Improving Financial Security through Federally Established Educational Requirements for Investment Professionals
Stephen A. Kovach
A Thesis is the Field of Government
After more than 100 years of regulatory policy, why is financial security still at risk for financial consumers? A wide array of evidence indicates that many investment advisers lack the human capital required to provide prudent advice to financial consumers. Further investigation reveals a fundamental problem with current minimum regulatory qualifications for employment in the field of investment management. This lack of oversight has devastating implications for financial consumers, with spillover effects that visibly harm the national economy.
The central argument of this thesis is that financial security can be improved through federally established, minimum educational requirements for investment advisers. In presenting this argument, I provide a working definition of public interest and financial security that is consistent with the literature.
I analyze regulatory policies that have been implemented in response to each crisis, which supports the notion that financial security is at risk for all consumers, particularly for low-income and African-American citizens. I argue that the underlying cause of this risk is substandard advice provided by investment professionals that intentionally steer financial consumers towards high-risk investment products and/or investment strategies that are unsuitable for their clients’ risk tolerance level. My thesis includes an analysis of prevailing theories that support my argument; an analysis of other theories concerning the cause(s) of financial crises; a review of current requirements for investment professionals; a comprehensive overview of the occupation itself; and the results and analysis of a survey conducted specifically for this study (n=891) that provides insight into financial consumer awareness of key polices that affect the investment industry, and the financial products in which they invest their money. I posit that if the government were to impose minimum educational requirements for investment professionals, it would (1) improve the overall quality of advice that financial consumers receive from the investment industry; (2) filter and sort individuals that lack the human capital needed to advise clients and manage their money; and (3) reduce the severity of the next financial crisis.
Table of Contents
List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
List of Figures/Graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii
- Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
- Public Interest and Financial Regulation . . . . . . . . . . . . . . . . . . . . . . . . . 11
Defining Public Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Determining When Public Interest Has Been Damaged . . . . . . 17
About Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Intervention vs. Non-Intervention . . . . . . . . . . . . . . . . . . . . . . . . 27
Regulatory Regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Discrimination and Policy Failure . . . . . . . . . . . . . . . . . . . . . . . 34
III. History of Financial Regulatory Policy . . . . . . . . . . . . . . . . . . . . . . . . . . 41
The NYSE and Customer’s Men . . . . . . . . . . . . . . . . . . . . . . . . 45
The Progressive Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
The Stock Market Crash of 1929 . . . . . . . . . . . . . . . . . . . . . . . . 51
Regulation Through the 80s . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Regulation Through the 90s . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
The Global Financial Crisis of 2008 . . . . . . . . . . . . . . . . . . . . . . 58
- Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
The Benefits of a Formal Education . . . . . . . . . . . . . . . . . . . . . . 68
Signaling Theory vs. Human Capital Theory . . . . . . . . . . . . . . . 69
Ethics and Moral Judgment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Occupational Licensing vs. Formal Education . . . . . . . . . . . . . . 76
Mix Messages from Policymakers . . . . . . . . . . . . . . . . . . . . . . . 85
Current Occupational Licensing for Investment Advisers . . . . . 88
Safety vs. Security: Clarification and Application . . . . . . . . . . . 95
The Efficient Market Theory and Premarket Testing . . . . . . . . 101
Financial and Business Simulators . . . . . . . . . . . . . . . . . . . . . 101
Education as a Filter and Sorting System . . . . . . . . . . . . . . . . 103
Other Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Racial Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Volatility Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Suitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
- Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
Policy Effectiveness Measured . . . . . . . . . . . . . . . . . . . . . . . . 118
About the Survey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Financial Consumer Survey Questions . . . . . . . . . . . . . . . . . . . 123
Financial Consumer Survey: Analyzing the Results . . . . . . . . . 134
Testing for Policy Awareness . . . . . . . . . . . . . . . . . . . . . . . . . 138
Measuring Public Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
Interpreting FINRA Case File Data . . . . . . . . . . . . . . . . . . . . 146
How Much Money Is at Stake? . . . . . . . . . . . . . . . . . . . . . . . . 149
- Summary and Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Bibliography. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
List of Tables
Table 1 Regulatory agencies responsible for the regulation of risk . . . . . . . . . . . 31
Table 2 Non-managerial licenses for investment management professionals . . . 81
Table 3 Licenses for financial professionals that manage other financial professionals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
List of Figures/Graphs
Fig. 1 Effect of the subprime mortgage crisis on the DJIA . . . . . . . . . . . . . . . . 21
Fig. 2 Market volatility – January 2008 to November 2009 . . . . . . . . . . . . . . . 22
Fig. 3 Consumer losses as a result of bank closings: 1921-1933 . . . . . . . . . . . 26
Fig. 4 U.S recessions between 1929 and 2008 . . . . . . . . . . . . . . . . . . . . . . . . . 31
Fig. 5 Pros and cons of multiple-choice testing . . . . . . . . . . . . . . . . . . . . . . . . 92
Fig. 6 Unsuitability as a percentage of total cases filed: 2010 to 2013 . . . . . . . 93
Fig. 7 Arbitration cases served by controversy involved: 2010-2013 . . . . . . . 95
Fig. 8 Recessions in the United States: 1797 to 2011 . . . . . . . . . . . . . . . . . . . 120
Fig. 9 Annual bank failures: United States: 1934-2011 . . . . . . . . . . . . . . . . . 121
Fig. 10 Number of arbitrations filed annually by inventors: 1999-2013 . . . . . . 145
Fig. 11 Relation of market volatility to case filings: 1999-2013 . . . . . . . . . . . . 148
Fig. 12 Percentage of financial assets to household net worth: 1945-2013 . . . . 149
This thesis explores the notion of establishing minimum educational requirements for investment advisers as a means of improving financial security. A history of financial regulation, beginning with the Investment Advisors Act of 1940, reveals significant post-financial crisis efforts by policymakers to implement policies that would prevent another crisis from occurring again. These policies address numerous factors that Congress identifies as the cause of financial crisis. By and large, they authorize increased regulatory oversight of investment firms and corporations through the creation of new regulatory agencies; the implementation and/or revision of regulatory policies; and the establishment of financial literacy programs for consumers. Nevertheless, between 1929 and 2008, regulatory policy failed to prevent thousands of bank closings, millions of foreclosures on residential properties, trillions of dollars in losses, and rushes on banks by consumers that desperately attempted to withdraw their money. This raises important concerns about regulatory policy effectiveness vis-à-vis financial security, and about public interest in general.
There are many possible causes for financial crisis, and many academic theories that provide possible explanations for its origin. Government response is often guided by academic research, as policymakers seek to understand why financial markets fail, and how they can improve financial security. Research demonstrates that each crisis exhibits its own unique traits, and policymakers respond to each one differently. One trait that is commonly shared by all financial crises is a broad failure among investment professionals (and more generally, the private sector) to remain true to ethical standards, and exhibit a high level of moral judgment. When a financial crisis occurs, policymakers identify lapses in moral judgment and poor ethical decision-making skills among investment professionals (and other areas of the private sector) as one of its causes. Ethics stands as one of the more challenging topics in business. The notion of creating policies that will force individuals to behave in an ethical manner is equally challenging. Yet, ethics is a topic that requires attention because when financial consumers are exposed to unethical practices, financial security and public interest is damaged. Thus, regulators need to implement policy that has the potential to filter and sort individuals that are more likely to adhere to ethical standards, and are more capable of exhibiting superior moral judgment.
