By Gavin Sharpe, associate director, financial services, RSM UK
In late 2023, the FCA announced it was changing the way Personal Investment Firms (PIFs) calculate the amount of capital they need to hold as redress for customer complaints under the Financial Services Compensation Scheme (FSCS).
So far this industry lifeboat has paid out a staggering £760m in liabilities owed when PIFs have ceased trading and the FSCS has had to step in to payout. These firms often fail because they can’t cope with the amount of customer redress needed to compensate for unsuitable financial advice. To address this, the FCA now wants PIFs to hold much higher amounts, so they have sufficient resources to pay claims themselves, and FSCS won’t have to step in.
This change has potentially far-reaching practical consequences, both for firms and individual investors. The FCA’s consultation on capital redress for personal investment firms, known as CP23/24, closed in late March 2024. A final policy statement is expected in the second half of this year, before the rules come into force in early 2025.
The FCA is proposing firms set aside more capital at an earlier stage, specifically at the point when they receive complaints from customers. This is likely to be earlier than current practice across the industry. Doing so should build up a cushion to ensure firms have the financial resources needed to pay compensation. This avoids the risk that expensive claims have to be met by the FSCS if PIFs fail.
This may well have benefits for consumers, as the proposed change should incentivise firms to investigate and resolve complaints faster, so they can free up this additional capital. However, there are questions about how to ensure the new rules don’t unduly increase the financial burden on firms that are already doing the right thing.
Most people seeking advice from PIFs are retail investors planning for retirement and other important life events. Increasing capital requirements may have implications for the viability of
firms providing this crucial service. Some firms may find it a stretch to hold more capital, while also continuing to contribute levy payments to the Financial Services Compensation Scheme.
The costs associated with holding more capital could mean some firms are less profitable (or not at all). Some could exit the market, or may need to consolidate and merge with other, similar or larger firms. This process may reduce the choice available to consumers, as well as increase the costs associated with accessing advice in the first place. If a period of consolidation does follow these changes, in some cases, consumers could experience disruption in how (and from whom) they obtain their financial advice. The possible drawbacks are obvious since, in many cases, consumers will have built up long-standing personal relationships with advisors.
For firms, non-compliance with the rules could mean hefty fines, reputational damage, personal liability of company directors and even possible closure.
In the longer term, the FCA has already made clear that these changes should be regarded as the first steps on a journey, where PIFs may be heading for a more challenging regulatory regime, aligned to the approach adopted by larger and more complex firms, following the introduction of the IFPR rules in 2022.
The introduction of those new rules governing capital and liquidity in 2022 fundamentally changed the regulatory landscape for more complex investment firms. PIFs currently rely on an exemption (Article 3 MIFID exemption) which means they don’t apply the same regime.
However, one perhaps unintended consequence of changes in 2022 was that some, simpler firms (previously known as ‘CAD exempt’ or ‘arranger / adviser’ firms) became subject to the more comprehensive Investment Firms Prudential Regime (IFPR) rules, while PIFs remain exempt. This means that a firm which used to be a CAD exempt will probably now have a permanent minimum capital requirement of £75,000 (once the transition period ends in 2027). In practice, a PIF carrying out broadly similar activities may currently have a much lower capital requirement.
The FCA is clearly attempting to strike a balance between how much capital firms should hold and the risks of the harm they pose. After analysing regulatory data submitted by PIFs, the regulator concluded that an increase in capital requirements to £55,000 would only require half the sector to raise any additional capital.
The capital framework for MIFIDPRU firms includes scope to consider the range and volume of activities undertaken by those firms. For example, the assets managed, the client money looked after, the number of trades placed, and the trading position risk assumed, all affect a firms capital requirement.
The advantage of activity-based capital requirements is that, theoretically, the level of capital requirements take into account each firm’s activities.The FCA appears reluctant to apply the same approach for PIFs. The result is that, to limit the risk, certain markets may be left underserved in the event PIFs may limit the number or range of products they offer.
It’s clear that regulatory attention on the PIF market is increasing. RSM recently facilitated a roundtable session with a range of firms to discuss the proposed changes and the potential impact on the industry. From feedback provided by firms, it’s apparent that increased capital requirements, liquidity requirements, wind down planning, and regulatory risk assessments can all be expected to drive up costs for PIFs. However, the industry has a very close eye on the regulator’s approach to implementing the new rules in a reasonable and proportionate manner, ensuring only those that fail to treat customers fairly are the ones to pay the price.
The Personal Investment Management and Financial Advice Association (‘PIMFA’), as the industry body which represents wealth and investment management firms, has raised a number of concerns surrounding the proposals, which focus on difficulties in assessing prospective liabilities, possible effects on the Professional Indemnity Insurance (‘PII’) market and the FCA’s supervisory approach. However, given the direction of travel, it may be unlikely that there will be much movement from the FCA when it finalises its rules in the second half of 2024.
RSM UK recommends firms should revisit their approach to monitoring complaints ahead of the FCA’s finalisation, ensuring they have a robust system of recording, assessing and monitoring those which could result in redress liabilities. If weaknesses are identified, a plan for remediation should be designed to ensure compliance before the planned implementation date in H1 2025.
