Series 2 Episode 11: Duty calls amid the changing face of UK regulation

Andrew Strange:

Hi everyone, and welcome to our latest Risk & Regulation Rundown podcast. I am Andrew Strange, your regular host, but for this episode, I am stepping back from my hosting responsibilities, and instead passing on the baton to my colleague, Tessa Norman.

Tessa Norman:

Thanks Andrew. Yes, given your interest and expertise in today's topic, it definitely makes sense for you to be sitting on the other side of the virtual table for this discussion. I will be guiding our listeners through this episode. As usual, we are recording remotely, so please note that this might impact our sound quality. In today's episode, we are discussing the UK regulatory regime, covering both the new consumer duty proposals from the FCA, as well as the wider changing approach to UK regulation and supervision that we are seeing in a post-Brexit world. As well as Andrew, I am joined by Conor MacManus, a Director in our Financial Services Regulatory Insights team, and also a former guest of the podcast. Andrew, let's kick off with the consumer duty proposals, could you give us a brief overview of what the FCA has proposed in its consultation paper?

Andrew:

Yes of course, thanks Tessa. This was a fairly long-awaited paper, some people may remember the discussion paper, which was published in 2018. At that stage, the regulator was looking at a range of potential options, from one extreme, a formal duty in some way enshrined in primary legislation through to the other extreme, maybe just saying that the existing treating customers fairly principle is enough. Where the FCA has landed in its consultation paper from the 14th of May is the proposal of a new principle, so a formal principle, with a subsequent underlying, and to quote the FCA, ‘suite of rules and guidance to underpin it’. Now, at this stage, they are not putting out details on what the rules or guidance could look like, but they have proposed two potential definitions for this new principle. One is to act to deliver good outcomes for a customer, the other is to act in the best interests of a customer. It's a debate we've had a lot internally about the relative weight or significance of those two terms. If you think about, perhaps a practical example, something like a mortgage, it's interesting. If you sell someone a mortgage, and then they subsequently end up in arrears, have you delivered good outcomes for that particular client, or is this an outcome for the wider cohort of clients. Equally, if you've got a not terribly competitive five-year fixed rate mortgage, are you acting in the best interests of a client, if you sell them that mortgage as opposed to actually making them aware that they might get a better deal on the open market elsewhere. So there's some interesting nuances and a lot of debate to be had around both what those potential definitions mean and then which one the regulator ends up with. I should also say a lot of this is clearly very complementary to existing work that a lot of firms are engaged with at the moment around things like vulnerable customers. The vulnerable customers guidance has a very similar focus on outcomes, which the regulator is trying to achieve through this consumer duty too.

Tessa:

Thank you, you’re right, I think the potential implications of those two different versions of that definition are going to be really interesting. My view is that they're perhaps both a little bit too ambiguous and there could be potential for unintended consequences, so it'll be interesting to see where the FCA lands on that definition. So what is the application of the proposed rules, how broad or narrow are they in scope?

Andrew:

I would argue they're very broad, and they're broad actually with three different lenses that you can apply to it. Firstly, in terms of the end clients that could be benefiting from this or caught by this, the regulator is talking about retail clients, but actually within that it's including small and medium-sized enterprises for regulated activity as well. So it's potentially quite a large cohort of people. It might be easier to think about it in terms of what it's not. It's not wholesale market participants, but it is pretty much everybody else. Secondly, it's worth thinking about where this hits the value chain for any particular given product. It's not just about the person who has the interaction with the client at point of sale, or in a call centre. It applies to everybody, including those people that manufacture products, even if you distribute through intermediaries and you don't have any direct involvement with clients, you're still very clearly caught by these proposed rules. If you look at the FCA’s recent work on the product rules under the MiFID II, where they did some thematic work earlier in 2021. A lot of firms really struggled when their end customer was just a nominee name or a nominee number on a platform, but actually there was an obligation in that scenario for them to be thinking about target audience and ensure their products ended up with the right target audience. This is exactly the same issue here around actually understanding who your end consumer is, and therefore how you can discharge your duty.

