PRODUCT GOVERNANCE for financial products is an increasingly important area for banks and regulators. In part, this reflects the increasing complexity of financial products as a result of technological innovation (for a discussion of related issues in Lexicon, see “Fintech and smart contracts” in China Business Law Journal, volume 7, issue 8; “Cryptocurrencies” in China Business Law Journal, volume 8, issue 9; and “Regulating crypto assets” in China Business Law Journal, volume 13, issue 4). This article explains the concept of product governance, outlines operational and regulatory fundamentals, and considers developments in jurisdictions such as the UK, Australia, Hong Kong and mainland China.
WHAT IS PRODUCT GOVERNANCE?
A simple definition of product governance as the concept applies to financial products is:
“How firms design, operate and sell [or distribute] financial products.”
A more detailed definition refers to the processes and procedures across the life cycle of financial products and makes reference to the need to comply with the design and distribution obligations:
“Product governance arrangements are the systems, processes and procedures in place across the life cycle of financial products that can help ensure that an issuer or distributor complies with the design and distribution obligations.”
In recent years, regulators across the world have imposed obligations requiring financial institutions to design financial products to meet the needs of customers in the relevant target market and to distribute their products appropriately. These obligations are particularly relevant to financial products that are distributed to retail customers. However, such compliance also concerns business banking and wholesale or institutional markets.
Recently there has been increased emphasis on product governance for the whole product life cycle. This includes both upstream processes, which covers product development and design, and downstream activities such as marketing, distribution, and post-sale monitoring and handling. In other words, the relevance of the concept of product governance does not end with product development and design, but continues to apply to downstream activities in respect of the banking or financial product.
The emphasis on processes and procedures throughout the product life cycle is important, as experience has shown that achieving appropriate product governance and oversight is as much about having the correct procedures and processes as it is about having the right products and documentation (such as terms and conditions). This emphasis on procedures and processes captures the need for effective communications (both internal and external), record-keeping, monitoring, product testing and training. It also captures the need to have the right communications with the right people at the right times. In this regard, the right people include management and the risk and compliance team.
Elements of product governance include:
- The need to identify the type or category of customer for which a product or service is appropriate, to be clear about the nature of a product and its associated risks, and to provide disclosure accordingly.
- The need to have robust procedures to assess the target market and to perform adequate stress testing in respect of areas such as pricing, valuation and associated risks.
- Ensuring that distributors have correct information about the products they distribute.
- The responsibility of senior management to formulate appropriate product and distribution strategies and to ensure compliance with the product governance requirements. This means that senior management needs to be satisfied with the training for staff, and that the risk and compliance team is involved in product design and at subsequent stages.
At the heart of effective product governance and oversight is the need to have the right culture within a firm and to minimise conduct risk, namely, the risk of misconduct and deficient conduct. Managing conduct risk and maintaining the right culture within a financial institution for this purpose are increasingly attracting the attention of regulators.
For example, in its regulatory guidance, the UK’s Financial Conduct Authority has highlighted four points in particular: the need for senior management to put customers at the forefront of product governance; the need to engage in robust stress testing as part of the product approval process; the need to strengthen the monitoring of products; and the need to ensure customers are treated fairly throughout the product life cycle.
In Hong Kong, regulatory guidance by the Securities and Futures Commission in respect of investment products notes the increasing focus on product governance at both the early stages and throughout the life cycle of products. The guidance highlights the need to have appropriate internal product approval processes, to keep proper documentary records, and to undertake regular reviews of all products. It also highlights the importance of getting input from all relevant personnel, including the credit, marketing, and legal and compliance teams.
The Hong Kong guidance further notes the importance of ensuring that distributors have the necessary product knowledge to understand the product and advise customers accordingly, and also the importance of identifying the correct target market, considering the interests of customers, and designing and distributing products accordingly.
WHAT CAN GO WRONG?
Poor product governance and oversight can result in inappropriate products and services being supplied to customers. It can also result in customer disputes or regulatory investigations and penalties.
Case law from Australia provides examples of poor product governance and what can go wrong. In particular, courts have noted that the concept of compliance culture goes further than simply putting in place expensive systems, or having people with job titles that include terms such as governance and compliance. Significantly, many cases have involved regulatory breaches arising out of the failure of banks to keep records. This highlights the importance of having the right processes and procedures in place.
In today’s world of rapid technological innovation, one of the challenges for regulators is how to ensure that regulation stays up to date without stifling innovation. One of the challenges for both regulators and regulated companies is how to categorise new products and business models for regulatory purposes. In recent years, these challenges have arisen in relation to new classes of assets such as cryptocurrencies, new business models such as buy now pay later, and new forms of business such as decentralised autonomous organisations.
In a background paper on new business models, technologies and practices issued in October 2022, the Australian Law Reform Commission discussed the challenges that technological innovation presents for regulation. In particular, the background paper suggests that the regulation of technological developments should be driven less by technology and more by the functions that technological developments perform.
In other words, regulation needs to be designed not by reference to the different types of technology, but by reference to the functions and outcomes that the technology produces. It is therefore necessary to achieve clarity around product types and the terminology used to describe financial products, particularly to avoid the risk of mis-selling financial products. Designing products with the needs and interests of clients in mind, disclosing the correct information about products, and having the right processes and procedures in place continue to be of critical importance.
REGULATION IN MAINLAND CHINA
The People’s Bank of China issued measures on financial consumer protection at the end of 2020: The Implementing Measures of the People’s Bank of China for Financial Consumer Protection. Article 9 of the measures provides as follows:
Banks and payment institutions shall establish and improve management mechanisms that cover the whole process of financial consumer protection, and ensure that the regulations and requirements concerning financial consumer protection can be effectively implemented in each link of their business, such as design and development, marketing and promotion, as well as after-sales management of financial products or services. The whole-process management mechanisms include but are not limited to:
- The mechanism of ex-ante review. Banks and payment institutions shall make ex-ante reviews for financial consumer protection, identify and rectify problems with the financial products or services in time which may damage the legitimate rights and interests of financial consumers, and effectively put into practice the review findings on financial consumer protection;
- The mechanism of in-progress control. Banks and payment institutions shall follow the basic procedures and standards in the marketing of financial products or services, and enhance monitoring and management of marketing conduct; and
- The mechanism of ex-post supervision. Banks and payment institutions shall assume the responsibility of post-sale management of financial products and services, and make timely adjustment to problematic or potentially problematic financial products and service rules.
In addition, article 12 of the measures provides as follows:
Banks and payment institutions shall evaluate the suitability of financial products or services based on their characteristics for financial consumers, reasonably rate the risk levels of financial products and services and the risk tolerance levels of financial consumers, and provide suitable financial products or services for the right financial consumers.
The above-mentioned provisions reflect the global regulatory trend towards imposing requirements on the design and distribution of financial products.
Andrew Godwin is currently a member of a World Bank team that is advising a central bank in Asia on potential reforms to its mandate. He previously practised as a foreign lawyer in Shanghai (1996-2006) before returning to his alma mater, Melbourne Law School in Australia, to teach and research law (2006-2021). Andrew is currently Principal Fellow (Honorary) at the Asian Law Centre, Melbourne Law School, and a consultant to various organisations, including Linklaters, the Australian Law Reform Commission and the World Bank.