WorldTrade Executive The International Business Information Source TM

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1 EuroWatch WorldTrade Executive The International Business Information Source TM Reporting on Legal and Regulatory Developments Affecting Foreign Companies Operating in the EU March 15, 2010 Volume 22, Number 5

2 FSA Financial Risk Outlook 2010 By Jacqui Hatfield and Christopher Parrott (ReedSmith LLP) On March 10, 2010 the Financial Services Authority ( FSA ) published its Financial Risk Outlook ( FRO ) for the next financial year. Below is a summary of the key messages the FRO contains. The FSA s Business Plan, set to be published in mid-march, will elaborate on the issues addressed in the FRO and set out the FSA s plan for tackling these issues. Why is the FRO Important? Through publishing the FRO, the FSA is able to set out its understanding of the current market conditions. It highlights risk areas, and shows firms which areas the FSA is likely to prioritize over the next year and where it will focus its resources. Jacqui Hatfield (jhatfield@reedsmith.com) is Partner and Christopher Parrott (cparrott@reedsmith.com) is a Trainee based in the London office of ReedSmith. Ms. Hatfield heads up the Financial Services Advisory Group, which sits within the Financial Institutions Group. She has a wealth of experience across the broad spectrum of the FSA regulated community. Her clients range from asset managers, brokers, banks, fund managers, fund platforms, exchanges, insurance companies, brokers, energy traders and corporate finance boutiques. The FRO is divided into four sections; each of these sections will be looked at individually. Although the position of the UK's economy, with a high public deficit and low interest rates, is fairly stable at the current time, this could change if there was a sudden rise in unemployment or loss of income, or if interest rates were increased before the housing sector had fully recovered. Macroeconomic Background and Outlook The FSA has commented that fiscal and monetary policy support has assisted to limit the length and depth of the recession. It believes that there will be a steady acceleration of economic growth in the UK during 2010, based on the signs of recovery of both UK and world GDP. 10 EuroWatch March 15, 2010

3 However the FSA has made some alternative scenarios; although the position of the UK s economy, with a high public deficit and low interest rates, is fairly stable at the current time, this could change if there was a sudden rise in unemployment or loss of income, or if interest rates were increased before the housing sector had fully recovered. The FSA views the UK economic outlook as highly uncertain because of this, and argues for a sustained, steady economic recovery with fiscal consolidation and gradual deleveraging. Due to this uncertainty, the FSA makes it clear that financial firms will be subject to continued high risk during 2010, and will focus on this issue. Financial Stability and Prudential Risks and Issues Although the FSA acknowledges that the banking sector has been stabilized by Government support during the financial crisis, the FSA foresees issues arising as some of this support is withdrawn throughout It will therefore focus on the management of financial stability and prudential risk, to ensure firms are able to cope with these issues. Banks and building societies will face particular pressures during the next year, due to a new regulatory regime being designed regarding both capital and liquidity. The FRO makes reference to the current regulations on capital maintenance, and it states that firms need to be aware that there are likely to be rules for significantly higher capital requirements than there were before the financial crisis. It also emphasizes the key role of stress testing, requiring tougher stress tests to be used so that a firm s business is tested when it is placed under severe (rather than just slightly adverse) financial difficulty, enabling firms to prepare for any further downturn in the economy. With regard to liquidity, the withdrawal of public support as described above will also lead to difficulties for banks. The FSA argues for a programme of gradual deleveraging, increasing customer deposits and using medium to long term debt, which can occur during the transition period to the new liquidity regime. This will also assist in the banks achieving another FSA objective; that banks are not focusing on short-term maximization targets, but on longer term profit optimization. For insurers, the FSA highlights the effects of the financial crisis with regard to possible increased claim costs. It advocates enhancing monitoring systems so that insurers take the possibility of increased claim costs into account when reserving. In addition arguments are put forward by the FSA that income for insurers is unlikely to recover quickly to pre-financial crisis levels. The FSA urges insurers to recognize that the only way to increase income dramatically would be through significant changes, but this would present greater risks. The implementation of Solvency II will also change the capital adequacy regime for insurance companies. Although it will not come into force until October 31, 2012, the FSA recommends planning in advance due to the amount of changes insurance companies will need to make with regard to disclosure and risk management (among other requirements). Firms should keep up to date with the implementing measures that the EC produce for Solvency II to ensure they are prepared for when Solvency II does come into force. The FSA will continue to commit resources to prevent deficiencies in risk management; they believe that before the financial crisis, many firms had a weak risk culture. This needs to be changed, and the FSA recommends change which comes from the top of the business, such as directors and senior management, who should foster a permanent attitude that is based on sound risk management practices and a strong ethical culture. Changes have also been advised to firms valuation, client asset protection and post-trade control procedures to enhance consumer confidence in the financial industry, and limit the possibility of another financial crisis. Although the FSA acknowledges that the banking sector has been stabilized by Government support during the financial crisis, the FSA foresees issues arising as some of this support is withdrawn throughout Market Risks and Issues The main risk to the market from the FSA s point of view is market abuse; the FRO states that effective market surveillance is becoming more challenging due to recent developments such as the increased fragmentation of equity markets. There will be emphasis during the next year in preventing leaks of inside information, and ensuring that firms have adequate anti-market abuse systems in place so that suspicious transactions are identified and notified to the FSA. The FSA will continue to undertake enforcement actions against firms which do not comply with the market abuse provisions. In addition to market abuse, the FSA has highlighted further areas which pose potential risks to the market; this includes deficiencies specific to the over-the-counter markets, for which the FSA advocates enhancing risk management (especially with regard to non-cleared products). The FSA has also warned against low capital positions at Market Infrastructure Providers ( MIPs ) due to high competition. This could in turn lead to a lowering of quality and standard of services as the MIPs attempt to increase profits, which the FSA is trying to avoid. Lastly the FSA recognizes that due to the financial crisis, firms may begin exploring innovative products. Financial Risk Outlook, continued on page EuroWatch March 15, 2010

