Twin-peaks regulation: key changes and challenges

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1 financial services Twin-peaks regulation: key changes and challenges november 2012 kpmg.co.uk/fs

2 Twin peaks: the new landscape On 15 and 16 October 2012, the fsa released publications outlining the approach to be taken by two new bodies, the Prudential regulation authority (Pra) and the financial conduct authority (fca), in regulating the UK financial services industry. The introduction of a twin peaks model is a major milestone for the regulatory reform Programme and is the first step in changing the UK regulatory structure in The new model will mean that deposit takers, insurers and major investment firms will have two groups of supervisors, one focusing on prudential (the Pra) and one focusing on conduct (the fca). all other firms (i.e. those not dual regulated ) will be solely supervised by fca. structurally, the new system looks like this: Producing and enhancing the stability of the financial services system of the United Kingdom, aiming to work with other relevant bodies including the Treasury, the PRA and the FCA. The Bank s Special Resolution Unit is responsible for resolving failing banks using the Specific resolution regime Bank of England FPC Contribution to the Bank s objective to protect and enhance financial stability, through identifying and taking action to remove or reduce systemic risks, with a view to protecting and enhancing the resilience of the UK financial system FPC powers of recommendation and direction to address systemic risk PRA Enhancing financial stability by promoting the safety and soundness of PRA authorised persons, including minimising the impact of their failure FCA Enhancing confidence in the UK financial system by facilitating efficiency and choice in services, securing an appropriate degree of protection, and protecting and enhancing the integrity of the UK financial system Prudential regulation Prudential regulation Conduct regulation Prudential and conduct regulation Systemic infrastructure Central counterparties, settlement Systems and payment systems Prudentially significant firms, Deposit takers, insurance, some Investment firms Investment firms and exchanges, other financial services providers including IFAs, investment exchanges, insurance brokers and fund managers Source: HM Treasury, A new approach to financial regulation: building a stronger system, 2011 The fpc will have responsibility for reducing risks to the financial system as a whole. The Pra is likely to follow direction from the fpc based on its view of the macroprudential environment and sectoral intelligence when taking firm-specific decisions, deploying prudential regulatory tools or developing policy. firms will be able to review the fpc s periodic financial stability report to understand the recommendations that the committee is making to the Pra and assess the likely direction of future macro-prudential regulation. exact numbers have yet to be determined, but around 25,000 firms will be solely regulated by the fca and around 2,000 will be dual regulated. To understand what prompted the split into the Pra and fca, we need only look at the mission statements of these bodies. The fca s vision is to make financial markets work well so consumers get a fair deal and the Pra s sole objective is to promote the safety and soundness of Pra authorised firms. The fca s focus, therefore, is on ensuring that services and products are designed to meet customers needs and that firms put the interests of customers at the heart of how they run their business. The creation of the Pra is an attempt to focus more closely on ensuring that firms are more resilient against failure, and minimising the impact that a firm s failure has on the UK financial system, while accepting that a zero failure regime is not a feasible proposition. 2 Twin-peaks regulation: key changes and challenges international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom.

3 There are big changes in what we are doing, and it is an exciting time to be putting these changes into effect.we will get a much clearer focus from splitting prudential and conduct regulation for banks and insurers, from introducing macroprudential regulation to help to protect the financial system as a whole, and from focusing our regulation on applying judgement in a transparent way. Andrew Bailey, Deputy CEO designate of the PRA (October 2012) international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom. Twin-peaks regulation: key changes and challenges 3

4 New Powers although the Pra will take a more forward-looking, judgement-based approach to prudential supervision, its powers will not change significantly from those that have been granted to the fsa. The new fca, however, has been granted new powers with which to supervise and enforce compliance with regulatory requirements. The fca s new powers will include the following: Area of focus Product governance and intervention New powers The FCA are not proposing that they should pre-approve new products, but have significantly increased powers in the area of product governance the design, operation and sale of products. They will intervene early in a product s life span and have the power to ban products that they consider pose unacceptable risks. Financial promotions Super-complaints Consumer credit The FCA can direct firms to withdraw or amend misleading financial promotions with immediate effect and publish the fact that a warning notice relating to a disciplinary matter has been issued. Certain consumer organisations will be able to make super-complaints relating to issues that affect large groups of customers. The Government will make its final decision on whether to transfer responsibility for consumer credit regulation from the OFT to the FCA during Around half of firms with credit licenses are estimated to be at present unregulated by the FSA. The other half could face additional regulatory requirements from 2014 if the transfer goes ahead. Competition This is another area where the FCA s approach is embryonic, but there will be a focus on promoting better services, choice and value for customers, and the FCA will distinguish between innovation that benefits rather than exploits customers. Examples of past competition failures include commission payments that incentivise advisors to favour recommending sub-optimal products, or a sales process that encourages customers to take out PPI without shopping around. 4 Twin-peaks regulation: key changes and challenges international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom.

