Donia O’Loughlin, FTAdviser, focused on the question of accountability of the FSA to Parliament (which prompted the TSC’s enquiry): ‘Mr Fowler does not blame the FSA for behaving like an unaccountable body. He said: “Parliament delegated powers of consumer protection to the Treasury who delegated it to the FSA, so therefore it is a mistake to say that the FSA is not accountable as it was up to Parliament to take and keep control. Parliament should have said that in any situation where regulation involves significant market intervention the FSA needed to come back to Parliament. It is too late, but whose fault is that? Parliament has itself to blame.”‘

Under the heading Fowler Drew: RDR will almost certainly disappoint, ifaonline  quoted Stuart’s report’s conclusion that ‘RDR is bound to disappoint because it will fail to meet its public policy objectives and widen the advice gap’ – although the paper in fact attributed the policy objective to the 2002 CSFI working party report, not the FSA. The paper argues that the FSA was at fault for never paying enough attention to the importance of access to advice and never explicitly addressing the trade off (via costs) between quality and access. 

Financial News (registration required) reported Stuart’s paper report under the headline ‘Adviser slams RDR ahead of Government review’ but the opening point, that the quality of advice consumers receive would decline, was not in the paper. The actual point was that a commission ban will improve outcomes by weakening incentives to give anything other than the best advice but there is no evidence higher qualifications for advisers will itself improve outcomes.

FT writer Charlie Thomas, writing in Pensions Management about the TSC’s findings, gave an accurate summary of Stuart’s position: ‘Fowler is concerned, as many IFAs are, about the middle-income, no-asset clients. Among his conclusions are that RDR will actually accelerate a widening of the ‘advice gap’ that stems from its difficult underlying economics, that the improvements in the quality of outcomes stemming from a commission ban are worth having, but there is still a risk they will not be obtained as the implementation proposals threaten to leak too much, and that with consultation on Simplified Advice not yet off the ground, it may be too late to rely on this to plug the advice gap.’

Stuart’s paper did not anticipate that the TSC would call for a 12-month delay to the implementation of RDR to January 2014.  However, in a written answer to a question from one paper, he did consider what the FSA might usefully do with its extra year, as follows:

1. Make sure it minimises ‘leakage’ in its new commission regime (eg from legacy business and products bought via ‘platforms’ and fund supermarkets) . 
2. Learn more about the non-IFA business models, notably wealth managers, commission stockbrokers and execution only brokers so as to identify better the likely impacts on these business models of its planned changes – and not just the impact of the ‘restricted’ advice label the TSC rightly told the FSA was a mistake.
3. Put more effort into developing a viable Simplified Advice solution to plug the gap left by pushing the advice model ‘upmarket’.

In most of RDR’s key respects, Parliament’s intervention has come too late, realistically, to delay or scrap it, although we highlight two aspects that it is not too late to work on: Simplified Advice and the proposed new distinction between Independent and Restricted Advice.

The impact of RDR will be to accelerate the widening ‘advice gap’ as rising costs push the entry level for access to advice beyond the reach of more people. The other side of the trade off is higher standards of advice for those that can reach it.  Higher standards are hard to argue with but, in light of the likely impact on access, the FSA needed a high burden of proof that the trade off was worth making. This it failed to do, with barely any rigorous quantitative analysis to support its presumption of better outcomes for consumers.

The paper supports the FSA’s actions on perverse incentives that have clearly damaged outcomes. Indeed, we have long criticised the FSA’s foor dragging on commission bias and its apparent inability to deal with high street banks’ remuneration strategies that clearly encourage mis-selling. The original independent reviews that highlighted these problems (including one I wrote up for the Centre for the Study of Financial Innovation) go back a decade or more. But if action on incentives could change behaviours as the FSA believed, it was not necessary at the same time to risk the trade off it did between imposing a ‘professional business model’ on the industry (a luxury the economics of the advice market simply do not support) and widening the advice gap.

Download Reforming the financial advice market: bridging the gap or widening the chasm

In my recent article in Citywire Wealth Manager I explain that the FSA is handicapped by assuming the problem is uncomplicated when it isn’t. It therefore provides guidelines to firms that are likely to lead to inefficient risk choices by both agents and clients. We can only guess at whether this leads discretionary clients to take too much or too little risk and which would do the most harm.

Citywire’s title was Why wealth managers are to blame for suitability crackdown. I blame the industry rather than the FSA not because they are our regulator but because they take their cue from the industry. If we adopt, as standard practice, facile processes for assessing personal risk preferences, assessing portfolio risks and then for ensuring the two match up for each client, the FSA is likely to adopt facile guidelines for each and apply them in a facile way. If this is what the FSA has done, and if it has distorted in any way its shocking findings, and if we want to make sure the FSA does not undermine investors’ confidence (as this exercise may have done), we first have to make sure our processes are fit for purpose. Denial is not without a cost.

Obviously we think we have thought about the problem, we have come up with different ways of defining it and different solutions (heavily quantitative) for dealing with it. As regular followers of our blogs will know, both draw heavily on Liability Driven Investment techniques.

Click here to read the full article.

If so, RDR may end up being judged as the wrong way to achieve better consumer outcomes – unless you only count the outcomes of people able to afford advice.

As background information, Stuart says that there are about 50,000 individuals authorised to deliver retail financial advice in the UK, mostly in small firms well dispersed across communities. Discretionary wealth managers and private client stockbrokers, also drawn into the RDR, represent only about 10% (and account for very few customer complaints against the industry). The largest sector in terms of ease of access (rather than numbers of advisers) are in high-street banks and so the recent decision by Barclays to pull out of branch-based advice suggests the FSA does have a case to answer.

