A sustainable conduct environment

Essentially we are about making markets work so that retail consumers achieve fair outcomes and wholesale markets operate with integrity – if these can be achieved then trust will be restored.  

We have all seen the conduct related events over recent and not so recent times and their cost – not just the immediate regulatory fines and redress costs, but also perhaps the more damaging erosion of trust in financial services and uncertainty about future business models of firms.

We know that a modern, growing economy in today's world requires consumers, investors and market participants to have a high degree of trust that when they buy, are advised or trade in financial services products they will be treated fairly and they can rely on the basic integrity and resilience of markets.

The response by regulators to what we have seen is, to somewhat different degrees by different jurisdictions, a much greater focus on conduct regulation and supervision – including of course the creation of the FCA in the UK as a dedicated conduct regulator for retail and wholesale markets, with a fresh approach that I will return to later.

The response by firms, at least as seen by us, has followed a journey from firstly recognising that the world has changed, to a certain amount of panic about how to deal with it, to thinking it can be fixed by significantly and expensively expanding control frameworks, to realising that the culture of the front-line businesses needs radical overhaul and lastly accepting that business models may need significant change as well. Investors in financial services firms appear to have accepted that pre-crisis returns are no longer achievable, are worried about the future, and unpredictable costs, but seem to think of them as almost a cost of doing business.

What we haven't collectively achieved yet is a more sustainable environment where we can all feel more comfortable that the number and severity of incidents where there is poor behaviour is reduced on a permanent basis so that trust is restored for the long term as opposed to everybody worrying about and expecting the next big thing. I believe that this is possible but will only occur if collectively we can align the interests of firms, their shareholders and employees with those of consumers and market participants.

Where I would like to start is exploring why achieving this alignment appears to be so difficult in financial services. In many other sectors, companies that are trusted and provide good-value products and services that consumers want, gain customers and business from competitors that aren't so effective at this. We all experience this first hand and see for example how a company like John Lewis prospers while others don't.

In an ideal world the same would be true in financial services so that firms who provided poorer value products and lost trust because they didn't treat their customers fairly would lose business until they either went out of business or competed their way back. The reasons that this market solution doesn't work in financial services are a combination of a number of factors – many of the products are complex and hard for a consumer to fully understand, many are long term in nature and judging fairness by a consumer is difficult, consumer understanding is poor, there is substantial consumer inertia, providers are not significantly differentiated and some markets are not sufficiently competitive.

These essentially are the reasons why a regulator is needed to act on behalf of consumers and investors to overcome the natural market incentive in favour of shareholders and employees and to redress the balance in favour of consumers and investors.

So, what should we, as the regulator, be trying to achieve and what is the approach it should have? Essentially we are about making markets work so that retail consumers achieve fair outcomes and wholesale markets operate with integrity – if these can be achieved then trust will be restored.  Our approach to achieving this is to be a regulator that is judgement based, pre-emptive and pro-competitive and prepared to be tough when things go wrong. This approach though is based on an outcome-focused philosophy.

I would like to explain further what this means and in particular what I mean by outcome focused. Regulatory philosophy has coined various phrases such as principles based, as opposed to rules based; intrusive as opposed to light touch and credible deterrence as opposed to the Governor's eyebrows. These may seem like variations on a theme but they do in reality encapsulate quite different approaches and this is true for an outcome-focused approach. What it means is that we are fundamentally interested in what consumers actually experience as outcomes and how markets work in practice and then try to fix the causes of what is leading to outcomes that are not, or may in the future not be, fair or leading to markets that don’t operate with integrity.

This translates to a model where firstly, we look at whole markets to see whether they are working in the interests of consumers and where market studies are the methodology to determine whether lack of competition is the driver of problems and where structural solutions may be needed. Secondly, at sectors where we use thematic work to look at specific problems where the right outcomes may not be being achieved and where changes in firms' behaviours may be needed. And lastly at individual firms where we are looking for key drivers of potentially poor conduct behaviour.

This means at the firm level, particularly for the large firms that have the biggest consumer and market footprint, we are looking at how the interests of the customer and market integrity are at the heart of how the business is run – this means our focus is on the firm's business model, its culture and front-line activities such as product governance and less on second-line controls. This focus on how the business is run, rather than how it is controlled, is a fundamental change and is directly linked to our outcome-focused philosophy.

What do we expect firms to be doing? I mentioned earlier the journey that we see firms as being on and I want to explore this further in terms of our expectations. We have said that we want firms to put consumers and market integrity at the heart of how they run the business. Unpacking this means that we expect firms to treat customers fairly while maintaining prudential strength and achieving a sustainable return for investors. In other words, we don't expect that the interests of customers should be subjugated either to prudential strength or the interests of shareholders or employees. This raises two questions: firstly, how should firms best ensure that customers are at the heart of how the business is run and secondly, how can the balance between customers, shareholders or employees and prudential authorities be maintained on an ongoing basis?

So, coming back to the journey that firms are on in terms of dealing with the conduct agenda. Firms have reacted in a variety of ways, from strengthening compliance, to building in stronger consideration of customer fairness through the product life-cycle, to launching cultural and behavioural change programmes, to setting conduct risk appetite, to changing incentive programmes and to thinking about business model changes. It is not for the regulator to be prescriptive about the right solution but I do want to make some observations about what we have seen and what seems to us to be the key elements of an approach that may work.

