The Financial Conduct Authority (FCA) has been focused on effective conduct risk management information since 2004 when, as the Financial Service Authority (FSA) it launched the Treating Customers Fairly (TCF) initiative.  The principles applicable to the gathering of effective conduct MI in the retail sphere are equally relevant to wholesale firms. This article explores some of the issues.

The TCF initiative was designed to protect retail customers from tied and multi-tied agents masquerading as independent financial advisors, and encompassed the whole product lifecycle:

1. product design and governance;

2. target markets;

3. product promotion and marketing;

4. sales and advice;

5. after-sales; and

6. complaint handling.

TCF was ignored by investment banks/ investment bank divisions of universal banks, because it was aimed at retail customers. Identifying conduct metrics for wholesale business has been a significant headache for them. This article aims to simplify matters, first by surveying retail metrics, then seeing whether the thinking behind them can be applied to wholesale activities.

In two 2007 papers, the FSA called out as good practice the following heads of TCF MI:

* conduct specific employee opinion survey questions;

* sales by product (especially volumes and commissions);

* product cancellation volumes;

* in general insurance, volumes of refused claims;

* complaints data and Financial Ombudsman Service decisions;

* number of products which were developed, but ultimately not sold; and

* annual product reviews, focused on continuing target market suitability, in light of any unexpected product behaviours (such as higher than marketed investment product volatility).

Positive cultural drivers, such as commission claw-back, salary only compensation, and bonuses tied to sales quality were all articulated that year, as were risks arising from existing compensation arrangements: senior manager targets tied exclusively to profit, income or growth, and employees promoted solely for the amount of business and the level of income generated for the firm (regardless of sales quality indicators such as complaints).

Given the nature of the above, is it reasonable that the wholesale businesses provide their Executive Committees and Boards with operational compliance effectiveness metrics? Common suspects, mistakenly identified as indicators of wholesale conduct risk include; statistics on wall crossing, mandatory training completion, open audit issues, staff attrition, hospitality given and received, whistleblowing investigations, and litigation.

The more willing add simple trade surveillance indicators: frequent booking and cancellation of a trade, irregular logins, and failure to take two weeks mandatory leave.

None of these metrics directly relate to product, or sales quality. Nor do they answer Clive Adamson’s (former FSA Director of Supervision), three questions for non-executive directors (NEDs) to be able to answer:

“How do we actually make money today, what is it we will do in the future to grow the firm and why is this fair?”

Towards a solution

As we learned in the aftermath of the 2008 financial crisis, sophistication is a scale. Local government, northern European pension funds, German Landesbanken , and most recently the Libyan Investment Authority, have all either alleged or successfully proven themselves as being at its lower end.

Investment banking firms/ divisions might consider which of their clients generate the most fees, and/or enter into the highest number of transactions, across structured products and exotic derivatives (on a net flow basis). They might then ask where, on the sophistication scale, these clients fall, and make a judgement on the fairness of offering them complex or illiquid products.

Profit and loss, cut by product and market, can answer Adamson’s money question when cross-referenced with rebates paid. Firms could also generate insight as to the sustainability of reported profits by aggregating exceeded desk trading and position limits, especially when combined with requests for profit and loss suspensions (monitoring this should be a standard control following rogue trading at UBS and Societe Generale).

Firms wanting to impress FCA supervisors would also do well to focus on financial forecasting and target setting. This annual process is a key driver of customer outcomes. If the current process is last year’s numbers plus a percentage, without any evidence of thought given to competitor activity, customer demand, and regulatory and political headwinds, then it may create targets which are impossible to meet safely. There are two simple solutions. Manipulate the numbers, or manipulate the customers. All firms should recall the fates of Tyco, Wordcom, Enron, Bear Stearns and Lehmann Brothers.

To date, retail customers have bought, and then complained en masse about: structured capital at risk products (split caps and precipice bonds), pensions advice, mortgage endowments and payment protection insurance.

Wholesale customers have bought, then sued over: interest rate swaps, collateralised debt obligations and derivatives contracts linked to manipulated global inter-bank offer rates, precious metals fixes and FX rates.

In many cases, regulated firms have paid out more than they took in, taking into account operational litigation, and compensation costs.

Ultimately, the test of effective conduct risk MI is whether it helps boards know that the money their firm makes is money it will keep.

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