As part of the continued regulatory scrutiny and oversight of the transition away from LIBOR, on 27th February 2020 the FCA published another Dear CEO letter addressed to all UK‑regulated asset managers. The FCA makes clear it is essential for asset managers to reflect on the points raised in the letter and to take appropriate action.
It is an indication of the importance that the FCA attaches to LIBOR transition for the sector that it has chosen to write again to asset managers, having covered this topic as recently as 20th January in its letter to CEOs setting out its asset management supervision strategy.
The letter encourages firms to “prepare now for the end of LIBOR” and be “in no doubt” of their responsibility to facilitate and contribute to an orderly transition. The letter sets out clear expectations as to the specific actions asset managers should be taking in terms of their:
Further insights and requirements are grouped below, by area of focus:
The LIBOR transition plans asset managers have in place are expected to:
Effective transition plans will likely align with priorities and milestones outlined by the FCA and industry initiatives such as ISDA’s work on benchmark fall-back adjustments where appropriate.
There are some key priority actions asset managers should have already taken or, if not, need to immediately:
Furthermore, we expect that FCA supervisory teams will focus on understanding how asset managers have factored this Dear CEO letter into LIBOR transition programmes, and action plans, throughout 2020 and beyond.
The UK and EU have set out their official negotiating positions for the trade negotiations which began on 2 March.
The UK’s overarching position makes it clear that the Government will not agree to any obligation for its laws to be fully aligned with the EU’s – sovereignty is paramount. The EU’s stance, meanwhile, is to ensure open and fair competition between the two markets, including securing a commitment from the UK to maintain a robust regulatory level playing field.
This note sets out the opening negotiating position around equivalence and market access for financial services (FS) firms, and identifies some differences between the UK and EU’s positions.
The EU is clear that, given the geographic proximity and economic interdependence of the UK and EU, the future partnership with the UK “must ensure open and fair competition, encompassing robust commitments to ensure a level playing field” - the UK and EU’s commitments should prevent unfair competitive advantages to ensure a durable relationship.
The UK’s overarching stance is equally clear, yet quite different – it will not agree to any obligations for its laws to be aligned with the EU’s, or for EU institutions to have jurisdiction in the UK. Notwithstanding this, in relation to FS, the UK’s desired Comprehensive Free Trade Agreement (CFTA) should include “legally binding obligations on market access and fair competition” – in line with precedent in the free trade agreement negotiated with Canada. David Frost’s recent speech1 puts this in context – the UK’s focus is to make UK laws relevant to UK markets. The ability to commit to legally binding obligations to ensure fair competition is not perceived to be in conflict with the UK’s overarching stance.
The prospect of achieving a CFTA including market access provisions for FS firms will be contingent on progress made in the overall trade negotiations; FS firms will be keeping a close eye on this as the negotiations progress. In particular, firms will be keen to see progress made before June 2020, by which time, the UK Government will take stock of how far the negotiations have progressed. If it decides that there is insufficient progress, the Government’s focus will switch to domestic preparations to exit the transition period in an orderly manner.
The EU’s position is to ensure that equivalence mechanisms and decisions remain defined and implemented on a unilateral basis by the EU, with transparency and appropriate consultation with the UK. This is to preserve the EU’s regulatory and supervisory autonomy.
The UK’s position is to carry out unilateral FS equivalence assessments, distinct from the CFTA. The UK’s position emphasises that currently it has the same rules as the EU, and therefore there is a strong basis for concluding comprehensive equivalence assessments before the end of June 2020. The ambition to conclude equivalence assessments before the end of June 2020 was outlined in the non-binding Political Declaration, agreed between the UK and EU in October 2019.
In a bid to remove uncertainty around equivalence assessments, the UK is keen to ensure that there is a structured process for the withdrawal of equivalence findings, with appropriate consultation with the EU, to be agreed as part of the negotiation. However, there is no mention of a structured withdrawal process in the EU position.
The absence of a structured process for withdrawal of equivalence findings between the UK and EU would create uncertainty for firms seeking to rely on any equivalence assessments, particularly as in some cases they can be revoked with only 30 days’ notice. There is precedent for equivalence being effectively withdrawn – in 2019, the European Commission decided not to renew its equivalence decision in relation to Switzerland’s financial market rules and the EU Markets in Financial Instruments Directive and Regulation.
Whilst Michel Barnier, in a speech last week2, recognised that equivalence decisions are, and will remain, unilateral EU decisions, he clarified that EU will not separate equivalence from the broader trade negotiations. This will therefore have implications for the timing of, and uncertainty around, any FS equivalence decisions. However, on balance, we think that both parties will agree on a mechanism to minimise any adverse financial stability impact to both markets from 1 January 2021 onwards.
The UK Government will be seeking to ensure that the CFTA establishes regulatory cooperation arrangements, including appropriate consultation and structured processes for the withdrawal of equivalence findings. The UK envisions that such arrangements should be based on existing frameworks with the EU’s trading partners, with particular reference to the regulatory forums established under the EU-Canada and EU-Japan free trade agreements.
The EU is also committed to cooperation on regulatory and supervisory matters but does not explicitly refer to previous EU agreements with other third countries.
Supervisory cooperation is one of the essential pillars that would facilitate a positive equivalence assessment for both countries. We expect supervisory cooperation agreements to be in place, whatever the outcome of the trade negotiations or the equivalence assessments. These will be necessary for firms to be able to offer cross-border services and establish branch structures, but they will not be sufficient.
One of the UK’s stated objectives is to have an independent policy on data protection at the end of the transition period. This suggests that while the General Data Protection Regulation will be the starting point, the UK Government may choose to amend or apply a different interpretation to some of its requirements.
However, both parties are committed to maintaining a high level of data protection, and on this basis the UK will still seek an adequacy decision from the EU before the end of 2020 to maintain the free flow of personal data. However, given that multiple UK national regulations interact with GDPR, any changes or court judgements in domestic regulation in one sector may have a cross-sectoral impact on the interpretation of data laws.
The ability to move data freely between the UK and EU27 has a big day-to-day operational impact on firms and therefore FS firms will need to monitor this area closely.
