Written Evidence submitted by Financial Conduct Authority (FCA)

[SME 0140]

1         The FCA welcomes the inquiry of the Treasury Select Committee into lending to SMEs. We recognise that there are significant challenges to regulating the market for financial services for SMEs.  The regulatory perimeter is complex, high-profile issues have raised questions about banks’ treatment of SME customers and the regulatory response to these issues may be difficult for SMEs to understand.  To assist the Select Committee its inquiry, this submission sets out:

(i)                    FCA powers;

(ii)                   FCA approach;

(iii)                 recent FCA initiatives; and

(iv)                 challenges for future regulation.

Section 1: FCA powers

2         The FCA’s powers in respect of SMEs vary according to the financial service being provided by their bank or finance company.

3         The Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (“RAO”) is secondary legislation, made by HM Treasury, which sets the perimeter for regulated financial services under the Financial Services and Markets Act.  The RAO is based on activities that are carried on in respect of specified financial products.  In most cases, the scope of a regulated activity is not dependent on whether the customer is an individual consumer or a business though there are some exceptions.[1] 

4         Firms carrying on regulated activities generally require authorisation and the FCA Handbook details the different rules that apply to these activities.  Examples of regulated financial services used by SMEs include bank current accounts, contracts for difference such as interest rate hedging products (IRHPs) and insurance.  With the exception of those loans to SMEs covered by mortgage or consumer credit regulation (see further below), traditional bank lending to businesses, including SMEs, is not a regulated activity.

5         On 1 April 2014, the FCA became responsible for consumer credit regulation.  Lending money to borrowers, offering goods or services on credit, or engaging in specified ancillary credit activities, are now regulated activities under the RAO.  This includes lending to sole traders and small partnerships, but only up to £25,000.  Lending above £25,000 is unregulated if it is wholly or predominantly for business purposes.  Loans to limited companies and other corporates will remain unregulated.

Payment Services Regulations

6         The Payment Services Regulations 2009 contain an authorisation regime for non-bank payment service providers, and conduct of business rules for both banks and non-banks providing payment services.  The regulations apply to transactions with all retail customers, small charities and micro-enterprises – i.e. businesses employing fewer than ten persons and with a turnover or annual balance sheet that does not exceed €2 million.  Payment service providers may agree with larger corporate customers (i.e. including SMEs that are larger than micro-enterprises) not to apply some of the conduct of business protections.

Competition Powers and Payment Systems

7         The Financial Services (Banking Reform) Act 2013 provides the FCA with concurrent competition powers, which apply to financial services generally rather than the specific activities and products listed in the RAO.  From the date these powers become effective (expected to be April 2015), the FCA will therefore be able to investigate corporate lending from a competition perspective, even though this is not a regulated activity under FSMA.

8         From April 2015, the new UK payment systems regulator will become fully operational.  One of the new regulator’s objectives is to ensure that payment systems are operated and developed in a way that takes account of and promotes the interests of service users, including SMEs.

Complaint Handling, Ombudsman and FSCS access

9         Authorised firms are required to follow FCA complaints-handling rules in respect of almost all regulated activities and some unregulated activities.  These rules generally only apply to complaints from so-called “eligible complainants” which includes businesses that are micro-enterprises.  For example, a complaint by a micro-enterprise about business lending over £25,000 would be covered by the complaints-handling rules even though business lending is not regulated under FSMA.  Micro-enterprises would also generally be able to refer such complaints to the Financial Ombudsman Service (“the FOS”).

10     The Financial Services Compensation Scheme (FSCS) uses the Companies Act 2006 definition of a small company to determine whether the company is eligible for compensation under the scheme.  For these purposes, a company is a small company if it meets any two of the following: turnover not more than £6.5 million; balance sheet not more than £3.26 million and no more than 50 employees.  Sole traders would also be eligible to claim under the scheme and there are separate size limits for partnerships that are eligible to do so.

Section 2: FCA approach to SMEs

Regulated Activities

11     Our approach to protections for SMEs using regulated financial services reflects the risks posed by different financial services and products to customers, which in part reflects EU legislation.  This enables us to offer differing levels of protection to small businesses depending on their size and the risks and complexities of the products in question. 

12     The conduct of business rules relating to banking, payment services and mortgages (subject to the additional limitations referred to above) use simple metrics to determine which businesses are covered.[2]  Businesses that exceed these metrics may still be protected by other FCA rules, for example, the FCA’s Principles for Businesses, and the FCA could still take enforcement action in respect of breaches of Principles which occurred in relation to these activities.

