Conflicts of Interest: Connecting Enforcement and Supervision

The FCA announced enforcement action against a commercial broker and a fine of £4 million in late 2017 as a result of failures associated with the broker’s management of conflicts of interest. The details of the case are here.

Conflicts of interest can be anywhere, and firms are well aware of that. However, there is a qualitative difference between the conflict of interest that an individual might have with, say, a supplier, and what the FCA identifies as an ‘inherent conflict of interest’ in the business model or ownership structure. This is the risk that commercial intermediaries must manage.[1] It is not static, and it changes as intermediaries take up other activities where they act as an agent of the insurer.

The FCA has also undertaken a thematic review of commercial insurance intermediaries focusing on this issue. (It published the results in 2014 here.) The FCA evidence included a survey of small and medium enterprises (SMEs).[2] This suggests that many SME customers do not fully understand the intermediary’s role and how it may have changed in recent years. For example, four of five SME customers expect an intermediary to get quotes from two insurers, which is not consistent with how intermediaries operate, in particular for micro SME customers (fewer than nine employees).

There are wider messages from this enforcement action for the practical management of inherent conflicts of interest. To begin with, there should be a regular process to identify conflicts of interest.  This might be challenging but following the sources of revenue would enable a robust identification of conflicts and of the impact of changes in the business model.

While a policy on conflict of interest is a regulatory requirement, it needs to be comprehensive enough to enable staff in the business to actually manage conflicts of interest. This would require specific guidance articulating how to deal with customers, including what information to collect, what checks to undertake, and the production of meaningful management information.

Business arrangements such as ‘preferred facilities’ are not ruled out but must be managed and monitored carefully, taking into account links to brokers’ remuneration, how the firm presents itself to SMEs, the existence of ‘Chinese walls’ and customers’ (probably limited) understanding of the intermediary’s role.

Any quality reviews by the first line should be designed with a view to oversee how inherent conflicts of interest have been identified, managed and mitigated. The process should be risk based, i.e. always applying the same degree of checks to all brokers is unlikely to be appropriate.

Last but not least, as ever, culture is a factor. If statements from senior management do not recognise and support the need to manage inherent conflicts of interests, don’t expect much of the above to be in place.

The FCA will usually say something about how the case was discovered, by either supervisory activity or internal review. I was puzzled that the FCA was rather vague on this occasion. On reflection, I suspect (but cannot be certain) that there may be a dependency with the FCA’s thematic review on conflicts of interest mentioned earlier. If that’s the case, it is useful for firms to understand the potential consequences of being unprepared for a thematic review when invited to participate.

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[1] This risk is not exclusive to commercial intermediaries. It exists in other parts of financial services and has also been covered in other FCA enforcement activities.

[2] Businesses with fewer than 250 employees.

Risk and Compliance Management: Horizons for 2014/15

The UK’s FCA published recently its Risk Outlook and its Business Plan for 2014/15.  They provide a useful indication of the breadth of the regulatory challenges and evidence of a top-down approach to address them. 

The structure of the Risk Outlook is similar to last year’s.  The inherent risk factors such as information asymmetries, do not change overnight unlike the economic and market environment.  The main aspects of the changing market environment that caught my attention were:

1.    the continuing household indebtedness reflecting the growth of unsecured lending, mainly credit card, and forecast increasing household leverage (Figures 6, 18 and 19 of the paper);

2.     lenders’ forbearance in the mortgage market, supported by low interest rates; and the FCA concerns about the cost to consumers (fees and accrued interest);

3.     the stable and risky profile of mortgage lending; about 40% of mortgages have high-risk features – LTV in excess of 90%, loan to income ratios in excess of 3.5 and terms in excess of 25 years (Figure 22);   

4.     the differential impact of increasing interest rates (mortgage customers, those accumulating wealth and near retirement and those considering an annuity purchase).

