The FSA's retail strategy
Speech by Clive Briault, Managing Director, Retail Markets, FSA
FSA Retail Firms Division Conference
27 February 2008
Thank you all for coming today. This is our second Retail Firms Division conference and I am delighted that so many of you have joined us. I hope you have found the morning challenging and stimulating and that it has provided an opportunity to share thoughts and views with us and with other delegates.
Before we let you have lunch I want to draw together some of the themes of today's conference by setting out our retail strategy and the key risks and priorities for us this year.
The FSA's retail strategy
Our retail strategy is to make retail markets work more effectively and efficiently and, as a consequence, to help retail consumers achieve a fair deal. That has been interpreted by some as being limited to Treating Customers Fairly. But it goes much wider than that. Our retail agenda is based around four "pillars" which reflect what we consider to be the four main features of an effective and efficient retail market. These are:
- capable and confident consumers;
- clear, simple and understandable information provided for, and used by, consumers;
- soundly managed and well resourced firms who treat their customers fairly; and
- proportionate, risk-based and principles-based regulation.
Alongside these pillars we also focus on structural problems in the market that might seriously hinder the achievement of an effective and efficient retail market. Hence our work on the Retail Distribution Review, where we are looking for market-led solutions to significant structural problems in the retail investment market.
And we are clear that, to deliver succesfully on our retail agenda, we need to:
- work in partnership with industry and other stakeholders; and
- deepen our understanding of the economic context and drivers of the retail financial services markets. Indeed, a deeper understanding should enable us to enrich our retail strategy with a clearer picture of what success might look like in terms of vibrant and viable business models.
As set out in the Business Plan we published earlier this month, we will be taking forward our retail strategy in 2008 under three main headings:
- first, prudential supervision. We will continue to work with firms - both retail and wholesale – to address issues raised by current market conditions and, in particular, to ensure that firms maintain adequate capital and liquidity;
- second, conduct of business. We will continue to drive forward our Treating Customers Fairly initiative, the Retail Distribution Review, our enhanced small firms strategy, and our financial crime priorities; and
- third, financial capability. We will continue to roll out our five-year strategic plan to deliver more capable and confident consumers.
Prudential issues: adequate financial resources
There can be no doubt that current market conditions are challenging. Consensus forecasts, on which the central scenario in our Financial Risk Outlook is based, suggest a less benign outlook for the UK and global economies, and within this we expect the difficult market conditions to persist for some time. Moreover, there are significant downside risks. It will therefore come as no surprise that, as we said in our Business Plan, a major supervisory focus for us is that all types of firms – retail and wholesale – continue to maintain adequate financial resources.
Hector touched this morning on the particular difficulties that Northern Rock faced, and the lessons we are learning from that and from developments more generally over the last seven months. I do not intend to cover the same ground. But I do want to mention the industry and regulatory response to recent market conditions.
I begin here by recognising the huge efforts across all sectors – and particularly the banking and building societies sector - that have gone into managing what for many of you will have been unprecedented market conditions. For banks and building societies this has included:
- Assessing your funding and liquidity positions. Firms should be protecting themselves from current vulnerabilities by actively putting in place adequate levels of liquidity;
- Undertaking robust liquidity stress testing. Robust stress testing should form part of the risk management framework of all firms, and we would expect you to have revised your stress testing parameters in the last few months to take account of current and prospective market conditions;
- Assessing and stress-testing your credit risks and concentrations of exposures across your banking and treasury books;
- Assessing your overall capital positions in light of current and anticipated market developments, and considering, where necessary, how you intend to strengthen your capital position and enhance the quality of your capital. A key tool for this is your Internal Capital Adequacy Assessment (and all boards should have signed these off by the end of 2007): in this you are required to stress test your capital and to have a robust capital plan in place;
- Contingency planning against the worst outcomes, and reviewing and revising these plans in the light of market conditions. For example, we have been drawing the attention of deposit-takers to the need for contingency planning for retail deposit outflows. These plans might include the very practical issue of how to cope with an upsurge in retail deposit withdrawals, from branches, call centres and over the internet. And of course as well as having such plans it is essential that your staff at all levels understand what they would need to do; and
- Reviewing and assessing your medium and longer term strategies and the options open to you.
