Independent Research and Policy Advocacy

Regulator Supervision of the Suitability process: An example from UK

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Abstract

We have presented Suitability as the paradigm of choice for India’s financial system and have put forward the idea of Suitability as a board-approved process that each financial services provider develops and adheres to across all functions of the firm. This ex-ante liability for the firm is complemented by increased supervisory responsibilities for the regulator, in addition to an ex-post redressal mechanism to handle complaints arising from wrongful advice and sale. We share results of such a supervisory effort by UK’s regulator, the Financial Services Authority (FSA).

Background:

The Financial Services Authority (FSA) undertook a mystery shopping review of the quality of investment advice in the retail banking sector between March-September 2012, specifically to check whether firms were giving their customers suitable investment advice. Mystery shopping is a supervisory tool used by regulators across the world, and is considered to be among the more intrusive approaches to supervision of market players. The exercise spanned 231 mystery shops across 6 large firms in UK. The representatives of the exercise posed as customers looking to invest a lump sum and were seeking investment advice.

Results:

While three-fourths of the mystery shop customers received good advice, the quality of advice was under question for the remaining one-fourth. All 6 firms exhibited some form of ‘poor advice’ – where customers were at a risk of suffering detriment as a result of being recommended products that were not suitable for their needs and circumstances. Poor advice reflects a breach of FSA’s Conduct of Business (COBS) Rules and the FSA’s Principles for Businesses. The table below summarises the cases1 of poor advice:

 Nature of poor advice  Instances observed in the mystery shopping exercise
Poor risk-profiling
Risk profiling tools with complex and limited questions • Questions within a tool that required customers to use percentages to calculate potential investment losses based on different scenarios and then confirm the level of loss they were willing to accept.
• Advisor failing to check whether customers understood a question from the tool even when the customer was struggling to answer it, and instead proceeding to execute the advice.
Unclear customer risk category descriptions The middle-risk category at a firm highlighted the potential to lose money but did not indicate the extent of potential losses; this was further exacerbated by advisors failing to give further clarifications to customers.
Failing to check whether the results from risk-profiling tool are correct Advisor failing to check whether the customer’s ‘self-selected’ risk profile accurately reflected the actual level of risk he was willing and able to take with his investment. This was in spite of the advisor having identified that the customer had no previous investment experience and limited financial knowledge. (This is especially so because firms relying on risk-profiling tools need to ensure they manage any of its limitations through the suitability and ‘know your customer’ process2)
 Failing to consider customers’ needs and circumstances
Failing to consider customers’ financial circumstances and needs (13%3)  • Advisor failing to gather enough information on the customer’s income, current and future tax status, existing assets and regular financial commitments.
• Advisor failing to recommend the customer repay the existing credit card debt (that was accruing significant interest), and instead recommending investment in a collective investment scheme.
Failing to consider the length of time customers wanted to hold the investment (6%) Advisors recommending medium to long-term investments (product feature requiring customer to remain invested for 5 years) even though customers made it clear they needed their money after 3-4 years (in time for the customer to purchase a house for her son).
Failing to give customers the correct information
 Failure to describe or giving a misleading description of initial disclosure on the firm, its services and remuneration (13%) Advisor telling the customer ‘you don’t pay me a penny and you don’t pay the bank a penny for this advice’, while in reality the service was not free. Although the customer was not paying anything upfront, he would be paying indirectly through product charges. 
 Advisor making statements that were unclear, unfair or misleading (15%) • Advisor incorrectly stating, and reinforcing that the customer would ‘always get a return’ for a product and that the potential returns would be 3.5 times the achievable maximum return.
• Advisor making incorrect statements about how a fund was managed and failing to give risk warnings.
 Issues with suitability reports (17%) The suitability report mentions that customer wants to invest for ‘at least 5 years’ and was keen to follow a medium to long-term strategy, when in reality the customer had clearly stated she wanted to invest for 3 years and use the money for a holiday.(Such reports can cause further problems as it would be relied on by business monitoring and compliant-handling functions within the firm, and would go undetected as a case of poor advice)
Inappropriate use of investment sales aids • Advisor emphasising potential returns from investment without mentioning the potential for losses.
• Undervaluing the returns on cash deposits in sales aids in order to make other investment options look more attractive.
• Sales aid indicating a positive return on a medium-risk investment portfolio, and advisor emphasising the same, while in reality the medium risk portfolio did not guarantee a positive return.
Weaknesses in firms’ controls Unable to override the firm’s advice processes/systems, advisor deliberately entering inaccurate customer information (income or investment term) to overcome the system constraints. (This also had the added danger of generating inaccurate suitability reports which would be difficult for customer to use to complain if needed; nor would this manipulation be detected by monitoring teams)
Other factors causing poor advice may be at play for the following instances (possibly incentives, sales targets, performance management) • In spite of collecting all relevant information, advisor recommending an investment product when a deposit product should have been advised.
• Recommendations that appeared to be at odds with the firm’s advice policy.


1 – These are not mutually exclusive; a mystery shop may exhibit more than one of the instances below
2 – As per http://www.fsa.gov.uk/pubs/guidance/fg11_05.pdf
3 – % implies percentage of mystery shops

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