Then the final lens that I think also makes this really broad, is around the way the regulator wants us to interact in a business environment. The FCA is talking about four key outcomes they're thinking about. It is not just that front end client interaction piece. They pull out communications, they are talking about products and services, so the design element, they are talking about customer service, and they are also talking about price and value. So there are four key areas there that the regulator wants firms to think about. If we take just one of those as an example, so if we take value, then any firm that’s active in the general insurance market will have focused on value a lot over the last couple of years, any asset management business has done a lot of work around value in the last couple of years. My own experience working with asset managers is that the value assessment has been a real challenge for them, thinking about what is value, are we delivering value, what does value mean to our end customers, how do we evidence this, where can we ensure better outcomes, are we being challenging enough, what's the role of our non-executives? If you think about that level of work around value, and then extrapolate that out over the four key outcomes the regulator wants to look at, it really is quite a broad set of proposals.

Tessa:

I would definitely agree with you there. In the FCA’s own words, it describes the proposals as a ‘paradigm shift’ in the way that it regulates firms. So, in what way is this going to feel different for firms?

Andrew:

Well again, I do love threes, so I think there are three ways of looking at this as well. Firstly, on a theoretical level, this potentially has an impact on business models. Anybody whose business model is partially based on things like back books, or trail income, or consumer inertia, is going to find elements of this quite challenging. Equally, by the same token, anybody who goes out there to try and target subsectors, which are hyper-profitable or is using technology to access particularly niche parts of a market where they can create profits as well, is going to struggle with some of the value elements of it potentially. Practically, it's going to probably change the way people have to think about things within the business. There is going to be a greater emphasis on getting things right first time. This isn't so much about fixing stuff when it goes wrong - compensation, complaints handling, the ombudsman service - it's about getting it right up front, and that upfront bit really does start with the product design elements of this.

Then finally, it's about evidence. Previous initiatives we've seen around things like treating customers fairly were done at a time when we didn't have a Senior Managers Regime, and there weren't senior individuals personally accountable for delivering these things. So at a business level, your senior managers are going to be very keen to make sure they have the right evidence, and equally from a regulatory perspective, the regulator is very focused on data. The challenge from supervisors is going to come based on the evidence and the reporting that you do to the regulator. I think it’s going to be really important that you have a clear narrative from the regulator about what you are doing and how you're doing it. Certainly, if I look at work we've done on things like vulnerable customers, some firms have found that quite difficult - monitoring outcomes isn't necessarily something that inherently is easy to do. To have the right technology to support that monitoring, and also to be able to address things to meet the FCA’s expectations, has been quite tough.

Tessa:

Yes, I definitely agree with you there around some of the challenges that we’re seeing firms experience in the vulnerable customers space around data and monitoring outcomes. A lot of firms are starting that work already, in order to comply with that vulnerable customers guidance, which will be a good starting point for these potential proposals on a consumer duty, but a lot of them do have quite a bit more work to do. This feels like a good point to bring you into the discussion, Conor - that focus on outcomes seems like something that we are increasingly seeing from the FCA in other areas, and not just on vulnerable customers. Is that part of a broader shift in regulatory direction towards an outcomes-based approach, and if so what does that mean for firms?

Conor MacManus:

Thanks Tessa, I think so, that certainly seems to be the direction of travel of the regulators. We've had speeches from senior officials at the FCA, but also the PRA in recent months, talking about this concept of moving to a more outcomes or principles-based approach to regulation. The sense is that outside of the EU, the UK doesn't need to replicate the very granular rules-based approach to regulation, which characterises the EU’s framework, because that was designed in the EU context to drive harmonisation across multiple member states. So the focus is more around the regulators setting an objective that they want firms to meet, but providing more flexibility in terms of how firms actually meet that objective, in a way which makes sense to them as a business.

This isn't a new concept, and this is something that the FSA was talking about a lot prior to the financial crisis. We've seen a couple of examples of this already recently. The vulnerable customers agenda that we've talked about, the consumer duty, and another good example being operational resilience. The regulators are saying, ‘operational resilience is an objective that we want you to meet, how you do it will depend on your business model and your operating model’. So I think we are going to see more of this. In terms of the implications for clients, clearly there can be some benefits in terms of stripping out huge amounts of rules that firms need to comply with from a compliance perspective, and it also allows firms to embrace things, and deliver them in a way which makes sense for them as a business. The challenge will come around the amount of judgment that it will require firms to make around what that objective actually means in practice. If the regulators do move in this direction, firms will need to start getting used to a lot more ambiguity and judgment in the way in which they think about compliance and regulation more generally.

Tessa:

Absolutely, that greater flexibility I’m sure is something that a lot of firms would welcome but also there’s some kind of comfort and safety in having those detailed rules to fall back on and to make interpretation less ambiguous. What does this all mean for detailed rules then, are they going to gradually be phased out and become a thing of the past, or will they still be in place for certain areas?

