Conduct risk

Between January 2011 and December 2019, UK banks and insurers paid £38.3 billion in refunds and compensation for one mis-sold product: payment protection insurance (FCA). No market crash, no rogue trader. Just millions of sales that should never have been made.

Most risks come from outside: markets move, borrowers default, systems fail. Conduct riskThe risk that a firm's behaviour, or its staff's, leads to poor outcomes for customers or harms the integrity of markets. comes from inside: the firm, or its staff, behaving in a way that harms customers or markets. It has two faces:

Conduct risk grows from the things this module has covered: incentives that reward sales over suitability (L2.3.08: Risk culture and incentives), boards that do not ask how profits are made, and control functions too weak to say no. When it crystallises, it shows up as fines and customer redressMoney a firm pays to put customers back in the position they would have been in without the wrongdoing., which Basel counts as operational risk losses, and as lasting damage to reputation.

Case 1: PPI mis-selling (UK). Payment protection insurancePayment protection insurance: cover sold with loans and cards to meet repayments if the borrower fell ill or lost their job. was sold with loans, credit cards and mortgages from the 1990s to the late 2000s. It was meant to cover repayments if the borrower fell ill or lost their job. Much of it was sold to people who could not claim (the self-employed, people with existing illnesses), added without a clear choice, or sold with commissions that took a large share of the premium. Staff targets and bonuses pushed the sales.

After the regulator set out how complaints should be handled, the banks challenged it in court and lost in April 2011. Redress began in earnest: refunded premiums plus interest. A deadline for complaints was set for 29 August 2019. By then PPI had become the most expensive mis-selling case in UK history.

Case 2: LIBOR rigging. You met LIBOR in L1.6.05: Benchmark rates: from LIBOR to SOFR, €STR and SONIA: each day panel banks submitted an estimate of what they would pay to borrow, and the average set rates on trillions of dollars of contracts. Because the submissionsThe rate a panel bank reported each day as its estimate of what it would pay to borrow, used to set LIBOR. were estimates, not trades, they could be bent. Two kinds of misconduct came to light: derivatives traders asking submitters to move the rate to help their positions, and banks lowballingSubmitting an artificially low borrowing rate to make a bank look financially stronger than it was. their submissions during the crisis to look stronger. Step through what followed.

A customer took a loan with PPI and paid £240 of premiums at the start of 2006, 2007 and 2008. The complaint is upheld and settled at the start of 2016. Redress refunds the premiums plus simple interest at 8% a year from each payment to settlement.

• UK: the FCA's Consumer DutyThe FCA's rules, in force from July 2023, requiring firms to deliver good outcomes for retail customers., in force from 31 July 2023 (July 2024 for closed products), requires firms to act in good faith, avoid foreseeable harm and deliver good outcomes on products and services, price and value, consumer understanding and consumer support. Benchmark submission is now a regulated activity.
• EU: MiFID II (from January 2018) adds product governance and limits inducements; the Benchmarks Regulation (2016) regulates benchmark administrators and contributors.
• US: the Consumer Financial Protection Bureau (from 2011) polices unfair, deceptive or abusive practices; the SEC's Regulation Best Interest (compliance from June 2020) covers advice to retail investors.
• Asia-Pacific: Australia's Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (final report February 2019) led to new design and distribution obligations; Singapore and Hong Kong have fair dealing and conduct codes.
• Global: IOSCO's Principles for Financial Benchmarks (2013) and the FSB's misconduct risk toolkit (2018). Conduct losses feed into operational risk capital, covered in Level 4: Regulation, Capital & Accounting.

• Conduct risk is the risk that a firm's behaviour harms customers or markets. It comes from inside the firm.
• Its roots are incentives, product design, culture and weak challenge: the same governance failures as the rest of this module.
• PPI mis-selling cost UK firms £38.3 billion in redress from 2011 to 2019: refunded premiums plus interest, multiplied by millions of sales.
• LIBOR was bent by traders' requests and by crisis-era lowballing; fines, personal accountability (SM&CR) and transaction-based benchmarks followed.
• Today's regimes focus on outcomes: the UK Consumer Duty, MiFID II product governance, the US CFPB and Reg BI, Australia's post-Royal Commission rules.

Conduct risk

The risk that a firm's behaviour, or its staff's, leads to poor outcomes for customers or harms the integrity of markets.

Mis-selling

Selling a product that is unsuitable for the customer, or without explaining what they are buying.

PPI

Payment protection insurance: cover sold with loans and cards to meet repayments if the borrower fell ill or lost their job.

Redress

Money a firm pays to put customers back in the position they would have been in without the wrongdoing.

Submission

The rate a panel bank reported each day as its estimate of what it would pay to borrow, used to set LIBOR.

Lowballing

Submitting an artificially low borrowing rate to make a bank look financially stronger than it was.

Consumer Duty

The FCA's rules, in force from July 2023, requiring firms to deliver good outcomes for retail customers.