What’s in a name? In the case of big U.S. corporations, often times it’s a rich history, culture, values, brand loyalty, etc. So what have the executives at Wells Fargo been smoking these past few years? Fake account scandals, improper trading of retail investments, unneeded auto insurance, and apparently more to come. They’ve paid enormous fines so far in just a couple of years, including $1 billion this April1.
The intent of this article isn’t to cast aspersions on Wells Fargo, they are just the whipping boy of the moment, and deservedly so. Financial scandals are as old as time. A few years ago, we wrote about J.P. Morgan, and Citigroup and Merrill Lynch before that. Wells is just the latest example of what’s wrong in financial services for Main Street investors, retail investors. Main Street has never been well served by the finance industry. That doesn’t mean that, 1) there aren’t hard working ethical people within these big firms and, 2) Wall Street hasn’t served retail investors well in certain respects.
What does Wall Street do well? They raise capital. Large companies and start-ups all want to grow and so they come to Wall Street to help them raise the money to do so. This is done by issuing stock (equity) or bonds (debt). This is vitally important for our economy. Without this capital raising ability, we probably don’t have Amazon, Tesla, Facebook, Google, Netflix, FedEx, Microsoft, Apple, and the list goes on and on. Capital raises are how many American companies get the money they need to grow. That money comes from all kinds of investors, big and small.
Back to point number one. Employees of these big firms have a tough job. They are trying to take care of the retail customer while their employer, the large brokerage or bank, has conflicting priorities. The bank wants to maximize profits for shareholders and one of the best ways to do this is by selling proprietary investments to clients. Another way is to only offer third party investments that pay gatekeeper fees to be available through the firm, “pay to play”. These are conflicts of interest. Many years ago, Wall Street banks were privately held, organized as partnerships. The partners (owners) put their own money at risk alongside the money of their clients. In most cases, this caused them to act more prudently. With large publicly held financial companies, the shareholders number in the hundreds of thousands and become nameless and faceless. The executives have huge incentive-laden contracts that many times encourage risk taking, just not with the executives own money. This creates a problem.
We’ve stated many times over the years that the retail investor is under-served by Wall Street. To understand why you must break down how big banks and brokerages get paid. And we are talking mainly about investment services, not retail banking like home mortgages, checking and savings accounts. These firms make most of their money from three places: 1. Investment banking (mergers and acquisitions, raising capital through stock and bond offerings, etc.); 2. Commissions and fees paid by institutional investors that trade securities and buy proprietary investments in very large dollar amounts; 3. Retail investors. We list them in this order on purpose. This appears to be how they prioritize their businesses. Why is that? And is there a better way for retail investors to get a fair shake? We think so.
Most of these large firms follow a suitability standard where retail investors are concerned. We feel they should follow a fiduciary standard where they must put their client’s interest above their own. The large banks have been fighting this for years now. Both the U.K. and Australia have adopted the fiduciary standard for retail financial advisors. The big firms fight it because they have fatter profit margins on proprietary products and they want to protect the pay-to-play arrangements they have in place.
What’s the better way? Well, it involves quite a shift in how financial products are delivered to retail investors.
- Make everyone delivering financial advice adhere to a fiduciary standard.
- Eliminate commissions in this industry altogether except for those who trade securities.
- Financial services firms must either manufacture investment products OR distribute them, not both.
- Eliminate pay-to-play at brokerage firms, banks, and custodians. All parties in the “food chain” should charge for their services in a transparent manner. The consumer (free market) will decide if there’s value there.
- Stop the disclaimer madness created by the regulatory agencies. Investors do not read them – they are too dense. Much as we’ve created a plain language version of the mutual fund prospectus, the same should be done for government required disclaimers. The lawyers must be a part of this solution.
- Continue to simplify the communication of fees paid by investors so they can make confident decisions.
This is just a start but we feel it’s a good one. Our industry is largely against these types of changes. But the movement from large brokerages to smaller privately held registered investment advisory firms has exploded over the past 20 years and for good reason. These firms have a superior model and consumers are figuring it out. The number of brokerage firms and the number of brokers have decreased markedly over the past 20 years and the trend continues lower 2. Meanwhile, more investors than ever are looking for help. Actually it’s a great time to enter the financial advisor business as demographic trends are favorable. The investor must do their research and ask the right questions to make sure the advisor they choose has their priorities straight. Our next column will provide you with these questions.