The UK financial regulator recently warned the sector about the suitability of products still being sold to investors. A specialist advisor on such matters looks at the issues.

Editor’s note: Following a recent speech by Martin Wheatley, managing director, FSA Conduct Business Unit, of the UK’s Financial Services Authority, in which he questioned the suitability of products sold to investors, this article explores some of the issues. It is written by Ian Stott, client services director at The Consulting Consortium, an organisation that advises financial institutions on regulation – a major area of business today. As ever, while this publication is delighted to share such expertise with readers, it does not necessarily endorse all the opinions of the article.

Suitability continues to sit high on the agenda of the FSA and no doubt will feature prominently when the FCA, or Financial Conduct Authority, assumes its legal responsibilities on 2 April. The FSA continues to espouse the virtues of developing financial products for customers about whom product manufacturers have a deep understanding in terms of needs, wants and desires. This is as true for those developing products to sell directly to retail clients as it is for those distributing through third-party intermediaries.

The facts are simple and not really open to much interpretation: identify target markets, research their needs, develop products to meet those needs and ensure that those products are only distributed, direct or otherwise, to those retail clients for whom the retail product is suitable.

As if I needed to bang the drum any harder, the issue of suitability was again highlighted recently in the FSA mystery shopper report, assessing the quality of investment advice in the retail banking sector. Disclosure featured as an area of concern by the FSA, noting that many of the suitability reports they reviewed failed to reflect what was actually discussed during customer advice meetings, that suitability reports sometimes contained inaccurate information and that these reports often failed to explain disadvantages of the recommendation in the advice process.

TCC, through its projects with top-tier financial advice firms, can generally corroborate the FSA findings in this area. It has been signposted by the FSA several times in recent years that the UK wealth management industry has a significant responsibility to its clients to ensure that the advice they receive is suitable. We have seen guidance that has been explicit in the regulator’s requirements for firms to focus on positive consumer outcomes.

However, Wheatley points out again this week that the FSA evidence shows that some managers are failing to gather and record basic, up-to-date information from clients in respect of their financial objectives; their capacity for loss; their liquidity requirements; and their time horizons. In his words … “All pretty standard stuff”. I don’t agree that this is true for most firms. From what I have seen, it’s not an issue of collating and recording the right information, it’s more a case of figuring out what is missing.

The FSA’s mystery shopper report also highlights a problem that most involved in regulatory compliance will have experienced, which is that suitability reports on their own are not enough to evidence suitability.

Why are there still problems?

Let’s get to the point. How can it be possible that, against the backdrop of explicit regulatory guidance, the FSA continues to uncover evidence of wealth management firms’ business monitoring teams being unable to identify unsuitable advice when they carry out their file reviews? It is clear that from a documentation and disclosure perspective, Line 1 defence has all the “Know Your Client” information, the suitability report, the risk questionnaire and report as well as meeting notes and fund manager research. So how is it that suitability issues continue to plague compliance teams, when the suitability report clearly correlates with a customer’s risk profiles and personal circumstances?

The missing link here is that we have no additional evidence other than file documentation. This is why when the FSA “mystery shopped” customer meetings these were all recorded. Everything that was said between the advisor and the client was captured.

To sum up, Wheatley confirms that the latest FSA review into the wealth management divisions of six retail banks is “worrying” and the FSA has concerns both over the suitability of investment portfolios, as well as banks’ ability to demonstrate suitability in a significant number of customer files.

Worse, the FSA found that the firms’ own compliance departments identified a much smaller number suggesting some compliance departments are not “suitably” equipped.

I fundamentally disagree with Wheatley on this occasion. In-house compliance teams are intelligently sampling, on a risk basis, their new business registers and have been acting quickly to address unsuitability risk at their firms. However, the problem they face is that the Line 1 review process of assessing files only is fundamentally flawed.

The simple fact is that assessing a file does not always reveal “unsuitability” and unless the compliance teams actively engage in a programme of customer contact, the outcome of the advice suitability review will often be unclear.

The challenge is to create a verbatim audio recording of the advice meeting which compliance monitoring teams can test against the file documentation. Only in this way can CEOs, directors and boards demonstrate that they have effective control over their wealth management divisions.