Compensation scheme funding arrangements to be split as part of regulatory shake-up, FSA says

It is consulting (141-page / 3MB PDF) on changes to the way the Financial Services Compensation Scheme (FSCS), which can pay compensation to eligible customers of financial firms, will be funded once the FSA's regulatory responsibilities are divided between the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) from next year.

The regulator has not, however, proposed any changes to the existing funding class structure, citing the lack of a "suitable alternative".

Sheila Nicoll, the FSA's director of conduct policy, said that the regulator had tried to "walk the middle ground" with its proposals, recognising the competing interests of the different sub-sectors within the financial services industry.

"A viable compensation scheme is essential to financial services – investors and savers need to have confidence," she said. "The industry can agree on that, but as soon as it comes to discussions about funding, all such agreement immediately breaks down. Any changes that we make have to produce a system that is as fair as possible, but ultimately plays its part in underpinning confidence in the financial services sector."

The FSCS can pay compensation to customers if a regulated financial services firm – including banks, building societies, credit unions, insurers, fund managers and intermediaries – goes out of business or is otherwise unable to pay claims made against it. The scheme is funded by contributions from over 16,000 participating firms, based on their 'funding class' or the type of businesses that they carry out.

The existing funding model has been in place since April 2008. However over the past four years "significant payouts", including to customers of failed investment firms Keydata and MF Global, have led to "sizable levies" on some funding classes – which, in some cases, have had to be clawed back in the form of additional "interim levies" charged halfway through a funding period.

A review of the scheme initially began in October 2009 but was suspended the following year due to the uncertainty surrounding regulatory reform and the ongoing development of EU directives on deposit guarantee schemes.

Firms covered by the FSCS are organised into five broad classes – deposits, investments, life and pensions, general insurance and home finance – with two sub-classes in each broad class which are generally divided along provider and distributer lines. The amount of compensation each sub-class could be required to contribute in a given year is limited, with the other sub-class in its broad group required to contribute if this limit is breached. After this all other classes can be required to contribute.

Under the revised funding model activities, such as deposit-taking and insurance provision, which will be subject to the PRA's funding rules, will be subsidised separately to the "other activities" that will be subject to the FCA's funding rules. The FSA said that there would be no "cross-subsidy" between the two. This means that only those 'retail' classes subject to the FCA's funding rules will be required to make additional contributions if one or more of those classes reach their annual contribution limit for the funding year.

The FCSC will also be required to consider the potential compensation costs expected over a 36-month period, rather than over 12 months as is currently the case, which the FSA said should "smooth the impact" of charges and make funding requirements "more predictable" than is currently the case.

The FSA was recently reorganised internally into a 'twin peaks' model, intended to reflect the new regulatory structure under the draft Financial Services Bill. The changes are due to come into force from 2013. From this point the PRA will handle most of the day-to-day regulation and supervision of banks, building societies and insurers, while the FCA will take over consumer credit regulation from the Office of Fair Trading as well as take on the FSA's current conduct and compliance roles.

The Investment Management Association (IMA) described the proposals as "shocking and astonishing", arguing the financial burden of large claims should be split between all contributing firms. Intermediaries were forced to pay an additional levy amounting to approximately £160 per £10,000 of annual eligible income earlier this year as a result of "higher than average" payouts on Keydata due to the way classes were divided.

"These proposals expose different types of firms to completely different liabilities in a totally inequitable way," IMA chief executive Richard Saunders said. "Banks and insurers, which will in future be regulated by the PRA, are looked after in their own scheme with no exposure to cross-subsidy. But fund manufacturers, to be regulated by the FCA, will not only be responsible for compensation arising from the failure of fund managements firms but will also be obliged to stand behind excessive claims from the failure of distributors who mis-sold products of any type. These proposals send an appalling message to any global asset management firm deciding whether or not to locate in the UK."