- The FSA is not aiming to dictate product structure and will initially focus on product governance
- The FSA will create a single set of rules and guidance on product governance, and some (or all) of the existing guidance on Responsibilities of Providers and Distributors for the Fair Treatment of Customers, and other TCF material, will become rules
- The rule changes will support more intensive supervision of product governance (which some firms are already experiencing) and will strengthen the FSA's ability to take enforcement action
- The FSA will consider other interventions where products have the potential to cause significant detriment, or product features are causing such detriment
- The conduct regulator will be willing to make judgments on the value for money of products, and make regulatory price interventions if necessary
- Various European proposals which are yet to be finalised could impact on these proposals – there is some risk that some of the proposed UK measures may prove to be super-equivalent to the approach ultimately adopted in Europe
The FSA plans to create a single set of rules and guidance on product governance, as announced in its feedback statement FS011/3 "Product Intervention" published last week. This will complement the more intensive supervision of product governance that firms are already beginning to experience.
In addition, the draft Bill published last week with HMTreasury's White Paper proposes to give the new conduct regulator enhanced powers to make product intervention rules prohibitingor restricting authorised firms from exposing consumers to an economic interest in specified products.
This briefing highlights some of the key points emerging from the feedback statement, and considers the regulator's radically new approach to the protection of consumers, as the FSA chairman described it, and how the proposed reforms to the UK's regulatory framework will strengthen this.
The FSA's Product Intervention discussion paper DP11/01, published on 25 January 2011, proposed that retail financial services regulation should move away from its primary focus on point-of-sale, to an approach that actively regulates all aspects of the product life cycle, including the design, development and management of products.
The approach is premised on presumption that earlier regulatory intervention in the product chain could help prevent consumer detriment, although these proposals would not aim to create a zero failure regime. The FSA believes that product design, and decisions about how and to whom products will be distributed, can significantly influence consumer outcomes and help ensure that products marketed to customers in fact service their needs.
The feedback statement confirms the FSA's proposed approach, summarises responses to the discussion paper, considers where its product intervention initiatives will sit with other relevant work in the UK and at EU level, and gives some indication of the FSA's expectations for the future.
The proposed approach
The focus of retail financial services regulation has already begun to shift away from a concentration on achieving effective consumer protection through fair sales processes and transparency through product disclosure and financial promotions.
The Government and the FSA promise that the new conduct regulator will have a lower risk tolerance, and will intervene more intensively at all points in the value chain. As the FSA acknowledges, there is some risk of unintended consequences, disproportionate costs and, potentially, regulatory failure, in active regulatory intervention in the design, development and management of products.
For the present, the FSA's approach to product intervention will predominantly be supervision-led. The focus will be on product governance – the way products are designed, brought to the market and managed over their lifetime. More work will also be done on point-of-sale standards. Going forward, however, the FSA will consider additional interventions.
A single set of rules and guidance
The FSA plans to produce a single set of rules and guidance on product governance. A single source for material focussing on product governance may well be helpful for firms, as there have been a wide variety of soft guidance pronouncements, particularly in relation to the Treating Customers Fairly (TCF) initiative.
The feedback statement suggests that Principle 6 has failed to prevent some product failures, although that is more a reflection of the previous regulatory approach to enforcement than on the scope of the Principle. It also appears that respondents have raised some issues which cast doubt on the effectiveness of TCF to date.
The FSA envisages that some or all of the TCF material, including the Responsibilities of Providers and Distributors for the Fair Treatment of Customers (RPPD) will be converted into rules. The impact of this proposal for firms will very much depend on precisely which parts of this material become rules. The guidance was originally designed for a principles-based approach, with the express acknowledgement that it would remain possible for firms to achieve compliance with regulatory requirements without following that guidance. It seems that the proposed rules are likely to cover the matters set out in Annex 3 to the feedback statement.
It is important to note that some of these are issues which fall within the scope of the review of the Markets in Financial Instruments Directive (MiFID), which considers a number of potential organisational requirements for the launch of new products. The FSA's proposals for rules and the MiFID review proposals are set out here.
Of some concern will be the scope of any proposed obligations on product providers to assess how what is occurring in practice in relation to products they have designed corresponds to (or deviates from) what was originally planned or envisaged for the distribution of its products or services given the target market. The RPPD accepts that in some instances, a product manufacturer may create components that are later (without the component manufacturer's knowledge) subsumed into retail products designed and marketed to customers by 'retail manufacturers'. In such circumstances, the pure manufacturer may not have a contractual or other relationship with the underlying customer, and may not be aware that the retail manufacturer is using the product for itself or for an underlying customer.
The FSA's purpose in moving to a rules-based approach is said to be to add certainty for firms, but also, and perhaps of greater importance in terms of likely impact, to strengthen the regulator's ability to supervise (it is not clear how the current supervisory approach is in any way fettered by the use of principles rather than rules) and to take enforcement action.
The FSA suggests that as many firms already follow the RPPD guidance, the additional costs of complying with RPPD rules should not be so extensive, and would impact most heavily on firms where TCF has not been fully embedded, which the FSA considers to be those most likely to generate problems.