You will find plenty of venom directed at banks on this website but we still have to note that banks are the dominant force in distributing investment as well as savings products in virtually every country. So the public policy goal of access meant the FSA had one overriding priority for RDR: reform the banks but whatever you do don’t drive them out of the market. Oops.

As both an intermediary and a wealth management firm, we have two compensation levies to pay in relation to the total losses suffered by investors in Keydata products that were backed by investments in Lifemark, a Luxembourg Special Purposes Vehicle set up by Keydata. The bill arrived last week. Like everyone else, we had no idea how big it was going to be – 2% of revenues in our case.

The fact that consumers should be compensated against fraud and misselling is not at all objectionable to businesses, unless we are really myopic. We benefit from not having to carry capital to meet liabilities that are better pooled between us, and from not having to build, as our Victorian forebears did, grand temples in the High Street to indicate our financial strength and respectability. Kafka was not in the principle, only the implementation. 

My initial focus was on getting my head round when a product provider is (for compensation purposes) actually an ‘intermediary’ or agent and why product literature is not an integral part of a product when testing for product failure. Moving on, we had to start thinking hard about how many other structured products that have proliferated under the eye of the FSA might similarly now represent a potential compensation liability for our type of firm, rather than for product providers. We have to do this, as part of our required stress testing of capital adequacy. But coming to terms with our ‘loss’ seemed to need something else. By the week end I was really keen to understand how the eligibility to compensation was itself determined, even before the question of how it was allocated.  

Easier said than done – even with Google. I was exasperated by the lack of a clear narrative from the FSCS or the FSA about the Lifemark-related products. I wanted complete information, not little glimpses, that would satisfy me as an explanation of:

1. How the product literature gave rise to claims (other than in respect of the ISA issues already addressed by eligible claims)
2. Why the liability resulting in a legitimate claim to compensation lay with Keydata alone
3. What precise form the liability took (had the company not been insolvent would they have had misselling claims, or was the product failure itself covered by the FSCS?)
4. Exactly which products are covered by this claim – the applicability by categories listed by FSCS appears to relate to the tax liability issues, not the Lifemark failure as a whole.

The FSCS stated on 28^th September 2010: ‘We are satisfied that the marketing materials produced by Keydata to promote the products did not comply with the Financial Services Authority’s rules.  This means that Keydata may owe a legal liability to investors in these products, allowing us to pay compensation to anyone who is eligible under the FSCS’s compensation rules.’ Well, actually, that doesn’t satisfy me. 

Misselling

Is this a liability to put the investors back into the position they would have been in before investing, which (conventionally) ignores the performance of the product and looks only at how it was sold? I’m guessing it is, because the loss of value itself in the Lifemark bonds was explicitly ruled out by the FSCS as being protected. It also makes more sense in terms of the FSA’s directions to the FSCS (upheld after a judicial review) that the regulated activity involved was a distribution activity, not a management activity. The basis of the claim then looks like what we are familiar with as ‘misselling’. In this particular context, the only difference appears to be that it applies to all classes of investor, requiring no test of suitability case by case, as misselling usually does.

I can see why a failure in product literature might be a basis of a claim to FSCS compensation if it is because the provider is no longer around to sue (or refer to the FOS). But is that really what makes this an eligible claim and is that really the reason why it lies with Keydata rather than, say, the firms that gave advice on the strength of the literature, without adequate due diligence of their own? I would like to see that spelt out.

The obvious next step was to look to see what the failings in the literature were that would have made these products universally unsuitable.  The FSA and FSCS don’t appear to have given any more details so I had to look at the offering documents myself. I wasn’t just looking for the mistakes about whether these were ISA-eligible, which we already knew about (and have already paid the FSCS so it could pay HMRC). I read one of the documents and would merely observe that it is not self-evident in what respects it was non-compliant, let alone why that might lead to universal unsuitability. I am not surprised, though, because if it was that obvious you would have expected some professional reader to have commented to the press or even to the FSA.

A detailed explanation would allow us to form a judgement ourselves as to whether the liability is really universal to all investors, regardless of how they bought (direct or through a regulated advisory firm) or whether the product literature failings rely on the assumption they were being read by a direct investor, not a professional firm. We might be expected to think this distinction matters because the claims might otherwise be made against the advisers rather than Keydata and reach back to professional indemnity insurers (or even be met by fines raised by the FSA from advisers at fault). After all, we know a high proportion of these products were placed by a very small number of firms.

Product failure

Materiality would be important to our respect for the process leading to the levy. For instance, was a decision made that the underlying life insurance contracts were inherently unsuited to generating an income stream, as the product structure required? That would be pretty material. But it would also be quite different from the explanation given by Lifemark itself that it got the actuarial assumptions wrong – which sounds a bit like errors in investment assumptions, which we know are not covered by compensation.

Generic unsuitability, which sounds much more like product failure than literature shortcomings, would also imply that the FSA had plenty of opportunity to review this form of investment structure and deal with it generically, not necessarily singling out Keydata. Is the lack of explanation a cover for embarrassment, perhaps? 

Allocating compensation

Though the focus of my questions, and search for answers, shifted over the past few days from the basis of allocation of the levy to the reasons for the liability itself, I have not lost sight of the allocation problem. I find it difficult to respect the FSA’s current procedures for determining apportionment, which are by narrow reference to the function being regulated where a firm has separate permitted business activities. Those different functions have origins and purposes that were designed for reasons unrelated to liabilities for compensation. When applied to product liability, they appear counter-intuitive and counter-factual. Judging by the outrage from my peers, they clearly do not command the respect of the industry generally. That is unhealthy and has to be addressed.

I realise that any new procedures will need to take into account EU developments, as we are impacted by changes the EU wants to see made to compensation arrangements. But it would be helpful to see a statement from the FSA that it at least recognises the present reliance on distinctions between separate regulated activities may not be fit for purpose.