The UK’s Financial Services Authority is proposing four possible options for funding its industry contingency fund, known as the Financial Services Compensation Scheme.

The move comes in response to concerns raised about the fairness, proportionality and sustainability of the system’s current funding arrangements. The options are set out in a discussion paper published together with a report by Oxera, the economic consultants who were commissioned to write an independent analysis of the scheme.

The discussion paper proposes to divide the scheme into five broad classes (life and pensions; securities, mutual funds and derivatives; deposits; general insurance; and mortgages). It then proposes four options for future funding: the broad classes would stand alone with no cross-subsidy between each class; above the broad classes would be a general pool whose operation would be triggered by catastrophic losses which overwhelmed a single class; including sub-classes within the broad classes, where each sub-class would meet the first tranche of liabilities; or, a widening net with sub-classes, classes and a general pool.

FSA managing director David Kenmir indicated that it prefers the creation of a general pool above the various broad classes, “which initially apportions the cost of compensation to the broad classes, and then once claims exceed a certain financial amount spreads the cost amongst all those who contribute. We believe this will be much more robust than the present arrangements, will allocate costs to firms that have a mutual interest in maintaining the confidence of consumers who use markets within which they operate, and will be relatively simple to administer.”

After evaluating the responses to the paper, the FSA will bring publish draft rules for funding the scheme in a consultation paper this autumn. The FSA expects that these will not come into effect before October 2007.

“Having an effective system for compensating consumers for losses incurred when a financial services company fails is a vital part of the regulatory system,” Kenmir added. “We recognize that it is not possible to devise funding arrangements which will command universal support. However, through an open and fair discussion process, we hope to design funding arrangements which apportion the cost of compensation between regulated firms as fairly as possible. Discussions about this issue tend to focus on today’s problems such as endowment mis-selling, but the scheme must also be capable of providing compensation for tomorrow’s problems.”

“The FSCS plays a vital role in maintaining consumer confidence in the financial services industry, a role from which all firms benefit,” added FSCS chief executive Loretta Minghella. “We need a funding structure that is sustainable, that smoothes volatility in compensation bills and provides sufficient funding to let us get on with the job we are here to do. We believe that sharing compensation costs across broader classes of firms in future will provide the fairest and most resilient system for the longer term.”