What are we going to do with you?

What follows is the text of a very good speech made by Carol Sargeant of the Financial Services Agency at the Summit of the Financial Services Industry in Edinburgh, 7 May 2003.

We should warn readers who are:

....that reading this speech could be bad for peace of mind, may cause attacks of the Screaming Meemies, night horrors, involuntary bed-wetting or mysterious sweating attacks......

Dealing with consumers - the opportunities and the costs of getting it wrong

Make a customer happy and she will tell two friends, make her angry and she will tell everyone she knows". One of the problems of course with a lot of retail financial products is that the consumer will not know for a long time whether they should be happy or angry. I want to talk to you today about your retail consumers and the opportunities and costs of getting this part of your business wrong.

My proposition to you today is that the retail sector poses significant strategic risks to you, your top management and Boards and, moreover, that these risks are rarely explicitly identified, monitored and managed by you, to the potential detriment not only of individual consumers but also of market confidence and ultimately of shareholder value - which is I think a major pre-occupation for most of you.

Sadly, there are still many - too many - cases of misselling, misrepresentation and faulty products - that is, products that were never going to deliver what they promised from the beginning because of a design fault. The facts speak for themselves. £11.5bn of compensation will have been paid for pensions misselling, another £300mn for FSAVCs. Work on endowments continues and the compensation paid to consumers is around £600m and rising. And now we have splits and precipice bonds. Add to this the administrative costs of dealing with compensation - estimated at £2bn for pensions alone - and you are talking about a lot of money and literally millions of consumers affected with consequent damage to market confidence and of course damage to shareholder value. There may well be other unrecognised potential and actual risks lurking in your portfolios of retail products right now. What analysis and processes do you have in place to avoid these risks if possible, to spot them when they do arise, to manage and mitigate them?

The retail market place is already a risky and dangerous place for the unwary, the overaggressive and the poorly controlled, and the environment certainly shows no sign of becoming more benign. Actions by both government and companies are requiring individual consumers to take on much greater responsibility for their current and in particular their future financial health. The changes to state and personal pensions are well rehearsed - but there are other issues too including borrowing for university education. And these changes are happening at a time when markets are more difficult, competition is increasing, consumers have a better understanding of their rights and society is generally becoming more litigious.

The consumer, your customer, is having to take responsibility for deciding how much to save, when to save and what savings instruments to use - in many cases for the first time in at least two generations. They will also have the usual liabilities - mortgages, which is the dominating financial commitment for most, and consumer debt, both of which are at historically high levels - and some new ones, for example student loans. Consumers will have to actively manage their assets and liabilities over their lifetime in a way neither their parents or grandparents have had to do - and they will have to do this over a lifetime which may well see much more change in working and employment patterns than hitherto and more changes in lifestyles, more divorce, co-habitation and single person living. This will all - happily - have to be managed over a lifetime, which will on average be longer, and during which most people expect to enjoy a higher standard of living.

How well equipped are consumers - your customers - to deal with the planning responsibilities and risk management issues - including volatility risk - that this will demand? Most human beings are notoriously poor at long-term planning. People in the UK are also relatively inexperienced and unsophisticated when it comes to matters financial. This is hardly surprising after two generations of mainly welfare state and employer provision. Many consumers have also still not fully adjusted to the implications of a low inflation environment and probably don't understand the liability side risks they are running any better than their savings and investment risks.

It is hard to overestimate the extent of financial illiteracy amongst some consumers. Let me give you some illustrations from recent research. Many consumers have serious numeracy problems. Research by DFES has shown that one in four adults cannot calculate the change they should receive out of £2 after buying three items costing less than that. A significant number thought 10% of £300 was worth no more than £25. Some rather older research by the OFT showed that only 64% of consumers might be expected to draw the right conclusion when comparing 2 APRs and 23% of the sample could not explain what a percentage was.

A more recent survey by NOP for Invesco found that half of investors surveyed (and over two-thirds of the public at large) do not understand the difference between equities and bonds.

