portfolios are likely to perform in different circumstances so that any necessary action can be taken before such an event occurs or so that they can undertake some preparation towards an appropriate response.
So far, one society has applied successfully for Internal Ratings Based model approval under the Capital Requirements Directive. Three more are in the pipeline, with a further twelve expected. For those lenders taking advantage of this approach we will be looking very carefully at the assumptions you are making in determining how much capital you should be holding against the potential credit losses that may arise. In particular, we will be looking at stress testing results. We expect to see realistic and robust scenarios that demonstrate the potential impact on your business of a much less benign economic environment.
I have already mentioned sub-prime mortgage lending as a growing risk to firms active in this sector of the mortgage market. Here in the UK the sub-prime sector is a rapidly growing part of the mortgage market, estimated at 8% or more of total mortgage lending. And the number of lenders active in the sub-prime market has grown, with the entrance of both new lenders and lenders already operating in the prime end of the market.
We have seen existing prime lenders diversify their lending into the sub-prime market. I say "diversify", although in this case portfolio theory is unlikely to apply since the "diversification" is likely to increase rather than decrease risk. If you diversify away from prime mortgage lending into almost any other asset class, your credit risk is likely to increase.
The risks are particularly high where firms have no initial knowledge or experience in this specialised end of the market and are attracted mainly by the potentially wider margins available; margins that have been narrowing as competition intensifies in this market. We have seen cases where lenders have undertaken little or no analysis of the risks that go with those margins, and where it was far from clear to us how the senior management or the board of the firm could have taken a fully informed decision to enter the sub-prime market.
In a similar way, we have seen many new entrants to the commercial property market who have gone in without a robust assessment of the downside risks. This area also remains high risk.
I accept that the UK sub-prime market is not the same as in the US. Loan to value ratios have been less aggressive in the UK, and in the UK we have less of an issue with the low start adjustable rate mortgages with interest roll-up that seem to be causing particular problems in the US. However, we cannot completely ignore the parallels with our own market. For example, lenders are in some cases taking on substantial risks through a combination of high loan to value ratios and high income ratios, in part because borrowers are using additional borrowing against property as a means not only of debt consolidation but also of increasing their debt at regular intervals by taking as much advantage as possible of rising house prices. Continued house price appreciation may therefore be masking severe difficulties in some sectors of the housing market.
Placing a one way bet on rising house prices as a mechanism guaranteed to bail out both borrowers and lenders is not a sensible course of action - even a slowdown in house price inflation could expose a number of seriously over-indebted borrowers.
It is common practice to gain exposure to the sub-prime market through the purchase of loan portfolios from other mortgage providers, especially in the building society sector. Here, it is vitally important to ensure that risk is adequately assessed and priced.
The high level of sub-prime arrears also raises some important questions about the extent to which lenders have taken affordability into account when undertaking this lending. Our rules require both lenders and advisers to make an assessment of a borrower's ability to afford the mortgage, so high default rates should be prompting lenders to review their affordability models and to understand the root cause of high arrears.
Assessing affordability has three key aspects:
- to look at net income – that is, income after tax and having deducted expenditures such as borrowing costs, maintenance, dependant relatives and similar regular calls on available income;
- to consider whether the borrower can afford the payments, not just at the start of the mortgage but also when rates change, either generally or after an early discount or fixed rate period; and
- to consider whether the borrower can repay, or has a plan to be able to pay, the capital amount.
Although many of the findings from our study last year of the Quality of Mortgage Advice Processes were encouraging for lenders, we did find that while advice-giving lenders had robust processes in place for the assessment of affordability, these were not always followed and applied consistently. Indeed, much of our supervisory and thematic work to date has pointed to firms' assessment of affordability being a key area of concern in the mortgage market. So this will continue to be a focus of our thematic work over the next year.
We want lenders and advisers to apply appropriate lending criteria, including taking account of affordability; we want consumers to have a better understanding of the risks they may be exposed to when they take on debt; and when advice is offered, we want it to be suitable to the consumer's needs.
Treating Customers Fairly
The affordability of mortgage borrowing is one area where we currently have concerns over whether customers are being treated fairly, but our overall Treating Customers Fairly initiative is much wider and is at the forefront of our more general move to principles-based regulation.
