This month we look at the outcome of the British Financial Conduct Authority's high-cost credit review and the approach that the regulator proposes to take to regulating the claims management industry.

This month we bring you details of two significant documents: the outcome of the British Financial Conduct Authority's high-cost credit review, which contains extensive new proposals to reduce costs for consumers and give them greater control over their finances; and the approach that the regulator proposes to take to regulating the claims management industry. The FCA will take over the regulation of the sector in April 2019 and has proposed a number of new rules to improve standards and imbue consumers with some confidence about the process.

Automated investment services

The FCA monitors developments in the sphere of automated investment services and has published the results of two reviews of this market. The first involved seven firms offering automated online discretionary investment management (ODIM) and the second reviewed three early entrants into the automated advice market.

The FCA’s report highlighted a number of weaknesses in the market and the FCA provided each firm with 'feedback' about its situation when the review was over. As a result, many firms have made significant changes to their processes and controls and the regulator will keep pressurising them to make more.

Here are the main findings of both reviews, which will help the regulator develop its strategy for this market.

Disclosure

The review revealed that most of the ODIM firms that it sampled were not good at telling people about the services they were providing and the related fees. They did not say whether the service was advised, non-advised, discretionary or non-discretionary, and the regulator thought that the ways in which they compared fees was "potentially misleading." The old regulatory phrase that describes the duty of firms to tell customers about the nature of their services and fees is "clear, fair and not misleading."

Suitability

Every automated investment service must include a suitability assessment, the better to help it recommend a product to the customer that is suitable for his needs. The FCA identified a number of areas where firms were not meeting its expectations.

• The firms that believed that their services were suitable for all investors often failed to gather information about customers’ previous knowledge and experience.
• Some ‘streamlined advice’ models failed to gather enough customer information as part of the KYC ("know your customer") and 'factfind' process.
• Advisers had been intervening in the advisory process without keeping records of the nature of their intervention, making it difficult to prove that the eventual advice was suitable.
• Auto-advice options which allowed customers to disregard the recommended option did not provide adequate risk warnings or safeguards.

Vulnerable customers

The investigations uncovered weaknesses in the way firms identified and treated vulnerable customers. In some cases they required customers to identify themselves as vulnerable. The FCA wants firms to formulate ways in which they can identify and support vulnerable customers more appropriately when they design such services.

Governance

The regulator found little evidence that firms had given adequate thought to the specific risks associated with automated advice, especially when it came to cyber-security and the need for stress testing.

Overall, the management information collected by the services involved in the review focused primarily on compliance, risks, operational factors and marketing, but the FCA also exhorted firms to consider the ways in which they review the results that these services generate. While some firms did demonstrate clear oversight, others were unable to show the clear allocation of responsibilities. Let us now turn to FCA fines and penalties.

Director banned for misappropriating client money

The director of a debt management company was found to have used customers' money to purchase a second debt management firm, which the FCA believes demonstrates a lack of honesty and integrity.

During its investigation, the regulator concluded that the man, Darren Newton, was aware that he should only have used the money to pay customers’ creditors, or else he should have returned it to them. Instead he used it to fund the purchase of a second firm at a time when there was a £6 million shortfall in client money.

The FCA has published its decision notice, outlining its findings and proposing to ban the man from performing any regulated activity within the financial services industry. The decision is being disputed and therefore the decision notice is pending judgement by the Upper Tribunal.

FCA fines bank for AML failings

Canara Bank has been fined £896,100 and restricted from accepting deposits from new customers for 147 days after the FCA found that it had failed to maintain appropriate AML controls and remedy weaknesses that had been identified by a skilled person.

Confiscation order against convicted fraudster increased

The regulator has persuaded a court to increase the severity of a conviction order against an individual who was convicted of fraud because further details of his assets have come to light.

In 2014, the individual was convicted of operating an unauthorised collective investment scheme and of defrauding investors of more than £21 million. He was sentenced to seven years’ imprisonment and subject to a nominal confiscation order of £1 as he was thought to have no assets available as a result of civil proceedings and bankruptcy.

The confiscation order was increased to £31,905.33 because it emerged that he was a named beneficiary of his late mother’s pension scheme. As his mother died without making a will he is also entitled to one-third of the value of her estate. Once the estate has been administered, the confiscation order will be adjusted appropriately.

Turning technology against the criminals

The FCA’s executive director who supervises investment firms, wholesale firms and specialists, Megan Butler, recently delivered a speech at the FCA’s anti-money-laundering TechSprint event about the way in which software can combat financial crime. Below are the highlights.

