Consumer Duty - business model impacts

This edition of the newsletter looks at Consumer Duty. Specifically, the potential impact on business models. And how firms could take the opportunity of regulatory change to make better decisions about strategy and resource allocation.

1????????Consumer Duty

Consumer Duty is not TCF 2.0, a mere extension of existing provisions regarding the fair treatment of customers. It is a much more wide-ranging initiative, and a clear statement of intent from the FCA that they are seeking an industry-wide shift in the treatment of retail customers. The Regulator is looking for firms to address some of the persistent issues they see in the marketplace:

• Firms providing information that is misleadingly presented or difficult for consumers to understand, hindering their ability to properly assess products/services
• Products and services that are not fit for purpose in delivering the benefits that consumers reasonably expect, or are not appropriate for the consumers they are being targeted at and sold to
• Products and services that do not represent fair value, where the benefits consumers receive are not reasonable relative to the price they pay
• Poor customer service that hinders consumers from taking timely action to manage their financial affairs and making use of products and services, or increases their costs in doing so
• Other practices which hinder consumers’ ability to act, or which exploit information asymmetries, consumer inertia, behavioural biases, or vulnerabilities

The Consumer Duty initiative combines a new Principle, cross-cutting rules, and four outcomes.

And it is easy to see how the application of these combined elements will have an impact across many sectors of financial services.

2????????Business model issues

It is often the case that Conduct Risk occurs when there is a misalignment between the business objectives of a firm, and reality – be that the reality of the competitive landscape, or that of regulatory constraints. Firms that fail to recognise these shifts in reality, find themselves operating outside of risk appetite, as they chase unachievable goals.

The new Consumer Duty principle represents a significant shift in the regulatory landscape. It will impact how products are made, marketed, administered, and priced – and those changes will inevitably feed through into conversion rates, sales volumes, operating costs, and profits.

The scale of these impacts will depend on the business model (and risk appetite) of individual firms. For those organisations that are principles-led and outcomes focussed, the shift may not be too great. For others, operating at the limit of the rules, and not necessarily within the spirit of the guidance, Consumer Duty could present an existential threat.

Firms should be acting now to assess where the issues and pressure points are, and how the proposed outcomes and cross-cutting rules will impact their businesses.

2.1????????The product and service outcome

The Regulator is concerned with how products are made and also how they are distributed. The FCA expects manufacturers to develop products that are designed to meet the needs of a defined target market. And that the distribution process acts in the interest of customers, and ensures products reach their intended target customers.

The requirements of the product and service outcomes will be familiar to those currently operating under the PROD rules. But firms should note the additional overlay of the cross-cutting rules – the requirement to act in good faith, and to avoid foreseeable harm to customers.

These additional considerations mean there will certainly be some products that operate counter to the expectations of Consumer Duty, because they exhibit:

• Excessive complexity – which makes it difficult for customers to assess and compare costs, risks, and benefits or exit fees
• Unsuitability – where the product has been targeted at, or sold to, customers for whom it is not suitable
• Sludge practices – the FCA has highlighted a number of activities and elements of product design they consider to be causing consumer harm

Consumer Duty also presents challenges with how products are moved from manufacturing to sale. The FCA has long had issues with what it perceives as complicated distribution chains which add little value to consumers. They have recently acted in the Funeral Plan sector and outlawed commission payments to intermediaries – which has severely impacted the viability of that model.

Under Consumer Duty, there will be an onus on manufacturers to ‘select distribution channels that are appropriate…’ and to consider the cross-cutting rules. It is therefore easy to see that there will be challenges to some current distribution models. ?

Questions for manufacturers

• Can I demonstrate the tangible benefits my product provides to a clearly identified group of customers?
• Can I evidence that my product is being sold to, and bought by, these target customers?
• Is the distribution model acting in the interest of customers (as opposed to the interests of those firms in the distribution chain)?
• Do I understand how my product is sold, and to whom?
• Is there a clear (contractual) delineation between manufacturing and distribution? And in the roles and responsibilities of those parties in the distribution chain?
• Can I demonstrate an effective and well-documented process for onboarding distributors, for new product development, and for ongoing review (including the review of back-book products)?
• Can my senior managers evidence they have taken reasonable steps to: assess the products, monitor their sales, and take action to address customer harms?
• Can I easily exit an arrangement (both from a contractual and commercial standpoint), if it exceeds risk appetite?

