Building a common language in the mortgage market

Speech by Linda Woodall, Director of Mortgages and Consumer Lending FCA at the Council of Mortgage Lenders (CML) - Mortgage Industry Conference and Exhibition. This is the text of the speech as drafted, which may differ from the delivered version.

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I want to start with a quick thank you to the CML for inviting me to speak here today – and to thank Paul and the wider team at the Council of Mortgage Lenders (CML) for their constructive engagement with the regulator, both past and present, in helping to shape and implement the Mortgage Market Review (MMR) and other regulatory developments.

This is my first speech at a CML conference, and I am delighted to be here. As the relatively new Director of Mortgages and Consumer Lending within Supervision, I thought I would use the opportunity to talk to you about the Financial Conduct Authority (FCA) supervisory approach, and how this will feel different moving forward. As part of this, I’d also like to demystify some of the key elements of our approach, so we can begin to build a common language.

When Martin Wheatley spoke at the CML conference last year, he set out the vision for the FCA. He acknowledged the huge importance of the financial services industry, and its relevance to the lives of the cast majority of people in the UK. He also accepted that regulation has to strike the right balance between allowing the industry to thrive, while ensuring that markets work well and consumers get a fair deal. He explained that the FCA will expect more from firms and their interactions with their customers. But he also acknowledged that the regulator needed to change.

One year on, the vision is becoming a reality, and I hope that you are starting to see how very different financial services regulation will be. Much of the criticism of the regulator in the past – which we are now working to untangle – has been around the frustrations of retrospective action versus early warning, talking over listening, and inconsistency over predictability.

Our ‘common language’

I hope you’d agree with me when I say that there has been a genuine reform of the regulatory system. In our supervision of firms, we are keeping pace with the changing world around us with cultural reform of our own. Firms such as your own will find that our approach is different to that of the Financial Services Authority (FSA), in three key ways:

  • We’ll be exercising greater use of judgement.
  • We’ll be more forward looking.
  • And we’ll be more outcome-focused.

These three elements will form part of our common language with firms from now on, so it’s important for me to explain what they really mean in practice.

To make better judgements requires us to have a deep understanding of the sectors we regulate, and what the end customer is really experiencing. Sometimes this will mean that we will challenge even the biggest firms on decisions they have made; backed by judgements of our own. So for example, a firm recently tried to exclude a large number of customers from a potential redress exercise. We challenged their rationale, and, on reflection, the firm agreed that their decision had not been reasonable; and the exercise was extended to a wider group of customers.

To be forward-looking doesn’t mean we can predict the future, or anticipate every issue that’s likely to arise. What it does mean is that we are now more focused on the big issues that matter, and better at spotting risks to consumers and markets. We are dealing decisively with events that come to a head, and doing all of this more quickly, with better results.

Our work on the issue of interest-only maturity shortfalls is a good example of this. The numbers did not look promising – 2.6 million interest-only mortgages due for repayment over the next 30 years; 260,000 borrowers without a repayment plan; and, around 48% of these underestimating the financial challenge they face. Instead of sitting back to wait for the problem to crystallise, we have worked with the industry to encourage it to deal with the problem, by proactively contacting borrowers to check repayment strategies, and giving homeowners the opportunity and time to plan for the future. This is an area that we will continue to review and engage with the industry on.

And finally, we are now more outcome-focused. Policies and checklists are important, but they do not guarantee good conduct. And although sound record keeping is crucial, it isn’t good enough to meticulously document sales, if the ultimate outcome for the customer is that they walk away with a product that isn’t right for them. 

You are probably familiar with the new FCA way of supervising, and some of you will have already experienced elements of it in practice in your firms. However, I thought it would be helpful for me to give you a quick recap of the big picture, and the three pillars of supervision that sit behind our approach.

Our new approach has been designed to reflect the size of the firm, and its impact on consumers. We have four categories of firms: C1 firms are the largest, most complex firms whereas C4 firms are smaller, with typically simpler business models and products.

