The FSA has set out details of how structured products should be stress-tested.
Today’s final guidance from the FSA follows draft guidance in November triggered by a market review which found weaknesses in the way firms are designing and approving the products. The guidance applies to the design of structured products and the after-sales process.
The review was carried out between November 2010 and May 2011 and focused on seven major providers of structured products, responsible for about half of the structured products in the UK retail market by volume and value.
In the final guidance, the regulator says it is taking action with those firms where it identified problems, which includes requiring significant change to product governance arrangements where necessary.
The FSA stated in its draft guidance that firms should stress-test new products to ensure they deliver fair customer outcomes. This should involve testing the products to establish how they would perform under a variety of conditions, including a failure of the firm’s systems.
The regulator has set out in its final guidance more details of structured product stress-testing. It says that stress tests should be built in to the product approval process, with defined triggers for when they are, or are not, to be applied. They may not need to be applied in very simple repetitions of a recent product.
The regulator says stress-testing should be forward-looking as well as back-testing and analyse the resilience of the product over its proposed term.
Scenario testing of the products includes internal risks, such as the failure of the firm’s systems or larger than expected volumes, and external risks such as market stresses, interest rates and currency risks.
The regulator says where there is a value for money test, such as a comparison with cash, “there should be a sufficiently demanding hurdle rate to reflect the opportunity cost of the ’next best’ use of the customer’s money.”
Providers should establish the probability of stressed outcomes that are likely to be acceptable to the target audience.