The role of the Financial Services Compensation Scheme

Taking out a mortgage is one of the biggest financial commitments anyone can make. So it is important that consumers know what they are getting into, how it works, and what help is available if things go wrong.

It’s been over a year since the Financial Services Authority (FSA) became responsible for regulating mortgage advice. One of the benefits of regulation is, if things do go wrong, your customers now have access to the Financial Ombudsman Service (FOS), the independent service for resolving disputes between consumers and financial firms. It also means that if a firm can’t meet outstanding complaints against it, consumers can potentially seek redress from the Financial Services Compensation Scheme (FSCS).

FSCS is the UK’s statutory fund of last resort for customers of authorised financial services firms. It was set up under the Financial Services and Markets Act 2000 (FSMA) as the single compensation scheme for the sector, replacing previous schemes. FSCS pays compensation to customers of authorised financial services firms if they are unable to pay the claims against them. This will usually be because a firm has stopped trading and has insufficient assets to meet claims, or because it is insolvent. This is described by FSCS as being ‘in default’.

FSCS covers customers of authorised deposit takers (banks, building societies and credit unions), insurers, insurance intermediaries, investment firms, and mortgage intermediaries.

It plays a vital role – all firms benefit from the market confidence gained from the existence of a compensation scheme and without its help, thousands of consumers would have nowhere to turn. Since its inception in December 2001, FSCS has paid out over £650m in compensation to consumers who have valid claims against firms that are unable to pay. Claims against insurers and investment firms are currently two of the largest areas of activity for the Scheme. Fortunately to date, FSCS has received no claims relating to mortgage intermediaries.

Implications for brokers

There are many reasons why a firm may cease trading and is unable to pay the claims against it. Some claims for compensation arise many years after the transaction that caused the loss actually took place, and the firm has long since ceased trading. But what would happen if a mortgage broker did get into difficulties and owed its customers money?

If a mortgage broker has outstanding complaints against it, which it is unable to meet, then FSCS may be able to step in. On receiving a potential claim against a firm that has gone out of business, FSCS will investigate that firm’s ability to pay claims. As a fund of last resort, FSCS must be satisfied that there is nobody else there to pay claims before it can consider any claims for compensation.

If FSCS is satisfied that a firm is unable to meet potential claims, it will declare that firm ‘in default’. Declaring a firm in default is the final part of a process whereby a regulated firm (such as a mortgage broker) has been found to be unable to pay claims. This means that customers who have lost money as a result of dealings with these firms can then make a claim for compensation to the FSCS.

So, in summary the Scheme will declare a firm in default if:

• it has received at least one eligible claim (in accordance with our rules); and
• it is satisfied that the firm is unable (or likely to be unable) to pay claims against it.

It is generally not possible to forecast how many consumers might be affected by a particular default declaration. Not all consumers who dealt with a firm that is declared in default will have suffered a loss. But by declaring a firm in default, FSCS is letting people know that if they have lost money, it may be able to help.

Since 1 December 2001, when it became operational, FSCS has declared almost 1,000 firms in default. 1,838 firms were declared in default by one of its predecessor schemes, the Investors Compensation Scheme (ICS) (28 August 1988 to 30 November 2001). The good news is that, to date, none of these have been in relation to mortgage broking.

Money, money, money

It’s important to point out that FSCS can only pay compensation where a consumer has suffered a financial loss because of their dealings with the firm, for example, due to bad advice, and where the firm is unable to pay. Each claim is considered on its own merits. There are limits to the amounts of compensation that FSCS can pay to each consumer, set out under its rules which are made by the FSA. The maximum amount FSCS can pay in respect of mortgage intermediaries is £48,000 (100 per cent of the first £30,000 and 90 per cent of the next £20,000).

FSCS is funded by levies on authorised firms. The amount levied for compensation payments is an estimate of the compensation costs it expects to pay based on estimated claims for the 12 months following the levy date, assumed to be 1 July each year, allowing for fund balances. The management expenses levy is subject to an annual limit but is based on FSCS’s budget requirements for each year. In general it raises a levy once a year.

Readers will no doubt be aware that the FSA is currently reviewing the funding system for FSCS. A discussion paper on potential changes to the funding system is due to be issued in March. Under the current system, for levying purposes, FSCS business is split into sub-schemes:

• accepting deposits,
• insurance business,
• designated investments,
• mortgage advice and arranging (from 31 October 2004), and
• general insurance mediation (from 14 January 2005).

For each sub-scheme there are a number of contribution groups, based on the ‘fee blocks’ used by the FSA for allocating its own fees to regulated firms. Firms are allocated to a contribution group (or groups) according to their regulated permissions, i.e. the type of business they are authorised by the FSA to transact.

All firms contribute to the general running costs of the Scheme (the base costs element of the management expenses), in proportion to their FSA fees. Firms are levied for compensation costs by reference to tariffs set for the relevant contribution group. Levy invoices are issued and collected by the FSA in a single invoice covering FSA, FOS (Financial Ombudsman Service) and FSCS fees.

The levy FSCS can raise for its management costs is limited each year, according to the Management Expenses Levy Limit (MELL) set by the FSA after consultation.

There is also a limit to how much FSCS can levy sub-schemes for compensation costs in any one financial year. For mortgage firms, this is no more than 0.8 per cent of annual eligible income per financial year.

Types of claims FSCS might consider in relation to mortgage broking include:

• Where a consumer has not been advised about the different types of mortgage available, which resulted in them choosing a mortgage that was not suitable for them at the time. They have lost money as a result.
• If specific details of the mortgage chosen are incorrect, for example, a longer term has been selected than the consumer had intended or required, and the consumer has lost money as a result.
• If a consumer was advised to switch mortgages but was not given an adequate explanation of why a switch should be made, and the advice to switch mortgages resulted in the consumer losing money.
• If a consumer was advised to take out a lifetime mortgage that was unsuitable for their circumstances at the time and they have lost money as a result.

One of the key challenges for industry must be to prevent claims coming to FSCS in the first place.

However, providing protection when things go wrong is crucial to underpinning confidence in the sector. We hope you now have a better understanding of FSCS’s role.

Loretta Minghella is chief executive at FSCS