Prudential requirements

Following on from recent articles on the Retail Distribution Review (RDR), this week I want to highlight the fourth issues paper published by the Association of Independent Financial Advisers (AIFA).

The topic for this paper is the ‘prudential requirements’ – no yawning please.

The RDR doesn’t directly affect mortgage intermediaries, but the potential read-across is there to see, so mortgage intermediaries need to be aware of the key issues.

The issues papers are available for all to download from AIFA’s website, and are well worth a read.

Capital requirements

The RDR, and associated prudential requirements consultation makes a big play of the use of regulatory capital as a tool against mis-selling.

This includes the idea that those in charge of small firms are encouraged to promote better working standards by having their own capital tied up in a business – and that perhaps by increasing capital requirements it would create a stronger sense of professionalism.

It also suggests that capital is crucial in meeting compensation costs arising from complaints, as more claims could be paid from capital keeping the firm in business, rather than reverting to the Financial Services Compensation Scheme (FSCS).

At present a small mortgage firm needs to hold £5,000 in capital, increasing if they are particularly large or a network. This is a relatively historic figure, set at half the level needed to be held by an IFA, which itself was set years previously.

However, I am yet to be convinced by the need for more capital for mortgage intermediaries for several reasons. Quite aside from the fact that mortgage brokers have such a low level of complaints with the Financial Ombudsman Service (FOS) – under 3 per cent at the last count – I think it is difficult to see how capital affects mortgage advice and complaints.

Firstly, and as acknowledged in Financial Services Authority’s (FSA) research, the vast majority of complaints in the IFA community that lead to a claim on the FSCS stem from firms that have ceased trading over three years ago.

That to me certainly doesn’t suggest that firms are leaving the industry to avoid claims – ‘over three years’ would require rather a lot of foresight by a firm and plenty of time to rectify practices if necessary.

What I rightly see is a number of firms, particularly smaller organisations, where principles work hard all their life and retire. The industry is strong, but advisers are still mortal.

The second issue relating to this is professional indemnity (PI) insurance. While firms may have to make good excesses, surely PI cover should protect them against larger claims?

To that extent, regulatory capital is less relevant than robust PI insurance. Perhaps a review of the availability, exclusions and scope of this would be useful.

Thirdly is the fact that actually, most firms hold more than the minimum level of capital – with some holding considerably in excess of this. Tying up working capital could have a negative impact on the financial stability of a firm.

Not a behaviour driver

Overall though, my feeling is that regulatory capital is also not seen as a behaviour driver in the mortgage market. I genuinely believe that firms advise on the best outcomes for their clients, and that the presence of £5,000 or £50,000 of capital would make little impact on the behaviour of owner-advisers, and is clearly irrelevant to employees or to appointed representative firms.

What I think is more pressing, and that is identified in the consultation, is the idea of a ‘long-stop’ on advice. At present, the FOS actually works beyond natural law with no long-stop on complaints.

This means a firm can suffer complaints on an indefinite basis without limitations – never has a 35-year mortgage term looked so compellingly litigious.

What the paper does recommend – and something that I would wholeheartedly welcome being read-across to mortgage advice – is a long-stop, albeit if only set at 15 years.

This would allow firms to actually close cases off – and actually sleep tight in their retirement – knowing that after 15 years they no longer had liability for cases written.

Other points

Two other points worthy of consideration – firstly, the Markets in Financial Instruments Directive (MiFID) in Europe. MiFID is a maximum harmonisation directive for investment financial advice.

This sets capital at 25,000 with certain PI requirements. If the FSA wanted to significantly increase regulatory capital, it is difficult to see how it could justify this to the commission.

Secondly, and I think most importantly, is the example of AMI. We are a not-for-profit organisation. Why? Because we believe the best place for our members’ money is with them – working in their businesses.

Surely allowing a firm control of its own capital will allow it to be the most robust business, which is best for the industry overall?

As always, do read the issues paper – and think how this could translate into the mortgage intermediary advice market. The more educated we are on the issues now, the more prepared we will be for the future.