Taking stock

One year into statutory regulation, the industry has adapted pretty well in the main, though both the regulator and the regulated still believe there is a lot more work to be done to make the regime effective. Mortgage Strategy reports

How was it for you? With today marking the first anniversary of the Financial Services Authority mortgage regulation regime, has this been a year of positive engagement and progress, or one of confusion, frustration and doubt?

As is the case with any market readying itself for regulation, before Mortgage Day the pages of Mortgage Strategy were crammed with speculation about what firms could expect. With such a build-up and countless scaremongering stories regarding the bleak future in store for various business models, the weeks and months following the day itself must have seemed an anticlimax.

The FSA did not close down several thousand small firms, packagers were not summarily executed outside Canary Wharf and lenders were perfectly able to provide Key Facts Illustrations. OK, that last point may be open to question but what has been happening in the market since last October?

With one of the key arguments in the run-up to Mortgage Day surrounding the likely split between directly authorised firms and appointed representatives, it’s helpful to start with the figures. The FSA authorised 4,226 new firms for mortgage business, with a further 2,893 firms varying their existing FSA permissions to include mortgages. This gives a total of 7,119 firms directly authorised by the FSA for mortgage business.

Many of these are among the 13,808 new firms also authorised to carry out general insurance business. With 4,332 firms varying their permissions, the FSA has now authorised 18,130 firms for general insurance.

New mortgage networks abounded prior to Mortgage Day but how many took the AR option? While the FSA has details of 12,000 registered ARs, this includes investment and other ARs and no single figure for mortgage ARs is publicly available. But a quick calculation of the number of previously Mortgage Code-registered firms (10,500 as of October 2004) which have not become directly authorised, leaves a residual 3,400 firms.

Though some firms have opted to become introducer-only or leave the industry, around 3,000 mortgage ARs remain. The directly authorised community is easily the larger of the two and the final industry split is around 70% DA to 30% AR.

Whatever the forecasts offered by Hthat most dubious of columnists – the industry pundit – it is firms themselves that will have the greatest influence on the outcome of FSA regulation. There is certainly no consensus on its impact on the market. While some regard the requirements as a worthwhile process for the industry and its customers, others are sceptical and yet to be convinced that the cost and upheaval has been worth it. A third group remains deeply critical and would happily revert to the Mortgage Code at the first opportunity.

To gauge intermediaries’ views on the FSA regime, the Association of Mortgage Intermediaries asked firms for their views six months in. What was notable from the responses of the 575 individuals polled was the clear majority who welcomed the shift.

Asked what their view of being regulated by the FSA was, over 21.4% chose ‘very positive’ and 45% ‘positive’, 21.4% said ‘neither positive or negative’, 10.7% ‘negative’ and 1.5% ‘very negative’.

Firms’ views on the likely outcome of regulation were also broadly positive. Asked whether FSA regulation would raise industry standards and professionalism, 65.4% agreed with this compared with 30.3% who disagreed. As for the impact of regulation on consumer confidence in the mortgage industry, 42.4% thought this would also increase compared with 53.4% who did not.

But one clear concern was the tendency of regulation to lead to an increase in complaints, with 62.3% voicing their concern that complaints would rise under the FSA. And this for a sector with a positive record on customer satisfaction. Given this fact, and the broader view that little consumer detriment occurs at the hands of mortgage firms, there has also been great concern about the cost and time burdens arising from compliance, particularly for smaller firms.

A willingness to engage and comply has to be offset against firms’ frustration on this latter point. For small firms in particular, the experience of FSA regulation has challenged existing skills sets, whether relating to rules for financial promotions, regulatory reporting, independence and fee- charging, or aspects of the initial disclosure and key facts documents.

With their experience of the FSA prior to Mortgage Day, mortgage- writing IFAs had a distinct advantage over their previously non-regulated peers and for this latter group, managing the internal changes required for the threshold conditions, training and competence, and systems and controls requirements has been a challenge. FSA compliance skills are now must-haves rather than nice-to-haves, and “How have you dealt with this?” has become a standard conversational gambit at intermediary events.

Regulation has also struck many as unwieldy and needlessly complicated. Most intermediary firms do not have the resources to employ standing compliance staff, and balancing this limitation against the Handbook require- ments has proved to be a major frustration. The FSA’s production of tailored versions of the Handbook was certainly a welcome step but many still ask where all this came from and why.

Mortgage regulation was not, after all, necessitated by an endemic failure of borrowers by this industry.