It is clear that, as a starting position, both the UK and EU will seek to agree a CFTA, covering financial services at least in some shape or form. Unilateral equivalence decisions by both parties will be the key instrument used to govern interactions between the UK and the EU in respect of financial services. Compared to Single Market membership, market access is expected to be more limited, and less stable given equivalence decisions can be withdrawn. As negotiations progress, the likely outcomes in relation to FS will become clearer. In the meantime, we expect the UK to finalise the remaining memoranda of understanding (MoUs) on supervisory cooperation with EU member states – MoUs have been agreed with 23 of the 27 member states so far.
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1Speech by David Frost, the Prime Minister’s Europe Adviser and Chief Negotiator of Task Force Europe, on “reflections on the revolutions in Europe”, 17 February 2020.
2Speech by Michel Barnier, the European Commission’s Head of Task Force for Relations with the UK, on cooperation in the age of Brexit, 26 February 2020.
Threat Intelligence-based Ethical Red Teaming (TIBER) is increasingly being used by supervisors to enhance the preparedness and resilience of financial services firms to cyber attacks. Recent regulatory trends point to these tests increasing in popularity and frequency in the coming years. Boards may not only need to oversee such exercises regularly, but also demonstrably use the lessons learned in their firm’s cyber and operational resilience strategies. Senior managers (such as CIOs, CISOs, or in a smaller number of cases, CROs) will need to make the case to their boards that these are a valuable use of often constrained resources.
TIBER exercises can be costly and intensive programs that require close coordination with internal teams and external stakeholders. Firms can extract more value from these by not seeing them simply as self-contained tests. The different phases of the test, as well as the results, can provide valuable insights into areas such as a firm’s operational resilience, its exposure to financial crime, and its readiness to carry out large IT change programmes. Our experience is that they can act as wake-up calls, revealing sometimes unknown, large scale (and holistic) vulnerabilities. This can act as a trigger for more effective cyber transformation programmes.
Boards that prepare their firms for these tests, and understand how the results can feed into their overall business and IT strategy will adapt with more agility to what will become a more frequently required exercise in future.
TIBER tests are currently carried out only by the largest FS firms and financial market infrastructures, largely on a voluntary basis, or through persuasion. This is changing.
This rising tide is already being felt by some firms in jurisdictions that have adopted the TIBER-EU framework established in 2018 by the ECB. Belgium, for example, is implementing TIBER-BE for critical market infrastructures. Denmark has also introduced TIBER-DK (and includes the participation of major banks), and Sweden has followed suit. As supervisors continue to roll-out and hone this tool, more firms will be encouraged – and then likely asked – to carry these tests out.
Rather than seeing these tests as siloed exercises done to meet supervisory expectations, firms should embrace them as ‘points of the spear’ initiatives that, rather than simply honing their capacity to identify and contain a digital security breach, can be a critical part of enhancing the cyber and operational resilience maturity of the firm as a whole.
Firms that use TIBER tests to do more than address the deficiencies directly identified in the exercise will extract maximum value from what can be expensive endeavours. Showing how the tests, and the remediation strategies stemming from them, feed into investment decisions will also reassure a firm’s supervisors. Supervisors are likely to challenge firms that simply go back to business as usual after a TIBER test, or only address the deficiencies directly linked the compromised IT systems without addressing ‘bigger-picture’ vulnerabilities that underlie them. They might also consider such firms less mature in terms of their cyber resilience strategies.
In our experience, we see the following areas as those that TIBER tests can best feed into:
The EBA’s final guidelines, and the upcoming EIOPA guidelines, will already make TIBER tests relevant to a larger number of firms than today. However, the roll-out will be gradual as supervisors build-up their internal expertise, set up teams to manage relationships with both firms and ethical hackers, and decide on what the best governance arrangements for these tests are (such as whether it is the supervisory authority or the central bank which should coordinate tests).
Firms should seize the opportunity to start building their own programs for TIBER tests, if they have not yet started doing so. The following steps can form the basis for preparing effectively for them in future:
The use of TIBER testing as a supervisory tool is still maturing, and the EU’s approach to regulating cybersecurity in the financial sector will still be years in the making. However, TIBER tests are very likely to become a more prominent part of the supervisory toolkit going forward. The evolution of digital business strategies, cloud adoption and the constant mutation of the technology threats firms will face make this an inevitable outcome. Firms that put in place the right programmes early on, and recognise the tests’ value to strengthen their overall cyber and operational resilience strategies will face this change more confidently.
The UK general insurance prudential regulator’s five key concerns and why they matter
The UK’s Prudential Regulation Authority (PRA) sent two letters late last year to the general insurance market: one Dear Chief Actuary letter and one Dear CEO letter. These letters outline findings from the PRA’s latest reserve reviews and priority areas for general insurance supervision.
This blog highlights five key themes from these PRA letters and from our broader experience of the regulator’s perspectives and priorities. In summary, we expect general insurers will see the following themes raised increasingly frequently by the PRA in 2020:
The PRA has been concerned about the adequacy of firms’ reserves for several years. In 2018 the PRA highlighted potential weakening in casualty case reserves in particular, which it observed could point to potential future reserve deterioration. The 2019 Dear CEO letter specifically notes reported material reserve strengthening by some firms, and increasing areas of emerging risk in some US casualty lines such as financial and professional lines, medical malpractice and general liability classes of business. Casualty lines of business have also been included in the PRA’s recent reserve reviews.
This may not come as a surprise to many, given that casualty lines have historically been problematic for insurers. For example, it was partly casualty policies, in the form of a surge in US general liability claims related to asbestosis and pollution, which lead to significant challenges for Lloyd’s of London in the 1990s.”
Firms with what the PRA characterises as “material exposures to longer-tail casualty lines, who show a poor track record for reserving developments compared with initial assumptions, and those who have shown rapid growth” should thus be prepared for a more interventionist supervisory approach. Specifically, the PRA states that it will consider the use of s.166 skilled persons’ reviews of the adequacy of firms’ reserving governance, controls and reserving levels.
The PRA has shown increasing interest in the prudential implications of cultural and conduct weaknesses. The Dear CEO letter stresses the need to address corporate culture and individual behaviour issues within the London Market. The letter also re-iterated a point made in a speech by Anna Sweeney, one of the PRA’s Executive Directors of Insurance, which stated that instances of non-financial misconduct could speak to personal integrity and may have implications under the SMCR regime for the PRA’s view of the fitness and propriety of individuals.
