Farewell speech, made at the UK Finance Personal Banking Conference
I'm very grateful to UK Finance for giving me this platform.
It's now almost nine years since I joined FSCS as CEO. All organisations need new leadership after that length of time. New leader: new insight, new direction.
But one thing an out-going leader can offer is the benefit of experience. So this speech is, if you like, a distillation of my experience. Whether it amounts to wisdom I’ll leave you to judge.
Before I turn to the substance, a few preliminary disclaimers are in order.
The first is that these are my personal views, not those of FSCS. This is an indulgence that only outgoing leaders are allowed.
The second – more properly an explanation – is that I am going to be speaking throughout from the perspective of the people FSCS serves; namely, consumers. So I shall refer frequently to mainstream consumers or investors. My concern is with the great majority of our fellow citizens who are not financial experts and find financial products daunting.
Sophisticated investors can look after themselves!
And, last disclaimer – perhaps the most important – many of the issues I shall touch on are hard. It’s all too easy to be critical of the industry itself or of the regulators. I have worked closely with both now for nearly a decade. I have a great admiration for many and for the regulators in particular a large measure of sympathy too. They have a near impossible job.
Indeed, why I think the regulators job is so difficult forms the first part of my speech.
I want to begin by offering my perspective on some of the characteristics of the retail financial services market which make it unlike other retail markets and on the risks these characteristics create.
I shall then turn to the implications of these characteristics of the market for consumer protection and for regulation. My view is, broadly, that we still value choice too much, tolerate, in consequence, needless complexity and, despite some distinct advances, “nudge” or protect consumers too little. We also value “optimisation” excessively when often “good enough” will do.
To put it another way, we have yet fully to embrace the insights of behavioural economics.
That will then lead me into a discussion of the role of protection of the kind provided by FSCS and of that old favourite, moral hazard. On the whole, I’m not impressed by the moral hazard critique of FSCS. But, perhaps surprisingly, I do believe that FSCS’ protective net is currently cast too wide and that breadth contributes to bad outcomes.
Finally, I shall say something about the future challenges for FSCS itself as it enters its third decade.
A market like no other: retail financial services
Attributes of a efficient and effective market…
What would an effective market would look like?
It would be a competitive market in which firms’ success depended on serving consumers’ financial needs with good value, straightforward products.
Consumers would have a good choice of products to reflect their needs and appetite for risk, but would not need to be financial experts in order to exercise that choice. Cost and risk, in particular, would be transparent.
When it comes to long-term, high stakes choices – saving for retirement, for example – consumers would have access to independent, well-qualified financial advice. But there would also be good value default options for consumers unable or unwilling to make choices or to seek such advice.
Because this is a competitive market, firms would fail for commercial reasons. FSCS would protect consumers who have claims against such failed firms.
So how does the market as it is match up to this ideal?
FSCS’ compensation payments are an index of a market in trouble…
FSCS’ own compensation payments over the last decade provide a good starting point for my proposition that all is not well. Since I became CEO FSCS has paid out £3.3 billion in compensation. Those are costs borne by the industry and, one way or another, passed onto consumers.
Some of these costs flow from what you might call normal commercial failures of the kind that occur in any properly functioning market.
But the truly sobering thing is that a substantial proportion – over 60% - of those compensation costs are a result of mis-selling or bad advice. FSCS has paid out £2 billion in compensation because consumers have been advised or encouraged to buy wholly inappropriate products – everything from PPI insurance, to death bonds, to illiquid overseas property funds.
And this is avoidable, or, at least, should be. So why does mis-selling on this scale occur?
Features of the market that lead to trouble...
I think we can trace this to certain unique features of the retail market for financial services products.
Here is a market which we must all use to manage our lives and finances.
But this is also a market characterised by a bewildering array of products, by complexity – some deliberate – and by profound information asymmetry. Most consumers find financial products hard to understand. They shy away from making the attempt.
What’s more, many consumers are also, as FCA’s 2017 Financial Lives study showed, vulnerable in one way or another. They are under pressure, facing difficult life choices, but without the experience and knowledge needed to address those choices confidently.
Lessons of behavioural economics…
These are, in short, exactly the circumstances which behavioural economics, tells us will lead people to make poor choices. Confronted by choice and complexity, consumers will tend to put decisions off. They will discount the future heavily in favour of the present. They will be risk averse.
This is where information asymmetry comes into play because many parts of the industry are much wiser to behavioural economics than mainstream consumers.