The way we supervise firms on a day-to-day basis is based on three key pillars – the Firm Systematic Framework, Event Driven, and Issues and Products work.

Now we wouldn’t be a regulator if we didn’t throw in a few acronyms for good measure.  In place of ARROW, we are using our Firm Systematic Framework (FSF), to make forward-looking assessments of firms, and the risks they pose to our objectives. FSF is designed to answer the key question of ‘Are the interests of customers and market integrity at the heart of how this firm is run?’ – a question I am sure you are familiar with.  

The second supervisory pillar is based on dealing with issues that are emerging or have happened, and are unforeseen in their nature. We call this ‘event driven work’. It covers everything from issues arising from mergers and acquisitions to whistleblowing allegations; spikes in reported complaints to investigating reports of mis-selling – to name but a few. For all cases, we will act with pace and proportionality, with a focus on securing customer redress, where applicable.

The final pillar is broadly termed ‘issues and products’, and will be driven by the sector analysis led by our dedicated sector teams. This will identify and determine the extent of any cross-firm or product issues, and provide a basis for us to investigate and, if needed, mitigate. A live example of the third supervisory pillar is our ongoing thematic review into arrears and forbearance practices. While the review is looking at how lenders treat customers in arrears, this is primarily a pre-emptive review, to assess and mitigate the risks of a growing forbearance ‘bubble’.

We are also now considering what our cross-firm MMR testing may look like following the implementation of the new rules and guidance in April next year. We know our testing will be substantive, and will have strands touching on lenders, intermediaries and other market participants of all sizes. There are a wide range of topics that we could look at under this heading, including:

  • firms’ affordability assessment models;
  • the role of automated income verification; and
  • the development of firms’ interest-only lending policies.

This list is not exhaustive, and while it is too early to share any more detail today, I think it is safe to assume that one of our first priorities will be to ensure that firms are complying with the new responsible lending rules.

So that’s our three pillars, our ‘bread and butter’, which will form part of our common language in our supervision of the mortgage market. 

Key themes underpinning conduct risks

Whatever a firm’s corporate culture looks like, the fair treatment of customers and market integrity should be central – and it should not be undermined by people or business practices.

Another phrase, which seems to have reached almost mystical status in the mortgage market at the moment, is ‘conduct risk’. We are aware that our new approach has created some uncertainty for firms that want to make sure that they are doing the right thing, but are not quite clear what our expectations are in this space.

I’d like to make clear today that we do not have a master definition of ‘conduct risk’. A firm’s conduct risk profile will be unique to it; and there is no one-size-fits-all framework that can be put in place to assess it. 

I’ve spoken already about some of the key risks on my agenda for the mortgage market as a whole: interest-only, arrears and forbearance, and of course the MMR. There are other risks that we are still living with – for example mortgage fraud – and issues where we have a watching brief – like niche lending. But it may also help if I set out where we are coming from when we are thinking about conduct risk and this ‘customers at the heart of the business’ question.

First and foremost, our starting point will be to focus on a firm’s business model and strategy. We expect firms to be looking at their own business models and strategies, to see if they can truly say they are considering customer outcomes equally alongside commercial objectives.

This is because in the past we have seen features like aggressive growth targets; over-reliance on cross-subsidisation; or significant cost-cutting programmes leading to an unfair deal for customers.

It is worth mentioning, as an aside, that this focus on customer considerations is something our approach shares with the pending Mortgage Credit Directive. The Directive proposes new obligations on knowledge and competence for staff involved in activities like product manufacture, offering credit, intermediation or the provision of advice. One of the proposed elements of this ‘minimum framework’ is appropriate knowledge of business ethics standards. 

We expect the Directive to be adopted in the next few weeks. Over the coming year, we will be talking to firms about the UK’s implementation of this legislation. As further evidence of our new and more proactive approach, we have already set up two industry groups to help us explore the most effective and proportionate approach to incorporating the new requirements into our rules.