This chimes with the FCA’s recent Dear CEO letter to general insurers restating its expectation that firms tackle misconduct and its associated poor culture. As the Pricing Market Study and Distribution Chain Reviews have demonstrated, the FCA is increasingly using tools such as price intervention and SMCR accountability provisions to tackle some of these issues. The two UK regulators appear to be following a highly coordinated and complementary approach in this area.
Soft market conditions, coupled with catastrophe losses in 2017 and 2018, have put a strain on general insurers' profits from both an asset and liability point of view. This has meant that the PRA, together with Lloyd’s of London, have to date focused on firms’ business planning and associated remediation of under-performing books of business and this will undoubtedly continue despite recent signs of the market hardening. General insurance supervisors have so far been more focused on how current market conditions are affecting insurers’ underwriting activities compared to their investment activities. However, this year’s expected supervisory statement on the Prudent Person Principle (PPP) is likely to prompt further supervisory scrutiny of firms’ investment strategies, especially as firms increasingly “search for yield” in the low interest rate environment.
Market conditions have been exacerbated by recent years’ catastrophe losses, which have prompted a series of exposure management reviews by the PRA. The PRA appears particularly worried about loss creep, referring to significant ongoing uncertainty in gross loss estimation related to, for example, the 2018/2019 Japanese typhoon losses. The PRA intends to undertake a sample review of firms’ exposure management approaches to assess the adequacy of firms’ aggregated risk quantification against the changing characteristics of natural and man-made perils. The PRA also highlights concerns about data quality and model risk management in relation to the changing nature of both natural and man-made catastrophe risks, and we expect these to be pursued in supervisors’ practical review work, including in the climate change context.
The PRA first raised its concerns about cyber underwriting risk in 2016 and was the first regulator to issue specific guidance to firms, for example a supervisory statement, on the topic. Cyber underwriting has now also gained traction at an international level, with EIOPA prioritising the establishment of a sound cyber insurance market in 2020 (a topic which we discuss further in our recent blog on EIOPA’s 2020 Work Programme). The PRA’s review work in this area is likely to remain intense as many firms are still at the early stages of understanding and managing their silent cyber risk exposures.
This is of course a big focus area for the PRA and Bank of England more widely. The PRA has primarily been in an information-gathering mode over the past year, with general insurers having had to submit 1) input to the insurance stress test exercise, which included a climate change scenario; and 2) an initial plan to address the PRA’s expectations on climate change and an updated Senior Management Function (SMF) form, as per its policy statement. We expect the PRA increasingly to action its findings from this large amount of information gathered: formal supervisory guidance coupled with increasing on-site reviews, aimed at assessing the effectiveness of firms’ governance and risk management response to the PRA’s climate change requirements, are likely.
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1 The FCA also recently sent two letters to the general insurance market; one Dear CEO letter and one Dear Board of Directors letter. Alongside these the FCA has been working on a General Insurance Pricing Market Study and a General Insurance Distribution Chain Review. These publications and initiatives allow us to see where the FCA’s general insurance conduct priorities lie and how these align with the PRA’s own conduct concerns.
We predicted in our 2020 Regulatory Outlook that the Solvency II review would result in important changes for insurers to factor into their strategies and planning. Less than two months into the year, the review is already seeing twists and turns. This blog discusses two prospective important changes that now look likely to come out of the review – to the risk margin methodology, and to the euro long-term discount curve – and highlights connections with EIOPA’s concurrent project on IBOR transitions.
EIOPA’s Chair, Gabriel Bernardino, recently stated that “Solvency II was designed in very different market conditions” to the prevailing ultra-low interest rate environment. He suggested that EIOPA would recommend updates to both the risk margin methodology and the LLP1 for the euro, as part of “[ensuring] that the regime continues to be fit for purpose by being capable to reflect the evolution of the market conditions”.
The operation of these components of Solvency II in the low interest rate environment makes them arguably two of the most important topics in the Solvency II review.2 However, as recently as October EIOPA’s stated position was non-committal on the euro LLP, and that the risk margin methodology should not be adjusted.
So, what has changed?
In short, our view is that we are starting to see the political direction of the Solvency II review unfold: as we stated in our 2020 Regulatory Outlook, “the risk margin and the LLP for the euro are only likely to be reformed, in our view, should the European Commission provide the necessary political direction.”
Prospective changes on these two topics are best viewed in the round. There was plenty of discussion at DG FISMA’s3 January 2020 conference on the Solvency II review about how the objective should not be to increase the overall capitalisation of the European insurance industry. It is the implications for insurers’ capital that make changes to either the risk margin or the euro LLP potentially so controversial – EIOPA’s initial impact assessment indicated, for example, that a change to a 50 year euro LLP would reduce the market-wide SCR ratio in Germany by 182 percentage points.4
However, a package of changes could well balance a lower and less volatile risk margin against a lower and more volatile discount term structure, broadly balancing the effect on overall sector capital levels. Importantly, both components could end up being more market consistent - potentially by following similar approaches to the IAIS’s Insurance Capital Standard5 – hence arguably improving the design and risk-sensitivity of the Solvency II regime overall.
In practice, the drive to make these changes is likely to have come in part from the evidence gathered by EIOPA on the depth, liquidity and transparency of euro swap markets. We discussed this topic in another recent blog, arguing that EIOPA’s findings make maintaining the status quo of a 20 year LLP difficult to justify. The inevitable increases in capital that a more market-consistent euro curve would bring for some insurers could very well be balanced by a less interest rate sensitive risk margin. EIOPA is also likely to have received quite significant pushback on its consultation proposal not to change the risk margin, which will have created further pressure for continued review and potentially reform.
All of the above, however, begs the question of how the overall package of changes may be affected by the transition to new benchmark rates (IBOR transitions). The current Solvency II risk free interest rate term structures are commonly based on Interbank Offered Rates (IBORs). These ultimately need to be replaced by new discount term structures based on overnight index average rates (OIS), such as the Euro Short Term Rate (€STR) and the Sterling Over Night Index Average (SONIA).
EIOPA’s newly-released IBOR transitions discussion paper (DP) is primarily concerned with the transition from the old to the new curves, but also notes EIOPA’s assessment that none of the OIS curves can, at this time, be considered deep, liquid and transparent (DLT). EIOPA expects “that this can change rapidly within the next six to nine months”, but the transition methodology will be of great importance as the relevant DLT assessments evolve rapidly.
