Diploma in Professional Financial Advice UNIT 1: Chapter 1
Learning Outcomes: UNIT 1: FINANCIAL SERVICES, REGULATION and ETHICS 1 Demonstrate an understanding of the UK financial services industry, in its European and global context 2 Demonstrate an understanding of how the retail consumer is served by the financial services industry 3 Demonstrate an understanding of legal concepts and considerations relevant to financial advice 4 Demonstrate an understanding of the regulation of financial services 5 Demonstrate an understanding of the financial regulators responsibilities and approach to regulation 6 Demonstrate the ability to apply the principles and rules as set out in the regulatory framework 7 Demonstrate the ability to apply the regulatory advice framework in practice for the consumer 8 Demonstrate an understanding of the range of skills required when advising customers 9 Demonstrate an understanding of the financial regulators use of principles and outcomes based regulation to promote ethical and fair outcomes 10 Demonstrate the ability to apply the Code of Ethics and professional standards to business behaviours of individuals 11 Demonstrate an ability to critically evaluate the outcomes that distinguish between ethical and compliance driven behaviours
Contents: Chapter 1: The UK financial services industry... 4 1.1 Role and structure of the UK and international markets... 5 1.1.1 Life Assurance Companies... 5 1.1.2 Friendly Societies... 7 1.1.3 Banks... 8 1.1.4 Building Societies... 9 1.1.5 Unit Trusts, Investment Trusts, Open-ended Investments and Stockbrokers... 10 1.1.6 The State... 10 1.1.7 Retail Outlets... 11 1.1.8 Direct Telesales Companies... 11 1.1.9 Factors of a Successful Company... 12 1.2 The impact of the EU on UK regulation... 13 1.2.1 Single Market Legislation... 14 1.2.2 European regulatory architecture... 15 1.3 The role of Government... 17 1.3.1 Fiscal Policies... 19 1.3.2 Monetary Policies... 21 1.3.3 Supply-side Policies... 23 Page 3
Chapter 1: The UK financial services industry Financial services encompass a wide range of products and services available from different types of providers. The providers manufacture the products and then make these products available to customers using various methods known as distribution channels. The traditional providers include life assurance companies, friendly societies, banks and building societies, as well as the more specialised investment providers such as unit trust companies, investment trust companies and open ended investment companies (OEICs). Players which have entered the marketplace more recently include retail outlets and direct telesales companies, although these tend to be used as distribution channels rather than manufacturing the products themselves. In the financial services marketplace, there is an increasing trend for globalisation, with many institutions aiming to spread their networks and operations worldwide. The key to success in a globalised industry is the ability to adapt to the changing needs of customers. Customers are operating in an increasingly globalised environment and their needs and the way in which they do business are changing. For example, electronic commerce (E-commerce) is expanding rapidly and is revolutionising the way in which business is transacted; through mediums such as the Internet. Business can now be transacted on a truly global basis. Global financial services providers need to be able to apply their expertise wherever and in whatever form the customer demands. Page 4
One of the consequences of globalisation is increased competition between existing companies and new entrants to the market. Companies are comparing their size, capacity and premium income with international competitors. To be truly global and have competitive strength across a range of markets, size is important. The amount of merger and acquisition activity has significantly increased as companies have tried to consolidate their position to compete effectively in domestic and international markets. This trend is forecast to continue. 1.1 Role and structure of the UK and international markets Financial service providers offer a large variety of products ranging from a basic life assurance policy, to a savings account, to a portfolio of specialised investments. The providers also offer the services to accompany these products; the most important of these being personal financial planning where a product being sold is put into the context of a customer s overall financial circumstances. Other services include mortgage advice, estate planning, buying and selling of shares, portfolio management and so on. 1.1.1 Life Assurance Companies There are more than two hundred life assurance companies operating throughout the UK. Many of the companies are household names who have been operating for years (sometimes centuries!). These have been joined by newer companies; sometimes subsidiaries of European or other foreign companies, especially with the growth of the unit linked policy. Page 5
The trend for mergers and acquisitions has been particularly evident in the UK life assurance industry, for example, United Friendly and Refuge Assurance, AXA and Sun Life, and CGU and Norwich Union. There are two basic types of life assurance company: Mutual Companies Proprietary These may take several forms: Composite company Part of a marketing group Industrial life office Mutual Companies These are the more traditional life companies still operating on the basis laid down by the original guilds and mutuals. In a mutual company: The with profits policyholders are the owners of the company and have voting rights. The profits of the company are shared amongst with profits policyholders only. In recent years there has been a trend for demutualisation, i.e. converting from a mutual company to a proprietary company. This allows activities to be extended and equity capital to be raised. Life offices that have taken this route include Prudential and Legal and General. Proprietary Companies These are owned by shareholders and the profits of the company are shared amongst the shareholders and the with profits policyholders. Most companies, be they mutual or proprietary, offer a full range of protection and investment products which they market direct to the public and/or through intermediaries. Page 6
