Financial Conduct Authority entrenches 'culture' at centre of regulatory supervision

The Financial Conduct Authority (FCA) has highlighted for some time the importance of "culture" – once described by theorist Raymond Williams as one of the "two or three most complicated words in the English language" – and has made recent efforts to pin down more precisely what is meant by this concept and its implications and risks for firms in practice.

The FCA's Approach to Supervision consultation paper and its Business Plan 2020/2021 both outline how business models and culture can be the key cause of harm in firms and in March 2020 the regulator published a discussion paper (DP20/1) on driving purposeful cultures.

The FCA defines culture as the habitual behaviours and mindsets that characterise an organisation, and focuses on four key drivers which it believes can lead to harm: purpose; leadership; approach to rewarding and managing people; and governance.

Marc Teasdale, director of wholesale supervision at the FCA, in a speech given to the Investment Management Association in September last year, reiterated these four drivers and that culture is at the heart of how the FCA authorises and supervises firms. But it is the responsibility of everyone in financial services to focus on culture, with the FCA expecting leaders to manage the drivers of behaviour in their firms to create and maintain cultures which reduce the potential for harm.

Corporate purpose

The FCA sees a firm's purpose as being a description of its economic function and how it makes money. Although on one level it is just a description of a firm's business model, it also its reason for existing and why the world would be worse off without the value it provides.

This raises wider questions about the role of the modern corporation and the primacy of shareholder interests in relation to the interests of other stakeholders, Mr Teasdale acknowledged. The March 2020 discussion paper places the direction for firms to be more purposeful in the context of "stakeholder capitalism" – a challenge to the economist Milton Friedman's well-known contention that anything other than maximising shareholding value is spending someone else's money for a general social interest – and increasingly insistent calls for firms to take the lead on issues such as climate change, diversity and inclusion, the ethical use of data and ethical taxation.

This chimes with the emphasis now placed on environmental, social and governance considerations in the asset management sector. However, the FCA is not asking firms to fix climate change, for example, and it recognises the social value inherent within a business providing financial services and products. While the UK regulator will not try to prescribe what a firm's purpose should be, it considers that a firm's articulation of its purpose is a crucial driver of its culture.

Traditionally, the focus has been on risk and return. Asset managers now recognise that an important third dimension has evolved – which is impact. The term "impact adjusted profits" is likely to be heard much more often in future years. The Covid-19 pandemic and global focus on climate change is also fundamentally changing client needs within the asset management sector. The demand for sustainable investing is on the rise and the challenge for firms will be how they respond to this change, both culturally and from a leadership perspective. While the industry is making progress, there is a need for firms to think holistically across their purpose and strategy to determine how they want to contribute to society.

The role of governance

The speech last September presented governance as extending beyond the formal board or most senior levels to the broader set of processes, systems, controls and arrangements behind decision-making.

In its Dear CEO letter of January 2020 to alternative asset managers, the FCA stated that the purpose of the asset management sector was to protect and grow the capital of its customers and to oversee their investments effectively over the long term, but that overall standards of governance (critical to the success of firms in delivering long-term returns for investors) generally fall below expectations. Alternative investment managers should continue to consider whether they need to take action in relation to the six supervisory priorities linked to inadequate governance and identified in that letter: investor exposure to inappropriate products or levels of investment risk; client money and custody asset controls; market abuse; risk management controls; financial crime; and Brexit preparedness.

The FCA also considers the extension of the Senior Managers and Certification Regime (SMCR) to solo-regulated firms to be part of its wider work in transforming culture and governance in financial services. The regime's origins lie in the recommendation put forward after the financial crisis by the Parliamentary Commission on Banking Standards that UK financial services regulators needed to develop a new accountability system more focused on senior managers and individual responsibility.

Elements of the regime such as the requirement for senior managers to have a statement of responsibilities and the statutory duty of responsibility applicable to senior managers are aimed at achieving this. The FCA would no doubt hope that the transition from the approved persons regime to SMCR has gone beyond a rules-based compliance exercise to a more considered and ongoing reassessment of a firm's approach to its governance and culture.

Diversity and inclusion

The FCA also believes that diversity and inclusion (D&I) have an important role to play in supporting strong governance. In a speech delivered last year, the FCA's Christopher Woolard argued that diversity matters not just morally but because different voices around the table enable challenge. Misconduct can flourish in firms that do not value challenge and internal debate.

Mr Teasdale asserted that firms that seek out and welcome diverse and differing views are more likely to successfully identify and manage risks, be less susceptible to group-think, and generally make better decisions. Mr Teasdale also pivoted from diversity within an organisation to diversity in a client context: if the basic purpose of the asset management industry is to act in the best interest of investors that must mean all investors, irrespective of their gender, ethnicity or other characteristics.

For more detail on what D&I means for the investment funds industry, how the FCA is considering regulating the issue, and what steps fund managers should consider taking to get ahead of the curve, please see our Insight.

Bad culture

Poor culture often goes hand in hand with a breach of the FCA's Principles, particularly Principle 2 (due skill, care and diligence), Principle 3 (management and control) and Principle 11 (relations with regulators).

The FCA has a range of enforcement tools to crack down on misconduct, including private warnings, fines, public censure, the suspension, withdrawal or variation of a firm's authorisation, and sanctions on individuals knowingly concerned in a breach. In conjunction with that, or separately via its supervisory activities, the regulator can require firms to put in place remediation measures. Good culture is therefore not a "nice to have" and firms should take heed of the FCA's emphasis on this area.

Enforcement data in the FCA's 2018/19 Annual Report show 70 cases in the culture and governance category open at 31 March 2019, with 20 new cases opened in the year from 1 April 2018 (compared to 10 cases open in relation to financial promotions, for example). The FCA's 2019/20 Annual Report includes more case categories than the preceding year's breakdown but does not include culture and governance as a distinct category, suggesting, perhaps, that culture and governance may now be seen as underlying themes running through much of its enforcement action.

Enforcement decisions themselves specifically finding bad culture have, to date, been few and far between (The Bank of Beirut's £2m fine and suspension of activities - and related fines for the compliance officer and internal auditor in 2015 - was a notable exception in the context of compliance with anti-money laundering requirements and cooperation with the FCA). However, they will clearly form the basis of action where found in the future.

Cultural context

As firms continue to adapt to changed working practices as a result of the coronavirus pandemic, and deal with the potential effects of working from home on workplace culture in the broadest sense, the FCA is likely to continue its focus on culture and its key drivers. The emphasis on culture can also be seen in the context of the future of regulation and a move to a more outcomes-based approach, which gives regulators (and firms) greater flexibility but can be challenging for firms from a legal certainty perspective.

Asset managers have the tools to engender and generate change, and the active stewardship role that firms can play with respect to their investee companies is unique. However, the challenge also lies in how they demonstrate their commitment to change in the way that they themselves behave as companies.

To respond to the FCA's continued focus on this area, firms are encouraged to revisit and articulate their core purpose, ensure that this is understood throughout the business, encourage diversity of perspectives and experience, and consider how management information can be used to inform a firm's assessment of its culture on an ongoing basis.

Osborne Clarke is well placed to assist fund managers and other firms with cultural reviews, including advising in relation to governance arrangements and the supervisory priorities identified in the January Dear CEO letter and in the recent FCA speeches.