In this, the fourth of six articles on investigations and enforcement topics by Freshfields Bruckhaus Deringer, the authors consider the Financial Conduct Authority's (FCA) competition strategy in relation to investigation and enforcement.
This article focuses on its general competition powers and remit, which are already in place.
The FCA has a competition objective – to promote effective competition in the interests of consumers – and a corresponding duty to promote effective competition, so far as possible, when satisfying either of the co-existing consumer protection and integrity objectives. The significance of the FCA's competition ambitions are also clear from the grant to the FCA of competition powers concurrent with those under the Competition Act 1998, effective April 2015.
The FCA's approach
The FCA's overall strategy will be, to a significant degree, driven by its competition strategy. Focus will be on actual outcomes experienced (or likely to be experienced) by consumers, and the FCA will seek to identify and address issues before problems become "entrenched". In addition to a previous shift away from viewing disclosure of sufficient information to customers as enough for a firm to meet its obligations, the FCA will no longer assume customers to be rational decision makers. Consequently, the FCA will incorporate behavioural economics into its methodology, both in relation to investigations and the remedies imposed following enforcement. (See speech by Christopher Woolard, FCA Director of Policy, Risk and Research, on 2 June 2014 and speech by Martin Wheatley, Chief Executive of the FCA on 25 March 2014.
Investigation of issues
The FCA considers that there are four main contributors to market failure:
- behavioural biases;
- market power (including abuse of monopoly and collusion);
- information asymmetry; and
- externalities (where third parties are affected) and cross-subsidies (between different groups of consumers).
Specific issues may be identified via thematic reviews, market studies (which are in our experience more in-depth and focussed on competition issues) or market investigation references. Equally, issues may be noted during routine supervisory visits or self-reported by firms pursuant to their Principle 11 obligations.
The FCA expects market studies to be the main tool for identifying competition issues in regulated markets, and has so far announced 4 studies: general insurance add-ons, SME banking, retirement income and cash savings. Resources will be targeted primarily on areas with the greatest potential consumer harm, and those where the FCA is most likely to be able to intervene and assist consumers.
When considering products and practices within financial institutions, the FCA will look for early warning indicators of consumer biases that could lead to market failures, including:
- abnormally high profit margins;
- concentrated profits from a small group of customers;
- innovative products at an unexpectedly low price;
- contract features (such as teaser rates and default options) that target behavioural biases;
- reports of consumer regret
- consumer choices inconsistent with common sense; and
- customer confusion regarding details of products they have purchased.
A key driver behind the FCA's competition strategy is product pricing. The FCA will be looking out for complex and opaque pricing structures, as well as assessing value for money (for example by looking at claims ratios on insurance products). In the recent General Insurance Add-Ons market study, the FCA was interested to see research showing that varying the presentation of pricing information to consumers has a significant impact upon their ability to determine the best value deal.
On a firm-specific basis, supervisors and investigators will make qualitative assessments of consumers' true preferences. Where consumer choices contradict normal behaviours (such as preferring low cost products with high returns), or do not match stated preferences (for example regarding risk appetite or capital preservation), the implication will be that a problem exists. There will be a significant burden on the firm to demonstrate that those choices are appropriate and could reasonably have been made by consumers. Consumer research and data analysis carried out during any product testing phase may potentially assist at this stage – provided that taking advantage of behavioural biases was not the firm's strategy.
For wider market failures, the FCA will consider the context of the market, including the interactions between firms, other market failures present, and behavioural biases observed. For any market-wide analysis, the FCA is likely to seek primary data, via consumer research and experimentation, to identify consumers' true preferences.
Any solution to market failure will depend upon the perceived cause of the problem. Due to the complexity of the factors influencing market failures, identification of the root cause(s) for a failure will often be challenging. The FCA will consider the most probable causes and rule out those that do not fit the evidence well. Firms need to proactively engage with the FCA during this process, ensuring that the FCA has sufficient information to allow for a logical, methodologically sound process.
Following identification of the primary causes of the failure, a further exercise will be required to identify an appropriate response. If systemic issues are identified within the market, merely targeting the behavioural biases may be insufficient — a package of measures may be required. When assessing remedies, the FCA intends to choose the most pro-competition measure open to it, provided that it is compatible with the FCA's duties as a whole and consistent with its own overriding duty to regulate in a pro-competitive way. (Discussion following Competition — A new Mandate for the FCA, Deborah Jones, March 2014).
The FCA's new approach recognises that simple solutions, like the entry of more competition may not always be effective, especially where the problem is rooted in types of consumer behaviour. Behavioural economics may therefore be used both to identify the problems and potential solutions. Where it is identified that the behavioural biases of consumers are leading to poorer outcomes, the FCA may consider one or more of four solution types (on a forward-looking basis):
- Information (either providing more or prohibiting the use of certain materials).
- Changing the control environment (for example, by adjusting how choices are presented to consumers).
- Influencing the way in which a product is distributed.
- Requiring changes to the product (or banning it entirely).
In selecting solutions, a product ban is likely to only be used by the FCA as a last resort, when the product itself is
Following the General Insurance Add-Ons market study, the FCA suggested the following solutions (which at the time of publication of this article remain subject to consultation), which fall into the first three categories above:
- requiring firms to publish claims ratios;
- banning pre-ticked boxes (which exploit consumer inertia);
- improving how add-ons are offered via price comparison websites; and
- prohibiting the sale of add-on insurance at the same time as the sale of the primary product is concluded.
The proposed solutions may result in the introduction of new rules, and market practices will also evolve as a result of the inherent pressure placed on firms by the FCA's findings.
For any FCA investigation, if a firm is found to have breached an existing rule or Principle for Business, a review of past business and a subsequent redress exercise may be imposed.
Ideally, the FCA would prefer interventions to be tested before implementation, most likely via randomised controlled trials (RCTs) to evaluate differing approaches. RCTs may also be incorporated into redress exercises, to determine whether a communication style or format elicits an increased customer response rate. An RCT may significantly extend timescales involved. (See Test, Learn, Adapt).
Implications for firms
The evolution of the FCA's approach to its competition mandate continues, and will be focussed on consumer outcomes. Given the current spotlight on value for money and pricing, a high point of judgement-based regulation firms will need to be able to show that they have not taken advantage of consumer biases and errors to increase their profits. Although challenging, banks will need to consider whether, and if so how to identify instances where, consumer biases are driving sales.
To that end, product development records and subsequent regular analysis carried out by firms (as recommended by the FCA for demonstrating compliance with firm obligations) will be very relevant to many FCA investigations. Firms should ensure they have detailed records available. At the remedial level, identifying primary causes of market failures will be necessary and firms should proactively engage with the FCA to ensure that resulting remedial action will not unnecessarily affect other products or the market. The FCA continues to expect a constructive and collaborative approach, and will expect firms to take note of all its competition related findings.