04/03/2010
Author: Julian Korek
Comment: Julian Korek
Last week’s Financial Services Authority (FSA) survey may have absolved hedge funds of any systemic threat, but that does not mean that the UK regulator is planning to soften its supervisory
stance. In fact, it is clear that the FSA no longer wants to be seen as impotent in the wake of the recent financial crisis. With a 30% increase in the number of supervisors and the launch of more
intrusive supervision, there are strong reasons for hedge fund managers to take regulation and compliance increasingly seriously.
There has been plenty of talk of intensified supervision, but what does this mean in practice? Firstly, a 600% increase in fines handed out. Barclays was recently fined £2.45m ($3.67m) for
serious weaknesses in its systems and controls. This is only one example of the FSA’s increased wish to pursue cases as a credible deterrent. In the year to April 2009, the FSA brought 240
cases to enforcement and levied £27.4m ($41m) in fines, compared to 90 cases and £4.5m ($6.74m) in fines the previous year.
In a recent FSA regulatory update, it ascertained that it will move from its previous focus on individual firms – their systems, processes and probity – to concentrate on the overall
system, meaning macro-prudential risk, business models and strategies, as well as technical competence at individual firms.
Small firms should no longer think their size will keep them under the FSA radar. The FSA is launching an enhanced strategy with small firms. Moreover, there will be an increased frequency of
Treating Customers Fairly (TCF) follow-up visits and retail distribution reviews (RDR).
Individuals will also be under increased scrutiny. For persons in control functions, there is a new approach to approving and supervising persons performing Significant Influence Functions (SIFs).
Essentially, it will become more difficult to get through FSA interviews, and this higher level of oversight, has resulted in a backlog of cases awaiting approval at the FSA.
The FSA is also requiring more sophisticated stress-testing as part of its determination of whether firms are able to comply with the capital adequacy framework. The current models assume a
recession more severe and more prolonged than those which the UK suffered in the 1980s and 1990s and therefore more severe than any other since the Second World War. It assumes a peak-to-trough
fall in GDP of over 6%, with growth not returning until 2011 and only returning to trend growth rate in 2012. The requirement for stress-testing of models is likely to intensify even more in the
future.
In order to underpin the intrusive supervisory regime, the FSA has set out to build more competence and recruit more staff in specialist areas. The focus is on greater supervisory resources of a
higher quality. The FSA recently set out to recruit 280 extra specialist and supervisory staff, representing a 30% increase in their supervisory capacity. This increase in capacity will likely
challenge hedge fund managers and their need to be fully up to speed with current regulatory hot issues.
The FSA is also shifting its regulatory approach. A central part of the intrusive supervisory regime is the outcomes testing. Instead of reviews of high-level management information, the FSA is
using its resources to engage in ‘mystery shopping’ and ‘office visits’. This will serve the basis for the assessment of adequate systems and controls. Hedge fund managers
need to be prepared for visits.
Lastly, a focus on naming and shaming individuals. As if the increase in supervisory resources and intensified supervisory methods were not enough, the FSA is actively looking to set examples.
There is already a steady increase in enforcement cases and fines. In addition, the FSA has recently launched a number of criminal prosecutions for insider dealing. This has resulted in many
organisations finding that their executives are no longer considered ‘fit and proper’, or have been deemed unfit to hold senior management or control positions.
The FSA’s sharpening of its supervisory claws should not be underestimated. The increased risk of regulatory cost, as Section 166s, enforcement cases and fines are surging. Firms need to work
more actively to prepare for FSA visits and to review their internal controls and governance procedures. Otherwise, be prepared for spending most of your management time dealing with a long list of
remedial issues
Julian Korek is a founding member of Kinetic Partners, a hedge fund advisory firm
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