I would start by saying that fair treatment of customers is not, in my view, something that can be reduced just to a risk to be managed – that way leads conduct to be treated as a compliance question with ever expanding armies of compliance people checking that process has been followed – in other words a ‘tick box’ compliance approach. This is not in my view likely to improve outcomes for consumers or achieve integrity of wholesale markets just as tick box regulation by the regulator won’t be successful.

Both the industry and the regulator are on a journey working out respectively how to operate in this new environment and how to achieve the outcomes we all want.  

While I support a strong three lines of defence model, it seems to me that the conduct question is more a business model and cultural challenge and therefore should be firmly rooted in the first line. The fundamental reason for this is that fair treatment of customers and proper behaviour in markets are inextricably linked with how businesses are run or, in terminology I have used before, it is about doing the right thing for the customer.

The business model challenge is how to evolve current models into ones that are demonstratively 'safer' from a conduct perspective ie that consistently are able to deliver products and services that are good value, that genuinely meet the needs of the customer bases selected by the firm over their life cycle and are provided by firms that are trusted and whose delivery infrastructure is resilient. Given that consumer tastes are changing anyway, and new technology is revolutionising how consumers can access financial services, this combination represents a considerable challenge to existing models. Our perception is that firms are at the relatively early stage of working out what a sustainable business model is likely to be.

I would like to spend a little more time exploring the culture question. It is certainly my view that having the right culture is essential for achieving good conduct performance. This is not, though, a fluffy view of vague corporate aspirations or value statements, but a need for a more hard-edged embedding of business practices that define how decisions will be made through the firm at critical points of engagement with customers or dealing in markets.

Achieving an effective conduct- or customer-focused culture is challenging for firms particularly for those whose focus has been primarily on profitability and shareholder returns. We find that as firms are thinking this through, they frequently assume that a customer-focused culture is one that is based on customer satisfaction and devote their attention to improving the customer experience.

While we would applaud improvements in the customer experience it is not the same as our focus on fairness and firms’ cultural approaches must embrace this concept for them to be successful. From what we see, there are key drivers that set and re-enforce this conduct-focused culture with the most important being clear and ongoing leadership from the top of the organisation, constant re-enforcement, hiring practices, incentive structures, effective performance management, penalties for not doing the right thing all of which should set the tone for framework for decision making on a day-by-day basis.

What I have discussed so far covers how the regulator is reacting to the new environment and what firms should be doing. Other things being equal, this should improve the state of the world from a conduct perspective but doesn't necessarily ensure that this improvement is sustainable. To do that, more progress is necessary to achieve the alignment I talked about earlier between the interests of the firm, its employees and shareholders and the interests of its customers. Given that there is a natural market incentive for firms to favour the interests of shareholders over that of customers and that firms can exploit features of consumer knowledge and behaviour to allow that to happen, then the regulator has to work very hard to counteract that, unless incentives can be made to work that act to align interests.

Creating incentives that act to re-balance the interests of customers and shareholders is a complex question and involves a variety of stakeholders from the regulator, investors, and 'Society' at large. For example, Sir Richard Lambert has articulated the need for banks and bankers to have a duty of care to society and the proposed banking standards body will aim to raise standards across the banking industry.  Punishment through enforcement action by the regulator plays a part and this is an established form of incentive. Competition will play a part and that is why the FCA will be a pro-competitive regulator with a new competition objective and way of thinking.

Other incentives need to be improved on though and these relate both to the incentives on the firm and the individual. In retail markets it is already existing practice for us to require redress to be paid when mis-selling has occurred – this is a powerful incentive as it says that profits should be good profits as otherwise they will be paid back. We in the regulator need to ensure that we continue this approach and that firms see it as part of the incentive approach. To this end we will want, where possible, to introduce more transparency into redress schemes.

In wholesale markets we don't use the same concept of detriment and redress so we need to find something that has the same impact and incentive effect at the firm level. The answer is possibly a clearer effort to restrict the business of the firm in the area where there has been poor behaviour and, legal constraints permitting, this is something that we wish to consider doing.

At the individual level I believe there is more we can do to improve incentives. We are preparing for the introduction of the new Senior Persons and Certified Regimes which will emphasise personal accountability. However, this should be seen as part of a more comprehensive approach to individual accountability including use of attestations, where we ask senior individuals to attest to us in relation to a supervisory action, and the use of ‘malus’ and ‘clawback’ in the banking sector. We will want to use these tools in an effective but proportionate way so that it should be clear that there will be significant cost to individuals if conduct issues in retail or wholesale markets occur on their watch.

We also need to find ways of ensuring that the Boards and non-executive directors (NEDs) in particular are completely engaged in conduct issues and act as a key stakeholder to represent both the interests of the customer and the interest of shareholders. We have certainly been encouraged by the fact that conduct is now firmly on the agenda of boards. This is to be welcomed but I would like NEDs to go further and in particular ask three questions, and be satisfied with the answers, ‘How do we actually make money today, what is it we will do in the future to grow the firm and why is this fair?

In summary, both the industry and the regulator are on a journey working out respectively how to operate in this new environment and how to achieve the outcomes we all want.  This is complex and challenging for all of us and will involve the industry changing its culture and, in some cases, its business models. Likewise, we as the regulator, have had to fundamentally change the way we supervise the industry. To achieve long-term success, progress must be made in better aligning firms and their executives and boards with the interests of customers.  For our part, the FCA needs to be seen as both on the side of the consumer but also as a constructive and trusted regulator by the industry so that we can continue to have the debates we are increasingly having and collectively re-build the trust in financial services that is so important.