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Industry in depth
Deep impact
31 March 2007
Bill Warren looks at the impact of principles-based mortgage regulation
In reviewing the current state of the Financial Services Authority’s (FSA) move towards more principles-based regulation, there is no better place to start than its 2007 Business Plan. At its launch, John Tiner, the FSA’s chief executive, pointed out that ‘more principles-based regulation will produce significant benefits for firms, markets and consumers’. This is a big claim and only time will tell whether these aspirations will become a reality. In the meantime, what’s happening with principles-based regulation, and how is it affecting the day-to-day way we behave in our businesses?
‘Treating Customers Fairly’
The first topic under the overall heading of principles based regulation is inescapably ‘Treating Customers Fairly’ (TCF), which is number six in the FSA’s list of 11 principles for business, but number one when it comes to current exposure and emphasis. In a recent speech on the theme of more principles-based regulation and TCF, Clive Briault, the FSA’s managing director of retail markets, explained the six desired outcomes of TCF. The first, of these is that customers can be confident they are dealing with firms where the fair treatment of customers is central to the corporate culture. If this is news to any readers, they may be shocked to realise that the deadline for embedding this TCF culture expires today, 31 March. The point about this outcome is that TCF is a cultural issue that needs to be driven from the top of businesses, with senior management leading the process.
Looking at TCF as the prime example of principles-based regulation will help us to understand why the focus is on senior management’s role in creating the right culture, and how all the various strands of regulation knit together for the benefit of consumers. Weaknesses in a firm’s culture can lead to poor quality outcomes for consumers. For example, poor Training and Competence (T&C) arrangements tend to lead to poorer quality of advice. In addition, a system of rewards driven by sales-based commission may, without adequate controls, lead to mis-selling. Other elements of a firm’s culture, including leadership and internal communications, must combine with controls, rewards and T&C to create a culture that delivers TCF.
Three main responsibilities for principles-based regulation must be fulfilled by senior management. They must engage with the FSA’s desired outcomes and use the flexibility offered by principles-based regulation to set the direction and culture of their firm accordingly; they must make sure that necessary changes are made to ensure consistent delivery of the six consumer outcomes; and they must be sure that they are delivering at least the FSA’s minimum standards – for which they will need effective management information and measurement systems in place.
The next five consumer outcomes are explained as relating to different stages of the product life cycle. In summary these are targeting of products to specific areas; suitability of advice for individual consumer circumstances; products meeting consumer needs; clear information; no post-sale barriers and fair treatment over the whole product life cycle. In short, expressing the regulatory requirement in terms of what must be achieved downgrades the importance of following processes – but it does not remove the processes, for example, the rules.
Regarding the balance of principles versus rules, Briault points out that the principles do not displace the rules – because there will always be a hybrid approach containing both – and that the principles are themselves rules. However, rules have certain drawbacks. For example, they cannot cover all eventualities and, where there is a gap, it tends to be filled by retrospective rules, with the rule book growing larger and larger over time.
This brings us to the bigger picture that surrounds the TCF issue, and some examples of where the rule books are being made much smaller and – in the case of Anti-Money Laundering – have actually been scrapped. The process of simplifying the FSA handbook and removing unnecessary rules started back in July 2005 and it is ongoing. At the launch of the consultation process, the move towards more principles-based regulation was already the key goal, and the simplification of the handbook was described in terms of ‘eliminating or changing requirements which are more restrictive than needed to achieve the FSA’s statutory objectives, which do not deliver benefits that justify their costs, or which are not consistent with the FSA’s focus on senior management responsibility’.
Key areas
In the case of Anti-Money Laundering, the detailed rules were following the process described above – growing ever more numerous but failing to keep up with the fast moving pace of, for example, criminal money laundering practice. So, instead, the rules have now been replaced by brief, high level provisions in the senior management systems and controls sourcebook, making the whole senior management team responsible for delivering effective Anti-Money Laundering controls. Here, an important point has been made that also runs through the whole of the principles-based regulation versus rules concept. This is that principles give firms the flexibility to implement systems that are most appropriate for their own organisation, in order to deliver the desired outcomes.
Since the start of the handbook streamlining initiative, we have seen an number of other areas where rules have been cut back in favour of principles-based regulation. One example is the reforming of the approved persons regime, on which the policy statement and final rules were published in February 2007 and are effective from November 2007. The changes merge all the previous customer functions into a new single category and eliminate the need for firms to submit a form when an approved person wants to add or change their customer functions. It is estimated that these changes will save firms a total of £1 million annually.
Another key area where rules are to be simplified and reduced is that of T&C. At the end of February 2007 the FSA published CP07/4, the T&C sourcebook review. This sets out plans for ‘a shorter and more outcome-focused T&C sourcebook’. Again this is all about replacing detailed rules with high level rules and guidance, and it’s really only the rulebook that will shrink – not our obligations to ensure the appropriate level and quantity of T&C in our businesses.
The FSA needs to integrate the EU’s Markets in Financial Instruments Directive (MiFID) into its own rules by November 2007. Because of the MiFID requirements, the FSA was obliged to remove detailed T&C rules for wholesale businesses – those not dealing with private clients – which inevitably would have an effect on the equivalent rules for retail firms. The set of five ‘commitments’ currently outlined in TC1 are to be scrapped, because the MiFID competence requirement encompasses them, so there is no need for duplication within the rulebook, and the FSA now has to decide which of the old rules should be retained – at least for the time being. Overall, the aim is to give firms greater flexibility to decide how to achieve the desired T&C standards while still ensuring that consumers are protected.