Conor:

Yeah, I think so. Look, there will always be a regulatory rulebook and parts of it will always be detailed. If you think about, for example, prudential regulation, there's a lot of detail in there and necessary detail in terms of things like calculating capital requirements. I don't think we are going to move away from that to a world where the regulators just say, hold enough capital and that's an outcome which we’ll be happy with. But in other areas, operational resilience, as I mentioned, consumer outcome-focused regulation, it lends itself more to an outcomes-based approach, and we will start to see the shift happen in those areas more.

Tessa:

Andrew, what is your view on that, would you agree?

Andrew:

I would slightly disagree with Conor. One of the challenges I would put forward is we've seen lots of new initiatives, I’ve not seen any rulebooks being burnt, or any of that granularity particularly disappearing as yet. My personal worry, is always you end up with the awkward combination of both granular rules and thematic outcomes-based regulation too. I am quite keen on the intellectual argument that some of these themes could replace rules. I can see that it is risky, but if you are thinking about a business that is operationally resilient, so it doesn't fall over and if it does fall over, it can stand up again. If you're thinking about a business that's got enough money to make sure that if anything goes wrong, it can cover its costs, or it can wind down. If you've got a business that’s dealing with financial crime and money laundering issues, if it's delivering value to its customers, and it's working in their best interests under a consumer duty, and this is all underpinned by data. Then what can actually go wrong here? Intellectually I don’t see where there's the potential harm for consumers on the whole, and you haven't had to have the granular rules to get there. I would also draw on the fact that if you look at things like the FCA’s recent work around general insurance pricing, where actually now firms who are going through the renewal process can't be charging more or less than new customers. Again, we seem to be removing quite substantial risks to the outcomes for consumers here. I am beginning to think, actually maybe some of these themes and pillars could replace some of the rules that we've been used to.

Tessa:

It will be interesting to see how that evolves and I can imagine it definitely will be an evolving picture, and we are not going to move away from detailed rules anytime soon. Speaking of evolving pictures, another area that I wanted to get your thoughts on, Conor, is divergence. Clearly, as the UK continues to shape its own regulatory framework and potentially move away from EU regulations in certain areas, that can mean that firms with footprints beyond the UK are having to comply with multiple different regimes. That's something that we've talked about on this podcast in relation to a number of topics, including things like operational resilience and ESG recently. So how are we seeing that divergence play out and impact firms?

Conor:

The first thing to say is, obviously it's quite early days and the UK has only been out of the EU’s regulatory frameworks for six months. But for a number of years now, the Government and the regulators have been saying that post-Brexit the UK will do things differently from a financial services regulatory perspective, not for the sake of doing things differently, but to try and adapt the regulatory framework to the specificities of the UK market, or to encourage competitiveness of the UK. We are starting to see early signs of how that's going to play out. This year we've had proposals from the PRA and the FCA on prudential requirements for banks and investment firms, which largely mirror the EU’s version, but have made some changes, and in fact in a number of areas are stricter than the EU equivalent.

The Treasury is currently reviewing the Solvency II framework and both the Treasury and the PRA have been clear that they do want to make amendments to that. We have also had the proposals from the Lord Hill review into the UK’s listings regime, which makes some recommendations for quite a fundamental overhaul of the Prospectus Regulation that the UK onshored from the EU. That capital markets space is where we are going to perhaps see the most focus from Treasury and the regulators. We know that the Treasury and the FCA are undertaking a wholesale markets review really looking at in particular MiFID, and asking the question, what needs to change in a UK-specific context, what could we improve, with a real focus on competitiveness. We are expecting a consultation on that over the summer and potentially quite soon, but we are starting to see some areas of difference between the UK and the EU as you would expect.

I mean, for firms clearly there can be benefits from this. Making changes to regulation if it's disproportionate, very inefficient or costly, is a good thing, but that needs to really be balanced against the costs of fragmentation between the UK and the EU. Many firms have been used to doing compliance or regulatory horizon scanning at an EU level. Clearly, as the frameworks diverge, that becomes more challenging, and we are already starting to see that impact clients. For UK policymakers there is a difficult decision to make and balance to strike between the benefits of making changes where they are necessary to improve competitiveness or improve outcomes, with the cost associated with fragmentation between the UK and the EU.

Tessa:

In addition to those challenges, it also feels like the scope and breadth of regulatory focus is continuing to increase. What challenges does that bring for both regulators and for firms?