13     For investment products, there are two main categories of client – retail clients and professional clients. Retail clients would generally include smaller businesses these would be afforded more robust regulatory protection under our conduct of business rules than professional clients who are assumed to be capable of making their own investment decisions and understanding the risks involved in the particular transactions or services envisaged.[3]  Clients may have different classifications for different financial services and products.

14     As noted above, lending to sole traders and small partnerships is regulated under the new consumer credit regime up to £25,000 but all loans to corporate entities (such as limited companies) are excluded.  This regulation comes from a mix of requirements under the Consumer Credit Act 1974 (CCA), and FCA rules in the Consumer Credit sourcebook (CONC) of the FCA Handbook. In general, the CCA requirements and our rules do not distinguish between lending to individual consumers and lending to sole traders or small partnerships. However, our rules – for example on creditworthiness – are based around broad principles which are intended to be applied proportionately by lenders.  We do not therefore prescribe what checks must be made on affordability; this is for the commercial judgement of the lender, acting reasonably, having regard to the nature and amount of the credit and the potential risks to the customer.  As part of this, we expect lenders to take into account the sophistication of the individual borrower.

Unregulated activities 

15     For unregulated activities, including traditional bank lending to SMEs, the FCA’s powers are limited.  However, in determining whether a firm is suitable to carry on regulated activities, the FCA can take into account a firm’s behaviour in respect of unregulated activities.  For example, the behaviour of an authorised firm in respect of unregulated activities may be so serious that it called into question the firm’s ability to satisfy FCA threshold conditions in relation to suitability. 

16     Under its general rule-making power the FCA is able to make rules which apply to authorised persons in respect of regulated and unregulated activities.  However, the rule making power, like many of the FCA’s other powers, is linked to advancing its operational objectives. 

17     In broad terms, the FCA’s consumer protection objective is about protecting users of regulated financial services in their capacity as such and therefore the consumer protection objective does not generally apply to a person using unregulated financial services such as most SME lending.  Similarly, the competition objective is generally about promoting effective competition in the interests of consumers in the markets for regulated financial services which again would not include users of unregulated financial services.  The integrity objective is about protecting and enhancing the integrity of the UK financial system which would include acting with morality and honesty.  In principle, the FCA could make rules under this objective to address future behaviour of authorised firms which was immoral or dishonest even if it related to activities that were not regulated.

Section 3 – Recent FCA initiatives

18     Operating within the above framework, the FCA has taken a series of actions in respect of SMEs over the last year.

IRHPs

19     In 2012 we identified failings in the way that some banks sold IRHPs.  The banks involved agreed to review their sales of IRHPs and pay redress as appropriate.  As at the end of February 2014, over £482 million had been paid in redress.

20     IRHPs were sold to a wide range of companies, from sole-traders to international conglomerates.  To distinguish between the smaller companies that were unlikely to have the expertise to understand all the risks associated with IRHPs, and larger companies likely to have such expertise, we introduced a sophistication test based in part on the small companies thresholds of the Companies Act 2006.  Customers classified as unsophisticated were included in our redress scheme, customers classified as sophisticated were excluded from the scheme but were still free to complain to their bank and pursue their claim through the courts.  During the pilot review exercise, we found examples of bed and breakfast businesses employing large numbers of seasonal workers being classed as ‘sophisticated’, whereas subsidiaries of multi-national corporations and property development and investment companies were classed as ‘unsophisticated’.  Following the pilot, the ‘sophistication test’ was amended and a summary flowchart showing the final process, including other aspects of eligibility for the scheme, is set out in Annex 1.

21     We were able to take action in respect of IRHP mis-selling because the product was a contract for difference, its sale was a regulated activity under the RAO and our conduct of business rules applied.  However, we did not take formal action in respect of loans which have similar features to IRHPs i.e. a Tailored Business Loan (TBL), as this is not a regulated product.  In Annex 2 we set out why TBLs are not within our scope.

Lending Practices

22     In January 2014, reports by Lawrence Tomlinson and Sir Andrew Large raised concerns over RBS’s treatment of SME customers in financial difficulty.  We commissioned a s166 report to consider whether any poor practices identified were widespread and systematic.  If this proves to be the case, a second stage of the review will identify the root cause of these issues and make recommendations to address shortcomings.

23     We also required other banks to satisfy themselves that they had not engaged in any of the poor practices identified in the Tomlinson or Large reports.  We made clear to banks that whilst traditional bank lending was not a regulated activity, we nevertheless expected firms to act with integrity across all their activities.  We will discuss these findings with the banks.  We were able to arrange for a s.166 report to be prepared in response to the Tomlinson and Large reports, as these reports contained allegations of egregious and widespread poor treatment of SMEs which is relevant, for example, to some of Principles for Businesses and the threshold conditions.