The link to the Solvency II review discussions on the LLP for the euro, and the extent to which it is based on observation of DLT market data, is obvious. On first principles, any methodology changes agreed for the Solvency II review should be capable of application regardless of changes to the financial instruments underlying the market portion of the curves. However, an impact assessment carried out based solely on IBOR swap market data is clearly going to be of limited value to support a decision about the future, and there is likely an increased risk of unintended consequences with respect to insurers’ overall capital levels.
EIOPA has stated that it plans to carry out an impact assessment in the spring on what should be a narrowed down set of Solvency II review policy recommendations, and the European Commission also suggested that it intends to launch its own 12 week consultation on the review. Concurrently, EIOPA’s IBOR transitions DP is open until the end of April 2020, following which EIOPA will issue a consultation paper. It is, therefore, likely to be the autumn at the earliest before any more settled policy is apparent. We are unlikely to know the final legislative proposals for the Solvency II review until some way into 2021, and implementation, potentially with transitional provisions, is unlikely before 2022.
However, EIOPA’s spring impact assessment should, all being well, provide a clearer picture of its proposals for the risk margin, and should build on its previous analysis on potential changes to the euro LLP and extrapolation methodology. It may, also, start to provide impact analysis on the implications of the IBOR transitions for the eventual Solvency II discount curves themselves – setting aside the transition. Notwithstanding the limited amount of available DLT market data, insurers will need to evaluate how the revised curves will affect their products, capital, risk management strategies and business models. While larger insurers can very likely carry out all the necessary analysis in-house, some published data from EIOPA – heavily caveated as necessary – will likely be extremely useful for many insurers as they plan for the transition.
It now appears more likely than ever that the Solvency II review will produce a package of changes that may affect insurers’ capital and strategies to varying degrees. We expect insurers to remain engaged with the review in 2020, and indeed we recommend that they do so in order to make the most of the various remaining opportunities to provide comment and help steer the review outcomes.
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1 Last Liquid Point
2 The risk margin increases liabilities (and hence capital) in a low interest rate environment, while the LLP for the euro decreases liabilities by contributing to a steeper-than-market discount curve for long dated liabilities.
3 Directorate General for financial stability, financial services and capital markets union
4 https://www.eiopa.europa.eu/content/consultation-paper-opinion-2020-review-solvency-ii
5 For further discussion of the Insurance Capital Standard, please see our recent blog at https://blogs.deloitte.co.uk/financialservices/2020/01/international-insurance-regulation-is-the-post-crisis-reform-programme-now-complete.html.
Following a brief hiatus, we are excited to share additional insights on client lifecycle management. Our blogpost1 in November 2019 introduced some ideas around the potential benefits of applying customer lifetime value (“CLV”) lens to client lifecycle management, and how it can bring enhanced benefits for both corporate and investment banks (“CIBs”) and their clients. This month, we seek to demystify the factors CIBs should consider in applying CLV to their clients.
We enter the third decade of the 21st century with mixed feelings of optimism and uncertainty. The UK has left the European Union following Boris Johnson’s recent UK General Election Conservative-majority win and the world prepares for the upcoming US Presidential Election later this year2, while US-China trade relation quarrels continue3.
In the midst of these geopolitical and economic pressures, 2020 will continue to bring a raft of challenges for CIBs to acquire and retain clients. Banks will need to consider modernising their technology systems, implementing artificial intelligence (“AI”), employing digitally enabled processes, and innovating on products and services to create a sustainable competitive advantage in the marketplace. Furthermore, CIBs will need to renew focus on Environmental, Social and Corporate Governance (“ESG”)4, green finance, and bring enhanced client experience to ensure that they continue to attract clients and remain relevant within a dynamic global market. CIBs will need to consider how best they deliver CLV to their clients, which if done well, can enhance overall profitability.
CLV is the total net worth of a client relationship over the whole lifetime span of the relationship. It is intrinsically linked with profitability and sustainable growth of the business. The calculation of this value is important not only at the start but also throughout a client relationship and consists of several factors. Typically but not exhaustively, these factors include;
When applying these variables, a CIB will need to consider the significance of each factor in the calculation being relative to the journey stage their client is at: from a start up in the early years to becoming a household name.
For CIBs, the frequency of transactional activity may pose an additional challenge to calculating CLV. In contrast to traditional retail banking customer interactions, CIBs typically have lower volume but have higher value transactions. Cyclical activities (e.g. KYC re-assessments) undertaken by CIBs, are natural touchpoints and present an opportunity to identify and capture expected account activity, and re-assess the discount rate, probability of client churn and incentives to be offered to the client.
Historically, CLV has been widely adopted in retail banking and direct consumer driven businesses, but less so within CIBs. New entrants, for example FinTechs, crowd-sourcing platforms, and PE firms allow capital to be deployed outside traditional regulated markets, are changing the competitive landscape and increasing the risk of potential client churn. Many Tier 1 investment banks are recognising this and looking at ways to innovate their businesses. In a recent CNBC interview with JP Morgan’s Co-President, Daniel Pinto highlighted this, as he shared his outlook for 2020 and beyond, particularly on the dominance of Big Tech (Google, Uber and Facebook) companies: “…it’s only a matter of time before they participate in financial services in a bigger way. We have to assume that they will be real competitors”6.
CEOs, political world leaders, economists, journalists and celebrities alike gathered at the annual World Economic Forum last month to discuss global issues, with this year’s theme centred on ‘Stakeholders for a Cohesive and Sustainable World’7. Unquestionably, the state of the global economy and global banking industry continued to be a key discussion topic. The demographic landscape of clients is changing, along with their needs and wants, and it is crucial CIBs consider the current and future state of their client relationships to bring sustainable futures for clients and the CIB industry. Our next blog post will feature our insights on industries at the forefront of using CLV in their business model.
Following this article, there will be a series of publications that will address various topics in relation to client lifecycle management of corporate and investment banks with a focus on customer lifecycle value in capital markets.