We want to see a stronger focus from the senior management of regulated firms on the outcomes that really matter for consumers. A more principles-based and outcome-focused approach should encourage senior management to focus more on the Principles and the outcomes we want them to deliver; and should enable these outcomes to be delivered more effectively.
We want senior management to develop a greater understanding of how the Principles and our other high-level requirements should apply in practice; to drive and embed change throughout their firms; and to measure that this is delivering the right outcomes. A more principles-based approach also provides senior management with greater flexibility in how they run their business while meeting our requirements, and greater scope to compete and innovate while doing so; or indeed to compete by exceeding our minimum requirements.
We are challenging firms to treat their customers fairly throughout the whole of the product life-cycle, and thereby to deliver the six consumer outcomes:
- Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture.
- Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly.
- Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale.
- Where consumers receive advice, the advice is suitable and takes account of their circumstances.
- Consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and also as they have been led to expect. And
- Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.
I am pleased to see the emphasis that the BSA is giving to Treating Customers Fairly. Your recent annual report recognises this as an issue that is particularly relevant to building societies, and as I mentioned in my introduction, the BSA feeds in to our work in this area. It also works to support its members in implementing Treating Customers Fairly, having introduced its own working group which has formulated a manual for societies, to help them to embed Treating Customers Fairly.
We have recently completed a general assessment of progress by the industry - including building societies - against our end-March deadline for all firms to be at least implementing Treating Customers Fairly in a substantial part of their business. The aim of our March deadline was to stimulate action in firms that were slow to appreciate the significance of Treating Customers Fairly; to maintain momentum in those firms that were moving ahead with their Treating Customers Fairly initiatives; and to demonstrate how seriously we take Treating Customers Fairly within our more principles-based approach.
87% of medium-sized firms and 93% of major retail groups met the deadline. However, it is important to note that to meet this deadline firms needed to show they had allocated appropriate resources and responsibilities, developed plans and processes, and created capability to meet the Treating Customers Fairly principle. This does not necessarily equate to the delivery of the fair treatment of customers.
It is therefore essential that senior management continue to drive real change so that Treating Customers Fairly is embedded throughout their businesses as rapidly as possible. The March deadline helped to focus firms’ efforts and generated momentum within the industry as a whole. We need to maintain this momentum so we have decided to set two further deadlines.
By the end of December 2008 all firms are expected to be able to demonstrate to themselves and to us that they are consistently treating their customers fairly. One method of doing this will be to show that they are delivering, in particular, the six Treating Customers Fairly consumer outcomes we have identified. It is also clear that firms will need to have appropriate management information. We therefore have set an interim deadline of the end of March 2008 by which time firms are expected to have such management information or measures in place to identify whether they are treating customers fairly.
A few months ago, a chief executive of a major retail group explained to me in encouraging detail how his firm was putting its customers at the top of the firm's agenda. But when I asked how the firm measured the success of this initiative there was a long silence. I take the view that if something really matters to a firm then it will find a way to measure it, and will report this information regularly to senior management and the board. Treating Customers Fairly – and indeed meeting all of our eleven Principles – must surely fall into this category.
We know that some firms are finding the identification of appropriate management information challenging. To assist firms in this respect we will work further with the industry to help develop and share good practice.
As part of our Treating Customers Fairly initiative we have also looked at the relationship between product producers and distributors, and their respective responsibilities for Treating Customers Fairly. What does this mean for building societies as mortgage lenders?
First, there are a number of mortgage products that may be suitable for only a limited number of consumers, such as high income ratio and high loan to value products, equity release products and sub-prime mortgages. So, when designing a new product, societies should consider which types of consumer the product is likely to be suitable for, and equally importantly which types of consumer it is not likely to be suitable for.
Second, societies should select appropriate distribution channels, consistent with their products being bought by the types of consumer for which they were intended.
