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.
My biggest concern is...it still does not accurately reflect the risk an individual firm posesFinally, 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.
Let us start with some positives. The new system is certainly simpler and moving to an income-based measure means firms whose cost base includes high levels of salaries – to advisers and support staff – will no longer be penalised. In future, all firms, regardless of their business model, will have the same capital requirement proportionate to their income, which removes the ability for some firms to ‘game’ the previous expenditure-based system.
However, my biggest concern is that while the proposed system is simple and helps to level the playing field, it still does not accurately reflect the risk an individual firm poses.
Under the proposals, no differentiation is made between the areas a firm advises on and the products recommended. In other words, higher-risk firms have the same capital requirement as lower-risk firms.
Let us look at a couple of examples.
Firm A generates the majority of its turnover from ‘vanilla’ investments, such as Isas, Oeics, pensions and so on, but will have the same capital requirement as Firm B, which generates the majority of turnover from riskier areas such as occupational pension transfers, VCTs, EIS and Ucis.
Which firm poses more risk? Can it be right that they both have the same capital requirement?
Take another example. Firm A generates the majority of its business from ongoing adviser charges, transacts very little new business and takes on only a handful of new clients each year. Firm B is more transactional-based, with a low level of ongoing fees, and is actively taking on new clients.
My belief is that in both instances Firm A poses a lower risk based upon the likelihood or cost of a customer complaint. Firms working in vanilla areas, working with existing clients and deriving most of their income in ongoing fees are least likely to receive complaints.
I have thought about this long and hard and cannot see the logical reason for not requiring firms that pose a higher risk to hold more capital. The FCA points out in the consultation document that introducing such a differentiation would introduce a high level of subjectivity, require continual updating and could influence product selection.
I remain to be convinced; and I am confident that it must be possible to come up with a system where vanilla advisers are not paying for the mistakes of firms operating in higher risk areas.
There is a second area I would question and hope the FCA will reconsider.
At present I can see nothing that would ensure that a firm facing financial difficulty could not spend its regulatory capital, breach the rules and end up defaulting to FSCS. Perhaps it is time for us to have a system of compulsory deposits lodged with a third party, perhaps the FSCS. This would increase security for investors.
I welcome the principle of these changes – consumer protection will be increased, the system is fairer and certainly simpler. However, I am concerned that fairness may be sacrificed on the altar of simplicity. Not alll firms are the same and we need to find a system which acknowledges the risk posed by each advisory practice.
Steve Young is chairman of Sense Network
Key Points
Under the FCA’s capital adequacy proposals, the regulator wants to ensure that the potential harm to consumers is kept to a minimum.
The FCA points out that the average redress in the case of a pension or investment failure is £11,000.
Moving to an income-based measure means firms whose cost base includes high levels of salaries will no longer be penalised.