For further information in relation to this topic, please contact Rawad Halawi and Dinesh Sharma
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1 Deloitte, ‘Uncovering the benefits of client lifecycle value for investment banks during challenging times’, November 2019, https://blogs.deloitte.co.uk/financialservices/2019/11/uncovering-the-benefits-of-client-lifetime-value-for-investment-banks-during-challenging-times.html
2 Financial Times, ‘ What will 2020 hold for companies?’, December 2019, https://www.ft.com/content/65784240-1ff8-11ea-92da-f0c92e957a96
3 Guardian, ‘US and China sign Phase One trade deal, but experts are sceptical’, January 2020, https://www.theguardian.com/business/live/2020/jan/15/us-china-trade-deal-trump-tariffs-global-risks-uk-inflation-business-live
4 City A.M., “Investor demand for environment-friendly firms is becoming 'phenomenon' says top Barclays banker”, October 2018, https://www.cityam.com/investor-demand-environment-friendly-firms-becoming/
5 Deloitte, ‘Finally: Customer Analytics for Banks”, 2011, https://www2.deloitte.com/content/dam/Deloitte/us/Documents/process-and-operations/us-cons-customer-analytics-102711.pdf
6 CNBC, ‘JP Morgan’s co-president talks about his 2020 outlook, the Big Tech threat and socially conscious investing’, December 2019, https://www.cnbc.com/2019/12/27/jp-morgan-co-president-talks-his-2020-outlook-big-tech-threat-and-esg.html
7 World Economic Forum, ‘ Davos 2020: World Economic Forum announces the theme’, October 2019, https://www.weforum.org/agenda/2019/10/davos-2020-wef-world-economic-forum-theme/
Conflicts of interest are high on the FCA’s agenda, and are likely to remain so in future.1 They are a clear priority in the FCA’s 2019/20 business plan, and have also been flagged as an important area of concern in recent Market Watch publications. This blog outlines the conflicts that may arise for asset managers in the areas of personal account (PA) dealing, order allocation and outside interests in investee companies, and sets out some ideas to consider when deciding how best to manage these.
Conflicts of interest can arise in almost all aspects of a financial services firm’s relationship with its customers and the market, including for example in product design and distribution, investment strategy, order handling and allocation, and external relationships. In recognition of this, the FCA has adopted a principles and outcomes based approach as opposed to a detailed prescriptive regime. Consequently, there is an expectation that firms should monitor continuously any potential or crystallised conflicts between their interests and those of their clients.
Asset management firms have a particular responsibility in this regard because they are often in possession of inside information and have the potential to influence the market through the manner in which they trade and employ voting strategies. This puts the onus on asset management firms to be pro-active in undertaking self-assessments to identify existing and new potential sources of conflicts. Once conflicts are identified, it is important that firms are able to demonstrate to the FCA that steps have been taken to manage them appropriately. In particular, the FCA expects robust frameworks that not only identify conflicts but also analyse them at a sufficiently granular level, implement appropriate controls, and monitor compliance with those controls rigorously. In short, the FCA is looking for firms to move beyond a prescriptive tick-box approach to managing conflicts.
The FCA’s recent Market Watch 62 outlined a number of concerns the FCA identified from a review of wholesale broking firms’ systems and controls for PA dealing. These concerns will also be relevant for asset managers. Common failings the FCA identified included:
Some employees also reportedly believed that not being fully versed with the firm’s PA dealing policy provided them with a defence against breaches.
The following procedures, amongst others, may help to overcome the above control weaknesses:
Whilst the FCA’s rules in COBS 11.7 and 11.7A will be a useful starting point, a number of other sources set out the regulator’s expectations. The FCA’s 5 Conduct Questions (which the FCA is extending to asset managers), Principles for Businesses, and the Individual Conduct Rules (COCON 2.1)2 require firms to integrate personal integrity and customers’ best interests into all their business activities. Overall, the regulatory emphasis is on firms developing a proactive control culture rather than pursuing a tick-box approach.
Whilst the conflicts inherent in PA dealing are often focussed on in asset management circles, those inherent in order allocation are highlighted less frequently. However, the consequences of not managing these conflicts are equally serious, as evidenced by the recent multi-million pound fine paid by an asset manager for allocating favourable orders to higher fee-paying funds as opposed to lower fee-paying funds. This practise is also known as “cherry picking”. In this case, the FCA found that the firm had neglected to manage conflicts of interests fairly.
Asset managers need to ensure they have proper procedures in place to monitor trades that are allocated to clients or funds after they have already been dealt in the market. Ideally, procedures must require permission to be sought prior to allocating the trade in this manner. When monitoring such trades, all relevant factors must be taken into account whilst deciding whether a client’s interests were compromised, in the favour of the firm, a staff member or another client. There should be adequate records for all instances. Reflecting the FCA’s Principles for Businesses, SYSC 10 and COCON 2.1 rules, cases of misallocated orders are likely to attract scrutiny of the conduct of all parties involved.
If inadequately managed, conflicts of interests have the potential to create adverse perceptions of a firm among investors. Recently there has been heavy market scrutiny of common board memberships between asset managers and their investee companies and the potential conflicts this can give rise to in a range of possible areas including asset selection.
Asset managers need to ensure that any potentially conflicting interests in investee companies are recorded and disclosed to investors. Firms’ monitoring frameworks therefore need procedures in place to identify these and ensure that investment is limited in companies in which the conflicting interest may carry potential harm to investors and reputational risk for the firm. Importantly, the FCA expects asset management firms to foster a culture in which investment managers promptly reveal conflicting outside interests in investee companies to the firms’ Compliance and Audit functions.
Managing conflicts of interests appropriately will be a still greater priority now that the Senior Manager and Certification Regime applies to all authorised firms. The FCA has heavily scrutinised inadequate conflicts management within PA Dealing and order allocation and this trend is likely to continue. Firms with a culture that is seen to drive poor conduct and overly prescriptive procedures that are not regularly complied with, or regularly reviewed and updated, are running substantial regulatory risk. Moreover, given the rising importance of environmental, social and governance issues, the reputational impact of any regulatory censure or action due to inappropriate management of conflicts could be severe.
Consequently, in order to manage conflicts effectively, firms should consider employing a combination of:
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1 The obligation to manage conflicts of interests appropriately is enshrined in Principle 8 of the FCA Principles for Businesses and SYSC 10. Most recently the FCA has stipulated in its 2019/20 business plan that conflicts of interests are a sectoral priority for wholesale financial markets and firms that design and sell retail investment products. The business plan also states the FCA’s intention to continue to monitor the outcomes and reductions in harm from the various rules imposed by MIFID II, including more work on conflicts of interests in the wholesale market. MIFID II imposed stricter requirements on firms to manage or prevent conflicts where possible.