4 Financial Risk Outlook (from page 11) Although this could be beneficial to the market, the FSA wants to ensure that investors in these new products understand the risks involved, and that the level of risk taken by firms is appropriate. If risk is not monitored adequately, another financial crisis could be caused. Retail Conduct Risks and Issues Some consumers attitudes to risks have changed due to the current economic climate. Therefore the FSA wants to ensure consumers are protected when purchasing products (such as complex capital-protected or absolute return products) so that they understand the risks involved. There are two particular areas that the FRO focuses on; banks and insurance companies. The FSA questions the business models of retail banks, and will enforce regulations to prevent banks increasing their margins in ways that result in unfair treatment of consumers, and limit additional costs being passed on to consumers to maintain high profit margins. In addition the next year is likely to see banking break-ups and consolidations; the FSA are keen that firms manage the risks posed to consumers during these periods. As consumers focus primarily on price when purchasing and renewing insurance, it is the insurance provider s obligation to make their insurance products transparent so consumers can take into account any limits on cover before taking out the insurance. In addition to the areas mentioned above, the FSA will continue its focus on mis-selling of structured products (such as those backed by the Lehman Group), Payment Protection Insurance and complaints handling. It also urges firms to put in place appropriate plans before the Retail Distribution Review is implemented, to ensure the future sustainability of their business model. Sector Digests Alongside the FRO, the FSA published separate sector digests for four sectors; banking, asset management, insurance and retail intermediaries. These outline the main risks facing each of these industries. To the extent that there are key messages from the FSA in these digests, these have been noted above. Conclusion The FSA is still adjusting its policies in the wake of the financial crisis. As part of this, it will look to regulate all firms to a higher degree, to ensure market stability. Although the FSA is expecting a gradual economic growth in 2010, it has stressed that this growth is uncertain due to numerous factors. Firms need to take into account the factors mentioned above, as areas highlighted by the FSA (such as stress tests, capital maintenance and consumer protection) will come in for greater scrutiny during Jacqui Hatfield s Commentary on the FSA Financial Risk Outlook 2010 The FSA has published its Financial Risk Outlook, which together with the Business Plan due to be published next week, highlight the main risks and issues affecting firms, markets and consumers and the focus of the FSA in terms of resources and potential enforcement action Unsurprisingly the key risk this year is the fragile slow recovery in the economy, largely as a result of quantitative easing and other measures which are due to come to an end. Although [innovative products] could be beneficial to the market, the FSA wants to ensure that investors in these new products understand the risks involved, and that the level of risk taken by firms is appropriate. If risk is not monitored adequately, another financial crisis could be caused. As a result there will be a focus this year on the adequacy of stress testing and risk management. Banks will need to carry out severe stress testing, assessing their ability to hold a minimum core tier one capital ratio of 4% in severe but plausible conditions. The FSA have indicated that they will carry out intensive supervision and credible deterrence, namely enforcement, in this area. Banks will have significantly higher capital requirements than existed pre-crisis and in particular in respect of their trading activities and are warned that they should be aiming to build up capital strength and should have appropriate approaches to dividend and remuneration policies. An international package of reforms is due by the end of 2010, including reforms to the level and quality of capital, measures aimed at strengthening counterparty credit risk capital requirements, introduction of a leverage ratio, capital buffers and a review of trading capital requirements. These will be implemented through the Capital Requirements Directive. The emphasis this year is on firms implementing new FSA policies quickly and on keeping abreast of key developments. FSA policies should be expected in the areas of capital, liquidity, market abuse, implementation of Solvency II and the Retail Distribution Review ( RDR ). The FSA will be making pre-implementation visits to ensure firms are prepared for implementation of its policies, although it is surprising that they have sufficient resources 12 EuroWatch March 15, 2010

