Martin Davis: It's crunch time for networks

Martin Davis, the Openwork chief executive who will take over as CEO at Cofunds in the summer, explains why he believes the FSA was right to highlight network weaknesses...

Two paragraphs in the FSA’s recent Retail Conduct Risk Outlook 2011 seemed to take the network sector by surprise.

But was anything the regulator highlighted really that unexpected?

Under the heading “Systems and controls weaknesses in the network model”, the FSA report first stressed that: “A number of networks are under considerable strain, with continuing pressure on income and low levels of profitability.”

In the current economic environment, and with multiple regulatory financial strains to bear, that is, and remains, a statement of fact. The FSA’s next point however, was more revealing.

“In addition,” it stated, “supervisory activity with networks of various sizes continues to reveal significant issues with the control and oversight that networks exert over their appointed representatives, including monitoring procedures, levels of compliance resource and standards of due diligence carried out on incoming appointed representatives.”

It is no secret that many networks are struggling financially and that, at least partly due to this paucity of resource, their grip over certain aspects of their businesses is perhaps not as tight as it should be.

That is doubly concerning for the FSA because, as it points out, many networks – alert to the threat a lack of scale will pose to their businesses post-RDR – are seeking to rapidly expand their adviser numbers.

Against this backdrop, the FSA is clearly right to be fearful about the standards of due diligence being conducted on incoming ARs, and justified in expressing concern about the potential for these problems to worsen in the run-up to the RDR.

The key issue for networks, of course, is that their costs are rising at the same time as their income is falling – and is set to fall considerably further when advisers switch to fees. We are fortunate that we are well funded and supported, which affords us the means to help our advisers – both existing and new – transition safely through the RDR. It also means our growth will not come at the price of falling standards or in a slackening of our controls and oversight. But that position is clearly not universal.

It goes without saying that no network deliberately seeks to leave itself exposed to the serious problems highlighted by the regulator. The suspicion is simply that these issues have arisen over a period of time and, in all probability, as a consequence of neglect and/or corner cutting. It is not hard to see the appeal of doing something on the cheap – particularly when you feel you have no choice – but it is a hopelessly short-termist approach.

If a network plans to grow its business, it requires fully scalable compliance functions; but the FSA’s report suggests many may be far from that. Why? Have many networks simply failed to invest in the infrastructure to ensure that their advisers – now and in the future – are writing safe and compliant business? It seems they have.

The end game appears clear. Very few networks have the scale to survive the transition to the post-RDR world. Most of those seeking to achieve scale cannot afford it or achieve it in a fashion that satisfies the regulator; I would say their chances of survival are negligible. At best, I would expect four networks to be left standing in 2013, and I suspect resource – as much anything else – will be the one thing they all have in common.