What's around the corner? - The FSA's Retail Conduct Risk Outlook 2011

Posted on Thursday 10th November 2011

The FSA has published its "Retail Conduct Risk Outlook 2011" setting out what it sees as the risks facing the retail customers of financial firms in the future.

It's an interesting document running into 83 pages. I highlight the following:-

Major Banks

The FSA thinks complaints handling in major banks is poor. A change is necessary. In some banks this requires "sustained and vigorous effort from senior management".  The FSA speaks of weaknesses in banks' culture, particularly the governance arrangements, policies and control.

I see this a good deal.  The fundamental problem for banks is that they regard their customers as counterparties, i.e. people they do business with.  The notion that it gives professional unbiased advice to customers is foreign to a bank's basic culture.  This gets banks into all sorts of trouble particularly in the area of poor risk profiling (i.e. what can this customer afford to lose) and "bundling" one financial product with another (i.e. "borrow this money and buy this insurance policy" or "take this loan but buy this interest rate swap " ) More of rate swaps below.

The FSA highlights that banking profits have been under pressure because of low interest rates and there is therefore a drive to look for non-interest income.  That means fees from wealth management, financial advice etc.  I see no let up in the stream of clients we have with complaints about banks.

Structured Investment Products

These are contracts which promise certain returns in certain conditions; for example a return of 8% per annum provided that a particular stock market index does not fall below a certain point.

The FSA says that customers are interested in these because of current low interest rates and current market volatility.  Structured products offer some degree of capital protection, but customers investing in these take on a number of risks which some customers will find difficult to understand.  There is a danger that they are promoted in a way that is not clear, fair and not misleading and do not meet the individual clients' needs, circumstance and objectives.

I see a lot of clients complaining about bonds (usually investment bonds of some kind) which were sold as "safe" but turn out to have a number of risks hidden inside them.  There is usually a hefty commission attached as well.

Investment Risk Profiling

Financial firms are supposed to assess the risk a client is willing to take. There is a relationship between risk and reward. The client needs to understand this, and agree with his adviser where he stands.

The FSA suggests that ineffective risk profiling is a problem across different firms and is an important driver of unsuitable advice. Of the investment files it assessed between March 2008 and September 2010, half showed unsuitable investments which failed to meet the limits to the risk the customer was willing and able to take. 

I see this as well.  I often see files where information has not been collected, the customer's capacity or willingness to suffer loss has not been investigated and cash deposits or National Savings products not adequately considered.

There is no excuse for this - the exams that financial advisers are required to take highlight the need for adequate discussion between client and advisor on the risk a customer is willing or needs to take in order to achieve the desired reward.  Risk and award are essentially incompatible. It is much more attractive for a financial adviser to advise a risky product rather than something very boring like a deposit account.

Complex Products

The FSA indicates relatively new investment products are becoming popular.  Amongst these it lists traded life policy based investments.

Traded life policies are certainly a problem I see a lot of.  The essential feature of these is that the underlying life policies require feeding with premiums if they are to stay on foot.  If the lives assured in the portfolio of policies fail to die on time, then the portfolio must find capital with which to pay the premiums.  That capital may not be forthcoming, in which case the policies may have to be sold at a loss.  This risk seems never to be explained. The best known such scandal is KeyData, but we get to see plenty of others.

Cross Selling

The FSA has identified that several banks and building societies retail banking strategies involve cross selling, i.e. they try to sell more of their products to each individual retail customer.

The problem used to be endowment policies being sold with domestic mortgages.  Increasingly we are seeing interest rate swaps being sold with commercial loans to small and medium sized business (SMEs).  Typically the bank insists as a term of a commercial loan that the borrower takes out a contract to limit the effect of rises in interest rates.  The contract then provides for the borrower to pay the bank if interest rates fall. This is what is called a "derivative" contract. 

These derivative contracts are subject to the same rules for the selling of financial products as any other financial product, and bundling them up with another contract such as a loan, without advice specifically on it, is, on the face of it, completely unlawful.

When these were sold banks usually had a pretty good inkling that interest rates were going to fall. We have had a stream of clients facing demands from banks for payments due under these contracts.

Wealth Management

The FSA points out that wealth management and private banking services have suffered due to the diminished wealth of high net worth individuals, the decline in interest income and a decline in profitability from structured products (the sales of which have been hit by regulatory intervention). 

The FSA is concerned that poor practices, such as the unwarranted use of complex high cost products or selling wealth management services to customers who do not have enough money to justify the cost, may be a way for the banks to rebuild income.

What's missing?

A striking aspect of this FSA review is the concentration on banks and private banking/wealth management firms. There is little mention of the ordinary High Street IFA. We see this as tending to confirm what we see in our daily work, namely that the IFA community has cleaned up its act, and is now largely performing in accordance wit the statutory Conduct of Business rules. The larger players like banks have not yet got the message.

My practice

I am accustomed to advising in these situations. I remain keen to talk to people who believe they have suffered abuse at the hands of financial firms, whether in their personal capacities or via their businesses.  Please feel free to contact me if you feel I can help.