Consumers and the consumer lobby had no clear justification to vilify mortgage intermediaries as they had with advisers for their part in split-caps or pensions mis-selling, and major campaigns for mortgage regulation were notable by their absence. The decision was instead taken by the Treasury in December 2001 as a pre-emptive measure to protect consumers.

Not only was it hoped that statutory regulation would protect consumers in making their largest financial commitment, the move was also intended to simplify a crowded regulatory landscape. Several self-regulatory codes – the Mortgage Code, General Insurance Standards Council, and Institute of Insurance Brokers Regulatory Council – have been superseded by the FSA in the past year.

Broader economic concerns also fuelled the drive toward regulation, with awareness of the housing market’s volatility and memories of the 1990s property crash in particular still quite fresh.

Household debt, including mortgages, now totals more than 1trillion. While near-term risks have stayed low, the Bank of England noted in its June 2005 Financial Stability Review that “some vulnerabilities may be building” in the longer term as consumers increase their indebtedness. The FSA’s required risk warnings for financial promotions are an expression of these concerns.

While macro-level concerns such as these are addressed throughout the FSA’s work, the mortgage industry’s experience over the past 12 months also reflects strategic goals identified by the regulator in its retail agenda. This agenda expands beyond the mortgage industry per se, including pensions, insurance, and investment advisers and providers, and focusses on delivering four objectives. These are first, capable and confident consumers; second, clear, simple and understandable information for consumers (e.g. the Initial Disclosure Document and Key Facts Illustration); third, soundly managed and well capitalised firms who treat their customers fairly (the threshold conditions, Treating Customers Fairly); and lastly, risk-based regulation.

Anyone wondering what motivations the authors of Mortgage Conduct of Business and Insurance Conduct of Business had in drafting the regulations would do well to consider these points. All past and all future rules for lenders and intermediaries will be based on this framework.

For firms who harboured any illusions that Mortgage Day was a one-off calendar event, the reality of day-to-day compliance will have been a stark reality check. Though the FSA has commented that some of its rules – Treating Customers Fairly in particular – require only minor changes to firms’ existing procedures, systems changes have been required in all firms. This has been a major undertaking and FSA feedback makes it clear that not all have implemented the required changes appropriately.

From the outset, an objective of the FSA was to separate firms experiencing teething problems from those wilfully disregarding the rules. Throwing out the cowboys and establishing a level playing field became standard clich矣urrency for the exercise. After the authorisation process itself, this formed an important priority for the FSA and was orchestrated through its ‘policing the perimeter’ exercise.

If some have been surprised at the absence of highly publicised enforcement or suspension proceedings, this is partly due to the fact that many firms likely to have grabbed such headlines were identified and removed by the FSA at this early stage.

Over 600 new applications were investigated by the FSA on a thematic or one-on-one basis with remedial action required in many cases, while a further 500 withdrew from the authorisation process. As of March 31 2005 the FSA had refused applications from 35 firms and 19 individuals, with reasons for doing so ranging from failure to disclose significant issues in the application, prior criminal convictions, previous regulatory problems and bankruptcy.

Following inspections of firms labelled higher risk some months later, 130 small authorised firms have also been forced to take remedial action in the past year while 30 more have lost their authorisations to do business. These actions resulted primarily from these firms’ failures to meet the threshold conditions. Three individuals were also prohibited for not meeting the FSA’s fit and proper requirements, highlighting the regulator’s powers over individuals as well as firms.

So what has the FSA found among its newly regulated mortgage firms? While AMI has managed a dialogue between the regulator and the regulated, the process has been a challenging one for both parties. Never before has a financial regulator been required to authorise over 14,000 (including general insurance) firms in such a short period. Equally, firms have had to meet their obligations under the new regulatory regime, from the threshold conditions through to periodic fee payment and regulatory reporting.

While the FSA quickly recognised that significant progress had been made by the mortgage industry in adapting to regulation, subsequent investigations have revealed failures in both lenders’ and intermediaries’ implementation of the rules. For intermediaries, the most common of these relate to weaknesses in record keeping, ‘know your client’ information and adequacy of disclosure documentation.

These themes have been identified during mystery shopping exercises into equity release, sub-prime lending, disclosure documentation and individual work carried out with firms over the past year by the FSA.

Of the new mortgage intake, the vast majority of newly authorised firms are small firms. Not only are most well below the 3m threshold distinguishing small from medium firms, the majority have fewer than five advisers. The FSA was keen to measure the compliance of these firms (numbering almost 7,000) six months into regulation. The review placed particular emphasis on some firms considered higher risk, due to issues relating to the authorisation process and other intelligence work. Firms which had not been previously registered with the Mortgage Code Compliance Board were also deliberately targeted for inspection.