The FCA then translates these observations into statement about risks.  Again, the ones that caught my attention were:

1.     the challenge of making ‘appropriate’ profits; for example, making profits from non-core activities could undermine fair treatment of consumers or financial crime responsibilities; for insurers, this could manifest itself in the response to the Retail Distribution Review and moves to direct sales;

2.     the implications of short term cost-cutting strategies materialise as demand starts to grow and could result in poor management of firms’ back book;

3.     the adoption of technology may not be supported by adequate systems and controls or expertise; this could manifest itself on insufficient spending on existing technology or the use of big data without appropriate controls;

4.     plans to mitigate the risk of failures do not give adequate consideration to conduct implications such as in respect of the changes to terms and conditions in stress conditions.

The Business Plan then identifies priorities for the key sectors.  For life insurance, the priorities appear to be:

1.       suitability of products and services sold;

2.       fair treatment of the back book;

3.       the governance of with-profits funds.  

Interestingly, the FCA business plan also reflects new responsibilities which include supervising 50,000 firms in respect of consumer credit, enforcing competition law, implementing changes to the approved persons regime and the establishing a new payment systems regulator.   

All in all, it’s going to be a busy 2014/15 for everyone.

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The Piano, FCA Enforcement and Lloyds TSB, Halifax and Bank of Scotland

I heard once that you can’t learn music from the noise that a grand-piano makes when you drop it down a staircase.  Alas, we should be able to learn something about risk management from the FCA’s enforcement notices.  That’s one of my ambitions for 2014. 

I am starting with the FCA’s enforcement action on Lloyds TSB, Halifax and Bank of Scotland announced on 10^th December 2013 (here – all references are from this document).  The case relates to the lack of appropriate controls around financial incentives to advisers in branches.   

The FCA clarifies at the outset that there is nothing in the rules against “[incentivising] staff to sell a particular product” provided that a firm’s “systems and controls are sufficiently robust and sophisticated to mitigate effectively the risk of any adverse impact the incentives may have on staff behaviour”.

It is therefore not entirely surprising that the FCA articulates in detail the specific features of the remuneration system that added to the risk of consumer detriment, including

1.       variable basic salaries;
2.       bonus thresholds disproportionate effects for marginal sales;

3.       uncapped bonuses; and
4.       advanced bonus payments that could result in advisers being in debt. 

The FCA makes an interesting comment about the sophistication of the performance reward and the concern that senior management did not appreciate the potential consequences.  “The root cause of these deficiencies was the collective failure of the Firms’ senior management to identify sufficiently remuneration and incentives given to advisers as a key area of risks.” 

I was puzzled as to why this could happen.  Here are my own explanation from reading the details of the case.

1.     The complexity of the system makes it challenging understanding the incentive properties.  It seems that the system involved: (a) translating premium and product features into “points” (see example in page 15); (b) checking against target “points” monthly and on a rolling three months basis; and (c) translating points into pounds.  Inferring the incentive properties and potential product bias would not have been straightforward for busy executives. 

2.      A possible misunderstanding of the incentive properties of headline bonuses.  In some cases, the incentives could be small in absolute terms, e.g. £5,000 over a year if monthly targets were consistently met.  However, I wonder if there was an appreciation of the impact on behaviour for someone on a £33k salary (mid-tier adviser, para 4.29)  Indeed, the FCA says that the relevant governance committee “only considered the [remuneration] schemes at a high level” (para 4.104(1)).

Given that, it is not surprising that these performance incentives were not backed by appropriate controls.  In particular, it is not surprising that quality controls such as file reviews focused on sales that were regarded as ‘high risk’ by reference to customer rather than the adviser profile or track record. 

There are also two interesting comments in the enforcement notice about controls. 

1.       The main failure was not the absence of controls but the lack of appropriate linkages between relevant controls.  In particular, while there were certain quality assessments of sales, advisers could receive their bonuses even if issues had been identified.

