In this webinar for Digital Leaders Week 2017, Jane Walshe of Enforcd was joined by Mathias Wegmueller, Co-founder and Head of Business Development, Qumram, and Wendy Jephson, Co-Founder & Chief Behavioral Scientist at Sybenetix to discuss what RegTech can do, and also possible pitfalls to be avoided in its use.
The FCA has traditionally tried to secure the greatest good for the greatest number of consumers. Enforcd was interested to note that one of its key themes for 2017/18 remained independent financial advice, now the preserve of those with £250k of investable assets.
The following paragraph seemed relevant:
“Financial advisers may give insufficient attention to the total cost of investment products and of advice, which results in poor value for money for consumers.
What they’re talking about is the fee stack.
The IFA charges a fee (let’s say a modest £1,500). They may well then to go on to recommend a platform (most useful to the IFA, who would otherwise have to access separate share ISA and SIPP accounts) which levies a fee. The FCA has already spoken about platforms and the indiscriminate way in which IFAs place their customers’ assets on them. The IFA might then recommend that the customer place sums with a discretionary investment manager (DIM), who might then go on to place these with investment funds which apply a management fee (creating a DIM fee and an investment fee). Depending on the specialisation level of the fund, the fee might be split into an entry, on-going, and exit fee.
This generates a blizzard of costs and almost guarantees that, even if a client targets a modest rate of return (say 5%), their investment managers will have to place their assets in higher risk assets in order to generate the extra return that covers their costs.
This is behind the serial mis-selling of such exotic offerings as geared traded endowments, traded life policies (death bonds), and serried ranks of unregulated collective investment schemes offering exposure to property development (leisure and commercial, home and abroad), and other exotic schemes (most recently bioethanol production). On the regulated investment side, it means illiquid assets such as high yield (formerly junk), bonds, and securitised bank loans (organised as ETFs, or mutuals). It also means geared index trackers (ones which return n times the rise or fall of the index they are tracking).
What links all of these products is risk, not all of which flows from market exposure. Integrated Financial was fined £3.5mn for CASS breaches in 2011, by the Financial Services Authority (as was). 94,000 retail customers had their holdings on their platform, and the firm’s internal funding arrangements meant that at one point, client accounts were short almost £7mn.
Now one could argue that any wrap provider (SIPP, ISA, or fund supermarket), who holds client assets, introduces a risk that would not exist if the customer held their investments in single name shares, via CREST. The difference is that a customer might deal with a number of these, whereas an IFA will place them on a single one. Chance dictates that one wrap provider is more vulnerable than two or three.
DIM costs are another matter. The regulator will only pick a fight if the DIM goes outside mandate, churns assets to generate extra transaction charges, and/ or places clients’ investments in their own funds (without evidencing their suitability based on need or cost). The fact of four layers of fees will not necessarily go against the IFA (unless they failed to set out why DIM was the right solution, rather than annual rebalancing aligned to a model portfolio). Enforcd reviewed the publicly available fee schedule of Rathbones, a UK provider of investment management services. This allowed for a 3% introductory fee payment to the IFA, further quarterly fees to the IFA, and annual charges on a portfolio of £400k of £4,500+VAT.
Helpfully, the Financial Ombudsman Service has published two ombudsman decisions, covering the issue of Rathbones’ investment management non-performance. In short, you can underperform the relevant index by picking the wrong stocks, and collect your management fee, so long as the portfolio looks appropriately diversified:
“… the portfolio at this time had holdings across all the main asset classes. There were direct equity holdings as well as collective investments, which in turn added to the diversification by including the expertise of other fund managers. It was also invested globally in a range of sectors, and the asset weightings were relatively low.
The test here remains one of negligent mismanagement. So long as that’s avoided, the Ombudsman Service has the capacity to reject complaints based on performance. It’s curious then that the FCA’s partner in financial regulation does not, of its own accord, consider the issue of fees, and whether the same post-fee performance might have been generated with a few passive index trackers. Still, the examples given were issued in 2015, so there’s been plenty of time for the ombudsman to amend their approach.