2 These have replaced Principles for Approved Persons from December 2019 for all solo regulated firms
This publication has been written in general terms and we recommend that you obtain professional advice before acting or refraining from action on any of the contents of this publication. Deloitte LLP accepts no liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication.
Post-crisis regulatory reform for the insurance sector passed a significant milestone at the beginning of this year. While the banking sector has, for good reasons, dominated the post-crisis re-engineering of financial services regulation, the FSB1 nonetheless tasked the IAIS2 in 2013 with a similar objective for the insurance sector in the areas of resilience, supervision and systemic risk. The IAIS has now provided its response in the form of a package of measures that start in 2020.
Despite the undoubted importance of this task, insurers may be forgiven for wondering what has changed. The new measures are highly unlikely to result in immediate changes to regulation in individual jurisdictions. However, in our view their influence will be felt tangibly as insurance regulation evolves in the coming years. Understanding the reform package is, therefore, a precursor to understanding and predicting developments in insurance regulation within individual jurisdictions.This blog takes stock of the IAIS’s adopted measures3, and discusses three important areas in which they may materially influence future regulation:
As we discussed in our previous series of blogs, the Insurance Capital Standard (ICS) presents some novel approaches to market-consistent valuation and solvency that could influence the future development of Solvency II. In particular:
The Solvency II Directive is being reviewed in both these areas, and the ICS methodology is likely to provide important counterpoints to the current Solvency II approach. The calculation of the risk margin has proved controversial in the UK especially, and there is likely, in our view, to be significant pressure for the methodology to be reformed in the UK following Brexit, as we discuss in our recent report, Solvency II – Continuity, change and divergence in a post-Brexit world.
We emphasise that, despite its recent adoption, the ICS methodology has not yet been finalised. It will be implemented for monitoring and reporting only over the next five years, with some details to be filled in this year, and some critical decisions still to be taken (as discussed further below). In essence, this will constitute another five years of testing and evaluation. However, this could provide space for key differences between the ICS and other important global standards to be explored further, and potentially for further alignment and commonality, in particular during this important phase of the Solvency II review.
The ICS is highly unlikely to replace established solvency regimes such as Solvency II or United States (US) RBC. However, it is likely to be seen as a benchmark against which to measure the outcomes of different solvency regimes7, and/or applied to create a consistent view across multinational groups. The ICS is thus an important international standard, even if it is not itself binding as a matter of national regulation.8 Some of the most important questions on implementation, therefore, concern how the ICS will recognise and be recognised by other regulatory regimes.
This question is already on the IAIS’s workplan with respect to the future US aggregation method, which the IAIS will start to assess for comparability of outcomes from 2023. The IAIS is also highly likely to need to consider the same question for Solvency II. (For many internationally active insurance groups (IAIGs), this question will overlap with whether the IAIS decides to recognise internal model calculations as an acceptable “other method” for the ICS capital charge.) In our view, the IAIS is more likely than not to recognise these regimes as achieving comparable outcomes – a course of action that would provide a smooth path for the ICS to be, in effect, implemented in the US and Europe, despite the very different approaches to prudential solvency regulation in those jurisdictions.
A parallel question is whether the ICS might be recognised as equivalent by other regimes. For example, recognition as equivalent for use in Solvency II group solvency calculations could give the ICS an important practical role in calculating group solvency for some European groups.
The IAIS’s Holistic framework – in its final form a set of updates to the Insurance Core Principles (ICPs) – is focused on macroprudential surveillance and analysis,9 and on the measures that supervisors may apply in response, including preventive and corrective measures.10
The IAIS’s final position on macroprudential policy and surveillance needs to be viewed in the context of the near-continuous debate that has taken place on whether the insurance sector poses systemic risk and whether a macroprudential regulatory framework should be applied to it. Much of this debate has turned on whether individual insurers and/or the insurance industry as a whole create or amplify systemic risks, and whether the regulatory response requires a dedicated macroprudential toolkit on similar lines to that applied to the banking sector.
In ICP 10, the IAIS specifies expected powers which supervisors should be capable of applying in response to either microprudential or macroprudential risks. However, ICP 10 does not go into detail on how and when supervisors should exercise these powers where they identify financial stability risks. In particular, ICP 10 does not address what is likely to be a very difficult practical question, namely how supervisors should take action against individual insurers in response to systemic risks relating to the activities of the industry as a whole (it is easy to imagine how such actions could, for example, create level playing field issues).
The outcomes of the Solvency II review are likely to influence strongly the direction of any future macroprudential regulatory framework for the insurance sector. Consequently, whether the Solvency II review introduces dedicated macroprudential tools and powers – as recommended by EIOPA – will be an important decision for European insurers and beyond. In our view, the IAIS’s Holistic framework lends broad support to the concept of a macroprudential regulatory toolkit, but leaves unanswered some critical questions on how such a framework should be implemented.
While prudential insurance regulation has appeared broadly settled over the last few years following the implementation of Solvency II, the next few years could once again bring substantial changes to insurance regulation and supervision.
The IAIS’s ICS, ComFrame and Holistic framework are key components of the FSB-sponsored post-crisis regulatory reform programme for insurance. Accordingly, they are important inputs to future reforms of insurance regulation, in particular the Solvency II review, and the development of the aggregation method in the US. Understanding the settled form of these initiatives therefore provides essential context for understanding and predicting regulatory developments in individual jurisdictions.
The major caveat to the above, however, is that the ICS is, essentially, far from finalised, with substantial differences of philosophical perspective and in some cases outright disagreement between Europe and the US on its construction and approach. The next five years will, none the less, see the IAIS continue to develop the standard, as well as important discussions on how it will operate alongside existing regulatory regimes. In our view, it is essential for international insurers to remain engaged in the ICS project, both for the development of the ICS methodology itself, and with a view to how it will influence, affect, and be applied alongside directly-applicable jurisdictional regulation.
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1 Financial Stability Board
2 International Association of Insurance Supervisors
3 The IAIS adopted, at its annual conference late last year, the ICS, the Common framework for the supervision of internationally active insurance groups (ComFrame), and the Holistic framework for systemic risk in the insurance sector (Holistic framework). These collectively address capital, supervision and systemic risk assessment for the insurance sector. The ICS is a risk-based capital standard capable of being applied globally, and as such is by far the most important part of the package. ComFrame and the Holistic framework provide standards and guidance on the regulation and supervision of the insurance industry. They are not binding in individual regulatory jurisdictions, although IAIS members – of which there are 215 – are expected to regulate consistently with them.