These issues clearly have broader application beyond banks and building societies. I am sure many of you have been asking yourselves, and responding to, challenging questions along these lines in the context of your own businesses, particularly around stress and scenario testing and contingency planning. And in some cases – not least for mortgage brokers and wholesale funded mortgage lenders – you have already seen some of your competitors exit the industry.
Many of you have already been subject to visits recently as part of our liquidity reviews, or provided us with additional information. We have, for example, written to all life insurers asking for details of their illiquid assets and credit derivatives and their approach to valuing those assets. And we have worked closely with the asset management sector, particularly in relation to redemption requests in property funds. I record here my appreciation of the way you have responded to our visits and requests for information.
I hope, however, that the questions we are asking of you are very similar to questions you have already been asking yourselves as the senior management of your firms – and I hope that you asked them well before we did! It is disappointing to observe that in some cases the boards and senior management of firms have been slow to ask themselves the searching questions that they ought to have been asking in current market conditions, and have left themselves exposed as a result.
In stressed conditions, it becomes even more important that the dialogue between firms and their regulators is open and constructive and firmly rooted in achieving outcomes. In the main, I think this has been achieved and I am grateful to all of you that have played your part in achieving this. I hope we can keep the momentum and spirit of partnership going.
Over the next twelve months we will seek to target our resources in a way that is proportionate to the risks they are designed to mititgate. There are various ways in which we can flex our resources. In our Plan for 2008/09 we have increased our overall budget. And within this higher total we will be shifting more resources into supervision. We will also be looking to maintain our enhanced focus on liquidity, on stress-testing, and on gaining a better understanding of firms’ business models. This should be consistent with spending less of our resource on capital issues, following the successful implentation of the Capital Requirements Directive and the roll out of the Individual Capital Assessment regime, although in current economic and market conditions we need to keep a close eye on the adequacy of capital resources. We will also review the allocation of our resources between different sectors – say between banking and insurance - and between our prudential and conduct of business work. But that should in no way diminish the importance of the rest of our retail agenda, to which I now turn.
Conduct of Business
Our Financial Risk Outlook highlighted a risk that increased financial pressures might lead firms to reduce their efforts on meeting our conduct of business requirements. We will be challenging the senior management of firms to demonstrate to us that this is not the case. And it is important to be clear here that, despite current market turbulence, Treating Customers Fairly remains a key priority. For smaller firms, that are not relationship managed, we will deliver this through our enhanced small firms strategy, which should benefit all firms by improving standards in the industry more generally.
We recognise that senior management in many firms are taking Treating Customers Fairly seriously. As highlighted by the break-out sessions today, the challenges faced by the wide range of sectors covered by our Retail Firms Division are many and varied. But we see signs that many of you are seeking to embed the fair treatment of customers within the culture and particular business model of your firm. And we see improvements in product design and progress on the clarity of information in financial promotions and in mortgage and general insurance product literature. But most of you have further to go.
We have set two important deadlines for 2008. First, by March 2008 you should have evidence in place – through appropriate quantitative and qualitative management information and measures - to be able to test whether you are consistently treating your customers fairly and meeting the six consumer outcomes. Second, by December 2008 this evidence should be showing that you are indeed treating your customers fairly.
This is not a bureaucratic, process-driven approach. We simply want you to look at your business and identify which of the six consumer outcomes are relevant to you; to ensure that you have appropriate evidence in place to measure whether you are delivering the identified outcomes; and to consider what the evidence is telling you and – where necessary – to act upon it.
These deadlines are not negotiable. They should be met by all firms, irrespective of prevailing market conditions. Meeting the two deadlines will require sustained energy and commitment from the senior management of firms. We will take regulatory action against those firms that fail to fulfil their obligations, including, as appropriate, imposing demanding risk mitigation plans with challenging deadlines, varying firms' permissions, remediation work, and enforcement action.