5 [Twin peaks] will embed the forwardlooking, judgement-based approach and accelerate the move away from the old reactive style of regulation.the changes will not just be structural but involve behavioural shifts from both supervisors and firms. Hector Sants, FSA Chief Executive (March 2012) What challenges do these new powers create for your firm? Products will need to be tested before launch to ensure that they deliver to customer expectations all products should be regularly monitored using a holistic range of MI to ensure they remain suitable and consistently deliver good customer outcomes You will need to have robust controls to ensure that promotions are compliant yet commercially effective and are in line with the expectations of the fca and the approach of peer firms. staff responsible for approving promotions must have the right capabilities and competence to ensure promotions are compliant The regulator has given little guidance on new media but firms will need to be proactive in ensuring that communications made via new media, such as Twitter or facebook, are compliant firms should conduct product risk assessments to ensure that existing products will not be seen as taking advantage of customers, and can be demonstrated to provide value and benefit You should be able to show that your end-to-end sales process is not only compliant with the letter of the rules, but is also designed and operated in a way which minimises the risk of customer detriment through appropriate controls against inappropriate behaviours international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom. Twin-peaks regulation: key changes and challenges 5

6 Changes to the supervisory framework: PRA The Pra will focus on the big picture and on understanding where the main risks to the stability of the financial system lie, and so the test of materiality for points raised with you will be high. The Pra will be forward-looking, seeking to assess whether, on the balance of risks, there are vulnerabilities in firms business models, capital and liquidity positions, governance, risk management and controls that cast into doubt a firm s future financial soundness. risks to the stability of the financial system will be assessed via a five step risk assessment framework: PRA - Risk Assessment Framework Gross risk Safety and soundness Potential impact Risk context Operational mitigation Financial mitigation Structural mitigation Potential impact External context Business risks Risk management and controls Management and governance Liquidity Capital Potential impact Assessment will be directly through the impact of firm failure on real economic activity or the soundness of other intermediaries and through behavioural effects where vulnerabilities within one firm affect confidence in others. The PRA will consider whether and how the wider external macroeconomic and business complexity affect the execution of a firm s business model in a variety of different scenarios. System-wide risks (interest rates, excess credit growth) and sectoral risks (e.g. Credit concentrations) will be assessed. The PRA will evaluate the quality of a firm s risk management and governance. This will include an assessment of the adequacy and integrity of its risk management, systems and controls, culture, governance and the competence of its senior management. The PRA will consider a firm s financial strength. This will include an assessment of the level of capital a firm is holding against uncertainties about the valuation of assets and future risks; as well as the quality of its funding and liquid assets and its approach to liquidity management, including contingency planning. If a firm can be resolved in an orderly manner, the overall risk that it poses to the stability of the financial system will be lessened. Working with the Bank s Special Resolution Unit and the FSCS, the PRA will consider whether, and with what impact a firm could be resolved. All firms will be subject to baseline supervisory monitoring, comprising an (at least) annual review of a firm s resolvability, an assessment of the principal risks to financial stability, an analysis of a firm s financial position, discussions with senior management at the firm and compliance with minimum prudential standards for capital, liquidity and large exposures. Those firms that present the greatest risk to the stability of the financial system will be subject to more focus from the PRA. The PRA will also establish a Proactive Intervention Framework (PIF) which is intended, as part of the ongoing process of supervision, to identify early risks to a firm s viability and ensure that firms take appropriate remedial action. It will flag actions that the authorities will need to take in advance to prepare for the failure and resolution of a firm. What challenges does this new approach create for your firm? There must be a visible focus from the leadership team on risk management which manifests through documented risk-based decision-making Stress and scenario testing, including reverse stress testing, will be seen as a key tool for management in assessing the sustainability of the business model Your firm s leadership team will need to demonstrate a good understanding of the approach that you use to assess your firm s capital and liquidity adequacy You will need to evidence that your firm s overall governance arrangements, including Board effectiveness and oversight, are designed appropriately and operated effectively. robust governance should extend throughout the business to the front-line Your Management Information must be suitably detailed and robust to highlight key risk exposures There should be clarity of risk ownership with clear delineation of responsibility between the business and the risk function Your firm s risk concentrations and aggregations must be visible and it should be readily apparent how these are being managed 6 Twin-peaks regulation: key changes and challenges international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom.

