Regulation is reactive and thus has inherent flaws.
Could you imagine what shopping would be like if
retailers were subject to the same regulations as financial service
providers?
Before you browse the shelves, you need to fill out
an application to assess the suitability of products for your
lifestyle. When you finally enter the store, you barely catch a glimpse
of the products which that lie behind lengthy documents describing the
risks associated with buying the product.
Even the price tag is undecipherable because the
retailer must disclose how much profit they are making per sale, what
sort of relationship they have with the distributor, wholesaler and
manufacturer; any concessions they have received for product placement;
and any conflicts of interest that could be inferred from the
manager's, employees', friends' or relatives' owning of the product.
What sort of hours or services would this
hypothetical store provide? The store itself is operated by an
independent director-someone who has no stake in the long-term success
of the store and so has no personal incentive to make optimal
investment, strategic or operating decisions.
Laughable? Yet this is the regulatory environment that financial service providers must operate in.
Financial services are clearly different from
consumer goods. Though Americans spend more than they save, any given
product is a small fraction of our wealth; whereas, our savings and
financial investments represent our wealth which is to provide for our
families, our communities, our churches, our government and our heirs.
A financial product is not just something that is
sold; rather, it is a relationship that is fostered. Consumer goods
are, by definition, things that are consumed. Durable goods are more
like investments. We tend to derive some utility from these goods over
an extended period of time. It is with durable goods that consumers
tend to contemplate their purchase with more care since they will have
to live with their decision for a longer time period. So, to avoid
buyer's regret, consumers need to be informed more about their durable
goods purchase than their consumer goods purchase. It is the same with
financial products and services; clients need to be educated about the
product or service because it is not a commodity they are buying-it is
a relationship they are entering into.
There is also a significant difference between
financial products and retail products as far as the asymmetry of
information between buyers and sellers. Financial services
representatives are usually much better informed about the services
they provide than their clients, and this puts the client in a
vulnerable position. The relationship itself is incredibly fragile as
the client assumes their financial services representative is in an
advantaged position, so they are particularly sensitive to any
insinuation of impropriety. The client fears their future will become
the victim if they are taken advantage of.
This is where financial services representatives
must be responsible: not only to their clients, but also to their
colleagues. Just as bank panics were caused by one bank having a
crisis, which made depositors at all banks question the liquidity of
their own bank, so too does scandal in one part of the financial
services industry deteriorate the reputations' of everyone in the
industry.
Financial representatives and advisors have fragile
relationships with their clients that take time to strengthen. The
problem with reputations is that they can be destroyed or marred so
quickly and, often times, just by the insinuation of impropriety. In
theory, over time all businesses have an incentive to build investor
confidence, but in the short run, each individual has an incentive to
exploit the good reputation of others.
Unfortunately, we always live in the short run. This
myopia could lead to regulatory backlash that could be costly to
society as a whole: As less research is trusted, so research is
rewarded less, which leads to poorer quality research, which means it
is trusted even less, and we enter into a downward spiral of ignorance.
Regulators, employers and trade organizations have
to confront the issue of how to make doing good profitable. People are
self-interested, and this causes a myriad of problems if people bite
and devour each other for their own gain. Regulators deal with this
issue by making it costly to violate a rule, which would make it less
likely that someone would engage in the activity that the rule is
designed to prevent. To increase the expected cost of violating a rule,
regulators can increase the penalty for breaking the rule, they can
increase the probability of being caught, or they can do both.
What has happened recently suggests regulators have
found a way to increase the perceived probability of being caught along
with increasing the cost of violating the rules. When it is well
publicized that someone has been brought to justice, all people become
aware of the costs of doing wrong. In psychological terms, publicly
prosecuting violators creates consciousness, and imposes a social cost
on malefactors. This is one reason why traffic police keep their lights
flashing when they pull you over (that and it protects them from
getting hit by any gawkers).
Employers confront this issue-of making doing good
profitable-by creating compensation systems that are
incentive-compatible: employees behave in their best interest and
unwittingly behave in the best interest of the employer. Obviously this
system does not work perfectly (hence the prevalence of cubicles in the
work place, which make it easier to monitor the behavior of employees).
It can be argued that this is precisely what some have done in the
directed brokerage scandals: fund companies have rewarded sales
representatives for superior performance. The difference between quid
pro quo in the workplace and in the financial services industry is that
in financial services, this behavior is explicitly illegal.
Industries as a whole can adopt similar strategies
as societies have for directing individual behavior to coalesce with
group goals: adopt shunning and celebration rituals. Social
ostracization can make it socially costly to deviate from the ethical
norms of the group; whereas, celebrating ethical behavior serves as a
nonpecuniary reward.
The Securities and Exchange Commission has delegated
some of its regulatory oversight duties to the National Association of
Securities Dealers and other private, self-regulating bodies. This is
an efficient way of regulating an industry when all is going well, but
it rarely is effective when there is a wave of public outcry against
particular industry practices. There has been a lot of coverage lately
about soft dollar commissions and conflict-of-interest scandals
(especially involving mutual fund sales which have been alleged to
violate "anti-reciprocal" rules), so there is bound to be a lot of
public outcry against this apparent malfeasance.
The history of regulation has been one of reaction
and not pre-emption. Most laws and new regulations come about due to
past abuses with the hope of preventing further abuses. In response to
anti-competitive practices of business, we get antitrust laws. In
response to bank failures and fraud, we get new regulations on banking.
In response to questionable selling practices, we may get new
regulations on our profession.
One of the clearest dangers to the financial
services profession is when people cross borders; especially now, when
brokers are behaving as advisors. Provided that the advice given is
"incidental" to the service that is being offered, the law permits such
advising, but how do you define "incidental?" By pushing the definition
and testing its limits, the industry risks the government imposing a
stark definition. It is entirely foreseeable that just as there is an
implied warranty of merchantability in the market for goods, financial
assets that are sold by brokers could be afforded the same warranty.
Worse, when a merchant knows the particular purpose of a buyer, and the
buyer relies on the skill and judgment of the merchant, the merchant
gives an implied warranty of fitness for a particular purpose. Imagine
what would happen if the same protection was given to clients who call
their broker telling the broker exactly what their investment objective
is: If the broker advises the client into a particular instrument, the
client follows the advice of the broker and the goal is not met, then
the broker could be held liable for any loss.
It is up to the registered representative, the
registered investment advisor, and other financial service
professionals to behave preemptively to assure that there are no
scandals for regulators to respond to. In short, doing what is good is
more than just doing what is legal.
Brian J. Jacobsen, Ph.D., is an
assistant professor at Wisconsin Lutheran College and chief economist
at Capital Market Consultants.