The FSA's own research and that of the independent Consumer Panel is also revealing. One quarter of pension and endowment policy holders did not realise that their money was invested in the stock market. 57% of consumers never or hardly ever read the personal finance page in their newspapers. Consumers find financial information difficult to understand and frequently fail to read or retain the information provided. 56% of consumers agree or strongly agree with the statement "I find it hard to understand financial leaflets". Even products designed to be simple confuse consumers - only 33% of consumers thought cash ISAs were straightforward for example.

How often and how much do your product designers, delivery channel experts and marketeers test whether consumers really understand the product being offered, its relevance to them and its risks? Do they, for example pay any attention to generic or firm specific complaints data? Do they really understand the underlying causes of past and present problems in the industry? Do they really understand consumers' needs? Our impression is that the consumer's capacity to understand the product being offered and its appropriateness for their own circumstances does not feature highly in product or market analysis or design. This is very evident from much of the promotional material, which often focuses on form rather than substance. In particular the risk reward trade off is too often either not explained at all or relegated to illegible footnotes. And once sold there is not enough monitoring of the continued efficacy of a product or indeed of any unintended or unexpected side effects. There is rarely any after sales information or service to consumers except where FSA has required it.

There are some interesting comparisons to be made with the pharmaceutical industry where new drugs are routinely tested for safety and effectiveness before they are launched and this is then typically followed by post-sale surveillance to monitor side effects, dangers and continued effectiveness of a drug.

Much the same principles could be applied to retail financial products. Are the products properly stress-tested before launch? Do firms know whether the product and its risks are capable of being understood by the target consumer? Do firms themselves fully understand the product's sensitivity to any major market or economic shift? This kind of analysis should lead to better risk alerts to consumers at the initial point of sale as well as throughout the product's life. Pharmaceutical products typically come with guidance on the circumstances in which they should not be taken as well as warnings about possible side effects.

It is probably best not to push this analogy any further, but I would like to dwell a little on issues about brand, trust and customer loyalty which I am sure you will be discussing at this conference. Recent research has shown that 40% of consumers consider only one company when buying financial products. This might seem a successful outcome if you are the company they consider and if you are pushing brand loyalty and seeking consumer trust. But exactly how much do you want consumers to trust you as a provider and what do you mean by brand and loyalty? Blind, uninformed, ignorant trust strikes me as rather dangerous for the firm as well as the consumer. Challenging, well-informed consumers who understand the trade off between risk and reward should be a very important risk mitigation tool for firms. We in the FSA are working hard to improve consumer awareness and understanding, but I believe there is a very important role for you in the industry to play, both at the generic level and in the way you describe and explain your individual products at the point of sale and thereafter.

I hope I am by now beginning to persuade you that the shift of ever-greater financial responsibilities to relatively ill-equipped consumers in a challenging environment poses a very significant risk to you. There is one other risk I have not mentioned yet and that is legal risk. We see broadly two types of legal risk. The first is relatively straightforward. The law itself is not in doubt but a firm has simply failed to respond to the legal issue appropriately. This is a relatively straightforward systems and controls and operational type risk - but it needs careful management.

The second legal risk is more challenging. This is where the law is unclear, or it is in a state of flux or perhaps even though the law is clear it is widely misunderstood and/or widely ignored. Changes here will often be determined by changes in what society as well as governments consider is acceptable behaviour, but the detail and timing of change can be unpredictable.

Hitherto, legal risk has often been thought of as something that applies to derivatives and other new-fangled innovative products and structures in the wholesale markets. I would suggest that legal risk of both types is highly relevant in the retail sector and that the costs of getting it wrong in large portfolios of retail transactions can be very big indeed, not only in terms of compensation, but also in terms of administrative effort and damage to reputation.

Too often the types of risks I am talking about are misclassified as regulatory conduct of business issues and relegated to compliance departments to make sure that the form is observed and of course to keep the regulators at bay. Compliance departments do of course have an important part to play, but this is above all a strategic and business risk for firms. Boards should be asking themselves exactly the same questions about retail consumer risk as they do about market risk and credit risk. What is the firm's risk appetite? How is it measured, monitored and controlled? How often is the portfolio of risks reviewed? In a credit portfolio you would expect all credits to be reviewed on an annual basis with higher risks receiving more frequent attention and some perhaps placed on a watch list. Consumer risk is no different in principle.

