Risk Management

Consumer Duty: Will it do its duty to protect the consumer?

The Consumer Duty framework represents what FCA terms a “paradigm shift” in its expectation for firms to deliver higher customer care and protection standard. However, the Consumer Duty Framework (“Framework”) has the potential to deliver significantly more.

The reason being if implemented in its true spirit, it not only promises a fundamental change the way firms conduct business in retail markets but also create an effective Early Warning System (“EWS”) for developing stresses in the economy.

While the FCA has issued extensive guidance on its expectations of the firms, in our view the following principles capture the essence of the Framework.

  • focus on delivering good outcomes for customers, rather than product and service.
  • provide products and services that are (i) designed to meet customers’ needs (ii) that they know provide fair value (iii) that help customers achieve their financial objectives and (iv) which do not cause them harm
  • monitor and regularly review the outcomes that their customers are experiencing in practice and take actions to address any risks to good customer outcomes.

This goes significantly beyond elevating customer care standards. The Duty is to design products and services after taking into account all the variables that a well-informed and financially savvy individual would typically consider. And then monitor the performance of product or the services, over life, against the financial objectives, exactly like our model customer would do.

The FCA’s goal is to truly embed the essence of Consumer Duty into the DNA of every firm. Although every firm would claim to be customer-centric, what makes the Framework truly exceptional is the concept of Fair Value.

At Heart – is the Value Fair?

In financial markets, fair value is the value of a security or an asset, determined by reference to a market benchmark or other observable inputs. It is a market-based instrument rather than entity-specific.

In other words, the objectives or the reasons for an entity to buy or sell an asset has no bearing on its value.

However, under the Consumer Duty framework, the fair value must be established in the context of customers’ needs and their financial objectives. Clearly, a particular product may provide fair value to one segment of clients and not to others, if these two segments have different financial objectives, for example taking out a mortgage to get onto the housing ladder v/s buying to let.

It transpires that the firms must then endeavor to develop a much more evolved framework for determining the fair value rather than simply “relying on high-level or unevidenced arguments that their business models or ethos are inherently fair value”, as FCA pointed out.

A Case of Shifting Fair Value

This aspect is pivotal within the Framework. A meticulously crafted product aimed at delivering fair value to customers may lose its fairness due to various factors, including fluctuating interest rates.

This makes sense. The financial objective of taking out a residential mortgage is not simply to be able to borrow. The underlying benefit of a mortgage is to get on the housing ladder today and fully own the property, over a definite time horizon, by paying off the mortgage. This ability to pay off the mortgage is critical, as otherwise, a viable alternative would be to rent instead. However, in a rising interest rate environment, it is difficult to see how a residential mortgage continues to be “fair” if the capacity to pay off the mortgage is severely impaired.

Understandably, various guidance issued by the FCA do seem to deliver inconsistence messages: while acknowledging that market-driven pricing isn’t inherently unfair, it also highlights the risk of market rates making products unfair. However, we think this can be addressed by retaining a sharp focus on customer outcomes. Again, we will discuss this in detail in the next article in the series.

Consumer Duty Framework: Conceptually Unprecedented?

While groundbreaking in retail markets these concepts resonate with the evolution seen in other sectors of the financial services industry.

Two of the prominent examples are:

  • Delivering customer outcomes is in the same vein as driving measurable and positive social and environmental objectives through Impact Financing
  • Prioritizing customers’ financial objectives is exactly how the derivatives structuring practice evolved at top global banks, post the 2007 financial crisis.

Furthermore, it became imperative to monitor executed transactions through their tenor to ensure that they continued to be aligned with clients’ objectives, market conditions and idiosyncratic factors.

Support the Wider Financial System ?

Financial products, such as, the consumer loans and mortgages play a crucial role in the economy and perform a very important and desirable function. However, their indiscriminate promotion and distribution and inward focus in their design can also lead to adverse effects such as creating asset bubbles and mass defaults.

A robust customer-centric and dynamic fair value framework, in addition to protecting consumers,  would also ensure sustainable economic growth and avoid the repeat of the types of crises that almost collapsed the world’s financial system.

Equally important is the continuous identification of products failing to deliver fair value, serving as proactive detection of potential vulnerabilities.

This can establish an effective early warning system, enabling both market participants and the FCA to take preemptive action.

We firmly believe that a similar framework existed before the great financial crisis, the risks could have been mitigated to a large extent as both the regulators and the market participants would have been able to detect fault lines early.

This article first published in Thomson Reuters Regulatory Intelligence: Sign up