Issue 2 • summer 2014
WMA JOURNAL Working for the Investment Community & their Clients
Governance and culture
Governance and culture
The FCA: changing governance and culture The financial crisis, scandals and bank failures highlighted the relationship between governance and culture. Senior management will set remuneration and incentive schemes, dictate the firm’s vision and strategy, support the control functions and punish transgressions. The tone at the top trickles down an organisation. Effective governance is likely to create a positive culture within a firm. Ineffective governance will create the opposite.
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he Financial Conduct Authority (FCA) has been tackling the issue of changing governance and culture within financial institutions. It wants to hold senior management to account and ensure consumers are protected from exploitation and detriment. The FCA is creating this shift through: (i) the Senior Persons Regime; (ii) the ‘conduct risk’ agenda; and (iii) use of behavioural economics. Senior Persons Regime The most direct way the FCA is addressing governance is through changes to legislation and regulation. The Financial Services (Banking Reform) Act 2013 (‘Banking Reform Act’) will introduce a strengthened regime for regulating senior individuals within banks, replacing the current Approved Persons Regime. The new Senior Persons Regime will reverse the burden of proof whereby, provided certain conditions are met, the FCA will be able to take action against a senior person unless that person can demonstrate that he or she took all reasonable steps to mitigate the effects of a specified failing. This is a significant change and will make it easier for the FCA to take action against senior persons within banks. If the burden is upon senior persons to satisfy the FCA they took ‘reasonable steps, then decision making may be taken with an eye to future FCA action. It is likely that senior persons will expect decision making to be meticulously discussed and documented by the bank’s board, external advisors and other stakeholders to evidence a ‘reasonable’ approach. 20 WMA JOURNAL
The Banking Reform Act will also require senior persons to issue a ‘statement of responsibilities’ which will provide details of activities within the firm the senior person is responsible for. Firms will need to update the statement of responsibilities on a regular basis. Should a senior person leave the firm the FCA will require a handover certificate detailing how responsibilities will be met and if they should be made aware of any issues. This will enable the FCA to understand which senior person it needs to hold to account should a problem occur within an organisation As part of its move towards ensuring effective governance and accountability, the FCA has increased its use of attestations as a supervisory tool to hold senior persons to account. Senior persons are being asked to attest on the effectiveness of a particular control or arrangement (such as management of conflicts of interest) or attest that a particular action has been satisfactorily completed. Should a problem arise, the FCA can hold the signatory personally responsible. The impact of an attestation being provided at board level has inevitably been felt throughout the control functions. Before any senior person signs an attestation they must have confidence in their Chief Risk Officer, Chief Compliance Officer and compliance team, who must be well trained, qualified and skilled to undertake the necessary work to provide senior management with the reassurance to sign. Senior management will therefore need to understand and support the role of their control functions including providing sufficient resource and funding. This is likely to create a change in priorities for senior management as they spend increasing amounts of their time dealing with risk and compliance matters. Conduct risk The FCA’s conduct risk agenda is taking shape and is concerned with the extent to which a firm ensures its clients and market integrity is at the centre of way it conducts business. In its Business Plan and Risk Outlook, the FCA identified several conduct risk issues which will be the subject of regulatory scrutiny. It will likely conduct
thematic reviews into certain areas and use its supervisory role to create a consumer focused culture within firms. The FCA identified conflicts of interest as a source of conduct risk. Conflicts of interest can undermine market integrity and competition and cause harm to consumers. The FCA wants to ensure that firms have clear rules in place to manage conflicts, especially within the asset and wealth management sector. The FCA has specifically stated that it will assess how wealth managers and private banks control the conflicts of interest that arise when client assets are invested in in-house investments. The FCA will assess the effectiveness of controls on the identification and management of conflicts of interest, with a focus on information flows. The FCA’s scrutiny upon this sector continues following