Third, societies should provide appropriate information to both distributors and consumers. They should communicate to their distributors both the advantages and the risks of their products, and make clear which types of consumer the product is likely to be suitable for. And they must communicate clearly the nature of the product to consumers, including significant features outside the headline price so that consumers can make informed decisions. Firms need also to consider the low levels of consumer understanding of financial products, including mortgages. The development of increasingly complex products underlines the importance of lenders providing information which is clear, fair and not misleading.
Fourth, we expect societies to monitor that products are ending up with the right type of customer. I stress that we are not talking here about 'policing' individual distributors, but we do expect societies to monitor product sales at a high level and to take action where they see that products are finding their way to customers who are not part of the target market. So if you design a product that you expect to be suitable for 10,000 consumers, and you end up selling 50,000 of them, please have a think about whether they have been correctly sold before you crack open the champagne.
And finally, we expect societies to deliver an effective post sale service, so that their contact with customers, and any information they provide, continues to deliver fair treatment.
Simpler advice on simple products
There is one further issue which I would like to raise here today; namely the provision of simpler advice to consumers around a set of simple products.
This is not a new idea. When we introduced the Basic Advice regime for stakeholder products we said that we would review the outcome and would be prepared to consider extending the idea of a simplified advice regime to a different range of simple products. We have repeated this intention since then. I have said in a number of speeches over the last two years that we would positively welcome discussions with firms that have an interest in introducing a more straightforward advice regime, linked to a set of simple products, which could be rolled out in one or more of their branches, call centres or on the internet. We, in turn, would consider how to put in place a risk-based and proportionate regulatory regime to facilitate this, and how to ensure that consumers understood and accepted the nature and the consequences of such limited advice.
We can now place this possibility in a wider context. First, as was always the case, it must be desirable – provided adequate standards of consumer protection can be achieved – to drive down the cost of distribution so that consumers on middle to low incomes can afford to take some advice on actions that could make a large difference to their financial situation. This is not just about saving and investment but also about basic protection against adverse circumstances.
Second, the review of generic advice being undertaken for the Treasury by Otto Thoresen is exploring territory that could overlap very closely with simple advice on a simple set of products. Generic advice could, in some of its possible forms, end up with general advice to a consumer that he or she should take actions that could easily be implemented by taking out one or more simple products. In which case a firm offering simple advice on a range of simple products could either offer the equivalent of generic advice as the first part of that process, or indeed accept the outcome of generic advice from elsewhere as having delivered the first part of a specific simpler advice process. There might then be a short step from generic advice to the sale of a simple product to meet the identified consumer need.
Of course there are many crucial questions to be resolved here. But I would be very interested to know what appetite you would have in providing simpler advice around a range of simple products. And what are the key variables for you here – do you see enough demand for such a proposition? Would it be economically viable for you? And how large a factor in the equation would be the concern that there would be too much "advice risk" for you in the form of subsequent action by the FSA as regulator or the Financial Ombudsman Service as the body which resolves individual disputes?
Conclusion
To conclude, you are already well aware of the challenges you face in the years ahead. My role as a regulator is to focus on your need to prepare against the possibility of tougher conditions in your key markets; to take full account of the risks in areas such as sub-prime lending; to undertake robust affordability assessments as part of your lending decisions; and to move ahead to the next stage of fully embedding the fair treatment of customers throughout your businesses. In addition, I encourage you to consider the scope for a simpler advice regime on a range of simple products.
From their origins in the 18th century, building societies have come to play an important role in the finances of ordinary people and their families. Currently, some legislative changes affecting building societies are being progressed as a result of Sir John Butterfill's Private Member's Bill.
We welcome the opportunity, created by the Bill, to equalise the rankings of your members' savings, and of outside depositors, upon insolvency. You will, of course, all continue to do your best to ensure that a building society insolvency remains as rare in the future as it has been in recent history, but this change would nevertheless be an important piece of consumer protection.
We also welcome the prospect of greater flexibility for your statutory wholesale funding limit, even if currently you neither need nor desire to take advantage of it.
We committed in our 2007/08 Business Plan to work with the Treasury on both these matters, and we have done just that through the various stages that Sir John's Bill has already cleared. So we are pleased to see the overall progress this Bill has made. The Bill is a major contribution to adapting the building society model in order to ensure its sustainability long into the future.