A substantial amount of academic research and statistical data indicates a positive correlation between higher education and moral judgment. An overview of the literature indicates that higher education yields significant gains in both moral reasoning and overall stage growth. Moreover, after only two years of college, students gained nearly 5 percentage points on the Defining Issues Test (DIT), which exposes students to six hypothetical moral dilemmas in order to measure moral reasoning. Other studies show that students spending more than two years in college gain 11.14 points on the DIT. Still others suggest that the majority of moral development occurs during the first year of college. Essentially, when individuals complete a degree program from an accredited college or university, they not only exhibit enhanced cognitive skills (and other human capital), they also demonstrate superior moral reasoning capabilities as compared to those that did not go to college.
Other data shows an annual increase in the number of law suits and arbitration cases filed by investors, claiming that the advice they received from their investment adviser was not suitable. Legal action that involves claims of suitability indicates poor moral judgment and inappropriate ethical behavior on the part of the investment adviser, which in turn results in consumer losses, and ultimately, poses a threat to financial security. There are approximately 1.2 million investment advisers in the U.S. Collectively, investment advisers manage, and ultimately profit from, more than one trillion dollars worth of securities that trade on the open financial markets every day. Thus, by virtue of this occupation, it is vital that investment advisers exhibit high levels of ethics and moral judgment because their actions directly affect financial security. The above-mentioned facts suggest that financial security can be improved through federally established, minimum educational requirements for investment advisers.
Current minimum educational requirements for investment advisers include a high school diploma, and the successful completion of a standardized, multiple-choice examination. If current theories vis-à-vis the benefits of higher education hold true, this suggests that financial consumers might be receiving (and paying for) advice from individuals (investment advisers) that might not possess a level of competency and moral reasoning sufficient to effectively provide such advice. Nevertheless, the notion of improving financial security through the establishment of minimum educational requirements for investment advisers has never been introduced by Congress or the Senate. Moreover, scholarly work that specifically explores the notion of utilizing higher education for investment professionals as a deterrent to financial crisis is virtually non-existent. Thus, this study may represent the first of such research.
The financial industry is governed by fundamental uncertainty at all times. At any given moment, there are many factors affecting the financial markets, and thus, the value of investment portfolios. Among them are internal developments (what happens inside a publicly traded company); world events (war, civil unrest, natural disasters, and terrorism); inflation and interest rates (when rates increase, investors have historically sold equities and purchased debt securities); exchange rates (changes in exchange rates increase or decrease the cost of doing business in a country, which in turn affects individual stock prices); regulatory policy (political and economic policies that determine corporate and individual tax rates), and hype (stock markets are often affected by hype about a company, new product releases, or pending law suits). Other factors include corporate dividend rate, employee layoffs, the rate of unemployment, management changes, industry performance, investor sentiment, and economic outlook. Over the years, scholars have explored (1) how these factors affect the stock market, the economy, and household net worth; and (2) which economic and/or political theories provide the most appropriate explanation for financial market behavior. A literature review of contemporary publications points to a robust and continued effort to explain financial market behavior, and why markets fail. Some commonly accepted theories about financial market behavior suggests that it depends partly on the participation of states; that Keynesian economics might not sufficiently explain it quite as well as once thought; and that fear and greed contribute more to investor behavior than research, corporate earnings, or valuation.
There are many internal and external factors affecting the financial markets overall, and the individual prices of stocks and bonds; thus, it is highly improbable that a single theory fully explains why markets fail. Nevertheless, a trait commonly shared by all financial market behavior theories is the implicit goal of understanding which factors affect financial markets before, during, and after a financial crisis has occurred. When a financial crisis occurs, policymakers often try to explain it using one or more of these theories. In turn, the U.S. government has the option to respond to a financial crisis by either taking some type of action (intervention) or by not taking action (non-intervention). Some common interventionist responses to financial crisis include increasing or decreasing taxes; creating, altering, or dissolving regulatory agencies and policies; adjusting interest rates; and bailing out corporations that are at risk of failing. Once policymakers believe they have identified the cause of the market failure, their primary goal (if they choose to intervene) is to correct it by implementing policies that they hope will reduce economic risk (and thus, improve financial security) to an acceptable level. This process, if done correctly, improves the rate of unemployment, and restores consumer confidence, thus stabilizing the economy sufficient for a measurable improvement in consumer spending.
Any legitimate attempt by the government to restore a weakened or failed economy is, in principle, consistent with the tenets of public interest, which (as it pertains to financial security) asserts that citizens of a democratic nation have the right to a well-functioning, transparent economy that provides a manageable amount of risk in exchange for an appropriate reward. At the very least, effective regulatory policy would (1) sustain a stable, enduring economic environment that benefits all members of society in the long-term, both private and public alike; and (2) maintain a level of risk that allows investors to earn a reasonable profit on their investment capital without dramatically increasing the probability of complete and total loss of capital. Nevertheless, a history of numerous financial crises within the U.S. demonstrates that policymakers have not been successful long-term at preventing financial crisis from occurring again. Between 1929 and 2008, the U.S. economy succumbed to three major financial crises, and at least fifteen different recessions lasting between eight and forty-three months. (see figure 4) Moreover, each financial crisis is marred by total loss of capital and/or primary residence for millions of financial consumers, thus indicating that regulatory policies are not effective at reducing their exposure to excessive levels of risk. These failures in regulatory policy suggest that a different approach to reducing financial market failure is needed.
Historically, when the government chooses intervention to restore economic stability, it typically: (1) creates new policies and/or independent regulatory agencies; (2) eliminates existing policies; or (3) modifies existing policies and/or new regulatory agencies. Regardless of which course of action the government chooses, the post-financial crisis period is always characterized by both media rhetoric and scholarly analysis vis-à-vis the cause of the crisis. Some blame Wall Street investment firms; others blame the banking sector. Still others blame, “naive consumer-investors” that base their investment decisions on pre-financial crisis rhetoric, and invest in the financial and/or real estate markets without having the level of sophistication needed to understand the risks of their own actions. While the former concerns the private sector, and is usually dealt with by government intervention; the latter concerns the public sector, and often asserts that a fundamental lack of government-sponsored consumer education programs contributes to bad investment decisions. Accordingly, between 1929 and 2008, the government allocated resources to facilitate the creation of new policies, laws, and agencies designed to reign in rouge Wall Street firms and employees; modify banking laws; and/or bailout failed publicly-traded corporations. Secondarily, the government allocated resources to create new government-sponsored financial consumer education programs that supposedly improve financial literacy for consumers by enabling them to make better decisions the next time they decide to invest in the financial or real estate markets.