Though the FSA reported that the overall findings from visits on 51 firms’ sales practices and training and competence were encouraging, several shortfalls were identified.

Failures

  • Three firms were referred to enforcement for non-disclosure of details which might have affected their application for authorisation in the run-up to Mortgage Day.
  • Having been found lacking in basic qualification requirements for mortgage advice, one firm agreed to cease trading when confronted on the issue.
  • Failures in fact-finding and ‘know your client’ information were also identified, particularly where firms had made no effort to provide evidence of the suitability of their advice.
  • Seven firms were found to have inadequate training and competence procedures, and no procedures in place for monitoring staff.
  • 13 firms were singled out for failing to record details of the reasoning used to make recommendations, with particular emphasis on shortcomings in product research and the suitability of recommendations made.
  • 11 firms had failed to obtain sufficient client information to be able to demonstrate the suitability of their recommendation. Details such as existing mortgage, attitude to risk and credit history were not obtained prior to recommendation in these cases.
  • 25 firms had either not issued IDDs or KFIs at the right time or had issued inaccurate documents.

Some positive behaviour was also identified. The FSA acknowledged that senior managers in most of the firms visited had clearly set out to engage with and implement the required systems and controls. This is particularly important in the sales process and training and competence areas, and the FSA even outlined some examples of compliant practices identified. These included:

  • Strong senior management understanding of the MCOB rules.
  • Significant improvements in staff training, with this documented and logged.
  • Sufficient procedures for evidencing the suitability of advice given – particularly where suitability letters and comprehensive file notes were being used as standard.
  • Sufficient evidence of product research, from sourcing to final recommendation, and file notes explaining the process.
  • Sufficient client information – in particular, identifying the key information required to assess clients” needs and circumstances, attitude to risk, affordability and details of existing financial obligations.
  • IDDs and KFIs were presented on time and inclusive of the required information set out in MCOB.

FSA action is still required in some casesWhile the regulator will focus on supervision and working with firms to correct basic failures, more serious failures prompted the FSA to issue warning notices and threaten enforcement action. Some examples included:

  • Senior managers in three firms had little or no awareness of MCOB requirements. The FSA issues a report on the failures identified and a timeframe for correcting them, with a date set for a follow-up inspection.
  • One firm agreed to suspend its mortgage permissions due to training and competence failures and a minimal understanding of the regulations.
  • Four firms were warned that serious deficiencies had been identified in their sales processes. Again, a detailed summary of the failings and timeframe for improvement was sent to them.

Sub-prime mortgage lending has developed massively over the past eight years. But given the problems experienced in the past and the vulnerable position many sub-prime borrowers find themselves in, the area was due for review early into the new regime, as was a simultaneous survey of firms’ procedures for debt consolidation. Details were fed back to the industry in September.

The FSA was keen to check firms’ procedures for ensuring the suitability of recommendations for sub-prime mortgage products, both in terms of the recommendations made and advisers’ understanding of sub-prime products – a clear MCOB requirement.

A sample of 31 small mortgage firms were visited by the FSA with sales processes and hundreds of customer files analysed in detail. Though again the survey revealed some good practices in the market, the FSA emphasised the need for significant improvements. In particular, firms were failing to adequately document the suitability of products and advice given.

In 60% of the cases viewed the FSA found insufficient information had been obtained about the customer. Worse, 80% of cases lacked any evidence to show how the recommended sub-prime product met the customer’s needs. The latter issue is a particularly dangerous one for firms. The FSA was unable to find documentation to evidence why the circumstances of the client matched the product recommended. Even if the recommendation made is suitable, firms who fail to document this risk complaints or FSA action as a consequence of record keeping shortcomings.

Where cases involved debt consolidation, firms were unable to demonstrate that they had taken account of additional debt consolidation requirements. This included insufficient regard to costs associated with increasing the repayment period, appropriateness of securing previously unsecured loans and whether it would be more appropriate to negotiate an arrangement with existing creditors where customers had repayment difficulties.

Again, the common failing identified in all the FSA’s feedback has been the lack of documentation to evidence the suitability of the advice process and what actually happened. Though the FSA notes some firms were able to provide a verbal summary during the sub-prime exercise the lack of documented evidence is a failing.

While the survey found record keeping failures, two aspects were highlighted as positive. A majority (65%) continued to issue suitability letters to customers while 58% of firms intended to review clients’ mortgages once their credit profile had been rehabilitated.