Composite Companies A composite company offers general insurance, for example, house insurance and car insurance, as well as life assurance. Marketing Groups Many life assurance companies are members of marketing or investment groups that consist of a number of specialist companies. These can include investment management, pensions management, unit trust management, international subsidiaries and general insurance companies. 1.1.2 Friendly Societies Friendly societies are mutual organisations that offer a variety of savings and insurance products and services. Before the development of the welfare state, friendly societies provided cover for medical expenses as well as small savings plans for the general population. Membership of friendly societies reached a peak in 1945 when there were 2,740 active societies with 8.7m members. However since then the number of societies still writing new business has reduced dramatically. Many of the friendly societies still operating are small organisations, but there are a number of sizeable progressive societies marketing a range of industrial and ordinary branch life assurance as well as the traditional tax-exempt savings plans. These are available to anyone: from birth for a current maximum premium of 270 per year or 25 per month. Page 7
The Friendly Societies Act 1992 introduced important changes for friendly societies, enabling them to: incorporate and set up subsidiaries to operate in new markets, for example lending to members; acting as agent for another lender; establishing and managing unit trusts/oeics and new individual savings accounts (NISAs). Societies are now able to sell general insurance, investment management services and become involved in projects such as sheltered housing and residential and nursing homes. 1.1.3 Banks Banks offer a wide range of services to meet the everyday needs of their personal and business customers. Most people are familiar with personal services offered by the clearing banks such as secured and unsecured lending, including house purchase loans, bank accounts, credit and debit cards, and foreign currency exchange. Banks can arrange life and general insurance, either their own products or those of insurance companies, and offer investment opportunities such as unit trusts/oeics and NISAs. For higher net worth customers banks can provide portfolio management services whilst high street branches give instant share dealing facilities to customers. Other services include will writing, document and valuables storage and trustee and executorship. Using a bank as a trustee or an executor under a will has the obvious advantage that the trustee or executor is always willing and available to act when called upon. The major clearing banks operate nationally and also have branches overseas. There are also a number of regional banks operating in different parts of the UK, which provide services that match a regional identity. Page 8
As well as the clearing banks, more specialist services are offered by merchant banks such as investment management and corporate finance. These banks are mainly located in London but some have branches in other major UK cities. Overseas banks operate in the UK mainly to hold currency deposits, but also to service UK customers of international organisations. They also provide traditional banking services for foreign nationals living in the UK and Europe. 1.1.4 Building Societies Building Societies were originally established to enable a larger section of the British population to purchase their own homes. They use the money investors deposit to advance loans to those wishing to buy a house. The investors receive interest on their deposits and the borrowers pay interest on their loans. The mutual concept of the society was reflected in the type of accounts available, the basic type of building society account being an ordinary share or paid-up account. Money can be withdrawn or deposited with few restrictions and that money represents a share in the building society with the accompanying rights as the account holder becomes a member of the society. The interest paid normally varies with interest rate movements. The traditional role of the building society, as a non-profit mutual organisation has changed, especially since the 1986 Building Societies Act which gave societies the power to become public companies, if, of course, the majority of members agree. Page 9
1.1.5 Unit Trusts, Investment Trusts, Open-ended Investments and Stockbrokers As well as traditional life assurance and pension products, other investments regulated by the Financial Conduct Authority (FCA) are provided by unit trust, investment trust and open ended investment companies as well as stockbrokers. Stockbrokers offer a variety of financial services to customers in addition to buying and selling shares. They are authorised to sell a range of investment products and will give general and specific investment advice. Unit trust companies and investment trust companies offer collective investment vehicles, which professionally manage investments on behalf of a number of investors. 1.1.6 The State The State provides benefits such as pension, sickness and maternity benefits. However, such benefits are limited and will not provide for anything other than very basic living conditions. There are also State investment products such as Gilts which are bought and sold in a similar way to stocks and shares. In recent years, State pensions have come under pressure because the funds paid out to the increasing number of retired people have exceeded the amount of contributions paid into the scheme and people are living for longer. Changes are being introduced in an effort to contain these costs, including: increasing the State pension age to 66 by 2020 and then to 67 by 2026; and, the introduction of a single-tier State pension from 2016. Page 10