After each financial crisis, the notion of developing better educational programs for financial consumers emerges. Such programs assume that if individuals possessed a higher level of financial literacy, and knew more about the products in which they invest, it would somehow prevent (or reduce the severity of), another crisis from happening. However, the idea that such programs will actually be effective is challenging for the following reasons. First, it assumes that consumers (collectively) have sufficient financial leverage to cause markets to fail, when in fact, institutional (as opposed to retail) trading accounts for 46% of all trading at the New York Stock Exchange. Second, it suggests that people working in non-financial occupations have an educational background sufficient to understand the extremely large amounts of complex information needed to make prudent investment decisions, when in fact; only 30.4% of U.S. citizens have a bachelor’s degree. Finally, by creating educational programs for consumers, it sends the message that consumers are somehow to blame for the crisis. Doing so redirects blame away from the investment professionals that provide fee- and commission-based advice to financial consumers. Investment firms and advisers collectively manage nearly one-trillion dollars worth of securities and currencies each day, and they provide advice on said securities. Many consumers act (buy or sell securities) based on this advice; thus, it makes more sense to focus on education for those providing the advice, not on those receiving it.
The above-mentioned data suggests that the majority of individual investors posses neither the human capital nor the financial capital needed to cause financial crisis. It also suggests that investment advisers should bear the burden of prevention to a much higher degree than previously thought. This begs the following questions: does it make sense to point blame at financial consumers that merely want earn a better-than-average return on their investment capital or purchase a home? How thoroughly are consumers expected to understand the policies that govern the financial markets, and the complexities of the investment products that are marketed and sold to them by investment professionals? What can policymakers do to reduce the severity of the next financial crisis? Would it make sense to allocate more government funds to improve the educational requirements of investment professionals (rather than financial consumers) that manage, and ultimately profit from, the nearly one trillion dollars worth of securities and currencies that trade on the open financial markets every day? The information I provide henceforth attempts to answer these questions.
Public Interest and Financial Regulation
To begin, I start by defining financial risk and public interest, and how failures in regulatory policy affect financial security. Financial risk is often thought of as something negative; something to be avoided, and something that most people hope does not materialize. When making important decisions about their own money, individual investors often disregard risk in lieu of profits, only to adjust their investment strategy after they have suffered a major financial loss. Likewise, many policymakers adjust regulatory policy only after a major financial crisis has occurred. While the former hopes that risk does not materialize, and the latter addresses it after it does, both tend to behave as if it is not a component of the investment process. However, risk cannot be separated from investment performance or economic growth. It is neither something undesirable nor desirable; rather, it exists in all financial transactions, both mathematically and psychologically. In short, risk is permanent. Thus, the concern in the investment decision-making process is not to disregard risk; rather, it is to understand the limitations, restraints, opportunities, and threats that it presents to financial consumers. Likewise, the goal of regulatory policy is not to eliminate risk. Rather, it is to implement policies that will prevent systemic crisis (defined as a situation when all or most of the assets in a national bank system are wiped out, often resulting in runs on banks, spillover effects and damage to the public interest). Financial risk is also linked to investment advice and compensation. The Financial Industry Regulatory Authority (FINRA) requires that investment advisers provide advice that is suitable to the clients risk tolerance. A proportional relationship exists between risk and compensation. Thus, when investors assume more risk, not only does the probability of them losing money increase, but the potential compensation for investment advisers also increases. Financial risk (as it pertains to investment advice) can be categorized into two different categories: appropriate, or inappropriate. It is appropriate when investors assume more risk based on the advice of their investment adviser, and the level of risk they assume is consistent with their risk tolerance. It is inappropriate when an investment adviser pushes investment products on financial consumers, or recommends an investment strategy, that is inconsistent with said investors risk tolerance. Both FINRA and the Securities Exchange Commission (SEC) have identified specific types of inappropriate behavior (such as churning; unauthorized trading; failure to supervise; negligence; omission of facts; breach of fiduciary duty; unsuitability; and misrepresentation) that are associated with high risk, all of which pose a serious threat to financial security. For instance, in 2012, SEC charged Jefferies, LLC (a Boston-based investment firm) with failing to supervise its mortgage-backed securities desk during the Global Financial Crisis of 2008. According to the SEC filing, Jefferies employees were lying to customers about pricing, which mislead them (the clients) about the actual amount of money that the firm was earning.  A lack of supervision on the part of Jefferies about its mortgage-backed securities desk resulted in misstatements about the associated risk.
In 2003, SEC charged Invesco Funds Group, Inc. (a mutual fund company) with fraud and breach of fiduciary duty for allowing marketing timing. According to SEC, Invesco Funds Group fraudulently accepted investments by dozens of market timers for the purpose of enhancing management fees, and in so doing, breached their fiduciary duties to their shareholders. Jefferies and Invesco exemplify the tens of thousands of cases and law suits brought against investment advisory firms and their employees by the government. A democratic government is charged with many tasks, including the implementation of policies that benefit the public interest. Reducing risk and protecting financial consumers against unsuitable advice stands as one of these tasks.
Defining Public Interest
But, what is public interest? Public interest is central to policy debates, economic theory, the tenets of democracy, and the very nature of a democratic society. Although academia lacks a specific definition as to what constitutes the public interest, any such explanation would likely emphasize the well-being or general welfare for all members of society. According to U.S. PIRG (the Boston-based, non-profit, special-interest organization that focuses on public interest research and advocacy), tax reform, public transportation, healthcare, consumer protection, higher education, and financial security are among the primary issues that are important to the public. Collectively, these (and other) issues provide a base from which I define what is commonly referred to as public interest. Indeed, public interest is a broad topic that includes many issues, all of which are fundamental to the well-being of individuals and the society in which they live. This study concentrates on only one of these issues, financial security, by exploring the interaction between regulatory policy, public interest, educational requirements for investment professionals, and the risks facing financial consumers that invest large percentages of their personal savings in the financial markets.
More specifically, as it pertains to public interest, the term financial security refers to the risks associated with financial products such as stocks, bonds, or derivatives, and real estate products such as Mortgage Backed Securities (MBS) and/or mortgages (particularly subprime mortgages that are offered to individuals that are deemed a high credit risk, such as low-income minorities and African-Americans), and the manner in which these products are presented to the public by the financial and banking industries. This is not meant to suggest that there are inherent problems associated with investment products. While some products, such as stocks or derivatives, bear a higher level of risk as compared to other types of products, such as Treasury bonds or certificates of deposit (CD), the risk to consumers does not necessarily lie in the product itself; but rather, in whether the product is suitable for their risk tolerance. My thesis suggests that if the level of risk associated with investment products is inconsistent with risk tolerance, then financial security is also at risk.
