2. Risk Outlook
This chapter sets out our Risk Outlook and discusses our thinking on medium to long-term risks. It analyses the fundamental causes of risk and how these affect the financial services market and its participants, both retail and wholesale. It looks at what causes risks to arise, including changing environmental pressures, and sets out how we consider the risks we have found across the financial markets.
We set out more explicitly the risks that drive our priority-setting in the ‘Our priorities’ section of this Plan.
How we assess risk
Macro-economic, socio-economic, regulatory and technology developments have created new demands, risks and opportunities for both financial services consumers and firms.
Our intelligence-led approach allows us to bring together information both externally derived and from across the FCA to develop a cohesive view of the risks, issues, challenges and opportunities in a particular sector, viewed through a number of different lenses. These include competition issues, firm and consumer behaviour, regulatory and legal changes, among others. We use this process to identify the risks we believe are the most significant against our objectives.
Assessing these mid-term risks is the foundation of our planning process. We use this assessment to help decide our priorities, while ensuring we can remain responsive to rapidly emerging risks.
Environmental drivers of risk
Macro-economic and socio-economic developments
Macro-economic developments influence financial markets and consumer behaviour. These developments affect the dynamics of risk and return, shape expectations and drive consumers’ needs. In turn, they influence the products and services that firms are willing to offer, their profitability and the volume of financial products sold. The UK economy is integrated with the wider global economy through trade in goods, services and financial assets and is inevitably affected by global developments, as well as playing a part in driving them.
Socio-economics change the composition of UK society. This affects the ways in which people work, earn, save, spend and live. These developments influence the needs of our society, which the financial sector then adapts to meet. Some of these developments, including an ageing population, will have significant implications for financial services markets in the years to come.
Economic recovery driven by consumer spending
GDP growth in the UK remains around the historical average rate, as can be seen in figure 1, with the Office for Budget Responsibility (OBR) forecasting a GDP growth of 2.0% in 2016. UK growth is higher than many other European countries. However, the recovery from the 2008-9 recession has been relatively slow, both in the UK and internationally, and GDP has not caught up with its pre-recession trend. This slow recovery to date, plus growth going forward being stable around the historical average, may affect business models. While a ‘slow but stable’ forecast may motivate some firms to diversify and seek returns in other ways, other firms may become complacent and less motivated to review business models to reflect the new growth pattern and changed consumer needs. Firms might sell lower than expected volumes, and may respond by reducing their costs, seeking efficiency savings, or trying to sell more products to existing customers. Such changes to business models might create risks to consumers and market integrity.
‘UK growth is higher than many other European countries. However, the recovery from the 2008-9 recession has been relatively slow, both in the UK and internationally’
The UK recovery remains reliant on consumer spending. Although nominal wages are increasing, with an increase of 2.1% on the year in the three months to January 2016, real earnings remain below those immediately before the last recession, as shown in figure 2. When real wage growth is weak, consumer spending growth may rely more on the accumulation of debt which may become unsustainable over time. Although debt as percentage of income has been falling, it is projected to rise as shown in figure 3. Unsustainable levels of debt will make consumers more vulnerable in the event of a shock such as a reduction in income. This could quickly lead to them defaulting on their debt. It could also impact their long-term ability to access financial services products, or limit their credit options.
Employment patterns and the make-up of the working population have changed. As shown in figure 4, there has been an increase in self-employment, part-time work and temporary workers since the onset of the crisis (albeit with full-time employment rising at a slightly higher rate than part-time employment more recently). There also appears to have been a rise in the number of people employed on ‘zero-hours contracts’ in recent years. These kind of employment forms may involve less secure contracts and in some cases may make it harder for consumers to plan and save. This is likely to change the products and services consumers seek to fit their new income patterns.
‘Although debt as percentage of income has been falling, it is projected to rise’
Inflation and interest rates are expected to remain low
UK inflation remains historically low and has been heavily influenced by external rather than internal factors, such as commodity prices, as can be seen in figure 5. Consumer Price Inflation is forecast to be below target until 2018. Figure 6 shows the Bank rate and the expected interest rates going forward.
A long-term low interest rate has important implications for global economies. It can encourage or sustain high levels of indebtedness among borrowers as bigger loans become both more affordable and riskier in the event of unforeseen monetary policy changes. It can also fuel a search for higher rates of return among savers, potentially encouraging riskier investments. Consumers may buy products that they do not understand or that are not appropriate for their needs and which leave them exposed to higher losses.