We can see that in the prevalence of teaser rates for both savings and accounts and for mortgages – rates which re-set after a year to something much less favourable. These only work because of consumers’ inertia in the face of choice. So the inert or loyal subsidise the switched on or disloyal.
More seriously – and taking us back to FSCS’ experience – we can see behavioural economics at work in mis-selling. With interest rates at a generational low, consumers are desperate for better returns, but very unsure about how to achieve them. So when an adviser comes along – regulated or unregulated – and offers the beguiling prospect of great returns at no risk from death bonds, or overseas property, or storage pods, consumers sub-contract the decision with relief.
The market’s lack of resilience...
The final feature of the market to which I want to draw attention is its lack of resilience.
This is a polite way of referring to the chronic under-capitalisation of much of the advice sector relative to the risks it runs.
This remains a very fragmented industry, with many small players. Those players carry little capital – as little as £10 000 in some cases. In some cases their professional indemnity insurance carries an excess greater than their capital.
It does not, in other words, take many claims for mis-selling to sink most advice firms.
In short, the retail financial services market has important structural risks.
Vulnerable and poorly-informed consumers face a multiplicity of often complex products. In some cases this complexity is designed in to take advantage of consumers’ behavioural biases.
This often results in undue conservatism: inertia, under-saving and the avoidance of risk. But in a minority of cases, it means that consumers are too ready to trust unscrupulous or incompetent advisers who do not have the financial resources to put right the harm they do.
Reforming the financial services market
If the risks are inherent in certain structural features of the retail financial services market, it follows that part of the solution lies in structural reform.
I am often told that compensation costs are down to ineffective supervision by the regulators. I do not believe this.
While there are certainly things that we in FSCS, in partnership with the regulators and the industry can do at the margin – I’ll come back to these – it is delusional to think that any regulator could police such a fragmented market so as to anticipate harm before it manifests itself, rather than to react to its occurrence.
Instead, I advocate prioritising protection of the consumer over maximising choice. This means: simpler products, more default options; and better targeted communications, including about FSCS protection.
It also means promoting the consolidation or confederation of the advice industry so that it is served by fewer, stronger players with the professional and financial critical mass to maintain high standards and absorb most mis-selling claims.
Let me take these in turn.
Simpler products, better protection…
Encouragement to save will have limited impact without simpler products and better protection.
So I should revive the great work done by Carole Sargeant to specify the key features of straightforward products which do what they say on the tin – no more, no less. And I would kitemark products which meet those straightforward standards so that consumers can be confident they are buying good value.
I’d put the regulators in the frame to undertake the kite-marking – or at least perhaps the existing FCA Consumer Panel operating under FCA auspices.
This would, I hope, make it harder to market products which seek to exploit behavioural biases – accounts and loans with teaser rates for example – or products where complexity conceals high cost and hidden risk – structured products fall into this category.
To take a fairly straightforward example, as a vehicle for long-term investment, a low cost fund tracking major equity markets will always be a better bet for consumers than a structured product.
We can also extend protection to consumers by promoting the wider use of so-called default options which cut in when consumers find choices bewildering and hard to take.
These default options are now well-established when it comes to accumulating retirement savings. NEST has been a notable pioneer in this respect. The great advantage of these options is that they provide a sound strategy for investing retirement funds for consumers who do not have strong views of their own.
But such default options are much hard to find when it comes to investing retirement funds to generate an income in retirement. And yet, following pensions freedom, this is now the area where consumers confront both choice and risk.
It is certainly the area where FSCS has seen the greatest growth in claims in recent years as too many consumers are induced by bad advice to transfer money from occupational schemes in order to invest in risky and illiquid assets, usually held within a SIPP. FSCS has paid out compensation of £581 million for these claims in the five years from 2014/15. That compares with only £80 million in the four preceding years before pension freedom took effect.
How much better if the big providers of workplace pensions also offered good value default options for generating a retirement income?
Now, people’s objectives, circumstances and attitudes to risk differ. But I don’t believe that most mainstream investors differ so radically that it would be impossible to develop a range of default approaches catering to the most common circumstances and objectives.
We should give consumers this help which would, in my view, reduce both the risk of undue conservatism and the risk of reckless investment on the back of poor advice.
Is financial education an answer?
Before I leave consumers and the demand side of the market, it is implicit in much I have already said that the market would work better if consumers had more interest in, and a better understanding of, financial products – not to mention their own behavioural biases. Indeed, research published by FSCS last year showed that people would save more for retirement and would invest in different retirement products if they had a better understanding of FSCS protection.
So this must be an argument for education to raise financial literacy, right?
