Stung both by the global financial crisis and a variety of scandals in the financial services industry, Britain’s Financial Services Authority has decided that the traditional regulatory approach doesn’t work well enough in retail financial services. As a result, the FSA is now considering a variety of radical new tactics that could change the way regulators oversee retail markets.

Historically, the FSA has taken a fairly conventional approach to retail regulation, relying primarily on disclosure to ensure that consumers get a fair shake from financial services firms. However, in recent years, the regulator has become concerned that this method isn’t getting the job done. The FSA has initiated some significant reforms, including a move to do away with embedded commissions. Now, it is looking to go even further than that.

In a discussion paper released in January, the FSA is proposing a further shift in tactics and is contemplating a range of more intrusive measures — everything from banning certain products to slapping cigarette package-style warnings on them and requiring financial advisors to explain to clients why a pricier product is better than a cheaper alternative.

All of these new measures are under consideration, the FSA paper says, because the regulator has come to realize that there are “fundamental reasons why financial services markets do not always work well for consumers.” As a result, the FSA is adopting a new approach, based on early regulatory intervention to prevent possible harm to consumers rather than simply reacting to problems after they arise: “Our new strategy signals a decisive shift in our tolerance for the amount of actual harm or detriment we are prepared to allow to happen.”

The problem with the traditional regulatory strategy that relies primarily on disclosure to arm consumers to make informed choices is that it often doesn’t work, both because of the way consumers tend to behave and the fact firms can take advantage of these tendencies. The FSA paper notes that, in many cases, consumers ignore product disclosure altogether or don’t pay enough attention to it: “Patterns of consumer behaviour are open to exploitation by firms [and] product features can exacerbate these problems.”

The FSA paper indicates that retail financial market failures are often because of consumers’ lack of market power. Either consumers lack the information to make smart decisions or they don’t use it properly. The products are too complicated and confusing to allow consumers to assess their quality. Problems with financial products can take years to materialize — and once they do, it’s then too late to do anything about them. As well, consumers are unable to exert meaningful pressure on financial services firms by taking their business elsewhere.

All of these problems are exacerbated when distributors’ incentives are not aligned with consumers’ interests, the paper adds: “In many markets, consumers often cannot learn from their mistakes in ways that allow them to put pressure on providers to offer good quality and good value products. In such circumstances, firms may seek to benefit from using opaque charging structures or lowering quality levels.”@page_break@Typically, regulators have tried to correct these imbalances through disclosure. However, the FSA has now concluded that disclosure often doesn’t work — and the FSA views this problem as being peculiar to financial services: “Our view is that it is inherently more difficult for competition in retail financial services to be as effective as it is in other consumer sectors.”

So, the FSA is considering more intrusive tactics to try to level the playing field a bit on behalf of consumers. The FSA paper indicates the regulator may consider banning products that have characteristics of the sort that often end up causing consumer harm.

These features include: products that are complex, sold bundled with other products or are particularly opaque; products that charge layers of fees, have charges levied throughout the life of the product or fees that represent a barrier to exiting the product. For investment products, in particular, the red flags include: products that rely on unusual assets; misleading product names; ongoing fees that don’t reflect the level of service provided; and products that carry risks that are hard to assess.

Banning products isn’t something the FSA typically has done, nor is interfering with product pricing; however, the FSA is now considering that option, too, having “repeatedly found problems with the pricing of retail financial products” — whereby firms exploit the difficulty consumers have in understanding their fees.

The FSA paper proposes several ways to regulate pricing, including: simply capping prices; imposing a requirement on firms to ensure a product’s pricing structure is appropriate for the target market; requiring firms to test whether a product’s charging structure could make it uneconomic; or requiring advisors to benchmark their product recommendations against a low-cost substitute — in other words, when selling a mutual fund, for example, advisors could be required to justify in writing why a pricier fund is more suitable than a similar, cheaper fund.

“We are not saying that low charges are always best for all customers,” the FSA paper says. “For some customers, it may be better to pay higher charges to benefit from product features that are genuinely important to them.”

However, the FSA paper indicates that, in general, the default should be cheaper products — and that more expensive alternatives “should only be used where the benefits can be shown to outweigh the higher charges.”

In addition to these more radical measures, the FSA paper suggests that the regulator may entertain other tactics, such as issuing warnings to consumers about specific products that it sees as being particularly risky for the average retail investor — such as complicated structured products and leveraged exchange-traded funds.

Or the FSA may require firms to put cigarette package-style warnings on products that it believes may be dubious bets for retail clients. IE