Under Dutch law, the interests of clients must be taken into account in the manufacturing and distribution process of financial products. First, to prevent any mis-selling, and second, to maintain overall trust in the financial sector.
In order to ensure this, the manufacturing of financial products by financial institutions is governed by statutory requirements which obligate them to have effective product governance in place.
Scenario analysis
An important part of product governance revolves around conducting scenario analysis to determine whether a financial product meets – and at least does not compromise – the identified objectives, needs and characteristics of the clients the product was designed for (the target market).
Sectoral rules (such as the Insurance Distribution Directive and delegated regulations to the Markets in Financial Instruments Directive) and competent authorities, such as the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) provide some guidance as to what scenario analysis must entail.
However, the Dutch Authority for the Financial Markets (AFM) has concluded, based on its recent research on product governance, that there is a need for additional guidance on conducting scenario analysis.
On 17 April 2024, the AFM launched a consultation on guidelines (leidraad) for "scenario analyses from a client perspective", which emphasise the importance of scenario analysis for adequate product governance and provides guidance on conducting such analysis.
Overview of legal framework for product governance
Financial institutions, such as financial service providers and investment firms, must have adequate procedures in place that determine how financial products are manufactured (the Product Approval and Review Process, PARP). This process must ensure that a financial product is demonstrably the result of a balanced consideration of interests, which (thus) takes into account the client's interests.
The PARP must, as a minimum, ensure that:
- the target market of the financial product is well defined;
- the product information and, to the extent reasonably expected, the distribution of the financial product is tailored to the objective of the target market;
- regular monitoring and, if necessary, appropriate adjustment of the PARP takes place; and
- analyses are conducted to determine the functioning of the financial product as a whole and its individual components in various different scenarios.
At its core, a PARP must ensure that the interests of the client and of the company (and possibly other stakeholders) are considered, so that financial products are only manufactured in the interests of clients and suit the target market. By taking into account various different scenarios, financial institutions can determine to what extent their financial product fits the target market.
Whether, and how thoroughly, scenario analysis must be conducted ultimately depends on the (complexity of a) specific financial product. Some financial products, such as regular savings accounts, do not even require scenario analysis.
Different regimes for manufacturers and distributors
When it comes to product governance rules, the law differentiates between rules for manufacturers and rules for distributors. In short, manufacturers are financial institutions that manufacture or assemble financial products and offer these to the market. Distributors are financial institutions that distribute or sell financial products. The obligation to conduct scenario analysis only applies to manufacturers of financial products.
Distributors must however use the manufacturers' information, including information on the conducted scenario analysis, when deciding on their own distribution strategy. After all, distributors must themselves ensure that the financial products meet the needs, characteristics and objectives of the target market. Distributors may thus need to conduct their own analysis, which – the AFM suggests – may in some cases even include conducting scenario analysis.
Overview of AFM consultation guidelines
According to the AFM, financial institutions are well acquainted with conducting scenario analysis revolving around their own business, but struggle with conducting scenario analysis from the perspective of the clients. For example, financial institutions take into account the profitability of a financial product in various different scenarios, without taking into account the potential impact of its costs for the target market.
In the end, a financial product must demonstrably be the result of a thorough assessment of interests. Since scenario analysis are such a critical part of the product governance of a financial institution, the AFM decided to consult on guidelines on scenario analysis.
Conducting scenario analysis in practice
In order to conduct scenario analysis in the context of manufacturing a financial product, financial institutions must first determine which scenarios are relevant to the functioning of the product in relation to the target market, and which scenarios are less relevant. How relevant a particular scenario is depends on the financial product itself and what (potential) impact external factors may have on the functioning of that financial product.
Ultimately, financial institutions must identify all of the financial product's characteristics, all of the applicable relevant external factors and assess how different scenarios affect the functioning of that specific financial product. To map out the different effects of certain scenarios, financial institutions can make use of different fictional persons.
Which scenarios should be taken into account?
In its guidelines, the AFM lists various examples of scenarios that can be taken into account when conducting scenario analysis. However, it stresses that these are only examples, as each individual financial product requires its own assessment of which scenarios should be taken into account.
Among others, the AFM lists the following examples:
- Life events: with regard to certain financial products (such as mortgages) financial institutions should assess what the potential impact of relevant life events is on a client. Relevant life events could in this case be the death of a partner or permanently becoming unable to work due to sickness or disability.
- Macro-economic and other external developments: with regard to certain financial products (such as mortgages) external developments have a potential impact on a client. Relevant external developments could be changes in house prices or interest rates.
In its guidelines, the AFM provides for several components to be taken into account, to ensure that the PARP is conducted to a sufficient standard. Financial institutions must ensure that:
- relevant scenarios are established, taking into account all relevant aspects of a financial product, individually and jointly;
- scenario analysis is conducted thoroughly;
- results of these scenario analyses are taken into account in the PARP and contribute to a balanced consideration of interests;
- actions arising from the scenario analyses are carried out in a timely manner; and
- results of the scenario analyses are well documented.
The AFM emphasises that financial products must demonstrably be the result of a balanced consideration of interests. In the context of scenario analysis, this means that financial institutions must document (i) why certain scenarios are taken into account, (ii) what their results are, and (iii) how these results are used in their PARP.
Osborne Clarke comment
We recognise in the market that financial institutions struggle both with establishing PARPs and adhering to them. We therefore generally welcome the AFM's initiative, as it provides further guidance and clarity that can be useful in determining how scenario analysis can be conducted and how their results can be used in the PARP.
However, these guidelines are not meant to replace sectoral rules, which may require financial institutions to conduct specific scenario analysis (for example, the manufacturing of financial instruments must take into account the scenario that the financial instrument fails to become commercially viable).
In addition, as the guidelines are example based, they do not establish clear boundaries that financial institutions can rely on to ensure compliance with the scenario analysis requirement. As a result, financial institutions are likely to continue to find it challenging to comply with the regulator's expectations in respect of scenario analysis requirements.
The guidelines are currently only in consultation phase. The market can provide input and comments on them until 7 June 2024.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.