Bovill - the UK financial services regulatory consultancy - runs regular briefings. These are the slides from the March briefing on Conduct Risk. For more information visit www.bovill.com. Further information on the event is below: Conduct Risk: beyond the rule book “One of the features of regulation, historically, was that it was all about compliance. Were a particular set of rules followed? Could a firm demonstrate and document that it had followed those rules to the letter? This created a cottage industry out of compliance – but did not necessarily lead to good outcomes…”” Martin Wheatley, CEO, Financial Conduct Authority The FCA rulebook still matters, as any firm who has had a brush with the rules on client money and assets will know. However, the financial crisis showed that traditional compliance can mean the firm only knows what went wrong yesterday. Understanding what might happen tomorrow is equally important. Managing Conduct Risk is now a key FCA expectation. It involves understanding what outcomes will flow from today’s actions – for the firm, its customers and the financial markets more broadly. And the Conduct Risk agenda is now more likely to involve smaller firms. Bovill’s briefing looked at Conduct Risk and covered: • What is Conduct Risk and where did the idea come from? • What regulatory powers does the FCA use in its approach? • How can you manage Conduct Risk?

1. Conduct Risk – beyond the rulebook
Ashley Kovas, Head of Funds
27 March 2014

2. 2
Risk that behaviour leads to ‘poor outcomes’
Product provider doesn’t understand its proposed new product
Product is mis-advised / mis-sold
Product provider doesn’t manage its ‘product lifecycle’
Financial crime takes place (money laundering / market abuse)
Bank’s lending practices are unfair

3. 3
Agenda
What is conduct risk?
• Sharing the FCA objectives
• Dealing with the threshold conditions
• Understanding FCA supervision
• FCA Risk Outlook 2013
• Effective management
Managing conduct risk
• Managing conduct risk
• Assessing comparative risks – with examples
• Deciding who is responsible for conduct risk
Setting up your project
• Practical next steps in managing conduct risk

4. 4
The spirit of the rules, not the letter
“One of the features of regulation historically was that it was all
about compliance. Were a particular set of rules followed?
Could a firm demonstrate and document that it had followed
those rules to the letter? This created a cottage industry out of
compliance – but did not necessarily lead to good outcomes.
Indeed, Oliver Wyman released a report last year talking about
firms’ ‘obsession’ with compliance, their tendency to follow the
letter of the law, rather than its spirit”.
Martin Wheatley, CEO, FCA
12 March 2013

5. 5
An evolving customer focus
Treating
customers
fairly
Principles
based
regulation
Outcomes
focused
regulation
Conduct
Risk

6. 6
Understanding the ‘drivers’
FCA
objectives
FCA
Supervision
Risk Outlook
Threshold
conditionsManagement

7. 7
Sharing the FCA objectives
FCA strategic objective
• Ensuring that the relevant markets function well
FCA operational objectives
• Consumer protection
• Integrity
• Competition
“We will focus on the most important issues affecting our
objectives.”
The FCA’s Approach to Supervision, March 2014
FCA
objectives

8. 8
The consumer protection objective
• Risk
• Experience and expertise
• Consumer responsibility
• Information
• Appropriate care – degree of risk
• Differing expectations
FCA
objectives

9. 9
The integrity objective
• Soundness, stability and resilience
• Financial crime
• Market abuse
• Orderly operation
• Transparency of price formation
FCA
objectives

10. 10
The competition objective
• Needs of different consumers; information
• Ease of access
• Ease of changing provider
• Market entry
• Encouraging innovation
FCA
objectives

11. 11
Dealing with the threshold conditions
• Location of offices
• Effective supervision (including ‘close links’)
• Appropriate resources
• Suitability (‘fit and proper’)
• Business model
Threshold
conditions
The threshold conditions give the FCA power to make judgements
about a firm’s future conduct and the outcomes it may create
– and take action against the firm

12. 12
The ‘suitability’ condition
Matters the FCA can consider in judging a firm’s suitability
• Firm’s connections
• Nature and complexity
• Affairs conducted in an appropriate manner
• Compliance with requirements imposed by the FCA
• Adequate skills and experience
• Sound and prudent
• Financial crime
Threshold
conditions

13. 13
The ‘business model’ condition
• Sound and prudent
• Interests of consumers
• Integrity of the financial system
The firm’s business model (that is, the firm’s strategy for doing
business) must be suitable for a person carrying on the regulated
activities that the firm carries on or seeks to carry on.
Threshold
conditions

