The financial services industry appears to have muddled itself out of the crisis, but how can the wealth management industry ensure it serves clients better than in the past?

The financial services industry appears to have muddled itself out of the crisis and the wealth management market is now being eyed by a host of different types of players as a source of revenue growth. But as competition stiffens, how can the industry as a whole ensure it serves clients better than in the past?

For the financial services sector as a whole, the government seems to have one idea: legislate – so far, most notably with Dodd-Frank. This of course irks the industry as it raises costs, and these are likely in at least some cases to be passed to the end-user. Already, there appears to be a shift underway at banks towards rationalization of client segments with a focus on “preferred clients” (such as at Bank of America’s Merrill Edge and JP Morgan’s Chase Private Client units), as the profitability of transaction-only banking has been hit.

New regulation has raised hackles over issues other than costs though. For example, writing in this publication last year, private wealth management industry veteran Charles Lowenhaupt, chairman and chief executive of Lowenhaupt Global Advisors, said the family office rules mandated by the Act impose limitations on family offices in the way they can provide for distant relatives, employees and others, and will tend to “institutionalize” investment management.

The objectives of the Act

“The objectives ascribed to the Act by its proponents in Congress and by the President include restoring public confidence in the financial system, preventing another financial crisis, and allowing any future asset bubble to be detected and deflated before another financial crisis ensues,” writes law firm Skadden, Arps, Slate, Meagher & Flom.

These are laudable intentions, no doubt, but financial crises have existed as long as financial markets – and the eradication of one may indeed require the destruction of the other. On the other hand, Dodd-Frank marks “a profound increase in regulation of the financial services industry… [and] endows regulators with wholly discretionary authority to write and interpret new rules,” remarks Skaden.

An increase in regulation (and therefore costs) is not de facto a bad thing; many believe the financial industry benefited from an implicit government subsidy due to the transfer of cost of failure to the government, creating a bloated system and an unbalanced economy. It is larger institutions rather than smaller ones that benefit from this, though. There are also clearly market failures – such as information asymmetries – in financial services.

The issue is whether the balance of regulation is right or has gone too far, and also whether the regulation is of the right sort.

In a book recently authored by John Taft, CEO of RBC Wealth Management – US, entitled Stewardship: Lessons Learned from the Lost Culture of Wall Street, the author mentions that the Canadian banking system tends to focus on “enforcing guiding principles” as opposed to the US’s rules-based approach.

Indeed, it’s the scope of Dodd-Frank that has caused so much concern and the size of the document – at over 2,000 pages long – attests to its urge to create rules to cover all possible outcomes. However, as “futurist” at EDS Jeff Whacker is quoted as saying: you never see the bullet that kills you. Or, as Lowenhaupt puts it, “legislation closes the door when the horse is out of the barn.” It is reactive rather than proactive.

The fiduciary standard

One of the most pertinent parts to the wealth industry of Dodd-Frank is, under Section 913, a re-examination of the standard of responsibilities that brokers and RIAs adhere to. An SEC staff study later recommended a single fiduciary standard.

Currently, B-D relationships can be fiduciary in nature, but they need not be: a lot rests on what the client demands from the relationship. But herein lies a problem: broadly, there is not enough awareness about how financial transactions work, something not aided by a marketing-based – as opposed to truly educational – approach to corporate communications. According to a report from Citi, entitled Broker-Dealers as Fiduciaries?, the SEC found: “many investors are confused by the standards of care that apply to RIAs and BDs.”

Interestingly, many within the industry have called for a fiduciary standard. Crucially, a “fiduciary standard” implies a simple guiding principle rather than a set of rules governing behavior in every conceivable instance.

As Donald Trone, CEO/chief ethos officer of 3ethos, points out: “A code of ethics is based on values or principles; a code of conduct is based on rules. A code of conduct is designed to anticipate and prevent certain specific types of inappropriate behavior, such as a conflict of interest or self-dealing.”