Where customers had taken out interest-only mortgages, suitability letters reaffirmed the implications to the customer such as the need to repay the capital element and the potential payment shock that could follow switching to capital and interest repayment. Both examples highlight the positive examples of TCF already in place in intermediary firms.

The FSA reminded firms after this exercise of the need for information gathering for sub-prime mortgages and that this should go well beyond that required for vanilla customers and products. Failures were identified in processes for demonstrating the suitability of sub-prime mortgage products recommended, as well as the relevant facts regarding the customer.

Weaknesses in assessing customers’ existing needs and circumstances, their debt position and details of existing mortgage arrangements and income were also highlighted as requiring improvement. In evidencing suitability, the FSA offered examples of measures firms could consider such as comprehensively discussing the fact- find with clients and producing a check list to show advisers have reviewed the additional considerations for debt consolidation with customers.

Similar feedback to that provided after the small firms exercise was given to firms, though immediate enforcement action was also taken against three firms in an area which has attracted press attention in the past – self-certification.

Three brokers were identified as having assisted customers in exaggerating income levels to meet lenders’ criteria. The FSA has been clear that such action will be considered fraud and the firms in question were referred to enforcement for the failures.

In May, FSA feedback on mystery shopping into equity release sales made disappointing reading. The regulator undertook 42 mystery shops with 20 firms between December 2004 and March 2005. Included within the sample were 11 visits to mortgage brokers, 19 to IFAs and 12 direct to providers.

The findings painted a poor picture of the quality of advice offered on equity release. While there were particular issues with investing for growth and unsuitable investment advice, the main concerns relating to non-investment firms were insufficient fact-finding and product knowledge.

The FSA said advisers did not gather enough information about their customers to assess their suitability for products. And 60% of the mystery shoppers used said the downsides of equity release were not explained to them. The feedback outlined some firms’ failure to meet the FSA rules.

It will come as little surprise that equity release – or lifetime mortgages – have been categorised by the regulator as high risk. Though this is principally due to the potentially vulnerable nature of eligible customers it also reflects the in-depth knowledge required to advise on these products.

While a firm must check that its professional indemnity policy includes cover for this line of business (and home reversions where appropriate) training and competence, systems and controls and ongoing monitoring systems must also be in place.

Messages from the regulator, AMI and lifetime lenders have reiterated this point. This is not a market to just dabble in and further mystery shopping is expected early in 2006 to check these issues are being addressed.

Getting to grips with the Initial Disclosure Document and the KFI – what went in them, when they are provided, and how they should look – presented the first major point-of-sale test for lenders and intermediaries. Though lender KFIs have been slashed from the novellas produced immediately after Mortgage Day, the regulator was moved to write a ‘Dear CEO’ letter to lenders urging them to address the problem. In particular, this was intended to remind lenders that the intention was for a four-page document, not a 14-page one.

Results published in August provided more disappointing feedback on firms’ compliance with disclosure documentation rules. Issues were identified in lenders’ and intermediaries’ processes for providing these documents to customers. In over 50% of assessments, firms failed to provide appropriate disclosure documentation at the right time and in one-third of cases the firms did not provide one or either of the disclosure documents.

While the findings indicate the need for improved staff training and monitoring, a key issue is the quality of advice, which was not assessed. Failure to produce documents on time and failing a client through poor advice are separate things. Regardless of this, many firms have had to reassess their disclosure document process and further mystery shopping work will assess how well this has worked.

But what about the intermediary? While it is clear many brokers will have to improve internal processes for providing disclosure documentation and record keeping, FSA compliance is a big issue to manage. For many small firms, and indeed many of the larger ones too, no summary of the ‘one year in’ experience is complete without mention of financial promotions and regulatory reporting.

Glancing through the Yellow Pages or daily newspapers has been exasperating for firms, judging by the levels of complaints against non-compliant financial promotions. The FSA has been surprised by the volume of advertisements clearly in breach of MCOB, not least since tip-offs from intermediaries have led them to identify these in many cases. Failure to disclose APR rates for sub-prime business or the representative cost charged by firms head the list of failures, though some were still rumoured to carry Mortgage Code disclosures.

While the FSA has a team specifically assigned to promotions, firms have found these rules confusing. Some guidance has been forthcoming but much work remains to be done to communicate the improvements the FSA expects to see in this area.

Most recently, regulatory reporting has been the big bete noir for thousands of small firms. While the basic premise for this – lender data checked against data supplied by intermediaries online – seemed a sensible and efficient process, the design of the Retail Mediation Activity Return has attracted criticism. Despite assurances the return itself would not need to be audited, many firms have struggled with the balance sheet information and terminology used.