What should firms be doing?

Senior Management of financial firms habitually set risk tolerances for market risk, credit risk, insurance risk, operational risk and so on - and monitor against this. Firms also need to set risk tolerances for their interactions with retail consumers - this will include product types, sales methods and after-sales requirements. Some firms do this, but not enough.

There are a number of questions that senior management need to ask themselves (and these are based on observed good practice).

  • Does your new product design process take adequate account of the target market's ability to understand the product and its relevance to their needs? Are the products adequately stress tested, so that you fully understand and can explain to consumers what the risks are? There are some rather topical examples where this appears not to have happened. Splits and precipice bonds come to mind.
  • Do you regularly assess how economic, social and legal changes affect the needs of our customers? And what the implications are both for your existing business and for the types of new business it is in your firm's interests to be selling? Do you provide an adequate "after-sales service"? Mortgage endowments is an interesting example. Many firms were extremely slow to realise that the combination of an end to tax relief on mortgage endowment premiums in the 1980s and low inflation expectations in the late 1980s and 1990s had significant implications for the risk profile and suitability of mortgage endowments.
  • Are you doing enough to ensure that your advertising, marketing and disclosure material is comprehensible to consumers? Do you ensure that it has been checked for plain English? Do you consumer test it enough to check that the messages that consumers take from it are consistent with the messages you want to give and that the consumer gets a balanced picture of the opportunities and risks involved in buying the product?
  • Where you are advising customers, do you have robust standards in place that are clearly understood by your customer-facing staff? Do you set clear parameters for the types of consumers that should or should not be buying certain products? Do you have adequate procedures in place for monitoring the quality of advice provided (sampling of files, mystery shopping, customer profiles, etc.)?
  • Are your complaints handling procedures robust? How effectively are complaints analysed and the results used to adjust product design and sales processes?
  • And most important of all, as senior management, are you receiving sufficient management information at the right time to allow you to assure yourself that you know the answers to these questions?

How does this relate to the FSA?

We recognised at the outset that it would neither be possible nor desirable for the FSA to have detailed rules for every situation. We therefore developed our Principles for Business, which were designed to set out the fundamental obligations for regulated businesses. I am sure you know all eleven by heart, but it might be helpful to recap some of the principles that apply in particular to a firm's strategy in relation to its retail consumers:

  • Principle 6 - tells us that a firm must pay due regard to the interests of its customers and treat them fairly.
  • Principle 7 - that a firm must pay due regard to the information needs of its customers, and communicate information in a way that is clear, fair and not misleading.
  • Principle 9 - that a firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely on its judgement.

Compliance does, of course, have an important role to play in this area. But a compliance department alone should not be expected to set the type of strategic approach towards retail customers that a firm needs to take to act in accordance with these principles. For that reason we require firms to have a senior manager responsible for reporting to the firm's governing body on risks of regulatory concern which relate to fair treatment of the firm's customers and to protection of consumers' interests.

Firms' systems and controls in this area are explicitly assessed as part of the risk assessment process for firms. Firms which do not have adequate controls in this area will find themselves subject to more regulatory attention than would otherwise be the case.

But we also believe there is a commonality of interest between the FSA and firms in this area. We are currently doing some preliminary work to identify further examples of good practice in the industry and look forward to working with firms and trade associations to see if there is collaborative work we can undertake to help raise industry-wide awareness and standards in this area.

I want to emphasise that this is not a narrow regulatory issue that will be fixed by rules. The changes in the area of the retail consumer market brought about by the shift of major financial risks from the state and employers to individual consumers presents both a challenge and an opportunity for the industry. If the challenge is met, we can look forward to more well served, happy, confident customers, making fewer complaints and buying more products that they really need and understand - and a much smaller enforcement portfolio than currently seems in prospect.

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