We have had a couple of months to digest the FCA’s capital adequacy proposals.
It seems a good opportunity to consider the wider implications for the industry and ask whether the proposals achieve the regulator’s aims.
First though, a quick reminder of the reasons behind the changes.
Why does the FCA require advisory firms to hold a minimum level of capital?
Put simply, the regulator wants to ensure that the potential harm to consumers, if an advisory firm comes under financial strain or fails, is kept to a minimum. The FCA explains that it is to ensure firms are sufficiently able to deliver on their longer-term commitments and to absorb routine losses and legitimate redress claims against them, as well as to provide time to make appropriate arrangements in the case of market exit.
Currently, firms with fewer than 25 advisers must hold a minimum of £10,000. Firms with more than 25 advisers and networks must have the higher of an expenditure based requirement (EBR) or £10,000.
The EBR is calculated as 13 weeks of the relevant annual expenditure for a network and four weeks for most other advisory firms.
The FCA has highlighted a number of reasons why change is needed, which include a belief that the current minimum amount required to be held is too low, while the system can be prejudicial to certain business models and is too complex.
In the consultation document, the FCA points out that the average redress in the case of a pension or investment failure is £11,000. It will only therefore take two legitimate complaints and subsequent PI claims for the firm’s capital to be reduced below the minimum level required.
The regulator believes that the existing rules can act as a disincentive for firms to invest in their business, which may mean an increase to regular expenditure and, consequently, an increase in their capital requirement. The same may be true when it comes to employing the staff needed to run the business.
Finally, the regulator has recognised that the current system could “benefit from simplification”, which in turn may encourage new entrants into the profession and increase competition.
It is clear that the regulator is keen to create a far simpler and more level playing field. It is therefore proposing a move away from a fixed expenditure-based requirement, while increasing the minimum amount which must be held.
The new rules will mean most firms have to hold capital equal to 5 per cent of relevant annual income with a minimum of £20,000. No differentiation will be made based on the number of advisers within a firm.
So do the new rules meet the FCA’s stated objectives? Yes, however, there are areas where I have concerns and believe the proposals could be improved upon.