The UK financial regulator is shaking up how the scheme used to compensate consumers for losses will be funded in future, aiming to reduce uncertainty about the fees that firms must pay without putting clients at risk.

But almost as soon as the proposals were issued, they drew harsh criticism from parts of the financial industry.

The Financial Services Authority is proposing to overhaul funding arrangements, in place since April 2008, for the Financial Services Compensation Scheme, a group that has paid tens of billions to individuals in the wake of the 2008 crisis.

“Compensation funding inevitably means that different sectors have competing interests. Our role has been to walk the middle ground and produce a workable solution that we believe the entire industry can afford and live with,” said Sheila Nicoll, FSA director of conduct policy.

The FSCS compensates customers if a regulated financial services firm goes bust or cannot pay claims made against it. It is financed by levies from regulated firms based on the type of business they carry out (deposits, investments, life and pensions, general insurance and home finance).

The regulator proposes to set out two approaches for funding the FSCS’s costs: one for activities it expects to be overseen by the new Prudential Regulation Authority’s funding rules for the FSCS, such as deposit-takers and insurers, and one approach for other activities, like investments.

Big payouts

The past few years have seen big payouts by the organisation, such as £20 billion in 2008/09 for the deposit class to cover five bank failures, levies of £364 million from the intermediation class over the past four years and £230 million from the fund management class due to the use of cross-subsidy only in 2011. Meanwhile, the General Insurance Intermediation class has seen sharp rises principally driven by payment protection insurance compensation costs.

The FSCS could also consider potential compensation costs expected in 36 months following the levy instead of twelve months as is currently the case (except for the deposit class).  This would smooth the impact of levies on firms, the FSA said.

Criticism

The Investment Management Association, the industry group representing the UK’s fund management sector, argued the FSA’s ideas will force fund managers to pay compensation for claims for mis-selling of insurance products or structured products, which are not connected to the IMA, while the producers of these products will not be liable. The Association of Independent Financial Advisors was also critical.

“It [IMA] believes that, by failing to ensure the financial burden of paying claims falls fairly on firms, the proposals are fundamentally inequitable.  It therefore calls for them to be changed,” the organisation said today in a statement.

“The FSA’s proposals are shocking and astonishing. While it is essential that consumers receive any compensation they are due speedily and in full, the financing burden needs to fall on firms in a fair and equitable way,” Richard Saunders, IMA chief executive, said.

“These proposals expose different types of firms to completely different liabilities in a totally inequitable way.  Banks and insurers, which will in future be regulated by the Prudential Regulatory Authority, are looked after in their own scheme with no exposure to cross-subsidy.  But fund manufacturers, to be regulated by the Financial Conduct Authority, will not only be responsible for compensation arising from the failure of other fund management firms but will also be obliged to stand behind excessive claims from the failure of distributors who mis-sold products of any type,” Saunders said.

“Thus, if compensation arises as a result of mis-selling insurance products, part of the cost could fall on fund managers, but not on insurers.  Equally, if compensation arises from the mis-selling of structured products then fund managers might have to pay up but not the banks which create such products.  Firms which will be regulated by the PRA are deemed to be no longer part of the ‘retail pool’, which is manifest nonsense as they all have a wide range of retail products,” he said.

“These risks are not theoretical, as demonstrated by past events such as the Keydata collapse or pension and endowment mis-selling,” Saunders added.

In its reponse, the AIFA's policy director, Chris Hannant, said: “There has been a general acceptance that something has gone very wrong with FSCS funding and the onerous burden it has become for the sector. The FSA has made clear statements that the Compensation Scheme should be fair, affordable, durable, not volatile and based on affinity of activity. The current review needed to correct this imbalance."
 
“It is unclear how these limited reforms will correct these issues and we are disappointed that the FSA has not gone further in its review of the funding arrangements. Options such as pre-funding have seemingly been rejected without being subject to public consultation. We’ll be seeking to reverse the proposed increase in the threshold for the investment intermediation class which will be a further blow for advisors who are struggling under the cost of regulation," he added.