The UK regulatory shift in focus to Conduct Risk

06 December 2016

With the separation (in April 2013) of the FSA into the PRA (Prudential Regulation Authority) and the FCA (Financial Conduct Authority) an increasingly intrusive regulatory focus on Conduct Risk has been expected, indeed inevitable.

The focus is consistent with the way in which the FCA is seeking to fulfil its objective in relation to consumer protection, where they have stated that they are increasingly prepared to intervene earlier in the product life cycle.

By way of a recap of the actual rules themselves, the Conduct of Business rules, (including COBS – for investments, ICOBS - for insurance, MCOBS – for mortgages and home finance and BCOBs – for banking sourcebooks) provide the specific requirements firms must meet; these requirements have a direct impact on the treatment of customers. However these rules clearly can not provide complete coverage of a regulated firm’s activity.

In 2011 the FSA defined conduct risk as “the risk that firm behaviour will result in poor outcomes for customers”. More recently, conduct risk has been defined as “The risk that an institution acts against the customer’s best interest or in pursuit of their own”. In addition, it cannot be at all underplayed that there are major market conduct risk expectations of firms (especially the larger ones – including banks) post events such as the LIBOR scandal. Three main drivers of conduct risk have been identified by the FCA:

  • Inherent factors, such as information asymmetries, biases and inadequate financial capability;
  • Structures and behaviours, such as ineffective competition, culture and incentives and conflicts of interest;

  • Environmental factors, such as economic, regulatory and technological trends and changes.

Therefore, there is rising pressure on firms to adjust their business models and strategies.

A big example is that, for some years now (in large part due to increasing regulatory risks), many organisations have declared or were in the process of declaring an end to commission or target driven sales of financial services products particularly in the retail financial services sector and some appear to be fairly settled by having introduced effective processes, systems and governance to ensure ethical treatment of customers in the future. The costs of miss-selling, be it poor investment advice, PPI or interest rate derivatives are enormous and no doubt other such problems may be about tocrystallise as products such as interest only mortgages, near maturity and “endowment” policies show poor performance as to not be sufficient to repay outstanding mortgage amounts. The industry must ensure future product strategies are designed to first and foremost benefit customers and meet the purposes for which underlying customers buy them.

It is well known that the Prudential Regulation Authority is evolving its own version of conduct risk thematic supervision. The PRA’s approach, however, will be distinct from the carrying out of the sort of thematic reviews that the Financial Conduct Authority has inherited from the Financial Services Authority. Indeed in its own 1st April 2013 approach document, the PRA said it would be aiming to understand the sustainability and vulnerabilities of firms’ business models.

In closing, Jo Paisley (Director of the PRA’s Risk Specialists) said publicly that. “Vulnerabilities might include: unsustainable expectations of growth; heavy reliance on an inflexible structure of net interest income, with consequent exposure to a low interest rate environment concentrated funding sources which may dry up in stressed circumstances; or significant consequences following a change in credit rating. The PRA uses this work to focus its supervisory activity.”

By Geoff Walsh, Director of Regulatory Compliance at Experis and guest writer for the Institute of Chartered Secretaries and Administrators, ICSA.

Posted on: 06/12/16