Speech by Martin Wheatley, Chief Executive of the FCA, at the CFA European Investment Conference. This is the text of the speech as drafted, which may differ from the delivered version.
Business integrity has become a dominant preoccupation of investors: we know that the quality of client services is a significant factor in determining investors’ overall satisfaction.
Let me start with a thank you to the CFA for its long-standing commitment to promoting ethics, integrity, and professionalism in the investment community.
These concepts were not fashionable in the build-up to 2008. But they are an economic and societal imperative today. While leverage and capital have shaped much of the global reform of financial markets over the last five years, it is conduct and ethics that is now looming ever larger. Worldwide conduct issues – such as PPI in the UK, mortgage mis-selling in the US, and the mini-bond crisis in Hong Kong – are all symptoms that finance lost its moral compass.
For investment managers, this environment clearly poses some significant challenges. On the one hand, dealing with the complexity of international regulatory reform. On the other, rebuilding and reinforcing the trust that clients have in intermediaries like yourselves. It’s this latter challenge I want to concentrate on today.
So, how do we put clients front and centre of business models? How do we restore confidence in financial services? And how do you react – as an industry – to a society that demands something better?
A key issue here is that business integrity has become a dominant preoccupation of investors: we know that the quality of client services is a significant factor in determining investors’ overall satisfaction.
And this shift in investor emphasis is having an impact. International markets and firms are no longer competing so overtly on the basis of costs or returns, but on confidence, the integrity of the market place and its participants.
So, since 2008 we’ve seen territories introduce a wide range of consumer protection measures to this end. In Hong Kong, new requirements on product disclosure; in India, the banning of front-end fees; in Singapore, the introduction of testing for investors; in Australia, the best interests duty; in the European Union, AIFMD; in the US, the implementation of Dodd-Frank and the setting up of the Consumer Financial Protection Bureau, and so on and so forth.
The FCA approach
The essential point here is that good conduct – integrity if you like – is a global agenda and I want to argue this morning that in order to grasp opportunity out of austerity, Europe needs to lead that global agenda.
As many here will know, the UK response has been to position itself as a reformer-in-chief. The previous Financial Services Authority was replaced earlier this year by the Financial Conduct Authority and Prudential Regulation Authority, two new regulators with discrete remits.
This has effectively meant that prudential regulation – the safety and soundness of firms – has been separated from conduct regulation, which is about the broader behaviour of firms. We also have the Financial Policy Committee, with a remit to manage risks to the UK’s financial system and build its resilience.
The FCA’s focus on conduct regulation means there is much greater regulatory emphasis on integrity and ethics in the UK markets today.
If we trace back to around 2005 to 2008, the gestation period for many of the live conduct cases we’re currently dealing with in the UK – such as PPI and interest rate swap mis-selling – occurred during a time where, far from witnessing a reduction in rules, the FSA’s guidance expanded by some 27%.
Now while rules and guidance are of course important, the key point here is that they become a blunt instrument if used as a substitute for good judgement. Simply put, they are not enough, in and of themselves, to regulate effectively. As psychologist Abraham Maslow famously said, ‘if the only tool you have is a hammer, you tend to see every problem as a nail’.
The FCA’s solution to this has been to use a broader array of judgement-based tools and techniques – including competition, behavioural economics and more sophisticated modelling – to get under the bonnet of the financial services industry and make sure consumers – across the markets – are treated fairly.
Culture is notoriously difficult to measure and assess – let alone change. So to move things forward, the FCA is developing a deeper understanding of the sectors we regulate, and the consumer experiences within them.
We are also being more probing on sources of revenue – so, how does a firm make its money? As well as looking at how the firm business model delivers against the expectations of consumers.
The FCA toolkit is more sophisticated and more in tune with the changing political and societal context we are all operating in. It reflects where we are now and where we are likely to remain as an industry. It is also, I think, fairer to firms.