7 Changes to the supervisory framework: FCA Perhaps the most significant effect that firms will feel is in the area of supervision. The new approach to supervision demonstrates that the fca s focus has changed from assessing technical compliance to quantifying major business risks. To achieve this aim, supervision will be more judgement-based, starting at the firm s business model and strategy and leading to early intervention on the basis of assessment of conduct risk rather than crystallised issues. The first stage will involve re-categorising firms (a process which has yet to be finalised) according to the risks they pose to customers and the market, which will impact the approach to supervision as follows: Category Criteria Approach to supervision C1 C2 C3 Banking and insurance groups with very large numbers of retail customers Universal/investment banks with very large client assets Firms with a substantial number of retail customers and/or large wholesale firms Firms with retail customers and/or a significant wholesale presence Dedicated supervisor Firm-by-firm business model and strategy analysis Dedicated supervisor Firms grouped within sectors to identify common risks of business models and strategy Supervised by a team of sector specialists Sampling of firms business models and strategies C4 Smaller firms, most intermediaries Supervised by a team of sector specialists international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom. Twin-peaks regulation: key changes and challenges 7

8 Changes to the supervisory framework: FCA (continued) There are 3 main tools which will be used in supervising firms, with a much greater emphasis on identifying and mitigating potential customer detriment before it occurs: 1. Firm Systematic Framework (FSF) The FSF replaces ARROW with an approach that features the following areas of focus, to answer some key questions: Area of focus How is this different? Key questions the FCA will ask Business model and strategy analysis (BMSA) This is an assessment of the root cause of conduct risk rather than the issues-based approach of ARROW. Is the business sustainable from a conduct perspective? What are the future conduct risks? What do the margins on products tell us and where are the growth areas? Four supervisory modules: i. Governance and culture ii. Product design iii.sales or transaction processes iv. Post-sales/services and transaction handling For C1 and C2 firms, these modules will be assessed on an going basis, rather than the point-in-time approach of ARROW. The output of the FSF will be a focussed set of actions, rather than the long RMP under ARROW. Follow up work will be pushed onto the firm, using s166 powers where necessary, rather than being completed by the regulator. How effectively is the firm identifying, managing and mitigating conduct risks? Are products targeted at customer needs? Do the firm s processes support appropriate customer outcomes? Is the fair treatment of customers considered after the point of sale? Is Senior Management taking individual responsibility for the right areas? Note, in the remaining lifetime of the FSA the current ARROW cycle will be retained. So if your firm is due to complete an ARROW assessment before Spring 2013 it will still be subject to a supervisory review, however that review will consist of 2 supervisory teams assessing the risks against their new objectives. 2. Event-driven work Using a greater pool of flexible resources, the FCA will continue to react to crystallised issues, identified through, for example, complaints data, whistle blowers or more innovative use of intelligence derived from new media, for example. This intelligence-led approach is aligned with the desire by the FCA to take quicker and more decisive action to correct regulatory failures. 3. Issues and products Driven by sector risk assessment (SRA), this work will look at key product issues, emerging risks and firm specific risks. FCA action may take the form of policy, enforcement or efforts to promote competition, alongside or in place of more traditional supervisory responses. The FCA is clear that there will be a focus on wholesale as well as retail conduct supervision. While accepting that different customers have different experience and expertise, no categories of customers will avoid the scope of supervision. As we have seen with Interest Rates Hedging Products, which are originated in investment banks but are ultimately also sold to retail customers, these products are likely to come under greater regulatory scrutiny. 8 Twin-peaks regulation: key changes and challenges international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom.

9 What challenges do these changes create for your firm? Business Model and Strategy Analysis You will need to have conducted BMsa, which analyses your firm s market position through the lens of conduct risk. This should establish your conduct risk appetite and ensure it is aligned to your strategy, critically analyse your current and future strategy (including competitor analysis and considering the effect on consumers), identify the key drivers of conduct risk, highlight priority areas and incorporate an action plan to mitigate conduct risk Governance and culture Your governance structures should be operating effectively, aligned to a customer-focussed culture Your risk and compliance functions must be effective in meeting new regulatory challenges. This means a move away from monitoring technical compliance and adopting a forward-looking, judgement-based approach based on an assessment of risk. adopting a conduct risk approach will help define the role and priorities of risk and compliance senior Management must understand the new supervisory approach and you should be ready for your first FCA visit there will be more personal, individual accountability for key elements of regulatory focus Product design Product design drivers should be based on clear customer need evidenced through data or research. Design should follow from customer insight and focus on meeting customer expectations as well as achieving commercial targets Products should go through a clear gateway approval and sign off process which includes compliance, legal and consumer champion stakeholders which tests the customer value in new products. clear parameters need to be set where more light touch sign offs can be applied (e.g. little change in product features) Sales or transaction processes sales are fair and clearly describe the product, ancillary options and pricing structures in order that customers are able to make an informed choice as to the benefits and suitability of the product Where advice is given, it must be demonstrably suitable and take into consideration the hierarchy of customer needs Post-sales/services and transaction handling customers expectations are met and customers consistently obtain appropriate and fair outcomes after the point of sale (including complaints, customer communications and ongoing charges) Outcome testing should be conducted on a regular basis. Where customers are not obtaining consistently fair outcomes or where products fail to meet their reasonable expectations, the design of the product needs to be re-reviewed and amended appropriately in addition to any relevant remediation required. international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom. Twin-peaks regulation: key changes and challenges 9