As with various other current UK initiatives, there is a risk that the FSA's proposals could prove super-equivalent to EU measures currently in development - including legislative work on directives relating to Packaged Retail Investment Products, Insurance Mediation, Undertakings for Collective Investments in Transferable Securities and perhaps most significantly, MiFID. The FSA, which is actively engaged in European and international discussions, has indicated that the timing of any rule changes should reflect the outcome of the legislative process at the EU, as well as the domestic, level.
A supervision-led strategy...
In developing its new supervisory strategy for scrutinising products, the FSA will seek to identify emerging conduct risks in firms early, drawing on a wide variety of sources of intelligence, and will undertake:
- retail conduct risk analysis – the FSA's assessment of the environmental drivers of conduct risks used to identify risks that may emerge across the whole financial services market; the FSA's first Retail Conduct Risk Outlook was published in February;
- business model and strategy analysis – for the larger firms, a detailed assessment of conduct risks posed by the business models of individual firms, designed to produce a critical analysis of the firm’s current and future strategies, and their effect on customers – this feeds into more intensive supervisory work;
- supervisory assessment of products delivered – in selecting products for review, the FSA focuses on the inherent risk to customers, taking into account factors such as the transparency of the product structure, the complexity of the product, any limitations on access or the ability to switch products, layers of charges, and any inherent conflicts of interest;
- supervisory assessment of product governance – reviews of effectiveness, implementation of product development policies, and associated controls, procedures, and processes, focusing on:
product oversight – whether fair treatment of customers is built into a firm's oversight arrangements
- product strategy – controls to ensure that customers’ needs are reflected in setting and implementing the strategy and evidencing improvements from a customer perspective
- target markets – how this was defined, and how the approach is tested to endure appropriate matching of design to needs
- distribution strategy – evidence that the fair treatment of customers is built into the development and oversight of the distribution strategy
- incentives – measures to avoid conflicts of interest in remuneration policies and control risks in incentive practices for in-house sales staff
- risks and stress testing – the depth and breadth of risk assessment and stress testing to ensure identification and management of the risks to the customer, and evidencing how changes to product features mitigate those risks
- price and value - warning signals that indicate a product may not offer reasonable value for money for customers, whether product design is driven by features that benefit the customer, whether product costs are compatible with the objectives of the product; and
- execution and review – ensuring that products continue to work well for customers, including regular reviews, use of customer feedback and ongoing active management of the product.
- In-depth risk assessments are being implemented for the largest high-impact firms, and individual relationship-managed firms are also seeing the use of some of these tools. Smaller firms will more commonly encounter the product governance supervisory approach in the context of thematic review work.
... followed up with further action
Firms should, however, be aware that the feedback statement also refers to giving firms the right "to put their case" before further actions (such as enforcement) are taken. It is not clear from the paper whether this is intended to imply that enforcement be the FSA's tool of choice in this context. However, in the context of related thematic work, at least, the FSA has been very ready to reach for skilled person's reports, and to ask firms to suspend promotions pending the outcome of such reviews and any remedial action.
Some of the supervisory and enforcement tools currently available to the FSA include requiring firms to provide undertakings under the Unfair Terms in Consumer Contracts Regulations 1999, variation or cancellation of permissions (including restrictions or conditions on selling or promoting a particular product), the imposition of fines. As discussed below, the draft legislation aims to give FCA, as the new conduct regulator under the proposed legislation, the additional benefit of a new product intervention power.
The feedback statement confirms the FSA's view that it may well be appropriate to deploy most of the range of additional interventions considered in the discussion paper from time to time:
- Pre-approval of products: Regulatory pre-approval of products, which could have distorted consumer perceptions of product risks, has been ruled out, although "not completely" as it could conceivably be the best solution for a particular issue in relation to a particular product type in some markets. It is worth noting that the line between regulated entities and products can sometimes be a fine one – certain product-like entities such as open ended investment companies and authorised unit trusts in fact require regulatory authorisation.
- Pre-notification of products: For now, the FSA is not proposing to require firms to pre-notify products to the FSA before launch. However, pre-notification has expressly not been ruled out altogether, and indeed, in a separate consultation in January this year, was proposed in respect of capital instruments which firms wished to count towards their regulatory capital.
- Product bans: Banning products, mandating or banning product features or exclusions will be part of the regulatory toolkit, although the FSA thinks the powers will be used relatively rarely. (The European Commission consulted on the possibility of bans on products, practices or operations that raise significant investor protection concerns, generate market disorder or create serious systemic risk in the context of the MiFID review).
- Price interventions: The FSA (as FCA) will also be willing to make judgments on the value for money of products, and make regulatory price interventions if necessary. Although it accepts that the blanket use of price capping may have unintended consequences, and could reduce competition, the regulator may nevertheless wish to intervene where appropriate and consumers are at risk. Options that the FSA is currently considering include a regulatory requirement which would place firms under a duty to ensure that charging structures and overall charges are appropriate (more extensive in sectoral scope than the current RDR requirements), and a benchmarking requirement to help consumers in assessing value for money.