In the context of treating customers fairly, one of the important areas that we continue to focus on is with-profits, where there are approximately 32 million polices in force and more than £400bn of assets invested. Consumers continue to express concerns about the performance of with-profits funds; about the lack of transparency in these products; and about closed funds. Interest in other aspects of with-profit funds has re-surfaced in recent months, not least because of the negotiations between Norwich Union and the Policyholder Advocate in relation to the proposed reattribution of the inherited estate. It is therefore timely to remind ourselves of the original thinking behind our review of our regulation of with-profits funds that we undertook a few years ago.
It was widely recognised that management's exercise of discretion in with-profits funds had often been less than transparent. Moreover, there are sources of potential conflict, such as shareholders having an interest in not informing policyholders about valuable features such as guarantees, or decreasing the risk of the fund by investing in safer and possibly lower performing assets that reduce the level of capital support required by the fund. To address these issues, our with-profits review, which began in 2001 and was completed in 2005, recommended a comprehensive package of reforms to create a more robust framework of requirements relating to the fair treatment of with-profits policyholders. These rules were the subject of extensive consultation and led to benefits for policyholders such as the Principles and Practices of Financial Management (as well as their consumer friendly companions), new rules on charging market value adjustments, additional requirements on funds that close to new business, and the introduction of the role of the Policyholder Advocate.
These reforms have been in place for over two years now, so you could be forgiven for thinking that our attentions had drifted elsewhere. Not so. Having designed a new framework for with-profits we continue to focus on its implementation to deliver the intended outcome of Treating Customers Fairly.
Underpinning the delivery of fair treatment for with-profits policyholders is the fundamental need for robust governance. The responsibility of a firm's senior management has always been a cornerstone of our regulatory regime and we continue to focus on the effectiveness of the governance structures overseeing with-profits funds. A key part of this is how a firm introduces independent judgement in assessing the firm's compliance with its Principles and Practices of Financial Management and in its management of any conflicts of interest between different groups of policyholders and between policyholders and shareholders.
I am pleased to say that we have seen improvements in how firms' senior management have delivered fair treatment to policyholders and have implemented changes to their governance arrangements. Nevertheless it is clear that further improvements are needed and we will continue to challenge firms on the effectiveness of their governance arrangements. I comment on three examples of this today, namely the distribution of excess surpluses, the fairness of market value adjustments that are applied to policyholders that surrender their policies early, and the clarity of post-sale communications to policyholders.
Life insurers are required to assess, typically on an annual basis, whether their with-profits fund has a surplus of capital over and above what it needs to meet its regulatory capital requirements or as working capital – for example to support new business. In the interests of fairness between different generations of policyholders we require any excess surplus to be distributed – typically on a 90/10 basis to policyholders and shareholders respectively. We will continue to scrutinise very carefully any firm that does not plan to distribute an excess surplus because such inaction is likely to be inconsistent with its obligation to treat with-profits policyholders fairly. This distribution is quite different from a reattribution, which I will come on to in a few moments.
Another area where we have seen the benefits of our new rules is in the charging of market value adjustments. These are applied when a policyholder wishes to surrender their policy before maturity, and we insist that they are calculated on a fair basis, to ensure that those surrendering do not profit at the expense of those who stay. We are encouraged by the fall in the number of such adjustments in place, but discouraged by the need to challenge some firms that have failed to communicate clearly to their policyholders the existence of time periods when a market value adjustment does not apply. This takes me on to another important point, namely post-sale communications and continuing advice.
Providing clear and timely policyholder communications is a critical element of treating with-profits policyholders fairly. Our Insurance Sector Briefing published in May last year highlighted some good examples of clear communication, but also some significant failings, including a failure to mention or explain market value adjustment free dates or guaranteed annuity rates; the use of complex terminology without explanation; and a failure to explain how the actions of an insurer may affect the policyholder. Good policyholder communication needs to become the rule and not the exception. And under the Unfair Terms in Consumer Contracts Regulations we have obtained undertakings from firms not to use terms in their with-profits policies that are presented in unintelligible language.
Advisers also need to take some responsibility here. Where an adviser has created an expectation that there will be continuing advice for an existing customer, or has offered full advice to a new client, then this should include the review of any with-profits policy.