Global growth is forecasted to be lower than expected
Global growth is projected at 3.4 percent in 2016 as is shown in figure 7 above, which is lower than originally projected, following lower than expected emerging market activity and a more modest recovery in advanced economies.
In response to the reassessment of growth prospects and uncertainties, markets have become more volatile recently, including falls in equity and some commodity prices and exchange rate movements. We need to be aware of potential future shocks to the economy and the resultant risks, including on firms’ business models, both in terms of the asset value and the revenue assumptions that underpin these. The global outlook is influenced by ongoing and new economic or political shocks, such as geo-political tension and global political uncertainty, an ongoing slowdown in emerging markets, specifically commodity exporters and highly indebted emerging markets, lower trade and investment and unexpected monetary policy decisions.
The impact of changing conditions on markets
Shifting expectations about future growth or rate rises may cause increased volatility and uncertainty across bond, equity and other asset markets and firms may need to consider how best to mitigate against these risks.
Market volatility has the potential to create capital losses, some of which may be unforeseen by investors who may not have understood the inherent risk of these often very complex products, resulting in unexpected losses. We cannot control volatility in markets. However, in maintaining market integrity we need to understand which developments can potentially damage confidence in, and access to, financial services. Maintaining trust and confidence in markets remains central to the effective operation of financial services as a whole.
Demographics are changing the composition of the UK population
The shape of the UK’s population is changing, as shown in figure 8. We are becoming an older society, as the Productive Population Ratio (PPR) – the percentage of the population aged 15-64 – falls. As our recently published discussion paper Ageing population and financial services highlights, the number of people over 65 is expected to increase by 1.1 million in just five years. This shift, combined with lower returns on assets, is creating new socio-economic patterns. People will have to work longer and find new ways to adequately fund their retirement, while intergenerational wealth divides may be becoming entrenched. This ageing population will have different needs to other consumers, so business models and products may need to adapt to meet their demands.
Younger people are, in many cases, starting work later than their parents did, often with higher levels of debt, as is shown in figure 9, including student loans. They are making important life decisions later in life, including renting for longer and delaying home ownership, and will work for longer compared to the previous generation. Firms will need to consider how to appropriately respond to these changing needs and adopt new ways of engaging younger consumers.
Policy and regulation
Policy and regulatory factors can affect firms’ strategies, performance and the way they conduct business, thereby affecting the range of products and services offered and changing how consumers’ financial needs are met. This applies not only to new regulations, but also the ongoing impact of previous regulatory initiatives such as the Mortgage Market Review and the Retail Distribution Review.
Ongoing implementation of post-crisis regulation
In response to the financial crisis, G20 finance ministers and the Financial Stability Board prioritised new market and prudential standards. The EU and UK government developed a new regulatory framework for the financial services sector, with many new regulations, such as CRD IV and Solvency II, now in force and the rest being implemented over the next three years.
The focus of policy makers is now shifting to assessing the overall impact of regulation and placing greater emphasis on supporting economic growth. The European Commission is seeking to create a Capital Markets Union to promote competitiveness by boosting access to capital, particularly for small and medium sized enterprises, and to reduce dependence on bank lending.
Referendum on EU membership
The UK’s referendum on remaining part of the European Union will take place on 23 June 2016. As part of our normal activities, we are considering the issues that may arise, and that could have the potential to impact our objectives. This includes considering the immediate and short-term consequences of any vote to leave the EU, such as the potential for increased market volatility. The longer term consequences of any vote to leave would depend on the UK’s eventual relationship with the EU, which would depend on the outcome of negotiations between the UK Government and the EU.
While the proportion of the market accounted for by crowd funding platforms is relatively small, it may grow and become more significant, bringing opportunities and risks
Regulatory focus is increasing the accountability of individuals
Both the financial crisis and subsequent cases of wrongdoing and conduct failure showed that the culture in parts of the market needed fundamental change, with those at the top having greater accountability.
The Fair and Effective Markets Review (FEMR) also recommended further strengthening of individual accountability, after finding that failures in professionalism had led to conduct issues.