10 Changes to enforcement FCA Enforcement changes In terms of Enforcement, the FCA is committed to progressing the direction in which we have already seen the FSA moving. This means that we can expect to see: More enforcement cases, including the use of s166 powers More severe penalties, including higher fines An increased focus on action against individuals, especially senior management More criminal prosecutions for offences such as insider trading A focus on pursuing compensation for customers. In addition, the FCA will have the power to publicise the fact that it is taking enforcement action against a firm or individual. What challenges do these changes create for your firm? When problems occur you need to identify them quickly, remediate them effectively and learn from them You will need to demonstrate that key aspects of your business model or culture, such as remuneration and incentivisation, product development and training and recruitment are designed and operated in a way which takes into account the needs of customers The compliance function needs to have a prominent and defined role in key aspects of the business, including product development and overseeing customer interaction to ensure that good customer outcomes are achieved You must be able to evidence the tone from the top needed to demonstrate a customer-focussed culture Your firm s systems and controls must mitigate the risk of financial crime (fraud, money laundering and bribery and corruption) The FCA s core purpose is to make sure markets work well so consumers get a fair deal to do that we will have not only new powers, but a new supervisory approach and a new culture. Key to the success of this approach is ensuring that good consumer outcomes are built into the business models of the firms we regulate. Martin Wheatley, CEO designate of the FCA (July 2012) 10 Twin-peaks regulation: key changes and challenges international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom.

11 Summary of key changes We set out below the new Pra and fra regulatory frameworks. as you will see, these combine new elements and existing tools in a way that represents a new model and approach to regulation. The PRA s new framework Risk and impact identification PRA intervention Risk mitigation/ remediation Review Forward looking, judgment based and commensurate with the level of risk Risk assessment based on the extent to which the business model is sustainable Risk alerts: - Annual review of resolution plans - Assessment of compliance with capital, liquidity and large exposure standards - Regular contact with senior management Challenging but constructive relationships Focus on impact that firm failure would have on financial stability without relying solely on the resolution regime Policies and rules on firms resilience (covering such areas as capital, liquidity and leverage) Supervisory assessments and interventions Mechanisms to support resolution Early and proactive supervisory interventions designed to reduce risks to the stability of the system S166 reports Pillar II Capital add-ons Use of statutory powers to compel firms to take actions Restrictions on permissions Fine firms/individuals Prosecution through the courts Disclosure and market discipline Self reporting by firms Third party reviews Follow up supervision visits The FCA s new framework Risk and impact identification FCA intervention Risk mitigation/ remediation Review Conduct risk and market analysis Whole market/sector wide review Competition referral Self reporting by firms Business model analysis Firm/peer group review Market-wide policy interventions Increased use of third party reviews Risk alerts: Product/thematic interventions Individual firm risk mitigation plans Follow up supervision visits but - Product sales data Governance/risk S166 Reports these are no longer the primary tool - Regulatory returns/ framework effectiveness Product level prohibition complaints data Consumer redress programmes - Market intelligence Tougher enforcement action Conduct supervision activity Referral by consumer groups ( super complaints ) Where are the opportunities? The changes outlined here represent an opportunity to take control of and manage regulatory risk, by reacting quickly and effectively to the changing approach to supervision, to seize a competitive advantage. Consider the following... supervisors are more empowered to make judgements, based in part on the information you provide them. so take the opportunity to get it right - ensure your Mi allows them to make what you feel are the right judgements More pro-active regulation, looking to prevent issues rather than focus on remediation of crystallised issues, means international cooperative, a swiss entity. all rights reserved. Printed in the United Kingdom. that there is value in showing that you understand the root cause of conduct issues... not just deal with symptoms at the point where the failure occurs across the value chain. consider PPi as an example The Pra will focus on the big picture and on understanding where the main risks to the stability of the financial system lie, so getting it right will reduce the supervisory burden on the firm The fca will focus on the product lifecycle, including the power to ban products, so investing in robust approval processes and monitoring over the lifecycle will significantly reduce regulatory risk Twin-peaks regulation: key changes and challenges 11

12 Contact us Fiona Fry Partner financial services frm regulatory T: +44 (0) E: Giles Williams Partner regulatory centre of excellence ema region T: +44 (0) E: Nicholas Henderson Partner financial services frm regulatory T: +44 (0) E: Giles Adams Partner financial services frm regulatory T: +44 (0) E: Tim Howarth Partner financial services frm regulatory T: +44 (0) E: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. Printed in the United Kingdom. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. RR Donnelley I RRD I November 2012 I Printed on recycled material.