The regulator supports technological innovations that are designed to improve compliance, but understands the reluctance of financial firms to introduce new software that may increase regulatory risk. However, Ms Butler took the opportunity to remind attendees that firms and regulators alike have a public duty to explore all available options to prevent financial crime.

Employees of financial firms are on the frontline of detecting and preventing financial crime, with more than 920,000 internal suspicious activity reports raised during 2017. Firms refused to provide more than 1.1 million prospective customers with services because they were worried that they might be involved in financial crime. Firms also ended 370,000 relationships with existing customers for similar reasons.

Technology is playing an ever-more vital part in the detection of financial crime and the regulator is primarily concerned with results rather than firms' overheads. More and more firms are automating existing processes to cope with volumes and to reduce 'false positives,' particularly when monitoring transactions. Their next step will be to apply intelligent software, such as AI and machine learning, to spot suspicious transactions in real time. Old systems and biases are bound to make these processes hard to set up.

The FCA is frequently asked whether it will let firms ‘off the hook’ if something goes wrong with their new software. The answer is a resounding ‘no,’ but if firms test and oversee things well, they might be able to offset risks. Ms Butler concluded by asking firms to work with her organisation to develop new systems.

High-cost credit and overdrafts

High-cost credit is used by an estimated three million consumers in the UK, including the most vulnerable in society. As part of its effort to understand the causes of harm in the sector, the FCA has published proposals to reduce the cost to consumers and to empower them to take greater control over their finances.

Overdrafts

The FCA’s work in the overdraft market found that customers did not understand it very well and that price competition was weak. Charges are highly concentrated, with a minority of consumers paying the majority of fees and firms generating an estimated £2.3 billion in revenue from overdrafts in 2016. There is also a significant difference between fees for arranged and unarranged overdrafts, with firms making ten times the yield on unarranged overdrafts.

The regulator believes that four main things cause consumers harm:

• they are not very 'aware' of how they use their overdrafts;
• costs, particularly for unarranged overdrafts, are high;
• pricing strategies are complex; and
• there is a good deal of 'repeat usage.'

To tackle these problems, the FCA has proposed three remedies.

• It might require firms to provide "overdraft eligibility tools," either online or 'in-app,' to let each consumer weigh up the likelihood that this-or-that financial firm will allow him to run up an overdraft without a formal credit application.
• It might change the way in which firms present consumers with important information when they open their accounts for them, perhaps obliging them to state that overdrafts are a form of debt and to provide access to an overdraft cost calculator.
• It might require firms to enrol consumers automatically in an overdraft alert service and ban overdrafts from being displayed as part of consumers’ available balances.

The FCA has tabled some proposals to do with pricing and repeat overdraft usage for public comment. On the subject of pricing interventions, it is exploring the possibility of an outright ban on fixed fees, with arranged overdraft charges based on a single interest rate. The FCA is also proposing that arranged overdraft advertising ought to include a representative annual percentage rate to bring it in line with other forms of credit.

It proposes to ensure that unarranged overdrafts are priced by means of a single interest rate, which is a fixed percentage uplift of the interest rate used for arranged overdrafts. Nobody knows what this percentage uplift should be. On the subject of repeat overdraft usage, FCA research shows that repeat overdraft users are often in dire straits and can become dependent on their overdrafts. The regulator believes firms can do more to help these consumers, but have a commercial incentive not to do so. It has therefore proposed a two-tier system similar to the approach for tackling persistent credit card debt.

Rent-to-Own (RTO)

The FCA’s analysis of RTO pricing structures found that RTO goods (without add-ons) were on average 2.7 times more expensive than the cost of purchasing the goods outright and goods with add-ons were on average 3.7 times more expensive. The regulator found that RTO items were more expensive than if the product had been bought using another form of consumer credit.

To tackle this, the FCA is considering the merits of a price cap on RTO products and plans to undertake further study. It also intends to consult interested parties about a point-of-sale ban on extended warranties because consumers are often confused about the worth of these optional add-ons, especially as the costs can be significant. This ban will, if imposed, involve a two-day deferral period before the sale of an extended warranty can be concluded.

Home-collected credit

Fewer consumers use home-collected credit than in previous years, but those who do are (on average) borrowing greater amounts. Repeat and multiple borrowing is a common feature in this market. Although the FCA does not consider this to be a risk in itself, it is concerned that some consumers are being unduly influenced to keep borrowing.

The Consumer Credit Act 1974 restricts the canvassing and soliciting of cash loans outside trade premises without signed requests from the customers. Some firms consider the loan agreement the necessary proof to enable them to discuss further loans at any point in the future. The FCA believes that this undermines the Act's objective of protecting consumers from various things. Because of this, the FCA has drafted up some clearer rules and is inviting comments about them from the public.