5 to do this. This means that firms should keep abreast of developments and implement policies as quickly as possible. It is difficult to see that firms can be disciplined for failures pre-implementation but firms should be aware that the FSA has highlighted that it will be taking preimplementation enforcement action for mis-selling of commission based sales ahead of the implementation of the RDR. We will keep you abreast of developments by way of client alerts and can assist with implementation processes and procedures. Market abuse and insider dealing are still key focus areas for the FSA and we should expect more enforcement action this year. Firms should ensure that they have assessed the risks of market abuse within the firm, have effective anti-market abuse systems and policies in place and train their officers and employees to avoid (i) actions for market abuse being taken, (ii) enforcement action for inadequate systems and controls, including for not submitting suspicious trading reports and for failing to act upon suspicious client orders; and (iii) insider dealing actions being taken against its officers and employees which incur reputational risks to the firm. We can assist with drafting anti-market abuse policies, checking the adequacy of policies, risk assessments, provide practical recommendations and can provide market abuse training. In the retail sector, the focus will continue on insurance and mortgage brokers and more enforcement action is expected. The FSA will focus on the selling of structured products, PPI and MPPI, guaranteed products and life traded products. Consumers nearing retirement and consumers wanting high yield products to cover recent shortfalls are perceived as being vulnerable to mis-selling and to purchasing risky products they do not understand. There will be more focus on the adequacy of product design and development in addition to sales and distribution and complaints handling. Firms must ensure compliance with TCF, ensure that products do what they were designed to do, are not mis-sold and that their complaints handling is adequate as there is likely to be more enforcement action in this area. We can advise on the FSA s requirements and expectations and with compliance checks in these areas. Other key points to note are that EU credit rating agencies ( CRAs ) need to be registered by September this year and firms are unlikely to be able to use credit ratings of unregistered CRAs after December this year and therefore should be prepared for this. In addition the reform of OTC derivatives and key risks of non-cleared OTC derivatives is highlighted. Firms should be aware of developments in the area and how this will impact on them. They should also have adequate risk management processes in respect of non-cleared OTC derivatives. o

FSA RETAIL CONDUCT RISK OUTLOOK

March 2011 FSA RETAIL CONDUCT RISK OUTLOOK Client Briefing FSA s Retail Conduct Risk Outlook 2011 key points The FSA published its Retail Conduct Risk Outlook (RCRO) for 2011 on 28 February. In previous