• Stuart Fowler

FSA consults on product regulation

My first thought reading an exclusive interview in the FT yesterday with FSA head Lord Turner was why am I reading about a significant new regulatory initiative in one newspaper before there is even anything on the FSA website? My next thought was why is the FSA consulting now, before the split between prudential supervision and consumer protection has occurred? My last thought was why not take it at face value and see why the FSA thinks it needs different powers (or to excercise its existing powers differently) and think about whether that might actually stop the monkey business.

The discussion paper, which came up on the website later yesterday, is surprisingly underwhelming considering the FSA has been quite frank in its self-assessment of its past ability to anticipate and head off sources of what regulators refer to as ‘consumer detriment’. You might think that the lessons learned from episodes of failed products that mostly occurred long enough ago to have prompted my book in 2002 would already have informed regulation (or request for new powers). So is this really a revelation?

My analysis then was that there had been excessive reliance in both self-regulation and regulation by the FSA on sales process rather than product design. The first Financial Services Act followed the Gower Report in 1981, which had been set up in response to instances of fraud rather than misselling or generic product failures. Yet Professor Gower’s main recommendation, to focus on product design, was rejected in favour of focusing on sales process. I would not go so far as to say this was the wrong choice but rather than the idea of two alternatives was wrong. The two are, in most cases of consumer harm, inextricably linked. The effect of emphasising process was that the FSA was always behind the curve in anticipating, from product analysis, what the next widespread abuses would be. My view was, and still is, that a lack of cuteness about product design is the FSA’s Achilles heel.

In the FSA’s new discussion paper there is a definite nod to the idea that problems of design and distribution go together. An obvious recent case in point is Payment Protection Insurance. But its analysis of past failures lacks insight into the connection between design and distribution at the heart of several of the big generic product failures , including for example, with-profits generally and mortgage endowments specifically.

It is impossible to isolate the theoretical merit of actuarial ‘smoothing’ of maturing policy payouts to moderate outcome uncertainty from the practical context of manipulating payouts in the presence of marketing pressures, usually around competing on past performance of standard maturing policy types. The actuarial theory itself was flawed, ignoring the way deviations from long-term trends themselves trend rather than reverse quickly, which was a product design flaw. But it was the combination of both imperatives to over-distribute that led to later consumer disappointment. When with-profits policies were used to fund mortgage repayment, the flaw was not just in the generic design of the underlying product but the setting of premiums at a level based on past mean returns that therefore only afforded a 50% chance of meeting the objective, or even less if inflation was to moderate. Is that a product design fault or a sales process fault? I think that is a misleading distinction, as the premium is an integral part of the product, set by insurers, but distributors also needed to ask customers how certain they wanted to be. In most cases, given the need for the money and consequences of a shortfall, the answer to this question would have precluded the use of this product.

The FSA paper also harks back to the scandal of banks creating and distributing Structured Capital at Risk Products (SCARPs). One type, known in the market by the telling name of Precipice Bonds, was widely sold to the wrong investors. But you will not read anything here to suggest that, had the FSA examined the underlying option, it would have been able to identify as soon as they started to appear that they earned their high yields by selling catastrophe insurance. Why would little old ladies who normally need to buy catastrophe insurance (because they cannot afford to take on low-probability risks with high impact) suddenly start providing that insurance to investment banks on the other side of the contract? Supervising the sales process required (but lacked) insights about product design.

As an example of how I was reading this paper and just not seeing what I hoped to see, I was struck by one of the examples in the paper of the FSA stopping a possible source of consumer harm (page 33). A building society had come up with the innovative idea of selling structured fixed-term deposits with inflation protection. The inflation risk was fully hedged so it represented a new source of nominal deposits for the bank, diversifying its liabilities. It brought to consumers a really useful ‘real money’ instrument in a market otherwise restricted to National Savings & Investments. So what did the FSA do that stopped possible consumer harm in its tracks? It told the building society not to use the ‘misleading’ illustration for nominal returns it had chosen, which assumed a particular inflation assumption drawn from historic observation, but to use a lower one. It is almost irrelevant to point out that the building society had originally selected the same basis as NS&I used in its illustration, as I happened by chance to know (but the FSA does not mention). Some harm, considering the illustration has virtually no significance for selection anyway compared with the real return!

In this example, the obvious consumer risk that was different from that of a fixed-term bond is that the counter-party was an investment or commercial bank that provided the inflation swap. Now that is an important piece of information for consumers to know about, so they can consider whether they want to lend money to a UK building society or an investment bank like, say, Lehman.

I mention this of course because counter-party risk, inherent in an increasing number of product structures, was an accident waiting to happen. Again, I think the distinction between product design and sales process is somewhat unhelpful compared with the way the critical insight for the FSA would (should) have come from product analysis.

Where the FSA is on stronger ground is in identifying the role of perverse incentives, such as sales targets and bonuses, in misselling. I have no doubt that this is at the heart of the large number of upheld complaints to the FOS about unsuitable sales of (often) investment products by high street banks. Yes, it has identified the problem. But surely it has always had the right powers to deal with this. Where this lack of insight for so long came from I cannot quite figure. But it makes the rest of us mad because we might not have been able to prevent it rubbing off on retail advice firms generally. It makes us mad because RDR, welcome though it is, will bear least of all on banks.

I am sceptical of the FSA’s sudden conversion. But if it is real, it will need to be a lot cuter about product design and the connections between design and distribution than it has been in the past, otherwise it will continue to be outsmarted by the smarts in the product manufacturing world. It says (in this paper) that it has recruited with this in mind. That is good to hear. Unfortunately, everything we read from the FSA about process suggests there is still a simplistic understanding of the product world, so it makes false distinctions (black or white where it’s really grey) and misses the really important distinctions. This was a theme of my response to the FSA’s current guidance consultation on Assessing Suitability and it will be a theme when I get round to responding to this consultation too.

#costs #misselling #productregulation #structuredproducts


© 2016-2019 Fowler Drew Limited

  • Black Facebook Icon
  • Black Twitter Icon
  • Black LinkedIn Icon

Authorised and regulated by the

Financial Conduct Authority