The industry has welcomed “sensible” FCA proposals to move to an income-based measure for capital adequacy requirements.
In a consultation paper published last week, the FCA proposed requiring firms to hold 5 per cent of the income earned in the previous year, or a minimum requirement, whichever is higher.
From 30 June 2016 the minimum requirement will be £15,000, up from £10,000 currently. This will increase to £20,000 on 31 July 2017.
In September 2013, the FCA delayed new capital adequacy rules for advisers for the third time and said it planned to carry out a “fundamental review” of the proposals.
It had been due to introduce rules in December which would require firms to hold the greater of one month’s expenditure or £15,000 in capital, rising to £20,000 by December 2017.
But in February Money Marketing reported on industry concerns that basing the requirements on firm spending incentivised risky business models, such as those based on self-employed advisers with 100 per cent variable pay.
Personal Finance Society chief executive Keith Richards says: “The expenditure-based rules would have had very different implications depending on the size and model of a firm.
“Firms which have invested in employed adviser models or comprehensive support structures would have been the most impacted, and it is clear this was an unintended consequence the FCA wanted to address.
“The new proposals are sensible and show the regulator has listened to feedback.”
The Consulting Consortium director of advisory services Colin Wilcox says: “The proposals are a pragmatic step forward that should be largely fair to most firms and will be simpler to manage than an expenditure-basis calculation.
“Elements of the expenditure-based model were incompatible with the outcomes the RDR is seeking to achieve, so there is no surprise the approach has changed. Given the frequently delayed higher minimum requirements, most firms should be well on their way towards holding more capital.”
In its paper, the FCA noted the average Financial Services Compensation Scheme redress claim related to pensions or investments is £11,000, compared to the £10,000 current cap-ad minimum.
The regulator points out that an advice firm holding the minimum cap-ad with a professional indemnity insurance excess of £5,000 would only need to receive two legitimate claims to leave it with insufficient capital.
The FCA also admitted firms that hired more compliance staff or paraplanners could be penalised under the current framework where they have more than 25 advisers, as this would tip them over into having to work out their capital based on spending.
The regulator says it is concerned about this “cliff edge” effect for growing advice firms, and that the current rules “do not mandate enough capital for smaller firms”.
A full cost-benefit analysis has not been carried out because the FCA believes it is not “reasonably practicable” to quantify the benefits, as this would require modelling how firms are likely to behave under the new rules.
It has calculated that had the proposed cap-ad rules been in place, the FSCS levy would have fallen by £4m over seven years. This is compared to average annual payouts of £147m.
The FCA says: “To reduce the levy in a meaningful way would require much higher levels of capital resources to be held by each individual personal investment firm, which we feel is likely to be prohibitive for some smaller firms.”
It adds: “We believe it is appropriate for personal investment firms that may cause consumer harm to have the resources to put right their wrongs.”
Independent regulatory consultant Richard Hobbs says the estimated impact on FSCS levies shows the FCA’s proposals are like “moving the deck chairs around on the Titanic”.
He says: “Income does correlate to risk more strongly than expenditure, as the more business you do the more scope there is for things going wrong.
“But capital adequacy is never going to be enough to deal with the types of misselling claims we have seen in the past. If a firm is subject to a past business review it will fall on the FSCS regardless.”
Peter Chadborn, director, Plan Money: “Income is a reasonable measure as that implies either you have advisers writing high volumes of business, or you have a lot of advisers. The most important thing is that it is easy to calculate – and we are used to using income as a measure for things like professional indemnity cover.”
Capital adequacy rules: How we got here
November 2009: FSA publishes a policy statement on changing the minimum capital requirement from £10,000 to £20,000, and introducing an expenditure-based requirement of three months spending. The rules are set to come into effect on 31 December 2011
August 2011: FSA defers introduction of new rules until 31 December 2013
September 2013: FCA delays implementation again until 31 December 2015
May 2015: FCA consults on introducing income-based requirement for assessing capital adequacy rather than an expenditure-based one, as well as the minimum £20,000 level. Firms will have to set aside whichever is higher, with transitional rules starting from 30 June 2016