Effective regulation – so using judgement and looking forward to prevent crises as much as possible, ultimately should mean reduced enforcement activity; lower redress bills (PPI is now a £12bn problem and counting); and more confidence in your industry.
So this is not a zero-sum game, like a tennis or football match, where for one side to win, the other has to lose. It is a non-zero sum game – a strong, mutually-reinforcing relationship.
There’s advantage to be found for all of us in pursuing multi-national solutions, which provide a more level playing field for firms.
Two key examples of this for today – first the debate over the direction of asset management in the UK and Europe. Second, a brief look at the work the FCA is doing domestically with wealth managers.
On the former, the standards expected of asset managers today go beyond the relatively limited regulation of the past, which focused on setting boundaries and ensuring clients’ money was safe and secure. It is not just about old problems, such as mis-selling, misleading financial reporting and market fraud. Complex and less easy to untangle issues such as dealing commission, transparency, fund governance and corporate access have emerged.
Whether we agree with the steps other territories are taking to address concerns like these or not, from our perspective there’s no doubt – in the current integrity-driven context – that it’s better for the UK asset management sector to be a leader of the conversation, than to ignore it. For two key reasons.
First, because it is one of the world’s largest asset management markets – managing assets of over £5 trillion, nearly three times GDP in 2012 – and business integrity is now imperative for retaining investors.
Second, because we should not forget that a large proportion of the money that we manage is ultimately the savings and pensions of ordinary people around the world.
Clearly this puts the industry under significant moral pressure to remember where money originates – and to act as agents of clients by putting their best interests first. To treat money with the same care as if it were our own, if you like.
So the key question then becomes, is this happening? Are client interests front and centre? Or is there more we can do – collectively – to restore that trust link with investors?
We argue that there is enough ambiguity in the evidence to suggest there is significant scope to move things forward.
There is no doubt that UK asset managers are among the most professional in the global markets, the most respected.
But it is also clear that some firms are not taking their responsibility to clients as seriously as they could – with evidence of poor transparency and accountability in spending commissions charged to customers. As well as issues over firms pushing the definition of research – such as using client commission to pay for corporate access.
None of these challenges are uniquely Anglo-Saxon. Nor are they restricted to any one continent. But it is imperative that they are dealt with in order to build trust and confidence in the industry, and to ensure that Europe remains a destination of choice for investors.
So the conversation has shifted from debating whether something should be done, to focusing on what can be done.
Three key ethical questions for all of us to consider in this debate.
First, how to avoid conflicts of interest.
For example, when the funding of goods and services, such as research, is linked to trading volumes which generate dealing commissions, this can lead to pots of research commission accumulating, at a cost to the fund, which the fund manager has little incentive not to spend - irrespective of any value added by the additional services received.
And there is a real question mark over whether fund managers are properly scrutinising this spending, and assessing the quality and value of goods and services they receive in return, to ensure they are acting in the best interests of their clients.
How can investors understand what they are paying for, and whether their investment managers are getting value for money, when dealing commission is used to purchase bundled services, offered by sell-side brokers – which combine costs for execution, research and a variety of other services into one figure?
And does it allow fair competition for providers of independent research against the bundled brokerage model?
The bundling of services often masks their distinct value and can conceal a range of cross-subsidies, including between fund managers’ clients. This can effectively mean that investors in one fund may unwittingly be paying for research that has no value or benefit to them, but which directly benefits another fund under the same manager. We have to ask ourselves: how fair is this to clients?
Unlike annual management charges – which investors are fully aware of and on which fund managers overtly compete – incremental, transaction-based commission costs are not very transparent, are often overlooked, and are poorly disclosed.
And even when they are disclosed, the nature of the purchased services is often not provided in detail, thereby denying investors the opportunity to make meaningful judgements about whether their fund manager is operating effectively and getting value for money.
Third, market integrity.
We’ve seen examples of investment banks appearing to sell additional services such as corporate access to the highest bidder. So does this force asset managers to dig into their trouser pockets, possibly at the expense of their clients’ best interests and effective competition for research, in order to be favoured by the broker for access to their corporate clients?