14. 14
FCA’s approach to supervision
FCA’s supervision categories:
• C1 – 11 major groups
• C2 – 120 groups
• C3 – 400 firms and groups
• C4 – 25,000 firms
The FCA cannot supervise all firms in the same way but have the
same expectations across all the categories
FCA
Supervision

15. 15
The ten supervision principles
• Ensuring fair outcomes for consumers and markets
• Forward-looking and pre-emptive
• Focused on the big issues and causes of problems
• Judgement-based
• Ensuring firms act in the right spirit
• Business model and culture
• An emphasis on individual accountability
• Robust when things go wrong
• Communicating openly
• Having a joined-up approach
FCA
Supervision

16. 16
Supervising what matters
We will be proactive in identifying potential risks to
customers or market integrity
Your culture underpins everything you do, setting the
tone for the behaviours you promote and reward
Your business processes, from product development
to complaints handling should be designed to give
customers what they need and meet their expectations
…effective systems and controls designed to identify
and deal with conduct risks, as well as effective anti-
money laundering measures
…we will pay close attention to the way they
implement consumer and market-focused valuesGovernance
Systems and controls
Front line business
processes
Culture
Business model and
strategy
FCA
Supervision

17. 17
Applying the same principles to all
“The theme running through all these areas is the focus
on consumer outcomes and market integrity. We will
consistently apply this in all our dealings with every firm,
no matter how big or small, and whether you are active
in retail or wholesale markets. You will see this new emphasis
in our sector-based work as well as your
firm-specific assessments.”
FCA
Supervision

18. 18
Including culture in supervision
• Sectoral analysis and thematic reviews
• Regular baseline monitoring of regulatory returns
• Occasional routine tasks
• Four-yearly assessment
“The supervisory regime for many C4 firms is similar to the previous
regime under the FSA in terms of the intensity and type of
supervision. However, we are now looking at the culture and
practices of each firm to ensure you consider consumers and
market integrity in everything you do.”
FCA
Supervision

19. 19
The FCA Risk Outlook 2013
Firms do not design products and services that respond to real
consumer needs or are in consumers’ long-term interests
Distribution channels do not promote transparency for consumers on
financial products and services
Over-reliance on, and inadequate oversight of, payment and product
technologies
Shift towards more innovative, complex or risky funding strategies or
structures that lack adequate oversight, posing risks to market integrity
and consumer protection
Poor understanding of risk and return, combined with the search for
yield or income, leads consumers to take on more risk than appropriate
Risk
Outlook

20. 20
Effective management is integral
As part of Treating Customers Fairly, the FSA was concerned about
firms’ internal processes. These remain valid for Conduct Risk.
• Leadership
• Strategy
• Decision making and challenge
• Controls
• Performance management
• Reward
Management

21. 21
Managing conduct risk
Identify
Mitigate
MeasureMonitor

22. 22
Assessing conduct risk
Impact
Strong Acceptable Needs
improvement
Weak
Controls

23. 23
The framework for managing conduct risk
Identify
• FCA statutory objectives
• Management risks
• FCA Risk Outlook
• FCA Supervision
• Your own thoughts
Measure
• Impact/probability
• Proxies for probability include
control effectiveness
Mitigate
• Project based
Monitor
• ‘Audit’ style
• Management information

24. 24
Assessing your conduct risks – examples
Major new IT system
Advisers may not
understand X product
Product lifecycle
Market abuse
Testing completed, parallel
running going to plan, minor
glitches
Residual
Culture has improved,
however several further cases
of unfairness identified
Awareness training completed.
Post-trade analysis process
enhanced
Review undertaken, action
items implemented
Mystery shopping results fallen to
8% unsatisfactory, advisers training
programme to complete this month
Residual
Residual
Residual
ResidualUnfair lending practices
1
2
3
4
5

25. 25
Assessing comparative risk
1
2
3
5
4
IT system
X product
Product lifecycle
Market abuse
Lending practices
Impact
Strong Acceptable Needs
improvement
Weak
Controls
1 4
2 5
3

26. 26
Deciding who is responsible for conduct risk
• What role does Compliance have?
• What is the role of senior management?
• Governance – conduct risk committee?
• Do you need a policy for conduct risk?

27. 27
Setting up your project
1. Agree your firm’s approach to managing and mitigating conduct risk
2. Consider all relevant drivers in identifying potential conduct risks
Functioning markets
Consumer protection
Integrity
Competition
FCA objectives
Business strategy
Culture
Front-line processes
Systems and controls
Governance
FCA supervision
Customers – who?
Products / services
Management
Financial crime
Risk Outlook
Additional factors

28. 28
…and crucially
Anything else I haven’t thought of
relevant to the statutory objectives
as they impact on your firm