CP07/4 also explains that the MiFID contains a high-level competence requirement that requires firms within its scope to employ people with the skills, knowledge and expertise necessary to carry out the responsibilities allocated to them. Skills, knowledge and expertise are already the cornerstones of the existing T&C requirements, and the proposed changes are only to reduce the detailed rules, not the principle or the desired outcomes. T&C is highly relevant to three of the FSA’s all-important principles for business – principle two, which is conducting business with due skill, care and diligence; principle three – organising and controlling affairs responsibly and effectively; and principle six, which is, of course, TCF.
As with most complex issues, there are benefits and drawbacks to the greater role of principles-based regulation. If Tiner is right, and it delivers significant benefits, then it will have been worth all the effort. Until that happy day arrives, there will be huge pressure on compliance professionals to interpret the FSA’s requirements in terms of delivering against the principles, and turn it into practical actions. mi
A matter of principles - Nick Battersby – Compliance Director RAMP
The move to a more principles based regulatory regime will bring about significant change in the financial services industry. The FSA is committed to moving in this direction and there is broad industry support but some uncertainty about what it will mean in practice.
The FSA’s commitment to making this move should be seen as signalling a structural change in the way the UK financial services market is regulated. There will be fewer rules, the dismantling of many that currently exist, and a focus instead on principles. The drive behind this is to allow firms the flexibility of meeting regulatory outcomes rather than being focused on a “box ticking” mentality where demonstrating ‘good’ processes is seen as a safe harbour rather than concentrating on the outcome.
This approach will provide greater clarity about outcomes that really matter to the FSA, so the focus shifts from means to ends. By taking a more overtly risk-based approach to their assessment of whether firms are operating in line with these principles, FSA should be able to create incentives for firms to do the right things in return for a regulatory dividend, namely less regulatory intervention.
Looking at the FSA’s current handbook, it could be argued that regulation has become a many tiered obstacle to good business practice. For example, firms can currently fall foul of regulatory censure for technical infringements such as the wrong size KFI logo rather than through meaningful customer detriment. The FSA clearly believes that providing firms with the flexibility to decide what business processes and controls they should have will better align good regulation with good business.
In addition, the current regulatory process has been criticised as being based on hindsight. The move toward a more principles based regime should allow the regulator the freedom to keep up with market practice rather than react to past events
While it is too early to predict the effect of PBR on the intermediary market, there is going to be a larger burden on smaller firms, particularly those which are directly regulated. Moving to PBR will mean that smaller players who have not got the compliance infrastructure will have to buy in more expertise to ensure that their interpretation is soundly based and matches the outcome that the regulator is expecting. This will add to their costs at a time when margins are falling. Larger players will already have in house compliance resources to meet the challenges and therefore there could be more pressure on smaller practitioners to seek refuge within a mortgage network.
However networks will also have to look at structuring how they work and oversee their ARs. While the removal of many of the rules is a good thing, it also removes the comfort blanket of working within a visible framework and there is no doubt that correct regulatory interpretation is likely to be as much an art as a science.
Ends
A focused drive - Mortgage 2000 (author to come)
When we consider principles-based regulation we tend to think initially of Treating Customers Fairly (TCF), which of course is an attempt by the FSA to develop and give substance to the requirements around Business Principle 6, but of course there are another 10 principles in the FSA Handbook and they have all been around for a long time. What we are actually seeing is increased focus on the principles by the FSA as part of a trend that has been around for a number of years in both the Financial Services Industry and other sectors in the form of Quality Systems such as ISO9000 and in Investors in People. Of course these are not regulatory regimes but they have already applied the model: i.e. the movement from strict rules based approach to a more outcomes based approach. This can be evidenced in recent comments by the Chief Executive of the FSA, John Tiner, in his comments about proposed changes to insurance regulation where he commented that there ‘is now a strong case for moving to a differentiated regulatory regime, expressed in a more principles-based way, where the focus is on outcomes for consumers rather than processes within firms.’
One would expect that this would have a specific impact on individual firms but is this really the case. The FSA expects firms to have in place systems of control and as a part of this requirement all firms regardless of size would be expected to have in place procedures that reflect the requirements of the relevant FSA Handbook, MCOB for regulated mortgages for example. On a micro level then, this might mean that it is taken as done that firms will deliver the correct documentation at the right time within the mortgage sales process. Failures in this activity at procedural level should not be an issue for the regulator, they should be an issue for the firm. The Regulator should be focusing on the failure of Principle 3 in such a situation : i.e. a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. Thus the issue is not the breach of say MCOB 4.4.1 but rather a failure of SYSC 3.1.1. (That is not to say that the breach of MCOB 4.4.1 is not significant or that the FSA would not use such breaches in the event of Enforcement activity - because it would.) At a macro level, the relevance of this should be obvious: if the FSA doesn’t have to focus as heavily on the minutiae of petty breaches in MCOB (and the invariable follow up and correction of such errors, review of feedback for the firm - all of which takes considerable time) then it has a more effective and available workforce to get out and among the firms that it perceives as being a high risk and can therefore provide greater coverage of the industry that it regulates. It also arguably and potentially allows the skills sets of the inspection staff to be more generic and thus provides a faster route to competence for those persons.
If the FSA are going to focus more on output (e.g. the end result for the customer) rather than input (e.g. the procedures used to service the customer) then this raises questions around the FSA’s risk based approach. Not so much the fact of the approach but rather the quality of the intelligence that is used to determine it. One area that the FSA must surely be looking at therefore is the nature, content and focus of Retail Mediation Reporting as this must surely be a key part of the assessment of risk in individual firms. As a practitioner, I fail to see how the present reporting requirements assist the FSA other than in determining potential breaches in Threshold Conditions or for example in TC when a sole trader has forgotten to tick the box that says he has passed the approved examinations for mortgage advice.