(Dow Jones) A lot of attention has been given to the impact new financial rules might have on banks, but at least one analyst argues that the hit to profits at the large brokerage firms is being wrongly overlooked.

Rules under discussion by lawmakers and federal agencies could push brokers into selling less profitable, passive investment products, abolish mandatory arbitration clauses and wipe out established fees paid to brokers by mutual funds. The rule changes under discussion may even lead to brokers being held liable for their recommendations.

Vivek Agrawal, partner at consulting firm McKinsey & Co., believes that even a "moderately" strict set of new rules could significantly cut profit-per-broker at the largest firms. This pressure would likely push the firms into new ways of doing business, he added.

Agrawal and his team at McKinsey have calculated that the large brokerage firms make about $72,000 operating profit per broker, a margin of roughly 15%. But the increased regulatory oversight means much of that profit is in danger.

"We're at an inflection point for companies to use this regulatory push as a catalyst to change their business model," said Agrawal. "Less affluent clients will probably see the most changes" in their relationships with brokers, he added.

The very largest brokerage outfits, known as wirehouses, include Bank of America Merrill Lynch, part of Bank of America Corp. (BAC); Morgan Stanley Smith Barney; Wells Fargo Advisors, the brokerage arm of Wells Fargo & Co. (WFC); and the brokerage unit of UBS AG (UBS, UBSN.VX).

In the first quarter, Morgan Stanley's (MS) global wealth management group, which includes Morgan Stanley Smith Barney, saw pretax profit from continuing operations of $278 million, had $1.6 trillion in client assets and 18,140 of what it calls representatives. As of March 31, Wells Fargo had $1.1 trillion in retail brokerage accounts, and 15,119 financial advisers.

UBS's Americas wealth management group had a first-quarter pretax profit of $13.2 million. The unit had 6,867 financial advisers. Bank of America's brokerage income in the first quarter was $1.5 billion. On March 31, the firm had 15,005 financial advisers, with $751 billion in assets in 3.1 million active accounts.

Officials at all the firms declined to comment for this article.

More Oversight Equals Fewer Dollars 

The regulatory changes facing the brokerage industry come from three sources: Congress, the Department of Labor and the Securities and Exchange Commission.

Congress is currently discussing ways to bring together the different House and Senate versions of financial legislation, but Agrawal said it's likely that provisions to increase the funding and powers of the SEC will make it into a final bill, as will greater protection for whistleblowers and an end to mandatory arbitration for clients--measures that will likely ramp up legal and compliance costs.

Meanwhile, the Labor Department is looking at introducing more rules for brokers who provide advice on employer-based retirement plans, such as 401(k)s.

As originally proposed, the rule would require brokers to use a third-party-validated computer models or receive only fee-based compensation for advice given in these plans. The rule also suggests that brokers should consider price as a significant factor, but not past performance. The rules could lead to more index-linked mutual funds and exchange-traded funds being offered to clients at the expense of actively managed funds, which are costlier for investors and more profitable for brokers to sell.

And the SEC is considering long-mooted changes to fees charged by mutual funds that are typically paid to brokers, 12b-1 fees. A change in this area, even if it's simply full disclosure, could increase costs and create downward pressure on the fees.

Agrawal said the toughest scenario for brokers would be if the final financial bill holds brokers to a fiduciary standard--a change that could also come from a regulatory authority such as the SEC or the Financial Industry Regulatory Authority. Today, brokers are effectively salespeople, marketing investment products to their clients. Fiduciary responsibility would hold them liable for their suggestions, creating not only legal and compliance costs, but limiting which funds they could recommend.

Fiduciary responsibility is at the extreme end of what might be introduced, said Agrawal. Still, in this "worst case" scenario, profit-per-broker could disappear entirely, he said. Even in what he called the most benign scenario, the new rules might cut the 15% profit margin by 3 to 5 percentage points, he said.

Brokerage firms need to deal with this new world by changing their business model, said Agrawal.

"This is here to stay," he said of the push toward more rules and scrutiny.

"The retirement system in the U.S. will continue to go in the direction of consumers funding themselves," said Agrawal. "Given the kind of exposure [to markets] people will have, together with the complexity of finance and the lack of education on the topic, regulation will play more of a role."

In other words, the feds will keep leaning on brokerage houses to make sure investors are getting a fair shake. But this won't be cheap, for either the firms or their clients.

A New World 

Agrawal said the rule may push brokerage firms to give investors the type of services they're actually looking for.

For instance, investors stand to win from objective advice--a broker suggesting funds irrespective of what products the broker's firm offers--clarity about how much brokers charge and how they make their money, and fees that aren't based on pushing particular products.

"They should have been doing these things five or 10 years ago, and consumer surveys--and asset flows towards independent brokers--show that it's what investors want," said Agrawal.

But the changes will mean a smaller margin, which will affect how brokers work with the majority of their clients.

Agrawal said that, for instance, affluent investors will still have brokers, but their brokers will have many more clients. This will probably mean that more of their brokers' advice will be "off the shelf"--prepackaged or using computer models. And the mass affluent will be more likely to get their advice from a broker provided by their employers, in 401(k) plans, or even within individual products--for example seeing their asset allocation decisions handled by target-date funds.

"For most investors, the one-on-one model will simply be economically unviable, but it could mean a more efficient system," said Agrawal.

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