RegulationApr 14 2021

How to fix the FSCS levy

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How to fix the FSCS levy

Recent comments from the Financial Conduct Authority that the current level of the Financial Services Compensation Scheme levy is unsustainable may be seen by some as no more than confirmation of the blatantly obvious, but for others, a senior representative of the regulator making such a strong statement may be something of a watershed moment.

Either way, the issue of meeting the liabilities of failed businesses and capital resource requirements look to be back on the regulatory agenda.

That is no bad thing considering the FSCS levy for 2021-22 is expected to top £1bn – a 48 per cent increase on last year – of which investment advice companies will contribute £240m.

The increase is attributed to a rise in complex pension cases, further self-invested personal pension provider failures and an expected increase in business failures because of the Covid-19 pandemic.

The issue of meeting the liabilities of failed businesses and capital resource requirements look to be back on the regulatory agenda

There will be no increase in the total amount paid by investment advice companies in 2021-22 as the class will breach its limits for the second successive year.

That total, however, if spread across a smaller number of companies, may result in each being asked to pay more individually. So, a debate about improving the system, as the FCA put forward in its September 2020 Call for Input, is welcome.

 

Requirements

The objective of a CRR should be two things: to provide a capital buffer to enable a business to wind-up in an orderly manner (often conflated with working capital but not the same thing); and to ensure there are sufficient resources to meet liabilities to customers after it has failed.

Pre-Retail Distribution Review, there were three tests that businesses were required to meet. Test 1, the own funds requirement, set a minimum of £10,000 of available funds and Test 1A, adjusted net current assets, required positive net current assets after the deduction of certain items.

Most significant for larger businesses was Test 2, the expenditure-based requirement. Only networks and companies with 26 advisers or more were subject to this, which required them to hold a proportion of their annual expenditure (with a per adviser minimum).

This ranged from 13/52 (three months’ money) for networks down to 4/52 (one month) for standalone businesses.

The calculation of the EBR was set out in detail and there were some flaws involving the treatment of depreciation and amortisation of goodwill. Clawbacks and claims provisions in networks and self-employed models (where part of the provision due from an appointed representative or adviser was not automatically allowable) were an issue too.

Several businesses ended up successfully applying for waivers as a result. Some groups organised into multiple regulated entities, each one of which was maintained below the 26-adviser threshold to ensure they were not subject to the EBR at all.

Despite the drawbacks, the exclusion of smaller companies and 4/52 not being sufficiently large, the EBR had the virtue of being related to the costs of a business, thereby meeting the need to provide a capital buffer enabling it to wind-up in an orderly manner.

As part of the consultation around RDR, it was proposed to increase minimum capital from £10,000 to £20,000 and the EBR to 13/52 for all advice companies. In the aftermath of the financial crisis and with capital at a premium, however, the implementation of this was delayed (twice) and then scrapped, to be replaced instead by the current system whereby the CRR is determined by revenue.

Today, subject to certain minimums (including the £20,000 which was phased in), financial advice companies are required to hold capital equivalent to 5 per cent of revenue on investment business and 2.5 per cent of mortgage and protection business.

This is more aligned to the second objective of a CRR, which is to provide resources to meet liabilities to customers given it is based on a company's revenue rather than its cost base.

The detail of both regimes is obviously more nuanced. It is not possible to go into every element without regurgitating large parts of the FCA Interim Prudential sourcebook for Investment Businesses.

Cover and fees

I have also ignored professional indemnity insurance, the rules around which both pre- and post-RDR have required limits of indemnity to be based on revenue as well as additional, readily realisable, capital to be held in relation to exclusions and increased excesses. As PII operates on a claims-made basis, however, once a business ceases trading and stops paying its bills, cover can fall away relatively quickly.

When a business falls into insolvency, there is a defined order of payment under the Insolvency Act 1986. First are secured creditors who have a legal right or charge over property, physical or otherwise. Next come preferential creditors (employees in relation to arrears of pay and certain benefits, HM Revenue & Customs and claimants who have filed in court), followed by unsecured creditors. Where a business has failed, and PII limits have either been breached or cover has lapsed, it is easy to envisage there not being much, if anything, left behind to claim against in the future.

So, what about the solution? In its Call for Input, the FCA focused on the concept of polluter pays (an excellent principle meaning those making the mess should pay for it) and offered three possible approaches: i) businesses involved in "riskier" advice being required to hold more capital to avoid defaults in the first place; ii) those businesses being required to take out “more” or “different” PII; or iii) those businesses simply being required to pay more for the FSCS.

Requiring companies involved in riskier advice areas to hold more capital appears eminently reasonable. A distinction already exists between investment advice and mortgage and protection business under the current CRR. Requiring companies that undertake defined benefit transfer business, for example, to hold more capital than those that do not is a logical extension.

The change would need to apply to companies that have undertaken those higher risk activities in the past as well as those active in the space today to be effective. We have seen a large proportion of the industry cease operating in the DB transfer space in recent years, but they still have potential legacy liabilities.