Going back to our common language, firms continue to ask us what we mean by culture. Culture is not something we can prescribe, nor would we want to – it is for firms to decide the type of culture they want.  

But whatever a firm’s corporate culture looks like, the fair treatment of customers and market integrity should be central – and it should not be undermined by people or business practices.

In my view, culture is not only about setting out and reinforcing to staff the values by which a firm wishes to be known, and judged by. It is also about how its people demonstrate what is meant through their actions. Sometimes there is no better way than to get out there and see for yourself what is happening on the front line, by listening to or observing customer interactions in the sales and other customer-facing functions. You may find things are a little different to what you had expected. This is exactly the type of experience a chief executive from a high-street lender recently spoke to me about. 

You may have heard in recent speeches from Clive Adamson, Director of Supervision, about how we are assessing culture. Our approach is to draw conclusions about culture from what we observe within a firm – in other words, joining the dots rather than assessing culture directly.

This can be through a range of different measures such as:

  • how a firm responds to, and deals with, regulatory issues;
  • what customers are actually experiencing when they buy a product or service from front-line staff;
  • how a firm runs its product approval process and what factors it takes into account;
  • the manner in which decisions are made or escalated;
  • the behaviour of that firm in certain markets; and even
  • the remuneration structures. 

For example, some banks are now paying the price of selling complex interest rate swap products to small businesses, many of which lacked the expertise to be able to understand the product. Our review into this issue found that sales rewards and incentive schemes were likely to have exacerbated the risk of poor sales practice, with some customers saying they were pressurised into buying these products. Others were told that their loan would only be agreed if they took out the swap deal as well.

There is some good news in this space, however, in that early analysis from our cross-industry review into financial incentives shows that the largest banks have made significant changes to pay structures. Some are moving towards a more balanced approach, by introducing customer-focused measures.  And three have removed the direct link to sales incentives for front line staff in branches and call centres.

There is also evidence that major players are increasing their testing of consumer outcomes in face-to-face sales; all of which is really encouraging – but more still needs to be done. There are cases where less progress has been made, particularly in areas like investment and protection sales. 

We know that time will tell if the industry has truly turned a corner. Our review is continuing across all sectors and sizes of firms and we plan to communicate our full findings in quarter one next year.

But this review has not looked at how firms use non-financial targets, or performance management – other important features of the overall incentive picture. Again this is an area where you might expect further regulatory scrutiny as a consequence of the specific remuneration requirements in the Mortgage Credit Directive. The Directive draws out the particular need to ensure remuneration doesn’t distort either underwriting, or sales practice.

In assessing culture we will also look closely at governance. When I talk about governance here, I don’t mean in the ‘dry’ sense. I mean in the very real sense that governance is what drives things like information flows, and ultimately, the customer experience. Good governance will mean the right information filters up, and down, at the right time. Poor governance may foster a culture where bad news is kept under wraps, and he firm in question can’t learn from its mistakes.   

Overall, we will be looking at how a Board behaves in adopting and applying customer and market-focussed values. We are interested, for example, in how a Board considers high-return products or business lines; whether it understands strategies for cross-selling products, how fast growth is obtained, and whether products are being sold to the customers and markets they are designed for. 

Following this example through, good practice could be where a firm designs a product for a specific target market, and has a process in place to monitor that sales are made to the right types of customers; and takes action where this is not the case. Poor practice may be where a firm is not achieving the desired sales volumes and so widens the target audience, extends the distribution approach, and increases incentives; without thought for the impact on its customers.

So in that context, how are we different from the FSA? Our interactions with firms will reflect this focus on business model, strategy, culture, and governance. We will be asking different questions; using different supervisory approaches; and talking to a wider range of people in the business, rather than just concentrating on staff employed in compliance or risk departments. 

