Financial services industry gets ready for tougher regulation

Adviser firms must establish robust risk management and compliance procedures as the financial services industry prepares for tough regulatory reform, writes Michael Ralls from Kroll Background Worldwide.

As speculation abounds surrounding the likely actions of our new coalition government one thing is clear – the financial services industry should brace itself for tougher regulation and greater numbers of regulatory enforcement actions this year. Economic reform and tougher regulation to tackle white-collar crime is a common theme across both Conservative and Liberal Democrats’ economic policies, along with the intention to implement the proposed changes as soon as possible.

Some of the radical reform measures proposed include the creation of a ‘super-agency’, combining the powers of some of our current institutions to create a powerful fraud busting economic crime agency, and making companies liable for the actions of rogue traders and economic fraudsters on their payroll.

Inevitably, complying with greater regulation will no doubt bring with it additional administrative work for firms. However organisations should look beyond this inconvenience and realise it is actually an opportunity to establish more robust risk management and compliance procedures that will both protect them from risk and help ensure greater client confidence. It will create an environment where more people are acutely aware of their responsibilities and help ensure financial services firms are run by people of integrity who possess the necessary skills and experience.

Uncovering bad practice

Closer regulatory supervision will almost certainly uncover bad practices hidden during boom times and lead to increasing levels of enforcement activity. Against this background, it is noteworthy that last year, two key UK regulators, the FSA and the Serious Fraud Office released guidance encouraging businesses to self-report problems and to adopt a co-operative approach to conducting investigations and dealing with the regulator.

Last August, the FSA confirmed an extension to the approved persons regime for those that perform a ‘significant influence’ function at firms. The policy statement set out changes to the approved persons regime which improved the FSA’s approach to ‘significant influence’ functions by ensuring that those likely to exert a significant influence on a firm fall within the scope of the approved persons regime.

As is often the way with best practice guidance, the FSA was not prescriptive in its clarification of the extended functions, and the judgment of who falls into the extended categories is largely down to the organisation itself. Companies, especially those within the financial services industry, which has the broadest exposure to fraud of any industry, need to undertake internal reviews to identify their approved persons. The company is also expected to have undertaken its own checks to ensure the individual has the right qualities and competencies to carry out the role. This will entail obtaining background information directly from the individual then testing that information through public records or open sources such as corporate registries, civil and criminal court registries, regulatory agencies, press searches and, where appropriate, taking up third-party checks and references, regardless of whether the individual is based in the UK or overseas. A trained eye should then undertake comprehensive analysis, review and follow up on the results obtained to look to uncover information that would not otherwise have come to light.

Screening

Historically, the financial sector has been very good at conducting due diligence on hedge funds and other investment funds, but they often know little about the people behind the funds. This lack of thorough screening of senior managers, proprietary traders and fund managers has left firms exposed to unnecessary financial and reputational risk and under tighter regulations it will be of increasing importance that they demonstrate the same reasonable care in selecting the individuals charged with investing client monies, as they would in selecting the funds. Funds are selected on past performance and this is rigorously tested, so it makes sense the same is said of the managers who oversee them.

Financial services firms recognise the risks they face and devote resources to addressing the problem but not always consistently. Sixty percent of the financial services industry undertakes background screening of its staff as part of their countermeasures adopted to tackle fraud (Kroll Global Fraud Report 2009/10). However, simply administrating background screening does not provide adequate protection if it is not implemented correctly, for example, if it is left to a member of the administration team to perform the screening who may not have the training to analyse the results to draw out the information required.

Having all the information to hand and failing to spot any irregularities could result in a ban implemented by the FSA for not carrying suitable checks out in the first instance. However, with one in five companies last year implementing cost-cutting measures as a result of the economic downturn, internal controls have been one of the main affected areas. Companies need to consider whether cost-cutting in this area will actually deliver a saving as they will greatly increase their risk of exposure to fraud or a regulatory breach.

If the cost-cutting initiatives go as far as a firm choosing not to undertake essential screening, they need to be aware that a regulator may view this as deliberate avoidance of knowledge of the facts and could make them a guilty party in a crime. If information exists that would legally prevent a firm’s continued business with an entity or an individual but of which the firm is ignorant because it has not conducted the right checks and taken reasonable steps to gain knowledge of the facts, should an incident or crime occur, a regulator will see the firm’s decision to enter into business as having been based on its knowledge of these facts, and the firm would be more likely to be found a guilty party to any crime that took place.

Rather than cost-cutting at a time when risks are rising, it would be prudent for firms to actually invest more in training staff to undertake background screening to ensure that it is conducted to the appropriate level and in accordance with the regulator’s requirements, to provide the greatest protection against fraud and reputational damage, and ensure regulatory compliance.

Be proactive

It is important directors and senior managers at firms understand their regulatory obligations and have the relevant competencies and experience to carry out their roles with integrity. During this period of uncertainly as we await the formation of new controls, the tendency will be for companies to sit tight and wait to see what others do before taking any action themselves. However, this is unlikely to be tolerated and could lead to the imposition of fines and even tighter regulations further down the line. Firms should be proactive in establishing best practice procedures to tackle fraud and seek to work closely with existing and new regulatory agencies alike.