FCA Enforcement: Going Global

With the advent of 2015, some people have talked about New Year's resolutions but frankly I still had one enforcement case from the Financial Conduct Authority (FCA) from 2014 I was keen to review.  

The case concerns a general insurer, Stonebridge, selling a range of accidental protection products offering cash compensation.  The FCA imposed a fine of £8.4 million as a result of the breaches identified.  (Click here to read the full details of the case.)

The business involved outsourcing sales process to a number of third party companies.  The products were sold in the UK and in a number of European countries (France, Germany, Italy and Spain) over the phone on a non-advised basis.  Names of potential clients were obtained from a range of business partners which were remunerated when sales were made.  These business partners were not involved in selling the products. 

The case results from the breaches of FCA principles concerning the fair treatment of customers (Principle 3) and appropriate systems and controls, including appropriate risk management (Principle 6).  The case provides a number of interesting lessons about the interaction of risk management and regulation.

1.  Fines may become a small component of the cost to firms of regulatory enforcement

In this case and in addition to the fine, the company committed to undertake a range of voluntary measures.  This includes a review of past business sold in the UK and European countries and compensation where losses arise as a result of the failings identified in this case.  

In addition to that, the company has replaced its executive management team, has ceased distribution of all products in the UK and European countries and has undertaken a comprehensive review of its governance structure, including new terms of reference and risk management framework.

2.  The FCA is applying UK requirements to non-UK operations

This is intentionally blunt!  In more subtle phraseology, the enforcement notice makes a distinction between the failure “to pay due regard to the interests of customers in the UK and treat them fairly” (my emphasis) and the failure to implement adequate systems and control which applies to the entire business, including European business.  The FCA identified significant failures which included inadequate management information, executive and board oversight and compliance oversight.   

3.  The importance of proactively managing the process

I have already written on the importance of proactively managing the enforcement process and contrasted two different responses to technical breaches (here and here).   This case provides an alternative perspective.  

The starting point seems to be an FCA review of a sample of sales calls during March and April 2012, an action presumably arising from the FCA’s ongoing supervision of Stonebridge.  The enforcement case ends up covering sales all around Europe, post-sale cancellation and the company’s systems and controls. 

When confronted with the initial findings from a regulator, there may be a temptation to challenge the findings.  This would be appropriate up to a point.  

An alternative approach would be to accept the substance of the findings and consider how the underlying events could have happened from a risk governance perspective.  This would require reviewing governance arrangements through the company, the risk management framework and the effectiveness of the oversight provided by the second line of defence.  Hindsight is always a powerful tool but it seems that this course of action could have been more effective in limiting the potential consequences.

Finally, this case also illustrates other failures such as controls of outsourcing and a skewed sales incentive mechanism.

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This post has been added to the page FCA enforcement in this blog which links all the enforcement cases I have reviewed.

The Godfather of Freakonomics has passed away

Last week it was announced that Gary Becker had passed away.  He formulated his economic career around the application of the tools of economic analysis to broader social issues like human capital, crime, racial discrimination and family.  This wider application of economic analysis makes him the godfather of Freakonomics.  As a recognition for his research contribution, he received the Nobel Prize in Economics in 1992.

Becker’s Nobel lecture provides a good overview of his work and how he extended the traditional analysis of individual rational choice by incorporating a much richer class of attitudes, preferences, and calculations.  In this lecture, he also shared his inspiration to apply the tools of economic analysis to crime.  He was driving to an examination and was late.   He realised that to arrive on time, he would need to park his car and risk a parking fine.  He knew that enforcement was patchy so there was a chance of not getting a fine.   He made a decision to risk a fine.  The private benefits exceeded the costs!     

Understanding these cost-benefit considerations and non-market interactions matters to economic and social policy.   As he aptly said in one of the speeches at the Nobel Prize award:  “the widespread poverty, misery and crises in many parts of the world, much of it unnecessary, are strong reminders that understanding economic and social laws can make an enormous contribution to the welfare of people.” 

Daniel Finkelstein wrote an interesting article in The Times in which he stressed Becker’s contribution to the world of economics, by emphasising that economics is much broader than understanding how money moves in the economy and that it’s about: “understanding people’s incentives, and structuring social institutions in response to them”.  

When I studied economics, I don't think I appreciated the extent of this imbalance. Furthermore, there is a lot to be done and said to address it beyond the scope of this post.  Though I am with Becker that this is not about re-inventing economics and abandoning rationality, or as he put it eloquently: "no approach of comparable generality has yet been developed that offers serious competition to rational choice theory".  The key test is the generality of the predictions that arise from rational choice.   

So the Godfather of Freakonomics is not with us anymore.  Finkelstein summed it up much better:  “The world has lost one of its great thinkers.  Fortunately, we still have the power of his thoughts.”

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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.