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The FCA has increased the use of attestations as a supervisory tool its paper on dealing commissions. The FCA has also stated it will look at the agency duties of asset managers and assess whether they are acting properly and taking account of investor interests. Part of this review may look at effective management and governance and whether controls properly identify and mitigate risks. It is also likely that the FCA will want firms to demonstrate that a client’s investment strategy has been identified, is being followed and fulfilled. This will necessarily include evidencing a client’s instructions and risk appetite, as well as the nature of a firm’s relationship with third parties as it pertains to a client’s investment objectives. Pay and incentives play an important role in driving a firm’s culture. There is often a strong connection between a firm’s incentivisation arrangements and the delivery of positive www.thewma.co.uk
outcomes to consumers. Mis-selling scandals, such as PPI, usually have an element of ‘sales incentivisation’, whereby there is a disproportionate weight attributed to products sold, irrespective of whether the product is beneficial to, or required by the purchaser. The FCA will consider these payment structures and look to senior management to ensure incentivisation schemes are not leading to poor customer outcomes. The incentivisation and remuneration debate applies equally to the pay of senior management. The FCA introduced Remuneration Codes in response to the financial crisis which are designed to ensure pay practices do not encourage inappropriate risk taking and are consistent with sound risk management. The Codes also import deferred bonus payments and restrictions upon guaranteed payments. Behavioural economics The FCA has stated its use of behavioural economics as a way of understanding consumer decision making and to review the way a firm designs its products, promotional material and advises consumers. Behavioural economics suggests consumers are not rational, logical market participants but subject to behavioural biases which influence preferences, beliefs and decision making. Biases can lead to misjudgement which can cause individuals to make mistakes when selecting financial products, even though they are in possession of disclosed information that should enable good, informed choices. The FCA has identified several examples of biases upon consumer purchases. An individual may seek to avoid regret by purchasing a type of insurance he does not need. A consumer may borrow excessively to purchase products without considering their ability to repay the loan. Consumers do not tend to change their existing products such as current accounts. Firms can exploit this consumer bias by charging higher fees or not improving the product, knowing they will not lose consumers or market share. Firms can take advantage by framing their promotional material to appeal to biases. Behavioural economic research has identified certain biases affecting an individual’s beliefs which impact decision making. Consumers are often overconfident in their own decision making ability which may lead to over trading by certain clients. Over confidence is likely to affect investment decisions and cause clients to take undue www.thewma.co.uk
risk or fail to properly diversify their portfolio. The research suggests that clients will recall an investment loss more than an investment gain, placing undue emphasis on the former. This may dictate their reaction to future losses, including the length of time they hold a loss making position. Firms may want to use behavioural economics as an opportunity to better understand their clients. If advisors are able to understand these biases, they may be better able to question the client, better identify his attitude to risk and reward and better understand his investment objectives. This is likely to improve the overall relationship between the client, firm and advisor. Conclusion These are just some of the methods the FCA has adopted to change culture and governance of regulated firms. To some extent, it is succeeding. It considers behavioural economics to be a ‘game changer’ 1 and this has already informed the way the FCA communicates with its regulated firms and consumers. The FCA’s ‘conduct risk’ agenda has generated much debate within regulated firms as management try to understand how it applies to their firm and customers and embed conduct risk within their organisation. The Banking Reform Act will impose additional powers upon the FCA, enabling them to better understand and monitor banks and senior persons. It is likely the scope of the new Senior Persons Regime will be extended to apply to all senior persons within FCA regulated firms. The FCA will closely monitor the impact of these changes over this year and next. It will have succeeded in its aims if it perceives a positive shift in culture and governance amongst its regulated entities. However, it is likely we will soon see robust enforcement action. There is no better way for the FCA to demonstrate its commitment to tackling poor culture and governance than to prohibit senior individuals that fail in their duties towards clients or fine firms which cause significant consumer detriment. Jagdev Kenth Director of Risk & Regulatory Strategy Financial Institutions Group Willis Limited 1 Speech by Martin Wheatley, Chief Executive, the FCA, at the Australian Securities and Investments Commission (ASIC), entitled ‘Making competition king – the rise of behavioural economics at the FCA’, dated 25 March 2014.
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