4 Margin Over Current Estimate
5 The calculation of the MOCE is discussed further in our previous blog.
6 The calculation of long term discount rates is discussed further in our previous blog.
7 The most important future role for the ICS could, in theory, be as a benchmark against which different regimes can be assessed and mutually-recognise one another on a multilateral basis. Such an outcome appears highly unlikely in the short term, at least on a formal basis for major regulatory regimes, but comparable use on a non-binding and informal basis could well be imagined.
8 It is yet to be determined how, in practice, the ICS will be implemented as a “prescribed capital standard” (PCR) at the end of the five year monitoring period. The ICS may also, of course, function as a starting point for regulatory regimes developing risk-based standards in the future.
9 Insurance core principle 24 – Macroprudential supervision.
10 Insurance core principle 10 – Preventive measures, corrective measures, and sanctions.
The FCA recently published a consultation paper (CP) proposing a Single Easy Access Rate for cash savings. This blog summarises the proposals, sets out their implications, and outlines actions firms should consider.
Under the new rules proposed in the consultation, firms will have to offer customers a single rate of interest across all of their easy access savings accounts open for longer than 12 months, with this interest rate being set by the firm. This interest rate will be called a Single Easy Access Rate (SEAR). This means that while firms can continue to offer introductory rates of interest on easy access savings accounts for an initial 12 month period, all their easy access savings accounts will have to offer the SEAR after this period. Firms will be allowed to set two SEARs; one for their easy access cash savings accounts and one for their easy access cash ISAs.
While the FCA is now calling their proposed reform to the cash savings market a SEAR, it is in effect the same as their earlier proposal for a basic savings rate. The FCA says that it has changed the name in order to enhance consumers’ understanding of what the rate is and what it will offer consumers.
The FCA’s SEAR proposals build on a number of important trends we have observed within the FCA’s regulatory and supervisory approach, namely:
The proposed reforms have the potential to change the competitive dynamics of the cash savings market, with the FCA expecting longstanding customers to receive higher rates of interest on their easy access savings.
The FCA will be accepting responses to its CP until 9th April 2020. It will publish its final set of rules in the second half of 2020.
The FCA’s cash savings market study found that, due to a lack of competition, longstanding customers generally receive much lower rates of interest on their savings compared to customers who have opened their accounts more recently. In line with the FCA’s commitment to ensure fair pricing in financial services (which we have blogged about here) the FCA has used its 6 question ‘fair pricing in financial services’ framework to judge the fairness of the pricing practices it observes in the cash savings market. This is the second time the FCA has used this framework, following on from its initial use in the FCA’s GI pricing market study, and we expect this framework to play a leading role in future market studies.
The FCA found that harm was likely to be widespread: three quarters of consumers have an easy access cash savings account, but only 10% of these consumers had switched their account in the past three years. The FCA also found that customers with signs of potential vulnerability were more likely to have held their savings account for 10 years or more with the same savings provider. Given this, the FCA says it is “concerned that there are poor outcomes for a large number of the most longstanding customers” as a result of what the FCA considers to be unfair price discrimination when it comes to the interest they earn on their savings.
Figure 1 (below) shows how the typical rate of interest on easy access accounts declines over time, from ~0.7% for accounts opened in the past year to ~0.3% for accounts open more than 5 years ago. Furthermore, the vast majority of consumers’ balances are held in accounts which have been open for more than five years, meaning most consumers receive these lower rates of interest rather than the higher introductory rates on offer. This has led the FCA to conclude that longstanding customers often receive much poorer value for money on their savings than newer customers.
Source: FCA, Introducing a Single Easy Access Rate for cash savings, CP20/1, p5
The FCA’s SEAR proposals are intended to tackle the unfair price discrimination and poor value for money the FCA considers longstanding cash savings customers receive. The FCA hopes that its reforms will lead to firms competing on the SEAR, and that this competition will drive up the rates of interest on offer to consumers.
Alongside its proposals to introduce a SEAR, the FCA is also putting forward a requirement for firms to publish their SEARs, alongside data on the proportion of customers’ balances held in easy accounts that are on the SEARs, and the highest introductory interest rates on offer for easy access savings accounts. The FCA hopes that by making this information easy to find, it will encourage consumers and third party organisations (including online comparison tools) to look at both the SEARs and introductory rates when switching or open savings accounts; and that this in turn will drive banks and other savings providers to compete to offer the best interest rates on savings.
The FCA’s proposed reforms to the cash savings market are another example of the FCA’s increasing scrutiny of value for money and price discrimination. The reforms follow on from its continuing work in the general insurance and asset management sectors, and previous work around high cost credit. In short, the FCA is proactively targeting mass market retail products that it judges to provide poor value, with a particular focus on the value received by longstanding or back book consumers, who are in turn more likely to be potentially vulnerable.
More specifically, firms will want to assess how paying potentially higher rates of interest to their longstanding customers is likely to affect their business model and wider market strategy. A key question will be whether they want to offer market leading SEARs to their customers in order to attract and retain deposits. Firms will also need to assess what effect the FCA’s reforms may have on their liquidity and the assumed ‘stickiness’ of easy access savings deposits.
Firms may also benefit from reviewing their existing range of savings products and, where sensible, simplifying their range of products to dovetail with the FCA’s SEAR proposals which will likely limit the benefit of firms having a wider product range.
Firms should consider looking at enhancing the transparency and disclosure around the interest paid to longstanding cash savings customers. In line with the FCA’s promotion of good customer outcomes, it will expect firms to be active in identifying customers who may be receiving poor value and for firms to take action to correct this; for example, by encouraging such customers to switch to savings products with better rates of interest.
In summary, pending publication of the FCA’s final rules, we think firms would find it beneficial to:
It is estimated that over 40% of motor insurance customers and around 52% of household insurance customers in the UK opt to pay their annual premiums by monthly instalments1, with many entering into regulated credit agreements in order to do so.
The FCA is focused on the extent to which firms offering premium finance under regulated credit agreements are meeting the requirements of the consumer credit regime, including changes to the rules around creditworthiness and affordability.