Due to differential charging structures (think 1 per cent plus 1 per cent vs 3 per cent plus 0.5 per cent) the increased rate would need to apply to the total revenue of the company rather than that related solely to the specific activity. It is not difficult to imagine some larger companies splitting their businesses into lower and higher risk entities, as some banks did with toxic assets after 2008, in response to a proposal like this.

Requiring businesses to take out “more” or “different” PII if they undertake riskier business types does not look like a viable solution in the current marketplace.

Companies are already struggling to obtain cover for certain business types. Excesses are increasing, and exclusions are on the rise – with the associated increases in capital described above already biting some companies hard.

Imposing further PII requirements is unlikely to help in a market already struggling under the weight of potential DB claims and an increased Financial Ombudsman Service limit with constricted supply. Changes to Fos and a longstop date are likely to be necessary to improve this position long term.

Instinctively, asking companies undertaking riskier advice to pay more towards the FSCS has merit – in the same way that only investment advice companies pay towards the investment advice class, advice businesses conducting DB transfers could be asked to contribute to a special, supplemental class.

Over time, however, that risks intensifying, rather than alleviating, the last-man-standing effect that is the very antithesis of polluter pays. Rather than the cost of failure being spread across a broad range of advice companies, it would be concentrated only in those that had undertaken the business type and not failed. This does not appear to be the right answer.

Provider contribution

The concept of a provider contribution to the advice classes of the FSCS levy was not suggested by the FCA. To some extent, it is easy to see why.

Providers are already contributing the lion’s share across their various classes to cover the cost of failures and, while they benefit from advisers’ activity, they have no influence or control over the nature or quality of advice that leads to their products.

Many providers, including a new wave of fintech businesses, do not operate via intermediaries at all. Is it fair to ask any of them to pick up liabilities generated by advisers on top of their own?

There is also an argument about provider subsidy of adviser liabilities running counter to the spirit of separation between advice and manufacturing that was at the heart of the RDR.

Solutions

So, is there another answer? There are limited ways to reduce the liabilities on the FSCS and, in turn, on surviving companies: reduce the volume and value of claims; reduce the number of company failures; or increase the amount failed companies must leave behind before the FSCS picks up the tab.

A primary objective should, of course, be to try to minimise the incidence of poor advice, which will reduce the claims that fall to the FSCS over time. That means stepping in with colleagues and reporting issues where necessary as the FCA has recently championed.

In an industry where the overwhelming majority of advisers are highly qualified professionals with the best interests of their customers at heart, there have been far too many mis-selling scandals.

One proposal to reduce the liabilities falling on the FSCS is to increase the capital companies must hold via the reintroduction of an EBR. Here, businesses would be required to hold a minimum level of capital relating to their cash expenditure (meeting the objective of an orderly wind-up) as well as capital to meet future claims based on revenue and business type. For example, 4/52 of annual cash expenditure for small businesses, increasing to 8/52 for medium businesses, up to 13/52 for larger businesses. The £20,000 minimum should also be increased given it represents the PII excess due on just four successful PII claims.

With an EBR in place, the current revenue-based percentages could be scaled down, except perhaps for companies that undertake advice in certain riskier areas like DB transfers, effectively asking them to hold more capital as the FCA proposed.

To be effective, the capital calculated on revenue would need to be ringfenced from the assets of the company, so it is preserved for the sole purpose of meeting claims, say for a period of six years in line with the time-bar rules in the FCA Dispute Resolution: Complaints sourcebook. It could be argued that the readily realisable assets required to cover any increased PII excesses or exclusions should be treated in the same way. This could operate like funds under the Tenancy Deposit Scheme.

Businesses are already required to submit the necessary data to the FCA as part of the Retail Mediation Activities Return. Submission could be followed by a requirement to add additional capital to the ringfenced fund (or receive a repayment from it) as well as providing evidence that the EBR element is being met for smaller companies that are not subject to audit.

The fund would act as the first port of call for claims against the business following insolvency after other assets have been exhausted but prior to the business being declared in default and the liabilities falling on the FSCS.

As with almost every proposal, there are some obvious downsides. While capital is relatively cheap, particularly compared to the financial crisis era, it is easier for larger businesses to raise than smaller ones. A transitional period would certainly be required to enable companies to do so. Some businesses might choose to exit or consolidate with larger groups instead.

The impact of companies holding more capital on the FSCS default rate would take time to work through, probably several years. In the meantime, the FSCS would still have to be funded through the levy. This is something the industry could legitimately lobby government on to provide transitional support as part of creating a fairer system in a vibrant advice sector.

Being required to hold more capital is never going to be popular. But in the face of a seemingly ever-increasing FSCS levy, it must surely be part of the conversation.

By what other mechanism can the industry ensure that polluters really do pay?

Paul Dunne is a former regulatory and commercial director at Foster Denovo