The State encourages people to save for their retirement by the provision of tax incentives. However, that has not proved sufficient so new workplace pensions legislation has been introduced that aims to increase the level of private provision within the UK by introducing an element of compulsion. These rules came into effect on 1st October 2012 and will be fully in place by 1st October 2018. 1.1.7 Retail Outlets Most of the retail outlets which operate in the financial services marketplace are part of a joint venture with an existing provider and act as a distribution channel for its products. 1.1.8 Direct Telesales Companies Direct telesales companies, such as Direct Line, only transact business over the telephone and do not have a salesforce. They offer mainly general insurance products, for example house insurance and motor insurance. Most direct telesales companies do not offer life assurance and pension products due to the complexity of the products and the need for detailed financial advice. Page 11
1.1.9 Factors of a Successful Company There are pointers to the strength of any product provider, some of which will depend upon the type of financial services business undertaken: Size of new premium income per annum, which will reflect the success of the company in selling its products and its strength in terms of scale of operation Size of funds under management, which will show how successful the company has been on a regular basis and the financial strength it has in the market Economic expenditure, ensuring that income always exceeds expenditure to safeguard the policyholders interests Management strength, since the ability of the management will be the determining factor in a successful strategy Investment return, which will reflect the above and the expertise of the management in investment performance Past performance record is also a valuable indicator (though no guarantee of future returns) since the important aspect to a policyholder is the provision of good return for their investment Product innovation, quality of service and levels of administration In simple terms, the aim of a company is to make a profit in order to maximise the return to investors and, in the case of proprietary companies, dividends to its shareholders. This can only be achieved by successful investment, over a long term, based on financial and management strength. Page 12
1.2 The impact of the EU on UK regulation Now that trade barriers between European countries have been removed, individuals are free to choose the financial products and services from any providers within the European Union (EU). UK-based financial services providers can either set up European subsidiaries or market their products directly. This depends on the type of activities involved, for example, following the Third Life Directive, which came into effect in July 1994; life assurance companies can actively promote their products and services anywhere in the EU. Other institutions such as banks have to set up a subsidiary or acquire a stake in a European financial institution in the countries concerned, but can offer the same range of products and services as for domestic customers. Much UK financial services regulation originates in the EU. The EU is also very active in developing rules for Europe's financial markets that are designed to deepen the internal market. Since the UK has to give effect to European law, active engagement with Europe is essential. Indeed, around 70% of the policymaking effort of the UK financial services regulators, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), are driven by European initiatives, including the Financial Services Action Plan (FSAP). It is crucial that the standards developed in international forums are proportionate and informed by economic analysis. Otherwise, better regulation domestically would be more difficult to achieve. Page 13
1.2.1 Single Market Legislation There has been specific Community legislation promoting the single market since the 1980s. However, there was a step change when the FSAP was adopted by the European Commission in May 1999. It consists of 42 measures, including 24 EC Directives to be transposed into the law of each Member State, and Regulations, which apply directly in all Member States. The FSAP has three specific objectives: to create a single EU wholesale market; to achieve open and secure retail markets; and to create state-of-the-art prudential rules and structures of supervision. These objectives are designed to promote Europe's wider economy by removing barriers and increasing competition among financial services firms, thereby making markets more efficient and reducing the cost of raising capital to industry generally. Since 1999 the Community has adopted or updated requirements concerning, amongst others: the amount of capital which firms should hold; the rules they must comply with when carrying on business with their customers; the controls they must apply to counter the risk of money laundering and terrorist financing; the tests to apply when assessing the suitability of new controllers or large shareholders; the requirements they must impose to counter the risk of market abuse; and the disclosures which companies must make when seeking new capital. Page 14
