CONDUCT AND PRUDENCE: THE NEXT ACID TEST FOR FINANCIAL SERVICES?
Following on from the news that the Co-Operative Bank is to be investigated by both the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) for its £1.5 billion capital shortfall, Jim Muir, director of AutoRek, examines the impact of this latest announcement on the financial services market.
It comes as no surprise that the UK’s financial regulators have decided to launch a formal investigation into the events which led to Britain’s largest mutual, the Co-Operative Bank, revealing a £1.5 billion capital shortfall. The FCA’s investigation will focus on the information that the Bank reported in its financial statements about its capital position and will go back as far as 2006. In contrast, the PRA is undertaking an enforcement investigation that will also decide whether former executives should face fines or bans from the financial services industry.
The Co-Operative Bank is not alone in battling capital adequacy requirements. In 2013, an investigation by the Financial Policy Committee (FPC) warned that UK banks needed to find £25 billion in additional capital to cover losses on high risk loans, future compensation claims for mis-selling scandals and other risks. Since the investigation, the PRA has been responsible for meeting with UK banks to understand the extent to which they are undercapitalised and agree a strategy for addressing it.
The increasing focus on creating better capitalised banks reflects the regulator’s commitment to preventing another global crash. A recent survey revealed that nearly half of financial services executives currently believe the next major financial crisis is likely to be caused by a failure of financial controls. As a result, regulators are placing more emphasis on organisations’ financial stability and highlighting the importance of good governance to prevent the level of global contagion seen over the past four years.
The joint approach by the two regulators will see formal assessments of a risk of a temptation to engage in bad behaviour brought about by a shortfall of capital. The regulators are also likely to start imposing stricter sanctions on individuals who are reckless with clients’ money and assets.
In the year ahead, regulators will be introducing new measures,including criminal charges and potentially clawing back bonuses or pensions, to make the impact of non-compliance even more severe on individuals responsible for breaches of governance. Currently, just over half of executives (53 per cent) appreciatethat failure to comply with financial controls could jeopardise their job or their future career prospects. Of those, more than one-third of respondents (34 per cent) felt that they would lose their job as a result of a critical breach in the financial controls agenda, and just under one-fifth (19 per cent) reported that their career prospects would be damaged, even if they did keep their job.
Conduct and prudence
There will also be a heightened focus on holding those who neglect to institute simple financial controls accountable as the regulators closely examine the conduct of individuals and their approach to creating prudent financial markets. Measures such as reconciliations, record keeping and the segregation of duties form the basis of control frameworks that can help identify any anomalies and ensure that suspicious activities are escalated and resolved in a timely manner.
In addition, many banking organisations will be forced to prioritise investment in core modern banking infrastructures. Currently, most financial institutions cannot afford the risk associated with ripping out spaghetti systems so are surviving on systems that are one or two generations old. By creating modern infrastructures that bring together different feeds from legacy systems, there will be an opportunity to provide regulators with a clear report on where capital sits, how client assets are being handled and what protections are in place in the event of a failure.
Optimising systems will also generate a single view of customers. In a competitive economic environmentand an industry with low margins, it will become imperative for financial organisations to gain a better understanding of their customers and how they are using business services. Only then is it possible to understand customer needs and develop a proposition that ensures firms are delivering the right level of service and contact at all times.
However, stricter governance practices will come at a cost. As both the FCA and PRA take a tougher stance on breaches of financial controls, it is likelythat we will start to see smaller players exit the market as they struggle to meet demands for better integration of “conduct” and “prudence” practices and become closed-book organisations, be acquired or simply close.
The siloed nature of financial organisations, tougher regulatory requirements, the competing demands of different stakeholders and desire to return to growth and profits as quickly as possible has already changed the way that financial institutions operate. However, volatile earnings from some institutions should act as a warning that banks have not yet finished the transformation. Instead, financial institutions will be forced to prioritise technology investment, reconfigure operations, deliver the stable returns demanded by investors and dedicate more resource to proving compliance with financial controls.