Endowment mortgages, personal pensions, split capital investment trusts, payment protection insurance, interest rate swaps. The list of product innovations in financial services over the past few decades is long. Sadly, so too is the list of misselling scandals, and the overlap between these two lists is unavoidable and conspicuous. It also presents a serious and growing challenge to the industry.
Some of these product innovations have hit trouble for reasons of simple misselling. Products were sold to people who did not understand them well enough to work out whether they needed them or not.
"The inescapable conclusion is that both the costs and the risks of product innovation are rising"A person eligible to join their employer's final-salary pension scheme should not be advised to purchase a defined contribution personal pension, yet thousands were. Someone who is self-employed should not be sold an insurance product that pays out if they lose their job, but again, thousands were.
However, recent history also throws up examples of financial innovations where the question of right and wrong is less clear-cut.
Take endowment mortgages. Early purchasers of these products in the 1980s had few complaints - the markets performed strongly and borrowers generally got back at least enough to clear their mortgage principal and sometimes more. Or interest rate swaps. For years these provided peace of mind to borrowers facing the risk of higher outgoings. More recently, these swaps have become another badge of shame for banks as rates fell and borrowers ended up on the losing end of the bet. In both these cases, the products fell victim to a change in market conditions.
Change of authority
The switch from the FSA to the FCA in April last year placed greater emphasis on firms' conduct: how they sell what they sell, how they decide who their customers should be and how they monitor their own performance and practices.
Financial innovators will have to demonstrate that they did enough to be sure that the product they sold was suitable for the individual, that the buyer understood what they were buying, and that the sales process was fair and transparent. This is very good in principle, but it is fraught with practical difficulties.
First, the legal documentation is often far too technical and voluminous to be intelligible to 99% of potential buyers, so it will remain very difficult to demonstrate conclusively that the buyer understood what they were buying.
Second, the real profit in financial services comes from selling standardised products to large numbers of people. Maintaining a wider range of products, each of which is sold to a smaller group of customers, is more expensive and therefore less profitable.
Third, will companies be liable to misconduct claims if conditions change and products that appeared suitable at one time no longer look that way, as happened with endowment mortgages or interest rate swaps? That's a big risk and demands an ongoing assessment of suitability.
Risks on the riseThe inescapable conclusion of all this is that both the costs and the risks of product innovation are rising and that these burdens will be passed on to customers in higher costs and to shareholders in higher fines. It is probably prudent, therefore, to assume that henceforth, there will be at least four routine claims on the profits of financial services companies: taxes, dividends, remuneration and fines. Government, shareholders, staff and regulators will all take their share.
For financial services companies, the rule is now caveat vendor. For their shareholders, it remains caveat emptor.
The original version of this article, written by Andrew Davis, was published in the June 2014 print edition of the Review.