CP23/24 Capital deduction for redress: personal investment firms

“Polluters should pay” is the crux of the latest consultation paper published by the FCA, with proposed changes aimed at ensuring that firms responsible for consumer losses are the ones who foot the bill.

Despite the existing minimum capital requirements for firms, too many consumers are having to rely on the Financial Services Compensation Scheme (FSCS) to compensate for losses caused by advice received.

The main aim of the proposals is therefore to reduce the burden caused by a small proportion of adviser firms who have left the market having caused consumer detriment. This burden currently falls to the FSCS, and ultimately consumers and other adviser firms who are likely paying higher advice fees and higher levies respectively because of the compensation being paid out.

The FCA published CP23/24 Capital deduction for redress: personal investment firms on 29 November and is proposing changes to require personal investments firms (PIFs) to set aside capital for potential redress liabilities at an early stage.

Any firms with insufficient capital to meet the anticipated liabilities will be subject to an asset retention requirement which will effectively limit their ability to dispose, withdraw, transfer or deal with their own assets without notification or consent from the FCA, depending on the circumstances (see diagram 6 of the consultation paper).

Thirty-five questions are asked in the paper, and the deadline for responses is 20 March 2024.

Related to CP 23/24, the FCA also sent a ‘Dear CEO’ letter to remind firms of their existing obligations in relation to capital requirements and confirm that action will be taken against any firms trying to avoid the new requirements (e.g. carrying out corporate restructures or paying excess dividends).

The FCA also confirmed that applications and cancellations of permissions would be subject to extra scrutiny and included a reminder of existing notification obligations in the event of insufficient resources or firms seeking to reduce redress.

Who will it impact and what might actually change?

The proposals will impact most PIFs to some extent because, in keeping with the aim of being “data led”, there will be reporting changes to the Retail Mediation Activities Return (RMAR)  submitted by PIFs, albeit these changes are detailed as being “minor”. Under the current proposals, PIFs subject to consolidated supervision under the Prudential sourcebook for MiFID Investment Firms (MIFIDPRU) or the Capital Requirements Reporting (CRR), or group supervision under Solvency II, and which benefit from group risk assessment will be exempt.

Those involved in providing advice, complaint handling and finance will all be impacted, as well as senior management and governance functions.

The FCA says: “We will use this alongside the data we get about firms’ business models and activities, as well as other information we receive that could suggest risk of harm to consumers, to direct our supervisory focus”.

The main impact will be on firms estimating that it has liabilities in excess of its capital resources (£20k minimum or, if higher, 5-10% of its annual income from investment business), who will have to hold more capital and/or may be subject to asset retention restrictions.

What is the burden?

£760m in redress was paid by the FSCS for PIFs who left the market between 2016-2022. 95% of the redress was caused by 75 firms and 20,000 consumers were impacted, with an average compensation of £38,000. In some cases, consumers received the maximum FSCS compensation of £85,000, which means that their actual losses might have been higher and not compensated because the adviser firm was no longer around and the FSCS protection limit is £85,000.

Summary of the changes

• Require PIFs to quantify an amount for their potential redress liabilities (calculation methodology is number of clients x amount of redress x probability factor (likely a minimum of 0.28))
• Require PIFs to set aside capital resources for potential redress liabilities through a new capital deduction, and
• Require PIFs with potential redress liabilities that fall below their capital requirements to comply with an asset retention requirement

The FCA also hopes that it will encourage firms to settle redress quicker, to avoid having to hold capital and potentially being subject to the asset retention requirement.

Are the proposals significant?

The proposals do build on existing capital requirements and were “designed to be proportionate to minimise the burden on firms and target the firms most likely to cause redress liabilities”. However, in addition to issuing the ‘Dear CEO’ letter, there is an extended consultation period of 16 weeks and the FCA is also running a pilot of the additional data that will be collated to increase the likelihood of meeting the aims.

There are also wider considerations for the professional indemnity insurance market. The changes may drive improvements in risk management by firms and provide further incentives against the provision of bad advice and encourage resolution of recurring or systemic problems. The estimated annual compliance costs to small firms are £1,000, in addition to a one-off cost of £1,000. This increases to a one-off cost of £10,000 for a large firm and an ongoing cost of £40,000.

Will it work?

Only time will tell, and it depends on the result of the consultation. But the biggest issue seems to be that the proposals hinge on PIFs themselves quantifying the amount for their potential redress liabilities. There is a calculation tool and the FCA stipulate the methodology to be used, but the process still requires PIFs to identify, quantify and input the data.

Responses are due 20 March 2024, a policy statement is anticipated in H2 2024, and new rules are expected to take effect in H1 2025.