As the FCA identifies a culture dividend from diversity and inclusion, firms should prepare for more scrutiny

In the wake of the 2007/08 financial crisis, Neelie Kroes, EU Competition Commissioner, pithily summarised diversity and inclusion (D&I) shortcomings in the financial services industry with reference to a mythical ‘Lehman Sisters’ which, she said, would have weathered the storm better than the real Lehman Brothers.

In the last decade, society’s focus on D&I issues has steadily increased. It has been driven by public outcry in response to specific events such as the revelations that led to the #MeToo movement and the death of George Floyd which raised awareness of the Black Lives Matter movement. The broader societal focus on D&I has been mirrored in the context of financial services. Generally, regulators anticipate that D&I delivers a conduct and culture dividend, and frequently point to instances of academic research which support this conclusion.

It is in that context that the FCA CEO Nikhil Rathi delivered the address at HM Treasury’s launch of the Women in Finance Charter Annual Review 2021 in March. In this post, we look at the groundwork that Mr Rathi’s speech lays for regulated firms and individuals as they prepare for greater regulatory scrutiny in relation to D&I.

The Women in Finance Charter as a model for D&I initiatives

The Charter was originally launched in response to a 2015 review led by then Virgin Money CEO, Dame Jayne-Anne Gadhia into the representation of women in senior managerial roles in UK financial services. Charter signatories, of which there are now in excess of 400, pledge to:

• designate one member of the senior executive team to be responsible for gender D&I;
• set internal targets for gender diversity in senior management;
• publish annual progress reports; and
• have an intention to ensure that senior executive pay is linked to the delivery of those internal targets.

The Charter, with its emphasis on annual disclosure, has a broader impact as a model for other initiatives, for example, the Government recently commissioned the City of London to lead a Taskforce on Socio-Economic Diversity in Financial and Professional Services. Indeed, the disclosure approach aids the FCA to the extent that it is one proxy measure of culture. This is not to say that D&I statistics are sufficient to provide a full picture of a firm’s culture, rather, these may be one indicator.

It is true that there is little immediate comeback on firms which fail to meet their Charter targets; however, the new FCA CEO seems keen to add some regulatory stick to the reputational carrot.

Progress, but not yet proficient

Mr Rathi remarked on the success of the Charter in driving change, but set those positives against a broader, less congratulatory background – for example, he highlighted that while 62% of signatories had seen an improvement in female representation in senior management roles, women account for less than a third of the senior management population, that women receive 28% less pay, and women account for only 17% of those approved by the FCA.

He also discussed D&I more broadly, noting that fewer than one in ten managerial roles in financial services are held by people from ethnic minorities. “This lack of diversity at the top,” commented Mr Rathi, “raises questions about firms’ ability to understand the different communities they serve, and their different needs.”

With D&I being the key theme in three of the six speeches made by FCA personnel in the first quarter of 2021, and being either the central or a featured theme in all but one of Mr Rathi’s speeches since he took up his post last year, it is fair to conclude that the regulatory focus will continue.

We expect that firms will see a mix of targeted D&I measures and what could be described as a ‘lens’ type approach from the FCA.

Diversity and inclusion specifics

In terms of specific measures, Mr Rathi suggested that the FCA will add a sixth question to its five conduct questions (5CQ) annual survey of wholesale firms: “is your management team diverse enough to provide adequate challenge and do you create the right environment in which people of all backgrounds can speak up?”.

He also suggested that the FCA may seek to factor D&I into its consideration of applications submitted for approval for senior manager roles. We can foresee some challenges which the FCA would need to address in respect of this proposed approach to senior manager approvals. For example, if the FCA perceives a firm’s senior management is not sufficiently diverse, either at the firm-wide or business-line specific level, how would it deny an application for senior manager approval without tarnishing the reputation of the specific individual who is the subject of the application? Firms should approach this issue with caution, too, as the FCA may retain a record of an application being withdrawn.

In the context of capital markets, Mr Rathi acknowledged the approach which the NASDAQ has taken, requiring (most) NASDAQ-listed companies to have or explain why they do not have at least two diverse directors. He suggested that the FCA will look at following this lead.

The diversity and inclusion ‘lens’

Mr Rathi explained that the conduct regulator is engaging with the Prudential Regulation Authority (PRA) to formalise its approach to D&I under the Public Sector Equality Duty and its own objectives. We expect that this will lead to an approach which sees D&I consideration embedded into existing FCA activities and engagements with firms; and an expectation that firms appropriately embed D&I in their activities. This echoes the sentiment expressed by Georgina Philippou, Senior Adviser to the FCA on the Public Sector Equality Duty, in a January speech: “Ultimately, we want to mainstream diversity and inclusion into all of our regulatory processes – from the gateway, in policy making, through to Supervision and Enforcement and everything else we do.”

For firms which have a dedicated supervision team, this could manifest in, for example, how the FCA conducts deep dive exercises into the firm’s processes and procedures, and how it engages with senior executives through the regulatory cycle. Accordingly, firms may want to give some thought to preparing their senior managers and business leaders to be questioned by the supervision team on D&I matters. For example, a senior manager might be asked how they encourage greater diversity among their direct reports and across their area of responsibility alongside the predictable questions about risk.

The majority of firms will not have a dedicated FCA supervision team, but they may expect to see the regulator overlaying the D&I lens in communications, specifically annual or biennial portfolio letters, and in other multi-firm work, such as thematic reviews. For example, a product governance thematic review might ask the firm to explain what information sources it uses to inform its D&I assessment of products. Put more simply, firms could be asked: how do you ensure that the product you have designed is appropriately accessible; and/or how do you assess this accessibility has been achieved?

The FCA’s own Ethnicity Action Plan may provide firms with some insights for their own approaches to D&I and also into the FCA’s likely areas of focus for its information gathering with firms. In particular, the plan highlights the role of transparency and data to develop understanding and inform goal-setting.

In conclusion

The regulatory focus on D&I will be a constant, not least because D&I is one facet of the Environment, Social and Governance (ESG) agenda. Firms and firms’ leadership should prepare to be responsive to the expectations of regulators (and, in some cases, of their staff, customers and other stakeholders) on how they embed D&I and also on how the firm acts if it gets something wrong or a shortcoming becomes apparent.