Our Conduct Risk Outlook

Alongside these key themes, when considering conduct risk, I’d also encourage you to refer to our Conduct Risk Outlook. Our first Outlook, which we published before the launch of the FCA, set out our view of the inherent drivers of conduct risk. These were:  

  • information asymmetries:
  • behavioural biases; and
  • inadequate financial capability

Bringing these to life in turn, information asymmetries are the root cause of many conduct issues, and happen where one party in the transaction has superior information to the other. While it is accepted that financial services firms will have greater knowledge of financial matters than consumers, firms need to recognise this by designing products and processes that tell people what they really need to know.

Secondly, behavioural biases, which I appreciate is not an easy issue to deal with. Behavioural biases are prevalent in the mortgage sector because most people taking out mortgages are not really focused on the mortgage itself, but on the house purchase.  This can mean borrowers pay insufficient attention to fees and charges, and focus only on the initial rate and monthly cost, which may not deliver against their longer-term needs. Take the example of a product that has a very low introductory interest rate, but a very large fee. It may not be in the best interests for someone with a smaller mortgage to opt for this deal because it could work out more expensive in the long run. In the post MMR advisory world, firms offering a range of rate and fees options need to make sure that all things considered, they recommend a truly appropriate product.

Lastly, inadequate financial capability – this, combined with the other inherent risks, can create a perfect storm for consumers. The infrequency of important financial purchases such as mortgages, mean that people may not have the chance to build up their knowledge or confidence, or to learn from their mistakes.

A good example of all of these risks coming into play would be a proposition we saw pre crisis. Some lenders allowed over-indebted individuals, who were struggling to pay their mortgage or rent, to take out a self-certified mortgage. Some borrowers were allowed to remortgage and increase their borrowing, despite acute financial problems, without robust checks on the plausibility of their income, or the reasons for the financial stress.  Needless to say, for many, this did not result in a good outcome.  

We will be publishing our next Outlook in the first quarter of 2014. Although it is too early to say what will actually be included, many of the risks that we set out in this year’s paper are likely to be carried forward such as:

  • The search for yield in a low return environment and the impact on existing customers.
  • The impact of interest rate rises on vulnerable customers.
  • Failure to balance prudential soundness and profitability with good consumer outcomes.
  • Risks linked to new products being developed to meet the needs of an ageing population.
  • Poor controls over outsourcing.


I hope that this will leave you with something concrete to consider, if you haven’t already, in the context of your firm.  I also hope that this has helped to dispel any myths that mitigating conduct risks can be a tick-box exercise to satisfy the regulator. We’ve deliberately not been prescriptive in this area, because the financial services industry wants and needs flexibility in order to run successful and profitable businesses.

We also know that few firms will ever be able to rid themselves of all conduct risks, and that mistakes will be made. If and when this happens, the important thing is to be able to identify and quantify the event, and to make the correct decisions firstly, to rectify the immediate issue; and secondly, to take steps to prevent a similar issue happening again.

These latter points are particularly important in the context of a sound culture and governance. We recently fined Clydesdale Bank £8.9m for failing to treat customers fairly when it mistakenly undercharged 42,500 mortgage customers. When identifying the issue, despite the error being made by the firm, it wrongly sought to prioritise its own commercial interests by ordering immediate repayment from customers. This firm is paying the price for its decision to put its bottom line ahead of customer needs.

Our ultimate aim is to help restore confidence in financial services and improve outcomes for consumers. It is clear that society expects financial institutions and the regulator to be different. However, we all recognise that the new ways of operating, and especially culture change, will take time to bed in. 

There are also areas that are very new for us – such as our objective to promote effective competition in the interests of consumers. And our scope continues to change. We are gearing up to take over the regulation of Consumer Credit in April 2014, which will more than double the number of firms we regulate and directly impact a number of you in this room today. And, of course there is the implementation of the MMR and a consultation paper mid-year on the Mortgage Credit Directive – so plenty to keep us all busy.

Throughout all this we will continue to listen and engage with the industry through bodies like the CML, so we are predictable and transparent, and by building up a common language. This will be vital in helping markets work well. We look forward to your continuing support and active engagement.