FSA finds flaws in risk tools

13 January 2011 | By Natalie Holt

The FSA has warned advisers against relying on risk-profiling tools after identifying weaknesses in nine out of 11 tools it reviewed.

It published the findings of the review last week as part of a guidance consultation paper. The review looked at tools designed in-house by firms and those provided by third-parties, including platforms.

The regulator declined to specify which tools it found to have weaknesses but the paper includes examples of good and bad practice to help firms gauge if their processes are suitable.

The FSA says: “Tools can usefully aid discussions with customers by helping to provide structure and promote consistency. But they often have limitations which mean there are circumstances in which they may produce flawed results.

“Where firms rely on tools they need to ensure they are actively mitigating any limitations through the suitability assessment and ’know your customer’ process.”

The proposed guidance has been compiled based on cases from previous thematic work and a sample of riskprofiling and asset allocation methodologies used by banks, insurers, IFAs, discretionary and advisory investment managers, networks, platform providers and third-party tool providers.

The FSA also reviewed files from within firms where it had previously identified suitability assessment failings.

It found that of 366 investment files found to be unsuitable between March 2008 and September 2010, over half were deemed unsuitable because the investment selection failed to meet the customer’s attitude to risk.

The FSA acknowledges these figures may not reflect the quality of discretionary management or pension and investment advice across the whole of the market, as the review in some cases focused on higher-risk firms.

Despite this, the regulator says the level of failure in this area is “unacceptable”.

It found many firms it reviewed considered attitude to risk but did not take into account the client’s ability to absorb a fall in the value of their investment. The FSA argues investment selection should reflect both the clients’ willingness to take risk and their ability to do so.

It expresses concerns that client risk questionnaires often use poor question and answer options, have over-sensitive scoring or attribute inappropriate weighting to answers.

The FSA also says some firms are failing to have a robust process in place to identify customers who would be better off putting their money in cash deposits because they have a low appetite for risk.

Others areas of concern highlighted by the FSA guidance include poor description of risk categories and a failure to match the asset allocation with the customer’s risk profile.

The FSA is also concerned some firms focus too much on customers’ risk profile and do not take account of their other needs, for example those better suited to paying down debt rather than investing.

It says: “As we apply our intrusive and intensive supervisory approach, we will be looking to see how firms have acted on this report. We will consider, for example, whether firms have robust procedures, tools and risk category descriptions to establish and check the level of risk a customer is willing and able to take, as well as assessing the suitability of investment selections.

“We expect to see improvements in the standards of advice and private client discretionary management and will continue to take tough action where we identify poor practice.”

Firms wanting to respond to the guidance consultation should do so by January 28.

Finance & Technology Research Centre director Ian McKenna says: “I would hope that this marks the start of the dialogue between the FSA and the industry around risk-profiling tools rather than simply a brief foray into the area.

“Ultimately, it is essential that firms understand the process that is going on. Some of these tools are complicated and there are real risks if firms just adopt tools without getting to grips with how they work.”

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