A significant proportion – approximately 25% - of the estimated total of assets invested in with-profits is managed in funds that are closed to new business. This creates additional fairness issues, including the investment strategy of the fund, the management of charges and expenses as the fund size decreases, the fairness of the distribution of any inherited estate between different generations of policyholders, and the adequacy of senior management oversight at a time when firms can be less focused on devoting quality resource to this part of their business. However, it is worth highlighting that our last three with-profits payout surveys showed that being in a closed fund is not necessarily detrimental to a policyholder in terms of payouts – in 2007 16% of payouts from closed funds delivered first quartile performance, compared to 33% from open funds.
The reattribution of a firm's inherited estate is a particularly complex area and one that has resulted in much misunderstanding and confusion. It is useful to clarify five points here.
First, the inherited estate – and indeed the with-profits fund as a whole - is an asset of the insurer. It is used as capital for the fund, and one of those uses is to help protect the fund and its policyholders against adverse market conditions. Policyholders also have rights and interests in the estate, even if they do not own it in law. This is why our rules do not allow the firm to dispose of the inherited estate as it wishes.
Second, a reattribution is quite different from a distribution. In a reattribution, the capital is still needed as working capital, and therefore it may not be available for distribution to policyholders (and shareholders) in the foreseeable future. Indeed, it may never be distributed to policyholders or shareholders during the lives of many current policies. This is why we have created the role of the Policyholder Advocate, whose role it is to represent policyholders and negotiate with the firm on the value of what they are giving up. There needs to be a balance which takes account of the value of policyholders’ interests in the inherited estate and the value to shareholders of obtaining the estate.
Third, we have not sided with firms in allowing them to use the inherited estate to finance new business, strategic investments, compensation for mis-selling costs, and shareholder tax. On the financing of new business we are very clear that we would not allow a firm to write new business at a loss, or put another way, to deliberately erode the inherited estate. However, we do allow the estate to be used to meet the initial costs of new business provided the business is managed with a view to repaying those costs to the estate over a reasonable period – this can be in the interests of both with-profits policyholders and the firm. Similarly we allow strategic investments provided they do not harm the interests of existing policyholders. Shareholder tax payments are allowed where it is consistent with the firm's established practice and is disclosed to policyholders. As for allowing the payment of mis-selling compensation costs, we have concluded recently, in the light of the strength of views now put to us, that we will consult on whether, given the nature of those costs, they should be borne solely by the shareholders.
Fourth, shareholders do not receive a windfall dividend immediately after the reattribution. All money reattributed to the shareholders will be retained in the firm for as long as it is needed to support the with-profits fund. Indeed, if this money was not needed as working capital then we would expect it to be distributed to policyholders as excess surplus, rather than reattributed.
Fifth, we have an independent role to scrutinise the fairness of the reattribution proposals once the negotiation between a Policyholder Advocate and a firm is completed. Our overriding concerns are the fair treatment of policyholders and a proper balance of their interests against those of shareholders. A fair deal can be achieved in a variety of ways, but if we conclude that the proposals are unfair, we will challenge the firm, using our regulatory powers. In addition, some reattributions involve a court process and give policyholders the opportunity to vote on any deal they are offered.
Retail Distribution Review
The Retail Distribution Review is a key enabler for the delivery of our retail market objectives, complementing the work on Treating Customers Fairly, and providing opportunities for further applications of a principles-based approach. Our aim is to act as a catalyst to drive the development of market-led structural solutions that lead to better consumer outcomes and a more efficient retail investment market.
We closed the first discussion period for the Review two months ago. Many of you encouraged us to be bold and ambitious about wanting to improve outcomes for consumers in this market. We are very encouraged by the degree of engagement shown by the market to date – and we are absolutely committed to preserving the momentum here.
We intend to publish an Interim Report in April to be followed by a full Feedback Statement in October. The April paper will not contain any decisions on the way forward – that is for October. But we do want to use the April paper to play back some of the more promising ideas that you and others have suggested to us, and to signal where we want to gather more evidence and undertake more analysis and discussion with you.