Firms should be prepared and at least familiar with the forms in time for the next submission, but a need for clearer lines of communication between the regulator and the regulated has been identified.

Twelve months in, it is clear that both authorised firms and the regulator have much work to do before the FSA-regulated mortgage market works in a manner acceptable to both parties.

For intermediaries and lenders, the failures identified in the mystery shopping and thematic exercises must be addressed. Brokers have much to feel proud about in the way they treat customers but some firms are way off the mark. This must be addressed or the industry’s good reputation will be damaged by adverse publicity over compliance failures.

For the FSA, firms’ are adamant communications must be improved and that a perceived accountability deficit is addressed. Many small firms see the rulebook as being as distant from their day-to-day reality as Canary Wharf itself. A commitment to being a regulator “easy to do business with” is commendable and essential but hasn’t been reflected in firms’ experiences in applying the financial promotions rules or completing regulatory returns.

With reviews proposed of MCOB and ICOB over the next 12 months, chances will arise to improve some aspects. Firms should engage with the FSA and AMI in this process.

Finally, it is worth considering the pace of change which is part and parcel of FSA regulation. Just 18 months ago, the terms IDD, KFI, RMAR, MLAR, HLC, TCF, MCOB and ICOB would have been meaningless to most professionals in this industry. Now they are day-to-day realities.

Whatever point the mortgage industry has reached in its experience of FSA regulation, some things don’t change. Regardless of the regulatory backdrop, firms which adapt to challenges intelligently will be best placed to exploit their position and prosper.te the need for improved staff training and monitoring, a key issue is the quality of advice, which was not assessed. Failure to produce documents on time and failing a client through poor advice are separate things. Regardless of this, many firms have had to reassess their disclosure document process and further mystery shopping work will assess how well this has worked.

But what about the intermediary? While it is clear many brokers will have to improve internal processes for providing disclosure documentation and record keeping, FSA compliance is a big issue to manage. For many small firms, and indeed many of the larger ones too, no summary of the ‘one year in’ experience is complete without mention of financial promotions and regulatory reporting.

Glancing through the Yellow Pages or daily newspapers has been exasperating for firms, judging by the levels of complaints against non-compliant financial promotions. The FSA has been surprised by the volume of advertisements clearly in breach of MCOB, not least since tip-offs from intermediaries have led them to identify these in many cases. Failure to disclose APR rates for sub-prime business or the representative cost charged by firms head the list of failures, though some were still rumoured to carry Mortgage Code disclosures.

While the FSA has a team specifically assigned to promotions, firms have found these rules confusing. Some guidance has been forthcoming but much work remains to be done to communicate the improvements the FSA expects to see in this area.

Most recently, regulatory reporting has been the big bete noir for thousands of small firms. While the basic premise for this – lender data checked against data supplied by intermediaries online – seemed a sensible and efficient process, the design of the Retail Mediation Activity Return has attracted criticism. Despite assurances the return itself would not need to be audited, many firms have struggled with the balance sheet information and terminology used.

Firms should be prepared and at least familiar with the forms in time for the next submission, but a need for clearer lines of communication between the regulator and the regulated has been identified.

Twelve months in, it is clear that both authorised firms and the regulator have much work to do before the FSA-regulated mortgage market works in a manner acceptable to both parties.

For intermediaries and lenders, the failures identified in the mystery shopping and thematic exercises must be addressed. Brokers have much to feel proud about in the way they treat customers but some firms are way off the mark. This must be addressed or the industry’s good reputation will be damaged by adverse publicity over compliance failures.

For the FSA, firms’ are adamant communications must be improved and that a perceived accountability deficit is addressed. Many small firms see the rulebook as being as distant from their day-to-day reality as Canary Wharf itself. A commitment to being a regulator “easy to do business with” is commendable and essential but hasn’t been reflected in firms’ experiences in applying the financial promotions rules or completing regulatory returns.

With reviews proposed of MCOB and ICOB over the next 12 months, chances will arise to improve some aspects. Firms should engage with the FSA and AMI in this process.

Finally, it is worth considering the pace of change which is part and parcel of FSA regulation. Just 18 months ago, the terms IDD, KFI, RMAR, MLAR, HLC, TCF, MCOB and ICOB would have been meaningless to most professionals in this industry. Now they are day-to-day realities.

Whatever point the mortgage industry has reached in its experience of FSA regulation, some things don’t change. Regardless of the regulatory backdrop, firms which adapt to challenges intelligently will be best placed to exploit their position and prosper. l