Conflicts of interest

24     We have concerns over insufficient transparency, information asymmetry and conflicts of interest in general insurance, particularly in regard to SMEs.  In April 2013, we published a factsheet for general insurance brokers outlining expectations of their conduct when arranging premium finance plans for commercial customers, including SMEs.  In July 2013 we launched a thematic review on conflicts management among insurance brokers, focussing particularly on SMEs.  We were able to take action in respect of these issues as the products involved are regulated financial products.

Barriers to Entry

25     In February 2013 the FSA published a joint initiative with the Bank of England into reducing barriers to entry for new banks, with a view to improving competition in banking, including SME banking.  We have now implemented the ‘barriers-to-entry’ review and the number of firms in the pre-application stage has increased substantially.  We will report to Parliament on progress against this new approach to banking authorisations in June 2014.  However, we have already seen a threefold increase in the number of firms in pre-application discussions with regulators.

26     In October 2013, we have published proposals for the regulation of alternative forms of financing, including crowdfunding and peer-to-peer lending.  We believe these proposals will make the crowdfunding market more accessible, will help foster competition and facilitate access to alternative finance options while also providing necessary consumer protections.

Access to the Ombudsman

27     In our response to the PCBS, we committed to consider whether it might be appropriate to extend the jurisdiction of the FOS beyond micro-enterprises to larger businesses. We propose to consult on this in autumn 2014.

OFT/CMA Market Study into SME banking

28     We have worked closely with the OFT on the market study into SME banking and will continue to work closely with the Competition and Markets Authority (CMA) from 1 April.  The OFT/ CMA submission to the Treasury Select Committee provides an update on this work.

Section 4: Challenges in regulating SME lending

29     There are significant challenges in regulating the market for financial services for small firms.  As outlined above, the boundary between regulated and unregulated activities is complex, different protections are offered to different sizes of SMEs, different protections are offered in respect of different activities and products, and regulatory interventions can be difficult for SMEs to understand. 

30     We have asked HM Treasury to consider the potential that banks may game the regulatory perimeter by selling unregulated products that have the same economic impact as regulated IRHPs.  Amending the RAO to reduce this risk is a question for HM Treasury and for Parliament.  However, whilst amending the RAO in this fashion would address the known problem of tailored business loans, it would not address wider concerns over the difficulties faced by SMEs in understanding the regulatory perimeter.

31     As a regulator, we can take a series of actions to increase clarity for SMEs and ensure that our interventions address the specific needs of SMEs.  We are launching a review of the different small business definitions used across our handbook, with a view to eliminating any unnecessary complexity not driven by EU law.  We will also look to focus on SMEs as we develop our competition work, take account of SMEs as a distinct sub-set of consumer when designing thematic work and develop a communication and education strategy to increase SME understanding of potential detriment and awareness of sources of advice.  However, to answer the wider questions - how far SMEs should benefit from the consumer protection measures afforded to retail customers, how far SMEs should be expected to behave like larger more sophisticated businesses, and how far the market needs pro-competition interventions to make SME self-help a more viable option – will require a joined up approach across government, regulators, industry and consumer groups.

Annex 2

Interest Rate Hedging Products (IRHPs) and Tailored Business Loans (TBLs)

Since the launch of the review and redress exercise regarding the sale of standalone Interest Rate Hedging Products (IRHPs), concerns have been raised regarding some commercial loans taken out by customers.  These have a very similar economic impact to an IRHP coupled with a variable rate loan, and have been described as being ‘embedded’ IRHPs or Tailored Business Loans (TBLs).

A customer who has taken out a TBL may be faced with the same repayment features and potentially significant break costs that a customer would have faced had they taken out a variable rate loan and a standalone IRHP. This is because the bank will have entered into a separate IRHP with a third party in order to manage its financial risk of entering into the loan. The terms of the loan will provide that the borrower bears the bank’s costs of terminating the IRHP early should the customer terminate the loan early.  The interest payments on the loan may also reflect the terms of the IRHP that the bank has entered into.

However, under the regulatory regime as determined by HM Treasury and Parliament, TBLs are considered different products to standalone IRHPs and are not regulated.

Standalone IRHPs are contracts for differences (CFDs) for the purposes of Article 85 of the Regulated Activities Order. A CFD includes rights under a contract the purpose of which is to secure a profit or avoid a loss by reference to fluctuations in, for example, interest rates.  Where interest rate contracts are purchased separately to a variable rate loan which the client wishes to hedge, they are a form of CFD.

In contrast, TBLs are not CFDs because the purpose of the loan is not to secure a profit or avoid a loss by reference to fluctuations in interest rates.  Rather, the purpose of the loan from the customer’s perspective is to borrow money on the specified terms in the loan, for example, relating to the interest rate payable on the loan.