Questions for distributors

• Is my role in the distribution process adding value to the customer?
• Do I understand, and monitor, the benefits customers are receiving from the product?
• Is there a clear (contractual) delineation between my role, and that of the manufacturer, and other parties in the distribution chain?
• Can I demonstrate an effective and well-documented process for assessing the conduct risk of new distribution arrangements, and the ongoing monitoring of existing arrangements?
• Can my senior managers evidence they have taken reasonable steps to: assess the products, monitor their sales, and take action to address customer harms?
• Can I easily exit an arrangement (both from a contractual and commercial standpoint), if it exceeds risk appetite?

2.2????????The price and value outcome

Price goes to the heart of the business model. And we’ve seen with price interventions in the General Insurance and HCSTC sectors that the FCA can make a significant impact on a market.

When considering price and value, a key acid test is – where are the profits made? If the business model is built on cross-subsidies and tangential revenue streams it has inherent weaknesses. If the majority of profits are coming from areas the customer (or the Regulator) wouldn’t expect, the model is open to challenge. PPI was the classic example of this issue, where the underlying loan was merely a vehicle to enable the sale of the profitable insurance add-on.

With Consumer Duty, the Regulator has put the onus on firms to undertake fair value assessments, and ensure the total price paid by consumers is reasonable in relation to the benefits offered by the product or service.

Price and performance are also areas where firms have significant reticence about sharing information with each other. However, if manufacturers and distributors cannot obtain sufficient detail, in order to undertake a value assessment, it will be very difficult to justify the continued sale of the product.

Questions for manufacturers

• Do I fully understand the nature of the product, and its benefits and limitations (as experienced by the end customer)?
• Do I know the retail price that will be paid by the customer (at point of sale, and over the lifetime of the product)?
• Am I able to obtain sufficient information from distributors to make an assessment?
• Based on the consideration of price and benefits, am I comfortable that I could demonstrate that the product represents fair value?
• Does the product remain fair value over a reasonably foreseeable timeframe (e.g. through the renewal cycle, or with ongoing charges)?
• Could I demonstrate fair value across all customer types – including vulnerable customers who may have a different experience of the product?
• Does my value assessment hold true for closed book products?
• Are my senior managers clear they will be accountable for the outcomes of the value assessments?

Questions for distributors

• Do I fully understand the nature of the product, and the benefits and limitations the customer receives at point of sale, and ongoing (e.g. investment performance, or claims outcomes)?
• Am I able to obtain from the manufacturer sufficient information in order to make a value assessment?
• Can I demonstrate that the services I provide add value? At the point of sale, and over a reasonably foreseeable timeframe (e.g. with ongoing charges)?
• Can I demonstrate this value objectively, and also in comparison to other distribution methods (e.g. direct sales channels)?
• Could I demonstrate fair value across all customer types – including vulnerable customers who may have a different experience of the product?

2.3????????The consumer understanding outcome

With Consumer Duty, the FCA is not removing the obligation for customers to make their own decisions as to whether a product is right for them or not. But this is predicated on the assumption that customers will be provided with sufficient information in order to make that assessment.

In the Regulator’s view, there are many instances where firms are using information asymmetries and the exploitation of behavioural biases to sell products that customers would not have purchased – if they had fully understood the costs, benefits, and limitations.

The Regulator has concerns about what is communicated, and when and how. And it is the timing and channel considerations that will have the greatest potential impact on the business model. Online, robo-advice, and app-based channels are convenient and cost-effective for firms, but will they stand up to scrutiny when looked at through a Consumer Duty lens?

Questions for firms

• Are your communications tailored to the information needs of the identified target markets?
• Does this include vulnerable customers (in particular when considering the customer vulnerability of financial unsophistication)?
• Is your sales channel suitable for the complexity of the product, and the information needs of the target customers?
• How do you assess whether customers understand the information you have provided to them (particularly via online channels)?
• How do you use MI and monitoring to assess the effectiveness of your communication (e.g. complaints, claims declinatures, early cancellations)?
• Does your sales model benefit from customers: misunderstanding risks and benefits, being time-pressured, exhibiting inertia, having limited other options?

2.4????????The customer support outcome

The FCA refers to ‘sludge practices’, they have seen in the market – processes they consider to be designed to hinder consumers from taking action that would benefit them. These include excessively complicated procedures which drain a customer’s time, and present a barrier to achieving objectives – e.g. switching a product, making a claim, or lodging a complaint. Or delays in processing instructions which may mean customers lose opportunities or incur costs. Or processes that work for the benefit of the firm, not the customer (e.g. automated processes rather than contact with support staff).