When risk is widespread, or systemic, it often results in financial crisis. Some might argue that because the value of the stock and real estate markets are determined by the economic laws of capitalism, financial consumers will eventually incur losses. While this argument, in principle, may be consistent with the tenets of capitalism, it is inconsistent with the tenets of public interest when consumers suffer large financial losses because the financial or banking industries intentionally (1) omit pertinent facts about investment or mortgage products; (2) fail to accurately disclose the levels of risk involved with such products; and/or (3) fail to provide advice that is deemed suitable by regulatory standards. Such behavior negatively affects public interest because it creates an economic environment that typically bodes poorly for the public sector, yet profitable for the private sector. Thus, as it pertains to financial security, public interest can be defined as the right of all democratic citizens to live and work in a society whose economy is characterized by economic transparency, effective financial regulation, and judicial enforcement. To elaborate, economic transparency refers to an open policy adopted by the private sector that makes known to the public sector all material facts and conditions associated with a product, such as price, availability or the risks associated with purchasing it. By effective financial regulation, I refer to a regulatory system that (1) creates and implements policies that protect individuals against the type of unscrupulous (and illegal) behavior by the private sector that conceals the level of risk to the financial consumer; and (2) supports an economy that allows corporations to earn a profit, provided that they do so in an honest and ethical manner. Judicial enforcement, as it pertains to public interest, refers to a legislative system that can effect punishment against any organization or individual that is found guilty of violating federal regulatory policy. If these conditions (economic transparency, financial regulation, and judicial enforcement) exist, citizens of such a society can freely pursue their own self-interests, particularly when doing so leads to gainful employment, the purchase or refinancing of a primary residence, wealth creation, and a financially secure retirement. Moreover, if the above-mentioned conditions are met, organizations that operate in such an environment can build and grow a business that is profitable, contributes to the economy, and supports the community through the production and distribution of useful products and services.
Determining When Public Interest Has Been Damaged
Having a working definition of financial public interest is one matter; determining when it has been damaged is another. In other public interest issues, such as public health, public transportation, or the environment, researchers and scientists can measure how the actions of the private sector affects the public sector. For instance, if a company dumps chemicals into the water, and consequently, thousands of people become chronically ill; or if a tanker accidentally spills millions of gallons of oil into the ocean, and subsequently, millions of animals die, the damage to public interest can be measured by instance and prevalence rates of illness or death. However, determining the impact on public interest that results from financial losses is challenging, partly because over the past several decades, public interest research has waned, and methods used to measure public interest have not kept pace with those in medical or environmental sciences. Bozeman argues the need for a paradigm shift in public interest research and analysis, citing a “shortcoming of ideas and theories pertaining to public interest.” Bozeman notes that current public interest theories lack precision and rarely include analytical tools. This suggests a need by social scientists to develop methods that can determine when public interest has been affected by systemic crisis. The development of such methods would be useful to policymakers that implement regulatory policies designed to prevent another financial crises from occurring again. On the other hand, the notion of developing analytical tools that could identify when public interest has been damaged, as Bozeman suggests, might not provide the type of data needed to help reduce risk for financial consumers. As previously mentioned, public interest is damaged when (1) the private sector has not demonstrated economy transparency in its dealings with the public vis-à-vis the products it offers; (2) when financial regulation has failed to either create or implement policies that protect financial consumers; or (3) when the judicial system fails to punish those whose violate federal regulator policy. It is unlikely that an analytical tool could accurately assess when the private sector is not being transparent; or when existing regulatory policies are ineffective; or when the judicial system has failed to impose adequate punishment on those who violate regulator policy. At the very least, such a tool would need to (a) monitor all financial organizations in real-time for truthfulness of statements made to the public and identify when those statements are inaccurate; (b) determine when regulatory policy is ineffective; and (c) determine if the judicial system has affectively punished violators of federal policy. In short, such a tool is improbable, and policymakers that strive to improve financial security would benefit more by relying on theories and models developed by researchers and academia.
About Financial Crisis
By definition, a financial crisis is an interruption to financial markets that is commonly associated with falling asset prices (usually equities) and insolvency among debtors and intermediaries that spreads through the financial system, disrupting the markets capacity to allocate capital. It is often associated with panic, as financial consumers desperately attempt to withdraw their money after realizing that their bank may fail. During a financial crisis, investors sell assets and withdraw money from their banks or financial institutions as a means of preventing further losses or access to funds. Financial crises typically occur after the economy has exhibited high levels of risk. When risk runs high, financial consumers often misinterpret the market data by looking at the potential return on investment rather than the risks they face. FINRA asserts that risk tolerance is an extremely important component of the investment process, one that determines investment product suitability, or appropriateness. Investors that assume too much risk often panic during a financial crisis because they realize that the volatility of their investments exceeds their risk tolerance level. Consumers that invest during market peaks (the highest point between the end of an economic expansion and the start of a contraction in a business cycle) are exposed to the greatest level of risk because they invest when prices are at their highest.
To exemplify the relationship between risk and financial crisis, consider the events that preceded the Global Financial Crisis of 2008, or the Great Recession. Between 2001 and 2006, millions of financial consumers invested in real estate. This period represents unprecedented growth in the housing markets, which was followed by a two-year recession characterized by a 115% increase in seasonally adjusted unemployment, a 45% drop in housing prices (on average), and a 13.21% decrease in household net worth. Accordingly, a large percentage of investors who purchased homes between 2001 and 2006 subsequently experienced significant losses in household net worth after the housing market crashed. In turn, global financial markets dropped suddenly as investors worldwide panicked and sold securities in all asset classes. Figure 1 displays the reaction to the housing market crash in the Dow Jones Industrial Average (DJIA). The vertical lines represent intraday volatility.
Figure 1. The effect of the subprime mortgage crisis on the DJIA
Source: Yahoo Finance Historical Quotes Database
Between September 1, 2008 and March 1, 2009, DJIA dropped 34.9%. Intraday fluctuations show that the DJIA traded as high as 11,790 on September 1, 2008, and as low as 6,470 on March 9, 2009 (a range of 45.12% within approximately 6 months). By contrast, the S&P Volatility Index (VIX), traded from a low of 22.40 on January 2, 2008 to a high of 52.76 on March 1, 2009, with intraday prices ranging between 15.82 and 44.25, (see figure 2).
Figure 2. Market volatility: January 2008 – November 2009
Source: Chicago Board of Options Exchange
These wild swings in the financial markets exemplify the extreme levels of volatility that investors face when markets fail. I argue that the cause of this volatility (and subsequent market failure) is not the result of investment product failure (as some argue). Instead, the extreme volatility exhibited by the financial markets during this period was the result of substandard information and advice provided to financial consumers by the investment industry; and by the private sector (which used deceptive marketing and advertising methods designed to persuade consumers to purchase products that exceeded their risk tolerance). I further argue that this extreme level of volatility demonstrates a gross lack of moral judgment by investment professionals that are motivated by high compensation, yet show little regard for the financial security of their clients. This volatility is also a good example of why many consumers make rash decisions about their investment capital, both on the uptrend and on the downtrend. For example, when markets rise quickly, it sends a message to investors that if they do not invest immediately, they will miss out on potential profiles. Conversely, when markets drop quickly, consumers have little time to make prudent decisions about their investment capital. As I discuss later, this manic-to-panic cycle (1) indicates that many investment advisers lack the human capital required to provide prudent advice to financial consumers; and (2) can be explained (to a degree) by social and behavioral psychology theories.