We’ve seen examples of all three issues in the UK, with firms allocating significant cash sums of their Bloomberg and Reuters subscriptions to research costs, not all of which is justifiable.
We’ve also witnessed others paying nearly double the amount of commission for research from one year to the next simply because they traded more from one year to the next. In other words, there was no value link between service received and service invoiced.
On top of this, the serious issue of firms rewarding brokers for the corporate access they provide.
Now, I have no particular concerns over the purchase of corporate access. Clearly investors have to engage with businesses they invest in. This is nothing more than good corporate stewardship.
But questions do arise when you see cases of investment managers forking out thousands of pounds simply to gain access to the management of companies they wish to invest in. You have to ask: is this an eligible use of commission? Would we be willing to pay these sums with our own money?
To help move things forward in this, and other areas, the FCA last month launched an open conversation with the UK sector to find solutions to these challenges. And I’d encourage the CFA to play its part on the European stage.
Clearly there is an ongoing need to engage at the international level on this debate and other issues affecting the industry.
The FCA takes this engagement role seriously and will continue to do so. Acting in the interests of the markets by working with the European Supervisory Authorities, as well as key international organisations like IOSCO.
But there is a broader point here: namely that there’s advantage to be found for all of us in pursuing multi-national solutions, which provide a more level playing field for firms, many of whom operate on a global level.
These are not easy problems to tackle, but we want to see an industry that is equipped to do right by its clients, both today and in the future.
The second area to touch on today is the UK approach to wealth management and private banking.
The key issue here, again, is that the FCA is putting the interests of consumers and markets at front and centre of its work. And challenging firms to do the same.
So, our risk assessments are now more focussed on firm business models, strategies, culture, frontline processes and so on – rather than the traditional approach of focusing on controls.
On top of this, we are paying more attention to market trends and emerging risks – moving away from the old model of concentrating on the conduct of individual firms – so we can intervene earlier and be a more transparent, predictable regulator.
To support this work, the FCA has established a more sector-focused approach that is clearly delineated with the industry.
Now, regulatory infrastructure changes like these may sound dry and technical. Welcome to my world.
But they are important for the UK wealth management industry because they allow the FCA to respond to market risks more effectively. To move things forward if you like.
So, for example, earlier this year we launched a review into the wealth management departments of six UK retail banks. The key issue here: were firms able to demonstrate the suitability of customers’ investment portfolios?
Was there sufficient client information on file? Was the appetite for risk correctly managed? And were investment objectives aligned? All pretty standard questions – or so you would think.
But in a number of cases the evidence suggested firms could not determine suitability – or else revealed a high risk of unsuitability. Clearly demonstrating a lack of client focus – irrespective of any returns on their portfolios.
Those firms are now working to repair the situation, which includes making assessments of whether redress payments may be required.
But the episode does open up a broader debate around client care in the sector. So, here are some key questions for all of us to consider this morning – whether we are UK based or not:
Are oversight arrangements in your firms adequate?
Is client information up-to-date?
Is the market managing conflicts of interest?
Is it delivering the services clients sign up for?
Are portfolios consistent with consumer objectives?
Are industry participants clearly setting out their periodic reports?
Our ability to answer awkward questions like these will go a long way towards determining our response to the key question for today’s discussion: how well can we turn austerity into opportunity?
The culture of European investment has long been recognised as one of the most professional in the world. And I don’t believe events leading up to 2008 will permanently damage that reputation.
But as the CFA has made clear, re-building public confidence in the sector and shaping an industry that is fit for the future, is contingent on firms themselves taking the lead in cultural change.
Regulation is important, yes, but the business imperative now is that the investment management industry leads the debate around trust, confidence and integrity. Surely it is in all of our interests to be at the forefront of this cultural shift rather than trailing behind?
I am delighted that the CFA and its members are leading this work so effectively – as they have been for many years – and I am delighted that integrity, ethics, customer service and so on, are now – once again – so fashionable.