The UK Financial Services Authority (FSA) has recently published its Financial Risk Outlook (FRO). This identifies the FSA's views on the risks facing firms, consumers and the regulatory system in this challenging financial environment. Following the FRO, the FSA published its Business Plan 2009/10, which explains how the FSA intends to tackle those risks.
The FSA says it is making a clear commitment to increase its enforcement activity and penalties and improving and increasing its resources. The FSA's overall budget is set to increase by 22.6% to £415 million for the next year.
This note highlights some of the key issues arising from the FRO and Business Plan for regulated firms and individuals.
Outcomes Focused Regulation
The Business Plan refers to a new FSA strapline "outcomes-focused regulation", indicating a change of emphasis from its previous strapline "principles-based regulation".
According to the FSA, "principles-based regulation" means, wherever possible, moving away from prescriptive rules and placing on firms explicit responsibility to decide how best to align their business objectives and processes with the FSA's key Principles for Businesses. With its new strapline, the FSA has signalled a change of focus from judging adherence to Principles to judging the consequences of actions taken by regulated firms and individuals.
What precisely "outcomes-focused regulation" means in practice is as yet unclear but there must be an increased risk that the FSA will apply hindsight when judging firms' and individuals' actions. There is also an increased risk that the FSA will use speeches and other publications to articulate the "outcomes" it expects, thus, in effect, creating another layer of "rules" for firms and individuals to comply with.
The FSA has signalled a stricter regime for the monitoring of firms' liquidity (see its Consultation Paper CP08/22 in December 2008) and it will propose new liquidity rules (which are due to be published in the Turner Review at the end of this month). The FSA's Chairman has indicated that the FSA will require banks to hold up to 3 times as much capital against their trading assets. The FSA anticipates that many firms will need to reshape their business models to adhere to the proposed new rules.
In short, the main proposals cover the following:-
- Ultimate responsibility for liquidity risk lies with the board of directors who must establish the firm's liquidity risk tolerance. Senior management must, on an ongoing basis, review the firm's liquidity position and report to the board. The FSA says it will be reviewing these arrangements more rigorously.
- New requirements will include the need to have in place processes and systems to identify, measure, monitor and control liquidity risk and resources.
- High level standards of the current regime will be maintained.
- Requirements for firms to carry out stress testing and have in place contingency funding plans will be strengthened.
- An Individual Liquidity Adequacy Standards framework will be used to make sure standards are tailored to individual firms.
- A new regime will be put in place to regulate the liquidity of UK branches of foreign firms and entities forming part of a wider group.
According to the FSA, firms must understand the access they have to liquid assets which can be converted to cash if funding becomes unavailable and they must proactively develop alternative funding strategies.
Senior management responsibility and risk management
One of the priorities for the FSA in the Business Plan is to focus on individuals in significant influence functions. In particular, the FSA says it will address compensation structures, managerial competence and "risks from misselling".
The FRO highlights the need for senior management to ensure that risk management systems and controls are in place for all areas of risk in their firms. Individuals in significant influence functions need to ensure that risks are continually reassessed as market and economic conditions evolve. The FSA states that senior management need a clear understanding of the underlying risks to their business models. Prudential policy and accounting frameworks also need to be reassessed and stress testing and scenario analysis should form part of risk management, business strategy and capital planning decisions.
Treating customers fairly (TCF)
The FRO emphasises that firms, despite the difficult environment, must continue to treat customers fairly. The Business Plan indicates that this will be an area of strengthened focus and the FSA will monitor firms' engagement with markets, consumers and counterparties in order to reduce loss to consumers. The FSA says it will take tough action against firms failing to achieve TCF outcomes.
A number of risks to TCF are identified in the FRO:
- Lower levels of new business and lower persistency of existing business.
- Firms moving into new areas of business.
- Firms introducing unfair terms into contracts of sale.
- Higher levels of defaults, arrears and possessions.
- Higher claims on protection products.
- Misselling of financial products to consumers. The FSA focuses on the suitability of recommendations, on product description and on appropriate systems and controls.
- Cost cutting within firms. In particular, reducing expenditure on compliance should be resisted.
Financial crime and market abuse
A major concern addressed in the FRO and Business Plan is the possibility of market abuse and financial crime being exacerbated by current market conditions as incentives for committing financial crimes increase. Fraudsters also continue to pose greater threats as they use increasingly sophisticated techniques.
The key types of financial crime highlighted by the FSA are account takeover fraud, market abuse, fraudulent valuation of investments and the inappropriate handling of market rumours. The FSA highlights that robust and appropriate systems and controls are key to managing and mitigating financial crime risks.
The FSA is conducting a thematic review of anti-bribery and corruption systems and controls in commercial insurance brokers' systems. It will consider whether to extend the review to other business sectors.
Given the economic climate, firms may wish to diversify into different areas in order to increase sources of capital. If so, the FSA stresses, they must have the appropriate regulatory permissions and adequate controls in place for those activities.
More changes to the FSA's philosophy
The FRO and Business Plan do not present the whole picture. On 25 February 2009, before the Treasury Select Committee, the FSA's Chairman, Lord Adair Turner, indicated further changes to the FSA's philosophy of regulation. He referred to a shift in the belief that markets can be relied upon to correct themselves and in the appropriateness of regulation being "light-touch". He said that there would be a "revolution" in the FSA's style of banking supervision with the regulator's focus no longer being on only banks' processes and structures but on their strategies as well. Significantly, he also signalled that the FSA was considering becoming more involved in product regulation (at present the FSA regulates companies and their markets, not the products they sell).
These are challenging times both for the FSA, whose very credibility is at stake, and those that they regulate.