- Increasing prudential requirements on providers: The FSA had envisaged that this might be an appropriate tool for use in connection with smaller niche providers in certain markets – clearly it would not necessarily always be appropriate for the FCA to be seeking to impose such requirements on PRA-regulated firms. Whilst not ruling the use such tools out completely, the FSA accepts that careful consideration would be required before implementation, and that the potential impacts of any other proposed measures would need to be taken into account.
- Consumer and industry warnings, and mandated risk warnings: the FSA proposes to retain these as options, to be used sparingly on the basis of supporting evidence – there is some risk of requirements being super-equivalent to EU measures. Consumer and industry warnings can provide alerts about types of products which might cause consumer detriment at a far earlier stage than the publication of warning notices against individual firms (issued on completion of an often very lengthy investigation).
- Prevention of non-advised sales/limiting product sales to certain types of consumer: although a majority of respondents opposed this option, the FSA still believes its use could be appropriate for particularly vulnerable customers or in particular circumstances, where the benefits outweigh the costs. Some associated issues, including the possible abolition of the execution only regime, were raised in the context of the MiFID review consultation, and have yet to be resolved.
- Additional competence requirements for advisers: the FSA confirms that any competence standards developed would need to be consistent with the RDR approach. It proposes to consider qualifications for advice in respect of transactions that cannot be reversed (pension transfer specialists), as well as coverage and linkage around pensions and retirement planning later this year.
The new conduct regulator's operational objectives include, in addition to consumer protection, the promotion of efficiency and choice, and (so far as is compatible with its objectives)a duty to discharge its general functions in a way that promotes competition. The feedback statement suggests that these additional product interventions would not be used frequently, and not where the particular problem could be addressed by other regulatory actions or through effective competition.
A variety of other possible interventions were raised by respondents in the course of the consultation. To the extent that the FSA considers these, or any additional product interventions (made under existing powers) to be the most appropriate response, it will undertake analysis and consult further on rules for implementation.
The proposed product intervention power in the draft Bill
The draft Bill published as part of HM Treasury's White Paper last week would, if enacted in its current form, give the FCA the power to make general rules that prohibit or restrict authorised persons from entering into "specified agreements" that might have the effect of exposing consumers to an economic interest in specified products, and to provide that agreements entered into in breach of such rules are void and unenforceable against consumers. Contravention of product intervention rules would expose authorised firms to enforcement action.
This power would enable the FCA to make rules which would:
- capture all forms of economic exposure (e.g. providing, arranging, advising and selling) – the entering into the agreement need not constitute the carrying on of a regulated activity, nor does the agreement need to be with an authorised person;
- cover inviting and inducing persons to enter into such agreements;
- specify classes of persons who should either not be exposed to particular products, or only be so exposed if certain requirements are met;
- cover all kinds of products, whether or not there is a direct agreement between a provider and a retail customer;
- cover all kinds of agreements and arrangements, including deeds of trust or collective investment schemes; and
- provide for the recovery of money or property paid or transferred under a relevant agreement, and for the payment of compensation for any loss sustained as a result of paying or transferring money or other property under such an agreement.
The FCA would be able to exercise this power where it considered it necessary or expedient to advance its consumer protection or its efficiency and choice objectives. If the Treasury so provides by order, the power could also be used in support of the FCA's integrity objective – in that event, the order must be laid before parliament, and would cease to have effect after 28 days unless approved by a resolution of each House before the expiry of that period.
The threshold set for the use of this power is relatively low (for example, where a ban is expedient to advance consumer protection) given the potentially significant consequences for market participants and businesses. There is a risk of moral hazard here – and significant potential for unforeseen consequences. An interventionist approach could perversely reduce choice by stifling innovation and competition. The European Commission's view is that, save in extraordinary circumstances, any power to ban products should be consulted on, proper cost/benefit analysis should be undertaken, and any action should be based on based on appropriate evidence of risks.
The FCA will also have a specific power to give authorised persons directions to withdraw, or refrain from making or approving, financial promotions that are likely to contravene financial promotions rules, and to publish details of the direction. This will enable the FCA to respond to issues more quickly and without the process involved in applying for an injunction to prevent contraventions of relevant requirements under the existing section 380 of FSMA.
As the feedback statement acknowledges, the current regulatory system proved capable of tackling the issues that were inherent in the sale of payment protection insurance, although securing appropriate redress took some considerable time to achieve. To a large extent, the FSA already has the powers it needs, though the new powers would give the regulator considerably greater discretion to intervene at an earlier stage.
The FSA's product intervention initiative seems, on its face, essentially to be a reflection of the change in regulatory approach and the shift towards more intrusive and intensive supervision. The FSA is proposing to turn existing principles and guidance into rules, and is already focussing on product governance issues in the supervisory context.
Going forward, the FCA will also be vested with enhanced powers to facilitate early intervention. Its success will depend not so much on the availability of new tools, but rather on the regulator's willingness and ability to use the tools, new and old, at its disposal, and, mindful of the potential risks of unintended consequences, disproportionate costs and, potentially, regulatory failure, to do so proportionately, prudently and effectively.