Completion of the FSAP within a tight deadline was accompanied by a new legislative approach to developing and adopting EU financial services legislation, the Lamfalussy approach. Following the recommendations of the Larosiere Report this approach has been extended and strengthened with the creation of new European regulatory architecture. 1.2.2 European regulatory architecture Since January 2011 the European system set up for the supervision of the financial sector is made of three supervisory authorities: the European Securities and Markets Authorities (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA). The system also comprises the European Systemic Risk Board (ESRB) as well as the Joint Committee of the European Supervisory Authorities and the national supervisory authorities (i.e. in the UK this is the Financial Conduct Authority). Whilst the national supervisory authorities remain in charge of supervising individual financial institutions, the objective of the European supervisory authorities is to improve the functioning of the internal market by ensuring appropriate, efficient and harmonised European regulation and supervision. The European Banking Authority (EBA) Formally known as the Committee of European Banking Supervisors (CEBS) The EBA is an independent EU Authority which works to ensure effective and consistent prudential regulation and supervision across the European banking sector. Its overall objectives are to maintain financial stability in the EU and to safeguard the integrity, efficiency and orderly functioning of the banking sector. Page 15
The main task of the EBA is to contribute to the creation of the European Single Rulebook in banking whose objective is to provide a single set of harmonised prudential rules for financial institutions throughout the EU The EBA also plays an important role in promoting convergence of supervisory practices and is mandated to assess risks and vulnerabilities in the EU banking sector. The European Securities and Markets Authority (ESMA) Formally the Committee of European Securities Regulators (CESR) ESMA s mission is to enhance the protection of investors and reinforce stable and well functioning financial markets in the EU. As an independent institution ESMA achieves this mission by building a single rule book for EU financial markets and ensuring its consistent application and supervision across the EU. ESMA contributes to the supervision of financial services firms with a pan-european reach, either through direct supervision or through the active coordination of national supervisory activity The European Insurance and Occupational Pensions Authority (EIOPA) Formally the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) Among EIOPA s main goals are to ensure a high, effective and consistent level of regulation and supervision taking account of the varying interests of all Member States and the different nature of financial institutions. EIOPA s core responsibilities are to support the stability of the financial system, transparency of markets and financial products as well as the protection of policyholders, pension scheme members and beneficiaries. Page 16
The European Systemic Risk Board (ESRB) is responsible for the macro-prudential oversight of the financial system within the EU with the aim of ensuring a sustainable contribution by the financial sector to economic growth and preventing periods of widespread financial distress. There is also the European Central Bank (ECB) which is responsible for coordinating monetary policy and interest rates within the Euro zone (i.e. those countries that adopted the Euro as their currency). 1.3 The role of Government The UK Government has several crucial roles to play in the financial health of the country. It has a key role in the regulation of the financial services industry, through the Treasury under the authority of the Chancellor of the Exchequer. In 2010 the Treasury announced plans for a new regulatory framework within the UK and these changes came into force on 1st April 2013. They include: A new Financial Conduct Authority (FCA). The FCA has assumed the conduct and market responsibilities previously undertaken by the FSA. It also authorises smaller firms. The creation of a new Prudential Regulation Authority (PRA). This is a subsidiary of the Bank of England and is responsible for the authorisation and prudential regulation of larger firms, such as insurers and banks. The creation of the Financial Policy Committee within the Bank of England Details of the regulatory structure are covered fully in Chapter 4 of this unit. Page 17
The Government also has a key role in the provision of social welfare and benefits; an essential factor in the financial health of the country. Full details of the available benefits are covered in Chapter 2, and a useful website for more information is www.dwp.gov.uk, the Department for Work and Pensions. In this section we will concentrate on the economic and monetary role of the Government. Most national governments share similar macro-economic objectives: low and stable price inflation a high and stable level of employment economic growth and prosperity a favourable balance of international payments. Macro-economics is the study of how a national economy works and the interaction between economic growth in output and national income, employment and the general level of prices. A macro-economy consists of all the different markets for goods and services, labour, finance, foreign exchange and other traded items. Changes in the behaviour of producers and consumers in individual markets will therefore have an effect on the macro-economy and the rate of economic growth, inflation, employment and trade. Governments use policy instruments, including taxes and regulations, to help achieve their objectives through the impact they have on the actions of producers and consumers. Page 18