In October 2015, the Treasury announced its plans to extend the Senior Managers and Certification Regime (SM&CR) to all FSMA-authorised firms. This will include all the firms we regulate. Implementation is currently expected to happen in 2018. Once the relevant legislation is passed, the PRA and FCA will consult on and develop the detailed rules and guidance required for implementation. In doing so, we will build on the work done and lessons learned from implementing the SM&CR for banks.
Policies and regulatory intervention are encouraging competition and innovation
Government and regulatory policy in many financial markets is prioritising competition and innovation, underpinning economic growth and productivity. Increased competition can benefit consumers through lower prices, increased quality and greater product variety. In retail banking, the FCA and PRA have worked to simplify the process for authorisation to encourage the entrance of new challenger banks.
European and domestic policy measures have also supported new and innovative products, for example alternative lending models such as peer-to-peer. This has increased borrowing and savings options for consumers, though as with more traditional business models of lending and borrowing there needs to be a focus within the lending chain on underwriting standards, and an awareness by lenders that the peer-to-peer business model does not provide consumers with depositor protections.
Non-regulated firms are moving into financial services. They can offer innovative products and services which provide alternatives to those of traditional firms, challenging their business models and changing how third parties operate in financial markets. Some financial technology (FinTech) solutions, such as crowd-funding platforms, can improve access to financial services. Some of these firms, such as donation based or reward based platforms, sit outside our regulatory remit. While the proportion of the market accounted for by crowd funding platforms is relatively small, it may grow and become a more significant issue, highlighting the fact that innovation can drive competition and innovation, but may also come with new risks.
Policies and regulations affect the way different parts of the financial sector operate
In the housing market there are several drivers that affect the cost of housing. For example, the Government has introduced policies which aim to increase house building, widen access to the housing market and improve affordability. The funding for house purchases by financial institutions, on the other hand, is likely to be affected both by new securitisation capital requirements, which could impact the cost of mortgage funding and, in due course, by the adoption of a standardised floor approach by Basel which is also likely to lead to higher capital costs. The move to ring-fence retail banks may, over the medium to long term, impact the use of securitisation and thus increase funding costs. These factors could therefore give rise to risks to consumers from the reduced availability, or increased expense, of mortgage credit.
In the pension sector, Government policies are re-defining how consumers accumulate income and turn it into retirement funds (‘decumulation’). Pension tax relief has been reduced, auto enrolment has been introduced and the 2015 pension freedoms give consumers much greater choice in how they access their pension savings.
A secondary market in annuities is scheduled to commence in April 2017 to allow existing annuity holders to sell their annuity for a lump sum. There are several risks we need to consider, for example, the risks of mis-selling and poor value for money for consumers, particularly those with small pension pots and the risk that our interventions undermine competition or stifle market development.
Government policies are increasingly transferring responsibility to consumers
In some areas, such as pensions, Government policies are increasingly shifting responsibility for financial planning to individual consumers, which brings with it both opportunities and risks, such as the adequacy of consumers’ long-term financial planning.
As a result, many consumers have greater need for financial support and advice so they can properly assess their needs and decide how best to meet them. To analyse the barriers to consumers accessing guidance and advice, the Treasury and the FCA have completed the Financial Advice Market Review (FAMR). The Review makes a number of recommendations for the FCA, Government, and industry, aimed at creating a market that provides affordable and accessible financial advice and guidance.
Technology is rapidly driving the transformation of the financial services sector. It has the potential to increase competitiveness, innovation and efficiency, creating real benefits for both consumers and firms. However, it also creates risks, including for operational resilience, cybercrime, protection of information and financial exclusion. Firms need to focus on both infrastructure and culture to ensure that new technologies benefit both consumers and markets.
Technology is transforming how consumers use and access financial services
The growth of mobile and digital channels offered by firms has been supported by the creation and take-up of supportive technology, from mobile payment and digital wallet services, such as Apple Pay, to integrated billing. These aim to reduce firms’ costs while improving customer experience. However, these consumer channels may not meet the needs of people who do not have access to the internet or are not computer literate. In addition, the limited information and the speed of action consumers experience could lead to inappropriate decision making.
Consumers are increasingly using price comparison websites (PCWs). While this gives them greater information and product choice, it is also leading them to focus on headline prices alone, with the risk that their choices may be unsuitable. This focus on price alone may also affect competition on other product features. Developments in application programming interfaces may increase the feasibility of smart comparisons.
