In its business plan this month (July 15), the FCA said it was reviewing the capital adequacy requirements on firms as part of its review of the compensation policy framework.
It wants firms that fail to have appropriate capital, liquidity and reserves to cover outstanding redress liabilities and to hold financial resources “proportionate to the potential harm caused”.
Details of the review are to be published during the next 12 months but the regulator said it believes this will help reduce the level of Financial Services Compensation Scheme payouts and the levy.
But some advisers have concerns higher capital adequacy won't solve the problem and will instead push smaller firms out of the market altogether as they won't be able to afford to cover all their potential liabilities.
Darren Cooke, chartered financial planner at Red Circle Financial Planning, said: “Increasing capital adequacy won't solve the problem, all that stands to mean is that I will not pay as much on my FCA levy but I will have to keep huge amounts more cash in my business.
“No firm can truly afford to cover all their potential harm no matter how high you make the barrier so claims will still fall to the FSCS and you risk taking smaller firms out of the market altogether.”
Tim Morris, an adviser at Russell & Co Financial Advisers, said any costs should remain "reasonable" and in line with current requirements.
"It’s like anything, if you set that bar too high it will put firms out of business. You only need to look at the high street where business rates are unaffordable to most small independent businesses.
"They need to ensure advisers do not go the same way. If people wanted to move fully online for financial advice, they would be doing so right now. In my experience, that is not currently the case for most."
Meanwhile, others argued it was too early to tell what the impact on smaller firms would be.
Alasdair Walker, chartered financial planner and managing director at Handford Aitkenhead & Walker said: "I think the devil will be in the detail. I suspect higher capital adequacy requirements may well crowd out smaller firms, but I think liabilities will scale with firm size, and so without professional indemnity insurance being an important part of the discussion, it’s a non-starter."
Ricky Chan, director at IFS Wealth & Pensions, said smaller firms transacting higher risk business had the potential to do more harm than larger ones and this should be reflected.
But he did not think raising capital adequacy requirements was the answer to the industry's woes.
He said: “In theory, larger capital adequacy reserves should help somewhat as more capital is available to cover PII excess when there are multiple claims.
“However, I don’t believe that this alone will be sufficient to offset the rate of increase of FSCS compensation and therefore levies firm face.
“In addition, across the whole industry, this is an awfully inferior use of capital and I suspect there is a better alternative if this can all be pooled together and invested (like some form of endowment fund).”
He added: “Also, this does nothing to address the issue that if a firm winds up, there is no capital adequacy remaining to cover for future claims – these lead to higher FSCS payouts and levies in future.”
In contrast, Philip Milton, chartered wealth manager at Philip J Milton Company & Co, said he always thought capital adequacy requirements should be higher.
“It has taken the FCA, as the latest regulatory incarnation, thirty-six years since then to think about doing something about it,” he said.
“This is not to make life complicated for businesses in the sector but to recognise that if advisory firms cannot manage their own capital especially well or prove that they have more than a few brass buttons to rub together, should they really be endeavouring to suggest to investor clients that they can be entrusted to look after their assets?”
He said the compensation framework should be made less complicated than under its present structure.
“If advisory firms had more ‘skin in the game’ then fewer of them would go bust and fewer claims would be made to the FSCS,” he said.
“Maybe the FCA should also change how it treats loans from principals and directors too as at present there are constraints imposed which could cause financial distress to the lenders (at the wrong times) and costly accounting hassles whereas a simple rule for the firm ‘to maintain the minimum requirements at all times’ is adequate.
“That would encourage principals to leave more money in the business anyway.”
The FCA is reviewing the review of the scope and coverage of the FSCS and advisers have suggested FSCS criteria need to change in order to reduce the payouts.
Cooke said the FSCS should start by not paying out for things which were not covered by FSCS in the first place.
He said: “If your investment had no FSCS protection, then you get no pay out no matter who or how it was sold to you. Simple. No pay outs for London Capital & Finance, Basset and Gold and so on.
“Also any fines should be retained to cover the FSCS not paid to the Treasury.”
Chan agreed, saying the FCA needed to review the coverage and criteria of FSCS compensation as it was "unacceptable and unsustainable" for this to increase year-on-year, especially if paid out on unregulated investment failures.
The FSCS has paid out more than £57m to around 2,800 LCF minibond holders on the basis that the investors had been advised by the firm.
Mini bonds would normally fall outside the scheme's remit as they are unregulated investments but evidence of advice, which is a regulated process, meant they were covered.
The FSCS has repeatedly cited the millions being paid in relation to LCF as one of the main drivers behind its increasing industry levy.
It was forced to raise a supplementary levy for 2020-21 of £78m, partly due to LCF cases.
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