The UK’s Financial Services Authority is proposing reform to the funding of its industry contingency fund, known as the Financial Services Compensation Scheme.

The reforms are designed to create a funding system that will: be more robust and sustainable than the present arrangements; promote a greater degree of consumer protection and maintain market confidence; apportion the cost of compensation between regulated firms as fairly as possible; and,
be relatively simple to administer.

FSA director Graeme Ashley-Fenn said, “An effective system for compensating consumers for losses incurred when a financial services company fails is an important part of the regulatory system.”

The key proposals in the consultation paper relate to retail business and propose: introducing a ‘widening circle’ model of funding under which the first tranche of compensation costs emerging from a particular sub-class of firms is borne by that sub-class alone, while higher costs are shared more widely; and, expanding the overall financial capacity of the scheme – up to a maximum of £4.4 billion per annum.

The scheme would be divided into five broad classes (life and pensions; investments; general insurance; deposits; and home finance). Each class would have two sub-classes and above the broad classes would be a general retail pool. The initial tranche of costs would fall to the relevant sub-class, the next tranche to the relevant broad class and then finally above that to a general retail pool. This last resort would only be triggered in the event of a significant default, or series of defaults, which meant losses overwhelmed a single class.

Although wholesale business is not capable of giving rise to claims on the compensation scheme, the FSA in principle favours making it possible to have recourse to the wholesale sector for a proportionate contribution to funding the scheme. This is in recognition of the links between retail and wholesale business within the UK’s financial services and of the benefit the wholesale sector derives from public confidence in the financial system as a whole. It is expected the wholesale pool could add a further annual £1 billion – £2 billion of funding to the FSCS, further increasing its financial capacity. The FSA plans to set out its proposals for wholesale funding, and potential tariff measure changes, in a supplementary consultation paper later this year.

“While it is not possible to devise funding arrangements which will command universal support from the industry, there was general acceptance that the present arrangements were no longer fit for purpose. We believe the proposed model is more rational, fairer to the various players in the market and more robust,” added Ashley-Fenn. “The proposed system will be capable of meeting current issues such as endowment mis-selling, but more importantly, will now provide compensation for the ‘unknown unkowns’ — the future potential compensation claims which no-one has yet thought about.”

The FSA and the FSCS have worked closely with an Industry Advisory Group made up of trade associations and the Financial Services Practitioner and Consumer Panels and the FSA Smaller Businesses Practitioner Panel, to make sure that all viewpoints and arguments have been considered.

Subject to the consultation process, the FSA proposes that new funding arrangements will come into effect from April 2008.