Conor:

Yeah, that's something that we've seen increasingly over the past few years. If I think back to when I started my career in financial services regulation, just after the financial crisis, the regulatory focus was much narrower then, and perhaps understandably in the context because the focus was on ensuring the banking sector didn't fall over. But even when I left the PRA around five years ago, things which are very central to the regulatory focus at the moment, would have been seen as relatively peripheral, if you were thinking about traditional prudential or conduct regulation. Thinking about things like diversity and inclusion, climate change, ESG, the implications of technology change, they’re extremely central to the regulatory focus at the moment, but perhaps weren’t four or five years ago. This broadening focus has benefits; many firms are saying that they want more clarity around the regulatory approach to technology, things like AI and machine learning, before they adopt them. So that regulatory focus is very welcome, as it is in areas such as climate change and diversity inclusion, but that broadening focus brings challenges for firms. There is just a lot going on at the moment, a lot to keep on top of. This is reflected in the regulatory initiatives grid, which the regulators publish every six months. The latest iteration of that came out in May and it runs to around 40 pages now. There was something like 38 additional items added to the grid from the previous publication in September last year. It just shows the scale of activity at the regulators at the moment, and the breadth of that focus, which will certainly bring challenges.

Tessa:

Absolutely, as you said, just keeping on top of that horizon scanning, keeping on top of the regulatory agenda is a challenge for firms in itself, on top of a lot of the other issues that we've covered today. To finish with, I wanted to ask you both for a final takeaway message for our listeners, so what's the one area that you’d really encourage firms to focus on and to try and address in order to meet the regulators’ evolving expectations? Andrew, I'll come to you first.

Andrew:

Well, I am hoping that as I am a guest, not the host, I can have three things rather than one. The first one for me is around clarity and confidence of purpose for firms. So being able to articulate how you are delivering value, the good you are doing on a societal basis and so on, is really important. Having that clarity of purpose, and a really consistent message across all of your business, be that somebody who is working in the front line in the call centre, through to a non-executive director through to your board, s going to be really important in how you demonstrate what you are doing, explaining it to the regulators, and putting out your vision to your consumers.

Secondly, engage in the consumer duty proposals. The regulator is open to comments until the end of July, so firms have got about a month or so to respond to that. Clearly, as we've discussed today, some of the definitions have potential pitfalls, some of them are not entirely clear how they will work. It's really important that firms think about that on a business level themselves, and engage in that process, because this is going to drive a lot of the regulatory agenda going forward. Finally, I would say, it's time to think about pivoting to a new language. So for firms to be thinking about consumer outcomes and harms and things, it is the way the regulator is going, and actually bringing yourselves into that world and thinking about things in the regulator’s new terminology and new approach to life, is going to be really important to make sure that your interactions with the regulator work.

Tessa:

Thank you, and Conor what are your thoughts?

Conor:
I would definitely echo that point on purpose. The role that financial services plays in the economy and wider society is something which will increasingly drive the regulatory focus in a post COVID-19 environment, so it's a really important thing to focus on. The only other thing I will draw out is data capabilities and how important it is for firms to get this right. This has clearly always been the case when thinking about compliance and meeting regulatory expectations, but if you think about things like vulnerable customers, or the consumer duty, which really require firms to understand their customers and their behaviour very well, that really requires an investment in data capabilities. This is something that the regulators are very focused on at the moment.

As Andrew mentioned the FCA is very focused on becoming a much more data-led regulator, and the Bank of England has published recently a quite ambitious data strategy, really focusing on driving transformation of data capabilities across the financial sector over the next five to ten years. This is going to be absolutely vital and integral to the regulatory agenda in the medium term.

Tessa:

Thanks Conor, that data challenge is definitely something that we've discussed on the podcast before, just in the last episode on ESG, we talked about that and how critical data really is to firms getting their approaches right.

Thank you both for a really interesting conversation, it feels like we are seeing the next stage in the evolution of the FCA’s consumer approach. As you’ve talked about, Andrew, really wide-ranging impacts, including on things like firms’ business models, and touching on things like purpose, culture, accountability. Then it has been fascinating to hear as well about how that fits into the broader picture from Conor, so that gradual move towards a more principles and a more outcomes-based approach, and seeing how the UK’s framework is really starting to emerge and evolve outside of the EU. To our listeners, I really hope you've enjoyed this conversation as well, and please subscribe to future episodes, and don't forget to rate and review this series as it helps other people to find us. And please look out for our next episode next month.