Those recommending discretionary investment managers (for a significant slice of their customers’ money), should watch this space very carefully.
The independent financial advice (IFA) sector was given a clean bill of health by the FCA in May 2017. A suitability review of 1,142 individual pieces of advice given by 656 firms against the rules in the Conduct of Business sourcebook showed that in 93.1% of cases, advice provided was suitable.
You have to plough through appendix 1 to find that 481 of the 656 firms in the sample had a single file reviewed. The file was chosen at random, from advice given in 2015. Enforcd is pretty sure if an IFA told the FCA that its own quality assurance consisted of one file it would get short shrift.
What, if any, assurance can consumers draw from this? Simply that in 2015, 481 firms of IFAs gave a single good piece of advice. The advice in 2013 could have been terrible.
In January 2017, the Financial Services Compensation Scheme (FSCS) issued a press release, announcing three supplementary levies for 2016/17, totalling £114mn. Its Chief Executive explained:
“We will ask life and pensions intermediaries to pay their share of an additional £36m to fund compensation for the high numbers of SIPP-related claims we are continuing to receive, but also need to trigger a cross subsidy for the first time. These claims relate to advice to switch pension funds into high risk investments. We previously flagged the potential for high costs here…. And we currently expect a deficit of £15m on our home finance intermediation account due largely to the failure of one particular firm that gave bad advice to engage in risky property investments alongside mortgage advice.”
The FCA says everything is fine. The FSCS says it needs more money because of bad advice related to self-invested pension plans, and pension transfers. In 2017 alone, the FSCS declared 90 firms in default. Many of these were IFAs whose professional indemnity insurance claims limit was exhausted, and who couldn’t fund the Financial Ombudsman Service’s awards.
There’s an example, which won’t make it on to the FCA’s roll of enforcement notices (for the very good reason that it was not FCA regulated). Group First, a UK real estate developer, operates Store First Midlands Ltd. Store First owns and lets storage units. Rather than securing a commercial loan or mortgage, Store First sold its storage rooms to individuals, as investments. Prices started at £3,750 for the smallest room, rising to £30,000 for the largest. Sales literature gave an annual rental income of between £300 and £2,400 after charges. According to a DVD sent out to investors, a return of 8% was guaranteed for the first two years, followed by “guaranteed projected income rises of 10 per cent in years three and four, and 12 per cent in years five and six.” More people should have spotted that something can either be projected, or guaranteed. It can’t be both.
Store First, was linked by the Insolvency Service, via a First Group company director called Mike Talbot, to Transeuro Worldwide Holdings Ltd, registered in Gibraltar.
Transuero funded two cold callers (introducers) named Jackson Francis Ltd and Sanderson Clarke Ltd. These persuaded 500 people to place their assets in two pension schemes: Capita Oak and Henley Retirement Benefit. The scheme appeared to have been presented as follows: you transfer your pension, it will be invested in Store First units (with the guarantee and the projected double digit returns), and we’ll give you a non-repayable loan, which means you can have some of your pension money now. That was the pension liberation part. Something HMRC takes a very dim view of.
Store First Midlands Ltd was owned by Toby Whittaker, formerly of Dylan Harvey Residential Group, which acted as sales agent for a number of residential apartment schemes in Manchester and elsewhere in the North West. It received payments for off-plan reservations from buy to let property investors, and collapsed owing them £7mn in April 2009. The flats were never built.
On the 22nd of May 2017, the Serious Fraud Office launched an investigation into the activities of Capita Oak and connected parties, following the loss of £120mn.
One IFA who opted for voluntary liquidation was Anthony William Morrin (of AWM Financial Solutions Ltd). Enforcd searched the Ombudsman Decisions website, and found four complaints against him, related to SIPPs whose assets were invested in Store First Ltd storage units. The good news is that if the FSCS declares it in default, claims for losses arising from poor advice against an insolvent IFA are covered, up to £50,000.