Equally, there could be potential problems with the customer support outcome when excessive cost-cutting at firms leads to poor service and customer detriment, or when firms fail to invest in resources and infrastructure to keep up with growing customer demands.

Questions for firms

• Do you invest proportionally more in pre-sale service delivery, than post-sale?
• Do you have the capacity to deal with reasonably anticipated levels of customer demand?
• Do you have an appropriate framework in place to make your processes more resilient to incidents and outages, and to enable you to recover quickly when incidents and outages occur?
• Do you provide an appropriate standard of support to all customers – including those with low-value or closed-book products?
• Does your service provision accommodate the needs of vulnerable customers (in all their variants)?
• Do customers need to take unreasonable steps to achieve their objectives (e.g. switch, cancel, claim, close, complain)?
• Does your business model benefit, in any way, from practices that hinder the customer from taking action which would benefit them?
• When making changes to service delivery (e.g. going online-only or using robo-advice), can you evidence that you have taken into account customer outcomes (including vulnerable customers)?

3????????Assessing the impact of Consumer Duty

As noted, Consumer Duty will have differential impacts across various areas of financial services. Equally, within firms, individual products, processes, and services will present varied levels of risk. Firms should review their whole product portfolio through the Consumer Duty lens, and take an honest assessment of risk and reward. Too often I see instances of firms marketing high-risk products which are making little positive contribution to their bottom line.

The outcome of the product assessment will inevitably have some negative impacts (the challenge to the viability of some products) but equally, there will be positives (a greater understanding of which are the true ‘stars’ of the portfolio), as firms decide to:

• De-list – remove a product from the portfolio, because it cannot be brought within risk appetite.
• Develop – where products are profitable, but additional resources are required to ensure the risks can be controlled.
• Review – for borderline products, firms should be cautious of the temptation to increase risk, in order to push a product over the economic hurdle.
• Invest - products that are profitable and within risk tolerance are the stars of the portfolio and investment should be increased.

3.1????????Cost of control

In undertaking the product portfolio analysis, it is important for the business to have an honest conversation about the true costs – in this, ‘cost of control’ is just as important a consideration as ‘cost of funds’ or ‘cost of sales’.

These control costs are tangible, and can be quantified:

• Uplift of headcount within the control functions
• Increased budgets for staff training, to ensure they understand complex products
• More resources for Quality Assurance teams, to check a greater proportion of sales
• An uplift in call volumes and ‘average handling time’ to make sure customers understand what they are buying
• Increased system and process costs
• Fines and redress

All these costs should be acknowledged and apportioned, with the true costs of higher-risk products being recognised.

Firms that pay as much attention to Conduct Risk as they do to Liquidity Risk and Credit risks will gain competitive advantage by drilling down into the variables, and achieving more efficient resource allocation.

3.2????????The impact on the business model

The final, and most important, part of the process is to take the findings from the analysis and apply them to sales targets and forecasting. Returning to my earlier point about the gap between strategic objectives and reality – firms need to be realistic about future sales and revenue projections, in a Consumer Duty world.

3.3????????Finance as Consumer Duty champions?

Bringing Finance into the conversation on Consumer Duty, and the overall control of Conduct Risk, can have a huge benefit in this process. Finance can play a key role in helping to identify products and services which are bad for customers, and bad for the bottom line.

When SMCR was introduced, it was always a surprise how little emphasis was placed on the role of CFOs - considering how central they are in decisions on costs and forecasting. In too many firms, CFOs are SMFs without portfolios – on the responsibilities map, but allocated very little actual responsibility for the control of Conduct Risk

Questions for firms

• Does Finance understand regulatory risk?
• Do they understand that a sharp increase in monthly sales can be a cause for investigation rather than a cause for celebration?
• Do CFOs merely act as a postbox, distributing next year’s revenue forecasts from the Board to functional heads, or do they provide challenge on the viability of the numbers?
• Are Finance regularly meeting with the 2nd Line in order to understand, and contribute to, their role in controlling risks
• Does the CFO have responsibilities and role profile requirements related to the control of Conduct Risk?

4????????Conclusion

Consumer Duty will be a challenge for many, and a problem for some. But approached in the right way it can prompt a raising of standard, both within firms and across the market – which can only be of benefit to those looking to develop sustainable business models. It is to everyone’s gain if a greater share of the consumer wallet goes to products and services which are fit for purpose.