The connection between risk and financial crisis is made apparent by analyzing the housing market crash of 2008. The relationship between home values and the securities industry is more ambiguous. If a person loses his or her home, how does it relate to the value of securities that are traded publicly on the NYSE or other global exchanges? Moreover, how does this relate to my central argument, which asserts that regulators should establish minimum educational requirements for investment professionals in order to improve financial security? To clarify, mortgage-backed securities (MBS) are essentially asset-backed securities that are secured by a pool of mortgages. Between 2001 and 2006, millions of consumers purchased subprime mortgages that were backed by low-quality, mortgage-backed securities. During this period, investment banks bundled both prime and subprime mortgages into MBS (whereas before 2001, they were isolated from each other), thus creating the appearance that the probable rate of return on MBS was superior to other products. Many investors believed that MBS could not fail because they were backed by mortgages (which have historically exhibited lower-than-average risk). However, a major selling feature of these mortgages was the low entry point. Subprime mortgages have low interest rate requirements for the first year (which made them initially affordable for many financial consumers with weak credit scores and low income), but extremely high payments thereafter. In essence, monthly payment on a $500,000 subprime mortgage loan increased nearly 80% after the first year. This dramatic increase in monthly obligation left most subprime mortgage holders unable to make regular payments. Consequently, as millions of homeowners defaulted on their mortgages, MBS values dropped precariously because the assets backing them (mortgages) defaulted.
To suggest that the subprime mortgage crisis, and subsequent global financial crisis, was caused (at least in part) by unethical practices may be understating the importance that moral judgment holds in the investment advisory process. Whenever a financial professional sells a financial product to a consumer, his or her advice must be based on what is in the client’s best interest. Regarding subprime mortgages, investment professionals were (and still are) compensated in two ways: (1) through fees paid directly by the borrower, including the loan origination fee and credit fee; and (2) through a yield spread premium (YSP) by the lender. YSP is a bonus that a lender pays to the investment professional for placing (or steering) a borrower into a higher cost loan than that which the borrower qualifies. Put differently, on a $500,000 subprime mortgage, YSP@2% = $10,000. Estimates show that in 2005, 1.5 million consumers purchased $2.6 billion more than necessary due to YSP. This indicates that in 2005, investment professionals that sold subprime mortgages earned an additional $52 million in compensation by convincing financial consumers to purchase a low quality loan that was neither suitable for their risk tolerance, nor consistent with their credit scores. As millions of home owners defaulted on their loans (which began in September, 2009), volatility increased dramatically, financial markets dropped precariously, and many financial consumers lost both their homes and their life savings in a very short period of time. The previously mentioned behavior points to a serious lack of ethical behavior and moral judgment on the part of the brokers that sold subprime mortgages between 2001 and 2005. As I note throughout my thesis, moral judgment is positively correlated to years spent in college. As with other fields within financial services, minimum educational requirements to sell mortgages are a high school diploma, while licensing requirements are similar to those for investment advisers.
Other financial crises, such as the Great Depression (1929-1940), placed a similar burden on the financial consumer. For instance, between 1930 and 1933, consumers lost approximately $1,337 billion, and 9,096 commercial banks were suspended. Figure 3 displays the relationship between consumer losses and systemic risk between 1930 -1933.
Figure 3. Consumer losses as a result of bank closings: 1921-1933
Source: National Bureau of Economic Research
As indicated above, consumer losses increased as the number of commercial bank suspensions increased, thus suggesting that public interest is also affected by bank failures and suspensions.
Intervention vs. Non-Intervention
The above-mentioned data indicates that even after more than one-hundred years of government intervention and regulatory policy (which is designed to reduce risk henceforth), financial consumers continue to face levels of investment risk sufficient to cause significant (and sometimes total) loss of their principle investment. This fact exemplifies why policymakers need to consider alternative approaches to improving financial security. Between the financial consumer and the financial markets lie government policies that attempt to protect the public interest by regulating the financial industry. Financial security, and the methods used by the government to secure it, is one such public interest issue that comes under scrutiny during a major financial crisis. In response to a major financial crisis, the U.S. government often implements stabilization policies as a means of preventing businesses (usually banks and financial institutions) from failing. Advocates of governmental intervention claim that the most effective way to stabilize an economy on the brink of collapse is to increase government intervention. For instance, Chairman and CEO of Berkshire Hathaway, Warren Buffet, supported TARP (and government bailouts in general), noting that without government intervention, the global economy would likely collapse. U.S. PIRG argues that the American banking system lacks transparency and accountability, and places the full blame of the Global Economic Crisis of 2008 on Wall Street bankers. While U.S. PRIG does not support the use of taxpayers’ money to save failed banks, it advocates for increased government intervention as a viable preventative solution to future financial crises, and seeks improved economic transparency and stricter punishment for firms that violate regulatory policies.
By contrast, opponents of government intervention believe that utilizing taxpayers money in order to bailout the private sector subordinates the public interest to the private interest. For instance, Superior Court Judge Andrew P. Napolitano, argues that when the U.S. government utilizes taxpayers money in order to bailout failed businesses, it not only contravenes the concepts of free markets (which would simply allow weakened businesses to fail), it also violates each citizens Constitutional rights; specifically, the due process and equitable protection clauses of the Fifth and Fourteenth Amendments. Robert A. Levy, Chairman of the CATO Institute, a conservative public policy research organization based in Washington, D.C., asserts that Congress cannot spend taxpayers money to buy distressed assets based on good intentions only. According to Levy, TARP was unconstitutional because Congress has no constitutional authority to take ownership of private financial institutions. A primary problem with government bailouts is that they are not successful long-term. The government has been bailing out failed corporations since 1792. While bailouts may provide short-term economic relief, they do not offer a viable, long-term solution to financial crises. Whether bailouts do actually violate the Constitutional rights of U.S. taxpayers (as Napolitano argues), or if Congress truly does not have the authority to take ownership of private institutions (as Levy suggests) is beyond the extent of this study. What matters is that if the government continues to view bailouts as a long-term solution to financial crisis, financial security will continue to remain at risk.
Each financial crisis displays unique political and economic characteristics that present equally unique regulatory challenges. Accordingly, each crisis has developed its own group of policymakers, or regulatory regimes, that are charged with resolving the crisis at-hand. When financial crisis occurs, regulators either take some type of action (intervention) or they do not take action (non-intervention). When thinking about regulatory regimes, it is perhaps best to think of them as groups of prescription policies that are created by groups of currently-elected policymakers that strive to accomplish a common goal. Hood, Rothstein and Baldwin define a regulatory regime as a set of characteristics that are usually retained, “beyond the tenure in office of any one leader, government minister, or political party.” Regulatory regimes take action when relationships between social interests, the state, and the economy break-down. In other words, when there is a financial crisis, the government usually takes action to fix it. In response to each financial crisis, regulators typically create a specific set of policies designed to address the problem at hand. For example, between 1929 and 2008, the U.S. experienced three major financial crises, and at least fifteen different recessions lasting between six and forty-three months. (see figure 4)
Figure 4. U.S recessions between 1929 and 2008
Source: The National Bureau of Economic Research
During this period, regulators implemented numerous policies, and formed new regulatory agencies to manage those policies, (see table 1).