In our experience, firms offering premium finance are sometimes unaware of the full extent of their regulatory obligations under the consumer credit regime. This blog highlights key aspects of the recent rule changes and FCA reviews of the wider consumer credit market which have important implications for premium finance firms.
Firms offering premium finance secondary to their main regulated activity have, in Deloitte’s experience, often been unaware that they were undertaking a regulated activity until the FCA highlighted that they were providing credit under regulated credit agreements.
The FCA is clear that firms should be aware of whether they are arranging or providing premium finance under regulated credit agreements and ensure they have the right policies, procedures and controls in place to discharge their obligations. In particular, as it highlighted in its 2015 review of premium finance, the FCA expects firms to ensure that customers are provided with the information and explanations required under the Insurance Conduct of Business Rules (ICOBs), the consumer credit (CONC) rules and the Consumer Credit Act (CCA).
It also expects the credit agreement to be given sufficient prominence as part of the sales process to allow the customer to assess whether the proposed agreement is appropriate for their needs and circumstances, including the key risks of the credit, the consequences of non-payment and the costs related to the agreement.
In November 2018, the following key changes to the FCA’s rules around assessing creditworthiness came into force. These are applicable to firms undertaking consumer credit lending in relation to premium finance.
The new rules require that, when providing consumer credit, firms make a reasonable assessment not just of whether a customer will repay (credit risk), but also of their ability to repay both affordably and without this significantly affecting their wider financial situation (affordability risk). The FCA also provided an explicit definition of affordability risk, setting out the factors which firms should consider when assessing whether credit is likely to be affordable for the borrower2.
Firms must have appropriate methods and processes in place to assess affordability to the consumer, as well as credit risk to the firm. The assessment must be based on sufficient information – from the customer where appropriate, and from a credit reference agency (CRA) where necessary. Firms may assess credit risk and affordability as part of the same process but must ensure that this adequately assesses the risk to the customer of being unable to make repayments.
The FCA expects firms to take reasonable steps to determine the customer’s income when assessing affordability. This includes any likely reduction in income during the period of the credit, where this is “reasonably foreseeable”- such as retirement - and could have a material impact on affordability risk for the customer.
Estimating future changes in a customer’s income gives rise to challenges for firms who may be unclear about what assumptions, if any, they are required to make about the customer’s future circumstances or the information that they are required to obtain from the customer in order to assess this.
The FCA is clear that it expects firms to make the assessment based on information available to them at the time, or obtained after further enquiry, where appropriate. In some scenarios, it may be helpful for firms to factor in qualitative data, provided by the customer, which can help them reach a conclusion about whether a customer’s future financial circumstances may be reasonably foreseeable at the point of sale.
The scope of the creditworthiness assessment, and the steps taken to ensure it is a reasonable one, should depend upon, and be proportionate to, the individual circumstances. The FCA expects firms to “use their judgement to determine what is appropriate in the circumstances, having regard to the nature of their products and customers”. However, in deciding how rigorous the creditworthiness assessment should be, the FCA also expects them to have regard to information they know at the time that may indicate that the customer is in, has recently experienced, or is likely to experience financial difficulties or is particularly vulnerable.
This requirement exposes a potential tension for insurers, in particular, who may feel that, due to the essential nature of some insurance contracts, such as motor insurance, there is a risk of poor outcomes for some customers whose applications for premium finance are subsequently declined (including being declined at renewal) because they are experiencing, or have recently experienced, financial difficulties or vulnerability. Nevertheless, while the FCA rules are intended to offer firms flexibility in assessing affordability, we think that the FCA would be concerned about, and might challenge, any decision to offer premium finance based solely on the necessity, to the borrower, of the underlying insurance if the finance was unaffordable. However, we recognise that this is not a straightforward decision given the wider impact on the customer if they can’t obtain insurance e.g. a driver being unable to work if they are unable to obtain motor insurance.
The FCA’s review of the motor finance sector (March 2019) found that the way some commission arrangements are structured may lead to consumer harm on a potentially significant scale. As such, it is currently consulting on proposals to ban “discretionary commission models” where the amount of commission received by the broker is linked to the interest rate the customer pays and which give brokers the power to adjust or set. This has important parallels in the premium finance market where similar commission models exist.
Whilst the FCA says that it currently does not have the evidence to justify consulting on banning particular commission models in the premium finance market, it will consider further interventions if it identifies evidence of consumer harm. Firms will therefore need to demonstrate that there are robust controls in place to prevent commission arrangements from leading to poor outcomes for customers. As part of its consultation on commission arrangements, the FCA is also proposing clarifications to the commission disclosure rules to ensure that brokers across the wider consumer credit sector adequately disclose the existence of commissions.
The FCA’s review of motor finance also highlighted concerns about the controls lenders have in place to monitor compliance by brokers. The FCA was particularly concerned that some lenders appeared to take the view that it was sufficient to check only that a broker was FCA authorised. It reminded lenders that they are required to take reasonable steps to ensure persons acting on their behalf comply with CONC.
In assessing creditworthiness for premium finance, firms must balance providing access to credit for customers who would benefit, and can afford it, with sufficient protection for those who may be adversely affected by unaffordability. To ensure that their creditworthiness assessment process strikes the right balance, and that they are able to demonstrate effective controls and oversight in place, we recommend that firms undertaking consumer credit lending consider the following actions:
More generally, firms arranging or providing premium finance should:
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1 Datamonitor Financial, UK Personal Lines Distribution, February 2015 as quoted in FCA TR15/5 Provision of premium finance to retail general insurance customers,
2 See FCA CONC 5.2A.12
The firm must consider the customer’s ability to make repayments under the agreement:
1 as they fall due over the life of the agreement and, where the agreement is an open-end agreement, within a reasonable period;
2 out of, or using, one or more of the following:
(a) the customer’s income;
(b) income from savings or assets jointly held by the customer with another person, income received by the customer jointly with another person or income received by another person in so far as it is reasonable to expect such income to be available to the customer to make repayments under the agreement; and/or
(c) savings or other assets where the customer has indicated clearly an intention to repay (wholly or partly) using them;
3 without the customer having to borrow to meet the repayments;
4 without failing to make any other payment the customer has a contractual or statutory obligation to make; and
5 without the repayments having a significant adverse impact on the customer’s financial situation.