The UK Financial Services Authority issues warning on outsourcing

The FSA has written a ‘Dear CEO Letter’ expressing concern that the asset management industry may not have “effective recovery and resolution plans” in place should an outsourcing provider face financial distress or severe operational disruption which could lead to client detriment. The full text of the 11 December 2012 letter appears here.

The FSA states that firms’ Boards must consider the implications of outsourcing to a third party supplier and the regulatory requirements that apply. The FSA calls on firms to exercise “due skill and care and diligence” whenever they enter into, manage or terminate any outsourcing arrangement.

The FSA’s letter highlights its growing concern about the risks associated with asset management firms which outsource operational activities to third party providers. The FSA has been looking at firms’ contingency plans and has concerns about a number of them. These concerns include asset managers relying on the fact that an outsourcing firm is part of a financial institution that is deemed too big to fail. The FSA says that this approach is imprudent, as the FSA might actually allow such institutions to fail.

It also cites a general lack of awareness as to the time and resource constraints for bringing activities back in-house or transitioning them to another service provider. The FSA is concerned that a plan to transfer to another provider may not be a realistic option, citing concentration risk in the supply of certain activities. The industry, which includes custodians BNP Paribas, State Street, BNY Mellon and Citigroup, has seen consolidation in the past year, including the acquisition of Goldman Sachs’s hedge fund administration unit by State Street and SS&C Technologies’ acquisition of GlobeOp, the middle and back-office fund services firm.

The FSA is also concerned that, in a stressed scenario, contractual “step in” rights may prove difficult to enforce resulting in undue delay and/or operational risks to the detriment of customers.

As a consequence, UK-regulated asset managers are required to review their current contingency plans taking into account the observations in the FSA’s letter to ensure compliance with their regulatory obligations. Constructive feedback from the asset management industry as a whole is also solicited. The FSA will host an industry event next year to facilitate an exchange of views aimed at achieving “effective recovery and resolution plans in place for the asset management industry as a whole.”