Well, yes, but research also demonstrates, unfortunately, that broadly-based education campaigns have little or no impact. That is because consumers are simply not tuning in or seeing the relevance.
I don’t, on the other hand, think that means that we and the SFGB should give up. But we need to be much smarter about how we go about engaging with consumers.
In particular, we must get better at targeting relevant and consistent messages at consumers when they face major life events or contemplate major financial purchases. We need the industry’s help here. Our success, in partnership with banks and building societies, in raising awareness of FSCS protection of deposits to over 80% shows exactly what can be achieved.
Tackling the supply side…
So much for my observations on how we might re-structure the demand side of the market to give consumers more help and protection. But what about the supply side and the extreme fragmentation of the advice sector in particular?
Here I believe the regulators face a genuine dilemma.
Many small advice firms do a very good job. They are well-connected and well-respected in their local communities. They are well-qualified and provide sound advice. They are also, let’s be frank, good lobbyists who command political support.
But, as I have already outlined, this fragmentation is also a risk both to consumers and to the wider sector because it is difficult – I would say impossible - for regulators to supervise effectively and lacks financial and professional critical mass.
So what is the solution?
One is to increase their financial resilience by taking regulatory action to increase the capital such firms must hold or to improve the coverage and quality of the professional indemnity insurance they must take out. Indeed, FCA has just acted to do the latter and I welcome this.
But there are clearly practical and political constraints on the regulators here. Raise capital or insurance requirements too far and you begin to put firms out of business or raise the costs of advice to prohibitive levels.
I would propose a complementary approach and seek to bring about consolidation or confederation within the industry by setting standards for resilience and quality control which advice firms will find it easier to meet if they form networks or partnerships.
I have in mind here, for example, standards bearing on the due diligence needed in relation to an investment before it can be recommended to a mainstream investor.
Such standards would not force small firms out of business, but such firms would find it much easier to meet the standards if they confederated with other firms to share the costs of the research and corporate governance.
Higher standards of research and corporate governance could also help to lower the costs of insurance which could themselves be pooled.
So, in summary, I should address the structural vulnerabilities of the retail financial services market by giving consumers more protection and more help and by promoting greater financial and professional resilience within the industry itself.
These steps would, in my view, likely reduce the level of failure falling to FSCS.
Does FSCS itself contribute to compensation costs by fostering moral hazard?
FSCS’ critics will probably say that, in dissecting the structural flaws of the financial services market I have conveniently overlooked the charge that FSCS itself is a source of moral hazard. By protecting consumers, we reduce the incentive for those consumers and their advisers to take proper care and attention.
Moral hazard – more theoretical than real…
I am unpersuaded that moral hazard represents a serious risk.
Those who argue that it does, it seems to me, credit consumers with far greater insight into financial services businesses than is consistent with what we know about consumers’ actual behaviours and preferences.
Of course, consumers will tend to favour high rates of interest for their savings, over lower rates. They will be attracted by investments which promise high rates of return for low risk. They will like the sound of low cost insurance policies.
But it is implausible to argue that consumers make the link between such promises and the financial health and resilience of the businesses making the promises.
And it is implausible to expect, in the absence of FSCS protection, that consumers would be well placed to distinguish between the sound firm seeking to build market share with competitive offers and the unsound firm desperately seeking liquidity or running big commercial risks.
What’s more in a crisis, as we saw in 2007 and 2008, moral hazard is simply a luxury we cannot afford. Financial stability depends on reassuring and protecting consumers – up to defined limits – not on punishing them for excessive risk-taking.
Equally, I have seen no evidence at all that consumers who have been the victims of mis-selling or bad advice have embraced that advice because they expected FSCS to protect them if things went wrong. On the contrary, most consumers still do not know that FSCS does protect them in these circumstances.
And, as for advisers, I should say that it’s the relatively low cost of failure – particularly the modest capital at risk – that creates the moral hazard, not the protection provided by FSCS. At best the latter may salve a few consciences.
But the perimeter of FSCS protection is cast too wide…
I do, however, favour drawing in the perimeter of FSCS protection to exclude the many unregulated products which have cost so much in recent years.
As things stand, FSCS’ protection of investment and retirement products differs markedly depending on whether the consumer buys them direct or is advised to buy them by a regulated adviser.
Where the consumer buys direct, FSCS protects only insurance products such as annuities and some other collective investment products such as mutual funds.
By contrast, we protect consumers from the consequences of bad advice over a much broader field of assets, including, of course, those products – overseas property investments, forestry, storage pods, carbon trading futures and so on – which have generated so much of the compensation costs of recent years.