What’s the upshot of all this for anyone performing due diligence on products, before offering them to investors? Be wary of high returns. Be wary of nonsense phrases like projected guarantees. Be wary of company officers involved in insolvency. If you perform quality assurance for an IFA network, test more than one file a year. And if you want to do just one, ensure your random sampling is immaculately documented, and really random.
The Financial Conduct Authority’s 2017/18 business plan said this about motor finance:
“We are concerned that there may be a lack of transparency, potential conflicts of interest and irresponsible lending in the motor finance industry. We will conduct an exploratory piece of work to identify who uses these products and assess the sales processes, whether the products cause harm and the due diligence that firms undertake before providing motor finance.”
According to the Finance and Leasing Association’s 2016 Annual Review, “The percentage of private new car registrations financed by FLA members in 2015 was 81.4%, up from 75.9% in 2014”.
Data available to FLA members showed that over the 12 months to March 2017, an average of 82% of new car sales were funded using Personal Contract Purchase (ahead of hire purchase, leasing, and auto loans). In 2015, 984,000 new cars were financed by FLA members. Enorcd estimates that in 2016, around 800,000 consumers entered into PCPs.
The FCA took on responsibility for consumer credit regulation in April 2014. Since that time £40,725 million has been spent, using PCPs, on new cars. It doesn’t take a genius to work out that PCPs will be the FCA’s main focus.
The PCP combines elements borrowed from leasing, and hire purchase. A customer buys a car for a variable deposit and a monthly fee. After the 2-4 year contract term expires, customers hand the car back, make a “balloon payment” and own the car outright, or put any equity they have in the car towards a new model. The monthly repayments are lower than for traditional hire purchase.
The balloon payment is also called the Guaranteed Minimum Future Value (GMFV) and is the finance provider’s estimate of the car’s value after depreciation, made at the beginning of the contract. If the car is worth less than this figure, based on fair wear and tear and staying within a pre-agreed mileage limit, the customer can hand back the car. If the mileage has been exceeded, there’s a fine to pay (somewhere between 7 and 14p per mile).
Alternatively, the customer enters into another PCP. Only the equity built up in monthly repayments, and a positive GMFV figure can be put toward the next car. For example if the car’s value at the end of the deal was £9,000 and the balloon payment was £8,000, the difference of £1,000 could be used towards the next car (so long as it’s via the same finance provider).
Speaking to the Telegraph in 2014, Mark Norman, market analyst from CAP Automotive said:
“We’ve anecdotal evidence that customers have it inferred to them by the dealer that they will have equity left in the car when they more than likely won’t. Manufacturers doing this might be making a sale today but in three years’ time that customer may well not be able to afford another PCP and a new car sale will be lost.”
Enforcd reviewed a typical BMW finance offer:
BMW 118i 5-Door M Sport Sports Hatch. Four year (48 month) contract. 10,000 miles per year.
|47 monthly payments||£239|
|On the road cash price||£24,650|
|Our deposit contribution||£1,687.44|
|Total amount of credit||£18,853.56|
|Optional final payment||£9,828.13|
|Total amount payable||£26,858.57|
|Rate of interest||3.9% Fixed|
On the face of it, it’s a reasonable way to spread the cost of a new car. The customer puts up £4,109. Source of funds may be a credit card (soon transferred to a 0% deal), or a personal loan. The customer pays a total of £11,233 in monthly payments. If they give up the car at this point, they’ve paid £15,342 to drive 40,000 miles in a new car, for 4 years. At this point, it may or may not be cheaper to buy a four year old BMW 118i 5-Door M Sport Sports Hatch second hand. If it is, the customer hands the car back. If it isn’t, they buy the car (keeping it or selling it privately), or put the equity towards their next new BMW, retaining the difference.