Table 1. Regulatory agencies responsible for the regulation of risk
|Organization||Reason Established||Trigger Event|
|Securities & Exchange Commission (SEC) 1934||Regulate stock market; prevent corporate abuses stemming from securities sales||Great Depression; part of New Deal|
|Commodity Futures Trading Commission (CFTC) 1975||Regulate commodity future and options markets||No specific event|
|Federal Reserve System 1913||Panic of 1907||Panic of 1907|
|Federal Deposit Insurance Corporation (FDIC) 1933||To establish minimum deposit insurance for bank accounts||Bank -runs of the 1930s that stemmed from the Great Depression|
|Financial Industry Regulatory Authority (FINRA) 1939||Protect America’s investors by making sure the securities industry operates fairly and honestly.||1938 Maloney Act|
|National Credit Union Administration (NCUA) 1970||Supervise and charter federal credit unions. Unsure savings in federal credit unions.||Overhaul of the Bureau of Federal Credit Unions|
|Office of Thrift Supervision (OTS) 1989||Charters, supervises, and regulates all federally chartered and state-chartered savings banks and savings and loans associations.||Savings and Loan Crisis of the early 1980s|
Table 1 displays a list of the primary federal regulatory agencies that are responsible for regulating financial and economic risk. Indeed, there were many other regulatory agencies created between 1929 and 2008; however, those listed above are specifically responsible for protecting citizens from exposure to excessive levels of risk. Among them, only FINRA and SEC are involved with overseeing investment advisors as it pertains to the quality of advice they provide to financial consumers. At one point or another, since their inception, each of the regulatory agencies listed in Table 1 have failed to implement some (or all ) of the policies for which they are responsible, which in turn, created additional risk to financial security for the public. For example, some argue that the Fed acted irresponsibly after the attacks of September 11, 2001 by lowering interest rates to levels not seen since 1946. After the September 11 terrorist attacks, the Fed cut rates by 50 basis points on September 17, October 2 and November 6. At the November 6 meeting, the Fed noted deterioration in business conditions both here and abroad, and made room for more rate cuts. Accordingly, the Fed cut rates again at its December 11 FOMC meeting. The Fed kept its Federal funds rate target unchanged at its January 29–30, 2002, FOMC meeting, but continued to view risks as weighted toward weakness. Foleyin suggests that both economists and commentators alike blame Greenspan for the turmoil in the credit markets, citing the above-mentioned rate cuts, Wall Street’s invention of exotic debt products, and a flood of new money from emerging markets as the causes of making credit cheap. While the Fed’s practice of lowering interest rates may have helped generate economic growth in the short-term, it also contributed to the housing price bubble by making it easy for the banking industry to offer mortgages to borrowers that were previously deemed poor credits risks. In essence, Foleyin argues that Fed should have not cut rates to the levels seen between 2001 and 2006. Economist John Taylor from Stanford University also argues that the Fed should have never lowered rates beyond 1.75 per cent in 2001. According to Taylor, the consequences of the Fed’s excessive rate cuts resulted in massive consumer losses once the housing markets crashed, thus demonstrating how regulatory policy, which is designed to help both the private and the public sector, can help one but not the other. This is particularly evident among low-income, minorities that have historically experienced higher barriers to obtaining a mortgage loan, and higher-than-average interest rates on those loans.
Discrimination and Policy Failure
Academic studies often compare one financial crises to another, assuming that a positive correlation exists between them. Some contemporary theories argue that the Great Depression has much in common with the Global Economic Crisis of 2008, pointing to commonalities such as large monetary losses within the private sector, moral hazard, and high levels of government intervention. One school of thought suggests that the economic conditions immediately after the Global Financial Crisis of 2008 were more troubling than those of the Great Depression because in contrast to the 1930s, the U.S. is now a debtor nation and more households in the U.S. are in far greater debt. Others disagree, citing that macroeconomic indicators such as rate of unemployment, a commonly used gauge of economic health, peaked at 25% during the Great Depression, but only reached 9.5% during the Global Economic Crisis of 2008. Whether these financial crises share macroeconomic or political traits is beyond the scope of this thesis. What matters is that each crisis has produced data that provides policymakers with information sufficient to affect positive change in financial security. Yet, financial risk still remains high for both the private and the public sectors.
Sometimes, comparing the data between one crisis and another crisis yields useful information about public interest. One group in particular, minorities and low-income African-Americans, still face disproportionally high risk, despite nearly 100 years of regulatory policy that was designed to reduce risk. For instance, both the S&L Scandal of the 1980s, and the Global Economic Crisis of 2008 is marred by multiple instances of discrimination against minorities (in general) and low-income African-Americans (specifically). Some policies enacted during the S&L Scandal included affirmative goals for low to moderate income minorities, which in turn increased the level of risk to the financial consumers whose credit scores and income were low. African-Americans and low to moderate income minorities were the hardest hit during the S&L Scandal, as they were during the Great Depression, and the nonprime mortgage bust of 2008. According to the Joint Center for Housing Studies (JCHS) of Harvard University, minorities are far more likely to get higher-priced loans, partly because they have lower credit scores than white borrowers, and also because of the “racial/ethnic” segregation of residential areas that result from housing markets. This finding is confirmed by the Center of Responsible Lending, which reports that YSP is one of the reasons that black and Hispanic, low-income families are more likely to receive a lower quality, high cost mortgage as compared to white families.
Does the above-mentioned data suggest a serious lapse in moral judgment among the investment professionals that sold high-risk loans to minorities? Some research shows that people harbor implicit race biases which can be uncontrollable or unconscious. There are two schools of thought vis-à-vis the correlation between racial bias and moral judgment. One asserts that, “people have unconscious racial biases which cause discriminatory behavior surreptitiously.”  The other asserts that, “people are aware of their racial biases” but find it difficult to control them. The consequences of such research may lead people to conclude that, “individuals who engage in racial discrimination are not morally responsible or blameworthy for what they have done.” From a legal perspective, in order to be held morally responsible for an action, an individual must have, “awareness of its implications and control over its execution.” This suggests that at least some investment professionals might not be personally responsible for selling high-risk investment products to individuals that cannot afford to bear such risk. Yet, the notion that people cannot control their intent to discriminate against race is highly controversial. It comes down to a matter of intent. If investment professionals intentionally sold high-risk loans to low-income minorities and African-Americans for the sole purpose of earning YSP (as the aforesaid data indicates), then it could sustain an argument that they lacked moral judgment. However, it does not alleviate their moral responsibility, nor does it make them less blameworthy, as Cameron and Payne suggest. It would be a slippery slope indeed if policymakers were to dismiss responsibility based on an allegedly inherent predisposition to discriminate against race.