This is open to a number of objections.
One is that it is simply perverse for FSCS to offer protection for products which no mainstream investor should touch with a barge pole, even when recommended. Although I discount moral hazard, we should surely not cast the mantle of protection over things that are obviously unwise.
For another, this approach makes FSCS protection virtually impossible for mainstream investors to understand. Unlike with deposits, there is no straightforward and readily intelligible message we can give about what we protect and what we don’t. This is not helped by the fact that our protection for investment advice and investment products – up to £85 000 from April 2019 – differs from our protection for insurance products – 100% without limit.
So I advocate drawing in the perimeter of FSCS protection for investments and retirement saving products – whether recommended or bought direct – so that it embraces only certain collective investments: long-term insurance products, mutual funds, listed investment trusts and some index-tracking physical Exchange Traded Funds.
As a quid pro quo narrowing our protection, I would then significantly increase the level of our protection for retirement savings and advice on retirement savings so that no consumer is at risk of losing a major and irreplaceable part of their pensions. It surely cannot be right that some members of the British Steel Pension Scheme have lost ten of thousands of pounds as a result of mis-advice to transfer out.
Please note, this approach does not do away with the need for advice. It does not mean that mainstream investors cannot take on risk consistent with their objectives and risk appetite. And it does not cut off mainstream investors from any significant asset class.
But it does mean that FSCS will only protect investments in professionally-managed collective vehicles and only then if the advice to invest is clearly inappropriate for the consumer concerned or the funds are lost or misappropriated.
Now, clearly, the big objection to my proposal is that it potentially leaves consumers high and dry if they are badly advised to invest outside these revised parameters.
The regulators can help here by complementing this narrowing of FSCS protection by barring regulated advisers from recommending to mainstream investors products outside this boundary.
And FSCS, the SFGB and the industry can help by all making clear to consumers where the boundary of FSCS protection lies so that it is apparent to consumers that, beyond that boundary, they are operating at their own risk.
We shall, at least, then have a clear and compelling message. And consumers will have a strong incentive to pay attention to it – just as they have to FSCS’ messages about deposit protection.
FSCS: challenges for 2020s
And that brings me to some closing remarks about FSCS itself.
Though I hope some of the seeds I have sown will eventually germinate, I do not expect fundamental reform of the retail financial services market over night. The issues are intractable and everyone has other things to worry about now and probably for some time to come.
So FSCS and its protection will continue to be needed.
The future will, however, be different in important respects. I think that those differences are well-captured in the strategy for the 2020s - Protecting the Future - we published last autumn.
Although big failures will happen, the real challenge for the next decade will be facing up to the consequences of pension freedoms and the opportunities and risks those create.
So FSCS will need to be prepared for a wide range of eventualities.
Much depends here on improving the quality of information firms hold about their customers.
In the new world, our customers will tend to have more complex claims and more will often be at stake.
We shall need to provide these customers with an outstanding service – fast, accurate, easy-to-use and, above all, empathetic – which enables them to put their lives back on track.
To do that, we shall need to exploit digital technology effectively to provide a responsive service, with regular updates.
As I have discussed, consumers more generally will need better information about FSCS protection when thinking about the investment of their retirement savings. They will need that advice at relevant times, but especially when making decisions about their retirement pots.
And when things do go wrong, consumers will need to know that they can seek FSCS’ help without cost.
And, finally, FSCS, the industry and the regulators can prevent future failure and so reducing compensation costs.
We can be better at foreseeing risks and risky products.
We can be better at sharing intelligence about the directors and advisers involved in mis-selling so that they cannot simply re-invent themselves at the expense of consumers.
So there you are. Those are my observations as I leave FSCS after nine years.
The market for financial services is there to serve consumers. Profit in that market should flow from serving consumers well, not from skilful manipulation of their behavioural biases and exploitation of their discomfort when faced with products and choices they struggle to understand.
I have made some suggestions about how the market could evolve better to meet consumers’ needs. I hope, at least, those suggestions will provoke debate.
But whatever else happens, consumers will continue to need protection when things go wrong. That is what FSCS is there for.
I wish everyone at FSCS well in this third decade. It has been a great privilege leading FSCS through its second! I thank you all in the industry for the support you have extended to me and to us during the second decade.
 See here Nudge by Richard H Thaler and Cass R Sunstein which cites the problem of choosing a mutual fund for retirement. How is a consumer to choose between a capital appreciation fund or a dynamic dividend fund?