The key problem is at the affordability assessment and product design level. Enforcd assumes that no one wakes up thinking that they want to spend £15k to not own a car at the end of it. In that case, PCP is a lending structure designed with the needs of car makers with a dealer network to support. The structure of the agreement creates two sales opportunities (the sale of a new car, and its second hand sale). In both cases the manufacturer gets paid and the dealer can upsell the customer to a new car, or have a second hand car with a single owner and 40,000 miles on the clock to sell. Also, the carmaker is probably financing the whole loan, collecting more interest than they’d receive on cash.
A 2017 Telegraph article included results from its mystery shopping, which tested affordability assessments (a key plank of CONC, the FCA’s consumer credit handbook chapter):
“A salesman at one firm encouraged a customer, who said he had £400 total monthly disposable income, to apply for a deal on a Volvo V40 with heated seats and metallic paint. At a cost of £397-a-month it would have left the customer with just £3 a month to live on. To buy the car outright would cost £22,800.
Another firm suggested a £372 per month deal on a “premium” Hyundai Santa Fey, which retails at £31,406, could be suitable.
The offers were subject to the shopper passing basic credit checks, but salesmen appeared confident that the deals were affordable.”
The finance industry has been here before. In 2005, the FSA took on responsibility for regulating General Insurance. Its Principles applied to sales of payment protection insurance from this date. As such, it was able to argue successfully before the High Court in 2011, that even though it took many years for it to articulate how PPI sales ought to have been conducted, nonetheless, this was reasonably foreseeable by reference to the Principles.
There are further similarities, other than new regulatory requirements, between PCP and PPI: an FCA thematic review in progress, three years’ worth of newspaper concern, rapid sales growth, and a distribution network of non-finance practitioners (the first PPI mis-selling fines were handed out to shopping catalogues and retailers).
The final twist might be the half rule (from the Consumer Credit Act 1974): in the event of financial difficulty, the customer can end the hire purchase (PCP) agreement by paying half the purchase price and returning the car. If they haven’t, or can’t pay half the price, then they will still be liable for the difference:
With a financial downturn inevitable, it remains to be seen how well car dealers explained the risks of ‘owning’ a car funded using a Personal Contract Purchase. The potential impact on industry is demonstrated by Dollar Financial UK (a high cost short term lender). The FCA instructed a skilled person to conduct a review of its lending and collection practices. The review revealed that many customers were lent more than they could afford to repay.
Following discussions with the FCA, in October 2015 Dollar agreed to pay redress relating to loans taken out between 1 April 2014 and 30 April 2015 in respect of affordability issues. The agreed package (which also covered collections issues) consisted of a combination of cash refunds and balance write downs costing £15.4 million:
- 65,000 customers would receive a cash refund.
- 67,000 customers would have their current loan balance reduced.
- 15,000 customers would receive both a cash refund and a reduction in their loan balance.
A downturn that crystallises the problems with PCP will also cause new car sales to fall. So the lending arms of large global car firms may well be hit with £500 Financial Ombudsman Service complaint fees about affordability assessments, followed by the bill for large redress schemes at the same time as their income plummets.
Enforcd are teaming up with the British Banking Association to give another Enforcement Update Webinar, with market abuse taking centre stage.
Date: Tuesday, May 16, 2017
Time: 11:00 AM British Summer Time
Duration: 1 hour
What will be covered:
This interactive webinar will provide an overview of all UK financial services enforcement activity for the second quarter of this year, including a number of FCA cases on market abuse and confidential information and a PRA case published on the day of the last webinar.
It will review FCA cases against an individual where confidential information was shared via WhatsApp, discuss issues surrounding the use of social media platforms by those in regulated firms and the systems and controls required around these, particularly in the light of the GDPR. The Worldspreads market abuse case will also be considered, together with the recent action against a UK retailer ordered to pay £85 million restitution for market abuse.
The PRA case against a bank covers a wide range of themes including sanctions, relations with regulators (PRIN 11/APER 4), regulatory reporting, group risk and senior management, board and governance.
The webinar will finish by touching on the Supreme Court decision in the London Whale/Achilles Macris case.