He goes on to point out that codes of conduct can have the opposite effect, leading to behavior where individuals seek out loopholes in a “negative form of ethical discernment”, such as highlighted in the now infamous New York Times article by former Goldman Sachs employee Greg Smith. Instead, it is better to embed “the spirit of the law” into agents.

“The other issue with rules of conduct - most are so obtuse and opaque that only the ‘priesthood of anointed attorneys’ are permitted to interpret what is intended to be ethical behavior,” adds Trone. This is a criticism that could certainly be leveled at Dodd-Frank: that it benefits lawyers and consultants more than consumers.

From a historical perspective, Lowenhaupt says, legislation has failed: "In 2000 years, legislation has never worked. It has never protected families of wealth. The only sure protection is reliance on principles and standards set by the wealth holder and demanded of providers.

“We reacted to Madoff with surprise, as if these things don't happen often. We forget Enron, Homestake Oil, Stanford, Long-Term Capital Management and MF Global. In fact, Lehman and AIG were in the same year as Madoff.”

Harder in practice

This all sounds very nice in theory: we create a world where people do good instead of bad. But the “how” not the “what” is the hard part. Perhaps lawmakers cannot be blamed for looking aghast at the behavior of financial services providers – the fines meted out over the years by the SEC and FINRA, or the Ponzi schemes, or the insider dealing cases – and coming to the conclusion this is an industry that needs to be quelled, not encouraged.

However, whether or not pushed by the threat of regulation, the industry appears to be going further and working out ideas to make a principles-based approach workable. Taft’s book on the subject, which strongly advocates the principle of stewardship, is one example; Lowenhaupt and Trone, along with Campden Media, have founded the Institute for Wealth Management Standards to promote global standards on responsible wealth management.

Market forces also seem to be auguring a renewed focus on client service. It may take time for words to feed into action, but most firms now pay a lot of lip service to proactive client communication, putting clients’ needs first, and using a goals-based approach to investing to reduce mismatches between liquidity and risk and clients’ ability to bear them. And this hasn’t been driven by legislation, but by increased competition and client demands, along with media and public outrage.

A new business model

As Jeff Spears, CEO of San Francisco-based Sanctuary Wealth Services, argues, business models are key to this change. If employees and leaders have misguided incentives, it will severely clash with any code of ethics.

"If you create the right business model that allows advisors to do right by their clients, you only need minimal legislation,” says Spears. “Perhaps the biggest issue today is not a lack of legislation, but a business model that places the interests of clients and advisors in economic conflict. If you put an ethical advisor in a bad position, you could get bad outcomes."

Spears explains that this means firms need to accept a lower profit margin in the long term; the upside is sustainability.

“In fact, 10+ per cent annual capital market returns are not going to return anytime soon. Therefore, fees that wealth managers charge and wealth manager profitability will go down by a comparable percentage,” adds Spears.

Lowenhaupt also highlights the importance of the wealth holder setting standards that his or her family office employees or trusted advisors can follow, and having clear objectives against which performance – in a wide sense of the word – can be evaluated.

“The wealth holder must decide what the wealth is for and the principles governing that wealth. Once the principles are in place, family office staff or outside advisors can develop operating standards,” says Lowenhaupt. “The performance of the family office would be evaluated against these measurable and objective standards. This approach actually brings clarity, transparency and greater efficiency to the family office, while ensuring the appropriate level of protection for wealth holders.”

It is clear that wealth managers, from family offices to broker-dealers, will be operating in a new environment going forwards. It will be one of heightened scrutiny and legislation. In many ways, this is a price that is being paid for severe failures in the past. Whether the regulation helps or hinders the industry, and whether those paying the price were part of the initial failures, the only way the industry can garner more trust from clients and therefore avoid further unwanted attention from politicians is for firms to ensure their business model and ethical codes do the right thing by clients, and are followed by employees.