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23 November 2012

Transformation of conduct regulation: the new approach to conduct risk

While there may be a white out forecast in the Alps this Christmas the fog is beginning to clear across the 'twin peaks' of financial regulation.

In 2010 it was announced that the FSA would be split and that the UK would move to twin peaks regulation. Last month the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) released their detailed approach documents, outlining the relevant philosophy and activities of the respective regimes.

The legislative element of this, the Financial Services Bill, is currently in the House of Lords and is anticipated to receive royal assent in early 2013. This legislation will provide the legal foundation for the FSA to split in to the FCA and the PRA.

In response to the release of these approach documents Baringa will be producing a mini-series on what we see as some of the main areas to consider for financial services firms. This blog will focus on the key factors financial services firms should consider for conduct regulation under the FCA. A subsequent blog will be published later this month highlighting key observations relating to prudential regulation and the PRA.

Change in regulatory focus:

Under the new conduct regime, there will be a significant shift in focus towards the larger end of the market with many firms that are currently 'relationship managed' becoming 'flexible portfolio' or 'non-relationship managed'.

Those firms that lose their supervisor and become 'flexible portfolio' will need to ensure that conduct focused governance and process can be clearly evidenced to the FCA on an ad-hoc basis.  These firms will no longer be able to rely on supervisory knowledge or relationship with the firm when they are reviewed.

For larger firms this shift will mean a more intensive approach to supervision and more frequent regulatory challenge.

Change in approach to regulatory audit:

Firm Systematic Framework (FSF), the successor to ARROW, will be a key element of the FCA's conduct focused approach. FSF will primarily focus on the product life cycle and the governance around it. This will be driven by a 'business model analysis' which will identify the key areas for review by the FCA.

For those firms at the larger end of the market (classified as 'C1' and 'C2' by the FCA), this continuous, conduct focused review process will represent a significant change from the current ARROW process. These firms will need to review their regulatory operating models to ensure that they have an adequate reporting structure and robust systems in place to deliver data and demonstrate compliance to the FCA on-demand. Moreover, firms will need to be confident that any regulatory actions can be dealt with quickly and effectively to avoid potentially receiving a costly section 166 review. The increase in 'issues and products' or thematic work under the FCA will further increase this pressure on firms' regulatory operations.

Change in focus of regulatory audit:

The FCA will seek to use its business model analysis capability to better target areas for conduct risk in the firms it regulates and the products they sell. This increase in product focus is likely to be a change for some large firms that are used to being challenged primarily on prudential issues.

Firms will need to review their sales processes from both a compliance and customer service perspective to ensure that they are able to successfully manage the increased level of regulatory scrutiny without impacting the experience the customer receives.

Managing these potentially competing challenges could act as a real differentiator in today's highly competitive markets.

What firms should do now:

The twin peaks structure is already being implemented within the FSA and although the relevant legal entities won't be in place until next year, regulated firms need to immediately begin assessing the way in which these changes might impact their business. On a strategic level, a failure to understand the implications of these structural changes on regulatory interaction will in itself represent a significant regulatory risk to the organisation. Operationally, the demands placed on data infrastructure and reporting channels will intensify hugely in line with the rising expectations of a more proactive regulator. For those firms that demonstrate the flexibility to adapt to this new reality, the transition may potentially find that a number of competitive opportunities arise from a more comprehensive understanding of conduct in relation to their customers.


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