The regulator has also raised concerns about refinancing, as its research shows that 30–40% of home-collected credit is refinanced with additional borrowing, which often results in costs that are higher than they would be if the consumers were to take out additional loans. To deal with this and ensure that consumers are better informed, the FCA is proposing to require firms to make more disclosures to customers, giving them clearer information about the loan options available and the costs of refinancing when set against those of taking on new loans.

Catalogue credit and store cards

The FCA has analysed this sector and has identified four specific areas of concern.

• Credit offers. When accessing offers such as ‘buy now, pay later’, consumers often do not realise that the firms might charge them interest from the day of purchase if they fail to repay in full before the offer period ends.
• The fact that consumers have no control over credit limit increases.
• Poor treatment of consumers at risk of financial difficulty, including the increasing of credit limits that apply to those already struggling to make repayments.
• Flexible repayment terms that hide indications of problem debt and long-term debt, which can lead to significant costs for consumers.

The FCA is consulting interested parties about new rules to:

• require firms to do more to help consumers in persistent debt;
• give consumers greater control over credit limit increases; and
• make the communication of ‘buy now, pay later’ offers clearer and introduce prompts to help consumers avoid charges.

The regulation of claims management companies

The FCA has published its proposals for regulating claims management companies in a set of draft rules. It will begin to regulate the sector in April next year. It has three main concerns:

• customers should have the confidence to pick services which are appropriate for their needs and represent value for money;
• claims management companies should be authorised, meet standards and secure redress for their customers; and
• the regulatory regime should improve standards within the sector and the confidence of customers in it.

During its initial investigations in the sector, the FCA uncovered the following potential sources of harm.

• A lack of clarity about the costs and nature of claims management companies' services, which could result in financial loss for consumers.
• Poor levels of service.
• Spurious or fraudulent claims, which may increase prices in other markets.
• The danger that customers might purchase inappropriate services as a result of unauthorised activity or poor conduct.
• Disorderly wind-downs, which may result in loss or delays in the execution of redress.

Once the FCA assumes responsibility for the regulation of the sector, all claims management companies will have to re-apply for authorisation and will be allocated a window in which to do so. From April next year onwards, they will be subject to the FCA’s Principles for Businesses (PRIN), Threshold Conditions (COND), and General Provisions (GEN) and its rules to do with complaints handling and the "Claims Management: Conduct of Business sourcebook" (CMCOBS).

The regulator has issued proposals to make specific changes in the market. It is thinking of:

• requiring each firm to provide each customer with a summary document, which outlines service levels, illustrates or estimates fees and, if a statutory ombudsman or compensation scheme is in play, requiring it to provide him with a statement that tells him that he does not need to use a claims management companies to access such services before he signs a contract.
• requiring each firm that already has a relationship with a customer to provide him with regular updates about the status of his claim, including an estimate of any fees that it might charge when the potential value of his claim becomes apparent;
• calling for a prominent message to be displayed in all marketing material, outlining the nature of the fees associated with ‘no win, no fee’ services and how they are calculated;
• requiring claims management companies to hold records of all communications with customers for a minimum of 12 months, including call recordings, emails and text messages;
• requiring them to meet the prudential rules pertaining to the types of business they conduct and, if they are not solely lead generators, to hold enough capital to withstand unexpected financial shocks and prevent a disorderly exit from the market; and
• requiring those claims management companies which buy leads to undertake enough 'due diligence' to be able to show that the data gatherers have appropriate systems and controls to ensure compliance with the relevant laws that govern data protection, communication and privacy.

New data on the 2016 Sterling flash crash

The FCA has released new data which shows that the Sterling flash crash in October 2016 was magnified by dealers leaving the market. The exact cause of the flash crash, which saw the price of sterling drop 9% (or around £10 billion) against the dollar, has not been determined but factors might-include human error and a poorly calibrated algorithm.

The newly released trading data shows that traders reduced their activity from normal levels of around £32 million per second to £0.2 million per second during the crash. Investment banks also helped to increase transaction costs, with bid-ask spreads 60 times higher than normal. Another trend to emerge from this data was the existence of a "negative feedback loop" between the spot market and the OTC derivatives market, which prevented firms from hedging against liquidity risk easily.

To prevent future flash crashes, European regulators have taken steps, through MiFID II, to watch trading more closely and to ensure that certain classes of derivatives are traded on LIT exchanges, otherwise known as light pool markets, where the order books are made public for all who subscribe, rather than over the counter.