Policymakers must tread carefully when considering such data, and ensure that unproven statistical studies do not sway their efforts to develop sound policies that will increase financial security, and punish those responsible for defrauding financial consumers. Ineffective or poorly designed policy has already contributed to the financial problems facing minorities. Between 1935 and 1951, the practice of redlining (denying or charging more for banking and other services to individuals living in racially defined areas) was common. Financial institutions exploited segregated areas through the redlining policies developed by the Home Owner’s Loan Corporation (HOLC), a government-sponsored agency, whose purpose was to prevent foreclosure through the refinancing of home mortgages that were currently in default. HOLC operated until 1951, when it ran out of funds. During its operation, HOLC, refused mortgages to households living within redlined inner cities and integrated outlying areas. Initially, HOLC devised a risk-evaluation rating system for making loans in urban neighborhoods. High risk areas, which almost always comprised low-income, African-American neighborhoods, were redlined. HOLC redlined any neighborhood, even those with a small black population. Neighborhoods with the potential to attract black families were also denied funding. According to Powel, Kearney, and Kay the, “vicious cycle that kept blacks in isolated ghettos” was caused by HOLC policies. Powel et al. argue that HOLC’s discriminatory lending practices, “ensured that black families had virtually no options for receiving credit to purchase homes”, and influenced Federal Housing Administration (FHA) and the Veteran’s Administration (VA) underwriting policies, which prevented other federal agencies from providing loans. This was particularly true for low to moderate income monitories during the Great Depression, and the Global Economy Crisis of 2008. According to JCHS, minorities (particularly blacks and Hispanics) were more likely to receive a higher-priced home purchase loan than whites or Asians living in the same neighborhood. Likewise, during the 1980s, banks freely provided loans and mortgages to lower-income whites but not to middle or upper class blacks. Some of the risks facing minorities vis-à-vis housing loans finds its regulatory roots in policies such as those implemented by HOLC.
As the Savings and Loan industry became more competitive with commercial banks, regulators pressured banks and thrifts to offer loans to minorities and low-income borrowers, and in so doing, created a series of policies that inadvertently added risk. As banks and thrifts relied on credit scores and income as a means of determining loan terms and interest rates, low-income individuals with low credit scores received far less favorable rates of interest. Two policies in particular, The Home Mortgage Disclosure Act, and the Community Reinvestment Act, implemented affirmative obligations on thrifts, thus requiring them to lend to low and moderate income minorities. Thus is the paradox of regulatory policy as it pertains to public interest: the efforts by regulators to make loans more accessible to low and moderate income minority communities failed to consider precisely how the banks would be able to offer such loans at a competitive rate. Consequently, this placed pressure on both the banks and thrifts, and on the borrowers, with the former struggling to meet regulatory requirements, and the latter struggling to make their minimum monthly mortgage payments. Some might argue that these policies were discriminatory in nature because the majority of individuals that met this criteria (those with poor credit scores and low-income) were minorities. On the other hand, banks and other financial organizations that provide such loans would likely disagree because they are at-risk of losing money when borrowers default. While the above mentioned data might not necessarily indicate a pattern of discrimination, it does demonstrate how federal regulatory policy can place consumers at risk when either the policy itself, or the implementation of that policy, is inconsistent with public interest.
History of Financial Regulatory Policy
The minimum goals of regulatory policy, ceteris paribus, are to (1) protect citizens from the exploits of the private sector; (2) promote economic stability under unstable circumstances; and (3) hold corporations responsible for threats (and violations) to public health and public interest. As it pertains to the regulation of the financial industry, Congress and the Senate frequently propose bills and legislature in the House, and government agencies such as the SEC, the Federal Reserve, and FINRA are charged with managing the goals that such bills establish. In turn, investment professionals are responsible for ensuring that the advice they provide to financial consumers is consistent not only with these goals, but also with each individuals risk tolerance level. Systemic risk typically increases when one or more of these goals are not achieved. Thus, systemic risk increases when policy implementation fails, and/or when investment professionals fail to provide suitable advice to financial consumers. Historically, regulatory policy has strived to prevent systemic risk and increase financial security. While regulatory policy cannot prevent individual bank failures, it should, at the very least, prevent a widespread collapse of the banking industry. Some argue that one possible way to reduce the risk of systemic collapse is to increase regulation (through government intervention) of the financial industry. Others believe that increasing financial consumer educational programs would prevent (or reduce the severity of) financial crises. Still others argue that by applying some type of product safety regulation to the financial markets, consumers will somehow face less risk. Yet, more than one-hundred years of intervention and consumer education programs has demonstrated that additional regulation does not necessarily prevent financial crisis from occurring again. Moreover, it is questionable if the development of a product safety mechanism for the financial markets would actually improve financial security. While there are many possible reasons why regulatory policy has been unable to improve financial security for the millions of citizens that invest their money in the financial markets, my thesis argues that both regulators and scholars have overlooked one extremely important aspect of the investment cycle: the educational requirements for investment advisors. The following historical accounting of regulation for the financial industry (beginning with the stock market crash of 1929) provides a better understanding of the numerous policies that both Congress and the Senate have passed (or proposed) that pertain to the financial markets. It demonstrates that policymakers have never proposed legislature that would impose minimum educational requirements for investment advisors.
By definition, an investment adviser is either an individual or an entity that regularly (as a primary business) provides advice and/or analysis through direct or indirect recommendations, writings, or publications about securities and/or securities markets for compensation in any form. The regulatory registration requirements for firms are different than for individuals. While firms are required to register with either the state or federal SEC, individuals must pass one or more securities licensing examinations. Investment firm registration requirements are based primarily on assets under management (AUM), which is the amount of regulatory assets receiving continuous and regular supervisory or management services. Firms with more than $100 million AUM must register with the federal SEC; firms with less than $100 million AUM must register with the state SEC. Individual registration requirements are mandatory, with some exceptions. For instance, if an individual has less than 15 clients and/or less than $25 million AUM, he or she does not need to register. Other exemptions from registration include (1) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956 that is not an investment company; (2) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession; (3) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer, and who receives no special compensation therefore; (4) the publisher of any bona fide newspaper, news magazine, or business or financial publication of general and regular circulation; (5) any person whose advice, analyses, or reports relate to no securities other than securities that are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; (6) any nationally recognized statistical rating organization, as defined in section 3(a)(62) of the Securities Exchange Act of 1934, unless such organization engages in issuing recommendations as to purchasing, selling, or holding securities and/or in managing assets; (7) any family office, as defined by rule, regulation, or order of SEC; or (8) other persons the SEC may designate. Individuals that are exempt are not required to register with the SEC, nor do they need to pass an examination.  This definition has guided the regulatory efforts of policy makers since the beginning of the 20th century, and it has also helped executives of the New York Stock Exchange formulate their own internal policies.