In particular, I expect the April paper to cover three key areas:
- First, remuneration – where many of you have urged us to take a principles-based approach and not to prescribe a single option. Our intentions here are clear – we want firms to manage remuneration so that they avoid any conflicts of interest that might otherwise inhibit them from acting in the best interests of the customer. We want to shift the focus of remuneration away from the provider and towards the customer, thus removing the potential for provider-led remuneration to result in bias. We want providers to meet their responsibilities to design, target and market their products in ways that treat their customers fairly – and this includes the ways in which they remunerate both their in-house staff and third-party distributors. We want advisers to act solely in the best interests of their clients, not on behalf of providers who are paying them commission. And we want simple charging structures that are capable of being understood by consumers. So we want a market where it is in the interests of all firms to compete for customers solely on the basis of the quality and prices of their products and services, and where providers and distributors meet their responsibilities to treat their customers fairly.
- Second, professionalism – where there is considerable support from you for higher minimum standards and enforceable codes of ethics. However, you have also told us not to set the qualifications bar as high as the equivalent of Chartered status because of the potential for this to strip out significant market capacity; to take a balanced view of knowledge, skills and experience in measuring competence; and to make sure that we allow sufficient time for the industry to transition to higher minimum standards. We want the industry to take the lead in driving up standards of professionalism and indeed in setting those standards. We do not underestimate the challenge of achieving consensus across the whole industry, for instance in establishing a single, overarching professional standards board if that is to be part of the way forward. But such challenges must be met and we are determined to see that happen.
- Third, some of you commented on what our Discussion Paper called Primary Advice. The name had little support but many of you still feel that some sort of "sales" service – distinct from “advice” - is needed in the market. We agree, not least as a means of delivering higher levels of investment and saving. We need you to drive the debate here - what business models would work for you, and how will they deliver the right consumer outcomes? We are not going to design business models that you and your customers do not want to use. We are also mindful of the significant demand shifts that might be generated over time by Otto Thoresen’s proposals on the delivery of generic financial advice.
We are mindful that some of you run businesses that might be described as "niche" – by virtue of your particular product ranges, your affinity with particular consumer groups, or your approach to distribution. We recognise your concerns that market change might threaten your business models and we will take that into account when we consider the ideas further after April.
Financial Crime
Financial crime is very much in the news these days with a number of major incidents of data loss from both regulated firms and Government departments, and with a number of cases of fraud in the housing market. It is therefore absolutely right that tackling financial crime contintues to be a key priority for us this year. Our Financial Risk Outlook highlighted that tighter economic conditions could increase the incidence of some types of financial crime, or lead to firms diverting their attention away from tackling financial crime. Throughout 2008 we will continue to pursue the objectives of our three-year financial crime strategy: to gain a better understanding of the scale, incidence and impact of financial crime; to target poor performing firms and sectors; and to encourage the risk-based implementation of financial crime policy.
Financial Capability
On the demand side of the retail market our financial capability and disclosure intiatives aim to move consumers to a stronger position to influence the way that financial products and services are delivered to them. This will enable consumers to make better informed decisions when buying financial products and services.
More than ever before, we are being required to take responsibility for managing our personal finances. However, many people do not have the knowledge or skills to navigate the financial highway.
Increasing financial capability is something we work towards in partnership with others as part of our National Strategy. This has brought together a range of partners from the financial services industry (including a number of you here today), consumer bodies, voluntary organisations, Government and media, with the FSA providing leadership and co-ordination.
This strategy has already reached nearly 3 million consumers on the way to our target of providing financial education, information and guidance to 10 million people by 2011.
The more we can equip consumers to make their own decisions, or to have an informed discussion with their adviser, the more scope there is for competitive forces to deliver the right outcomes. This is also why we strongly support the Government's consideration of a national generic financial advice service and why we will be fully engaged in finding ways to implement the recommendations emerging from Otto Thoresen's review.
Conclusion
In conclusion, it is clear that 2008 will be a challenging year. The market and economic conditions are difficult. So within the retail agenda we need both to address the strains that these conditions place on capital and liquidity, and to help consumers achieve a fair deal. I hope though that we can continue to work together in partnership to meet these challenges.