1.3.1 Fiscal Policies Fiscal policy involves varying total public sector expenditure and / or the overall level of taxation to influence the level of demand in an economy. Expansionary fiscal policy may be used during an economic recession to boost demand for goods and services through tax cuts or increased public sector spending. Firms may respond by hiring more labour and increasing output. However, increasing demand can force up market prices and involve spending more on imported goods and services from overseas. Increasing imports will have a negative impact on the balance of payments. Contractionary fiscal policy may be used to reduce price inflation. It involves reducing demand in an economy through tax increases or cuts in public sector spending. However, firms may respond to falling demand by cutting their output and reducing employment. Increased taxes may also reduce work incentives and therefore productivity. Table 1.1: Impact of fiscal policy instruments Fiscal policy instruments Increase income taxes Reduce income taxes Impacts on consumers Disposable income is reduced and consumer spending falls Disposable incomes and consumer spending rise Impacts on producers Market prices and profits fall as consumer demand falls. Firms cut output and employment Market prices and profits start to rise so firms expand output and employ more labour Page 19
Table 1.1: Impact of fiscal policy instruments (cont) Fiscal policy instruments Increase taxes on profits Cut taxes on profits Increase indirect taxes on goods and services Cut indirect taxes on goods and services Increase public expenditure Impacts on consumers Consumers are not directly affected but may pay higher prices if firms cut output Consumers may benefit from reduced prices as output rises Consumers on low incomes may be hit hardest by price rises because they spend all or most of their incomes Consumers may expand their demand for goods and services as aftertax prices fall Public sector workers could be paid more. Low income families may receive more benefits. More public services could be provided for free Impacts on producers After-tax profits fall. Firms may increase their prices and/or cut output in response After-tax profits rise so firms may expand their output and employment Consumer demand may contract and profits fall. Firms may cut output and reduce their demand for labour Expanding demand will boost profits which are an incentive to firms to raise their output and demand more labour Firms supplying goods and services to government will enjoy increased revenues and profits, and may expand their output and employment Page 20
Table 1.1: Impact of fiscal policy instruments (cont) Fiscal policy instruments Cut public expenditure 1.3.2 Monetary Policies Impacts on consumers Public sector workers could suffer pay cuts or be made unemployed. Welfare benefits may be reduced Impacts on producers A cut in public spending on capital projects, such as road and school building, will cause cutbacks in the construction industry. Subsidies paid to other firms may be cut Monetary policy involves varying the interest rate charged by the central bank for lending money to the banking system in an economy. Contractionary monetary policy may be used to reduce price inflation by increasing the interest rate. Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people to save more in bank deposit accounts so they can reduce their own borrowing from the central bank. As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also reduce the amount of money they borrow to invest in new equipment. A reduction in capital investment by firms will reduce their ability to increase output in the future. Higher interest rates may therefore reduce economic growth and increase unemployment. Page 21
Expansionary monetary policy may be used during an economic recession to boost demand and employment by cutting interest rates. However, increasing demand can push up prices and may increase consumer spending on imported goods and services. Table 1.2: Impact of monetary policy instruments Monetary policy instruments Raise interest rates Cut interest rates Impacts on consumers Spending falls as consumers save more and borrow less. The foreign exchange rate of the national currency may rise. This will reduce the prices of imports. Consumers may buy more imports instead of home produced goods and services Spending rises as saving becomes less attractive and borrowing less expensive. The exchange rate may fall causing imported inflation. Impacts on producers Firms cut output and employment in response to falling demand. Firms borrow less to invest in new capital equipment, which may harm economic growth. Prices of exports sold overseas will rise if the exchange rate increases. Exporting firms may suffer falling demand and profits Firms increase output and demand more labour as demand rises. Firms may increase investment. Prices of exports sold overseas may fall if the exchange rate rises. Demand for exports may rise Page 22
1.3.3 Supply-side Policies Supply-side policies aim to increase economic growth by raising the productive potential of the economy. An increase in the total supply of goods and services will require more labour and other resources to be employed, will reduce market prices, and provide more goods and services for export. Supply-side policy instruments aim to encourage firms and employees to become more productive, and to remove any barriers that may prevent this. Supply-side policy instruments include: Tax incentives: Reducing taxes on profits and small firms can encourage enterprise. Tax allowances can also be used to encourage investments in new capital equipment and research and development (R&D). Subsidies or grants: These reduce production costs and also help firms to fund the R&D of new technologies. Education and training: Teaching new and existing workers new skills to make them more productive at work. Labour market regulations: Include minimum wage laws to encourage more people into work, and legislation to restrict the power of trade unions. Competition policy: Regulations that outlaw unfair and anti-competitive trading practices by monopolies and other large powerful firms. Free trade agreements: Removing barriers to international trade to allow countries to trade their goods and services more freely and cheaply. Deregulation: Removing old, unnecessary and costly rules and regulations on business activities. Privatisation: The transfer of public sector activities, such as refuse collection, to private firms to provide them more efficiently. Page 23