2.       “The large number of people involved in the process [of governance over the incentive schemes] and the fragmented nature of the controls.” 

This is a good illustration of the observation that the main challenge of risk management is to apply the appropriate “top down” vision and strategy.  In its absence plenty of activity and resources, leading to potential complexity, will take place as evidenced here but with limited effectiveness.  In this case, the fine was £28m which excludes remediation costs, compensation and management time.

Conduct Risk Regulation: the Global Dimension

I wrote a post not so long ago about conduct risk in the UK (here).  In the course of producing that work, I discovered an emerging global dimension to conduct risk and I have been looking into it.  There seems to be three strands to this:

1.  Work on financial consumer protection focusing on credit and coordination with other international bodies by the Financial Stability Board (here).

2.  Principles for financial consumer protection led by the OECD.    The OECD has developed 10 principles of consumer protection (here).  I have summarised them below.  They summarise neatly the extent of the challenge.  The OECD continues its work.  It has issued a draft paper (here) setting out more detail on some of the principles.  

3. Work on financial education through International Network on Financial Education (INFE) coordinated by the OECD.   There is an interesting set of principles developed by the OECD (here) and a web-site listing financial literacy programmes and related research (here). 

I find this interesting for a number of reasons. 

1.  If you believe that regulation can be improved by pooling knowledge and expertise, then there is something valuable here.  Given the domestic nature of retail financial markets, this is going to be an interesting experiment of supervisory design where the challenge will be to articulate workable approaches that can be tailored to national conditions rather than prescriptive solutions.

2.  While financial consumer protection is a good case of a market failure, in the genuine economic sense, not every policy intervention would necessarily pass a cost-benefit test.  If there was scope for an 11^th principle it would be assessing the costs and benefits of policy initiatives.  Interestingly, the principles on national strategies for financial education include impact assessment. 

3.  The explicit recognition in the OECD principles that effective competition in the relevant markets can deliver appropriate outcomes for consumers. 

4.  While the above points together with the underlying market failure add up to a reasonable case for this activity, it is interesting that policy-makers interest on this issue stems from the financial crisis – a feature of G20 summits since 2010.   

The G20 interest together with the OECD endorsement of the principles should give these initiatives momentum.  It would be interesting to see what are the national impacts of these initiatives.   

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OECD 10 principles for financial consumer protection

1. Financial consumer protection should be an integral part of the legal, regulatory and supervisory framework. 

2.  There should be oversight bodies explicitly responsible for financial consumer protection with the necessary authority to fulfil their mandates. 

3.  All financial consumers should be treated equitably, honestly and fairly at all stages of their relationship with financial service providers. 

4.  Consumers should be provided with key information about the fundamental benefits, risks and terms of the product, including conflicts of interest where an agent is also involved in the sale.  

5. Financial education and awareness should be promoted by all relevant stakeholders and clear information on consumer protection should be accessible. 

6.  Financial service providers and their agents should have an objective to work in the best interest of the consumer and be responsible for upholding consumer protection. 

7.  Financial service providers should put in place mechanisms to protect financial consumers’ assets from fraud, misappropriation and other misuse.

8.  Personal information should be protection through appropriate control mechanisms. 

9.  Financial consumers should have access to complaints and redress mechanisms that are affordable, independent, fair, accountable, timely and efficient. 

10. Competitive markets should be promoted to provide consumers with greater choice, create competitive pressure on providers to offer competitive products, enhance innovation and maintain service quality.

Conduct risk: old wine in a new bottle?

The establishment of the Financial Conduct Authority (FCA) as the new conduct of business regulator in the UK has brought a new focus to 'conduct risk'.  I have been working with BaxterBruce, a management consultancy, on this issue.  We have written a paper (here) summarising the recent changes in financial regulation that are relevant to conduct risk and identifying what steps businesses may consider to meet this challenge.  

There is also an emerging international dimension to conduct risk that I will cover in a future post.