Other examples of how technology can change the way products and services are offered is through crowdfunding and peer-to-peer (P2P) networks. They present a challenge to the position of established intermediaries, stimulating competition and meeting a clear need from businesses that often have limited conventional funding options. However, risks exist for consumers who do not fully understand the risks of investing in these innovative products, for example, the risks of default and the lack of deposit insurance such as that available when consumers deposit their money with banks.
The use of smart data and advanced analytics within financial institutions
The growth in digital technology has created large volumes of data, which firms can filter and use in marketing and product development, driving risk-based pricing and more personalised products, such as telematics in cars and more health and lifestyle based insurance. While commercially sensible for firms, this could present problems for higher risk consumer groups, who may face increasingly higher prices and potentially be priced out of the market, or face affordability or access issues in the future. Financial services firms’ use of consumer data for targeted marketing and tailored products also highlights potential security and privacy concerns, including hacking risks.
Advanced technology has been used by specialised external firms, allowing financial services firms to reduce costs and improve services by outsourcing processes to these specialists. Firms using third parties and adopting innovations from outside the sector may mean we have less oversight of the disruptive implications of these technologies. This delegation of control could affect a firm’s responsiveness and resilience in a crisis.
The expanding use of technologies such as Blockchain and Cloud technology can have benefits for individual firms and competition as they may disrupt existing business models. They also pose regulatory challenges.
New technology – risks and rewards
Blockchain technology represents an alternative approach to the safe storage of information of value such as trade execution, clearing and settlement and custody. It can provide for secure, transparent and immediate confirmation of information that can then be distributed to all interested parties without the need for a central record-keeping authority. While this new alternative approach has many advantages, it also presents new challenges related to data privacy, defect corrections, and trust in decentralised financial servicing.
Cloud technology when used appropriately can allow businesses to establish computing estates quickly via specialist firms that provide the computing hardware and associated services quickly and cost-efficiently. Firms can scale their business without large up-front investments, reducing barriers for new market entrants and improving competition. However, there are risks, including complexity of new outsource arrangements and increased dependence on the cloud service provider.
Legacy systems, cyber-attacks and organisational resilience
A lack of technological resilience among many firms, complexity as systems have evolved over time, the need to balance investment in innovation with maintaining existing systems and infrastructure and a lack of IT expertise at board level are some of the reasons this area continues to present significant challenges. Given the impact on firms, consumers and markets, this failure poses both conduct risks and potentially a systemic risk. Weaknesses in systems and a lack of expertise may expose firms to the increasing risk of cyber-attacks, posing risks to consumers and markets, though this is an issue that also applies to new entrants as well as firms with legacy systems. These attacks are inevitable but firms need to ensure that they have defences and plans in place to deal with them. We will focus on identifying the impact of operational resilience risks in the firms likely to cause the most disruption to markets and consumers resulting from an incident, and how firms deal with such risks and impacts.
Firm and market drivers
Firms’ culture remains a central focus
Culture remains a key driver of significant risks in every sector and the root cause of high-profile and significant failings. It impacts on individual behaviours which in turn affect day-to-day decisions and practices in the firms we regulate. Culture is therefore both a driver, and potential mitigator, of conduct risk.
We have historically seen a number of examples of how poor culture can result in severe customer detriment and undermine markets, such as the sale of PPI products and attempts to manipulate foreign exchange benchmarks. We continue to focus on the culture within firms, and will hold management to account (including through the provisions of the Senior Managers and Certification Regime) where cultural issues lead to internal controls that fail to promote and support the right outcomes for consumers and the market.
Conflicts of interest still driving risk
Conflicts of interest in wholesale banking can come from a wide range of sources. These include ‘vertical integration’, where a firm provides a range of different client services, playing multiple roles with multiple clients, that could lead it to further its own interests rather than acting in the best interest of its clients. In some parts of the wholesale markets, potential over-reliance on a small number of large clients, or on clients who have a dominant market share, may cause some firms to be reluctant to report suspected misconduct.
In investment management, conflicts of interest may occur where market participants do not prioritise consumers’ interests, and controls over how client money is spent may be lacking. The risk is heightened by limited consumer oversight and challenge.
We consider that conflicts of interest remain a key risk factor across markets, and will continue our work to ensure firms implement robust strategies to manage them.