The NYSE and Customer’s Men
When the Roosevelt administration implemented the Securities Act of 1933 (which primarily regulates the information disseminated to financial consumers by investment firms), and the Securities Exchange Act of 1934 (which primarily regulates the behavior of firms and individuals that sell securities to financial consumers), the registration requirements for investment advisors (stockbrokers) were a major problem. According to the Report of Special Committee on Customer’s Men (November 8, 1933), The New York Stock Exchange formed a special committee to inquire into the entire subject of the employment and compensation of Customer’s Men. By definition, Customer’s Men was the name given to broadly identify solicitors of commission business in listed securities, branch office managers, securities salesmen, assistants to partners, order clerks, statisticians, and other employees. Section II asserts that the title, Customer’s Men, was too broad, and recommended that the name be changed to commission man (an employee engaged primarily in the solicitation of commission business in securities. The modern-day equivalent of a commission man is a stockbroker and/or investment adviser.
The report largely focuses on the methods by which Commission Men are compensated, but it also highlights major difficulties that had previously existed about Commission Men regarding the employment of men that, “lacked an adequate knowledge of the securities business.” Section III of the report suggests that this, “evil can be met” by prohibiting Commission Men (investment advisors) from making any buy, sell, or other types of recommendations to clients until he has been adequately trained in the securities business. The report recommends the creation of a junior level commission man (today’s equivalent of an internship) as a means of allowing, “men of good character to secure education and training” in the securities business sufficient to work as a senior level commission man. The report also suggests that the employer should assume responsibility for such education and training, and that all junior Commission Men should not be permitted to make any recommendations without specific approval of a commission man or branch manager.
The Report of Special Committee on Customer’s Men (November 8, 1933) reveals much about how NYSE securities executives viewed the occupation of investment adviser, and who should bear the responsibility for training and education. First, the Special Committee on Customer’s Men was formed in January, 1930, approximately two-months after the stock market crash of 1929, thus indicating that NYSE officials recognized the need to evaluate, “all conditions resulting from the employment of so-called Customer’s Men by Members of the Exchange.” Considering the sudden and unprecedented drop in stock prices only a few month earlier, it’s not surprising that one of the primary goals of the report was to, “study ways of improving public opinion regarding Custom’s Men as well as general dissatisfaction within the business.” Second, NYSE officials recognized the importance of employing professionals with an appropriate level of education. Third, they believed that the employer, not the government, was responsible for ensuring that employees meet the minimum qualifications for employment. Finally, officials were aware of the, “many complaints” that were made to the Exchange with respect to transactions in connection with power of attorney, thus indicating that at the time of the market crash in October, 1929, stockbrokers were submitting buy and/or sell orders for clients without first communicating with the client. Put differently, stockbrokers were arbitrarily and regulatory buying and selling securities without clients knowledge of such transactions. The modern-day equivalent of this type of behavior is referred to as churning, and unauthorized trading. Other violations recognized by the report include order-timing (which involves omitting the time of an order, and waiting to see when it might be profitable before submitting said order); and record-keeping (stockbrokers and floor traders were not retaining slips, or sales tickets, after an order was placed). The findings of the committee set a precedence for future registration requirements for investment professionals by (1) failing to define an, “appropriate level of education” needed to work as a stockbroker; (2) suggesting that employers determine the level of education (which in turn, fails to create a standard, since each employee would most certainly offered a different type of training program to its employees); and (3) sent a message to policymakers that licensing, not formal education, was the best determining factor for individuals that wanted to work as a stockbroker.
In general, there are two types of stockbrokers that require registration: (1) institutional brokers that work for (and represent) firms; and (2) retail stockbrokers that work for (and represent) individual clients. Before the Great Depression, in order to work as an institutional stockbroker, firms were required to purchase a seat on the New York Stock Exchange, and pass an exchange-sponsored (not government regulated) exam. The only requirement for individuals to work as a retail stockbroker was employment by an investment firm. Neither firms nor individuals were subject to regulatory registration requirements until the implementation of the Investment Advisors Act of 1940 (a component of the Securities Exchange Act of 1934). The impetus of the Investment Advisers Act of 1940 (IAA) was the Public Utility Holding Company Act (PUHC) of 1935, which was also a component of the Securities Exchange Act of 1934. In essence, PUHC (also referred to as the Wheeler-Rayburn Act), established a theoretical base that prompted the SEC to investigate the behavior and activities of investment advisors. PUHC’s main functions were to (1) regulate electric utilities; and (2) prevent holding companies (companies that own stock in other companies as opposed to actually producing goods or services themselves) from engaging in both regulated and unregulated businesses. An efficacy study that was authorized by Congress to examine the investing behavior of holding companies that were regulated by PUHC led to the creation and implementation of IAA. The notion of creating and implementing regulatory policies (such as those mentioned above) as a means of stabilizing the economy and the financial markets, and thus, supporting public interest, finds its roots in the Progressive Era.
The Progressive Era
The Progressive era is a period in U.S. political-economic history characterized by bank panics, lax lending policies, a weak paper-money system, and a declining international economy. The Progressive Era brought forth profound change in America’s institutions and policies that still influences modern-day U.S. policymaking. The Progressive Era can be viewed as two primary movements in regulatory policy: international and domestic. While international policy largely focused on the formation of new global relationships and security, domestic policy sought to transform city governments from centers of corruption to honest, efficient and humane governments characterized by improvements in slum housing, education, and health. During this period, under the guidance of the Roosevelt administration, the national government improved and/or created several regulatory agencies capable of exerting influence over corporations. For instance, the Hepburn Act (1906) reinforced the Interstate Commerce Commission, thus allowing for stricter government regulation of the railroads. The U.S. Forest Service was empowered to guide lumber companies in the conservation and efficient exploitation of woodland resources. The goal of the Pure Food and Drug Act (1906) was to protect consumers from fraudulent labeling and altering of products, the goal of which was to reduce risk to consumers. Between 1902 and 1913, Presidents Roosevelt and Taft relied on the Sherman Antitrust Act of 1890 to increase regulation against corporations and limit monopolies and cartels. Taft also transformed the federal government by giving it access to enormous revenues, which helped to establish several regulatory agencies, including the establishment of a Tariff Commission (1916); the creation of the Federal Reserve System (1913) to supervise banking and currency; a broadened antimonopoly program under the Clayton Anti-Trust Act (1914); control over the hours of labor on the railroads (Adamson Act, 1916); and the creation of a agency that ensures fair and open competition in business (Fair Trade Commission, 1914). The creation of these (and other) policies and organizations signal a shift in policymaking that was prompted by a need to protect financial consumers, and subsequently, public interest through increased regulation (intervention).
The Stock Market Crash of 1929
Economic growth between 1913 and 1929 increased significantly, as the Roaring Twenties ushered in a new period of prosperity. By the end of World War I, tariff increases and tax cuts created an economic boom in the U.S. Accordingly, financial risk also increased, as millions of financial consumers invested in the stock market, the majority of whom invested on margin. By definition, margin entails borrowing against securities in an account for the purpose of purchasing additional securities. Margin trading is a complicated concept, one that even some investment professionals find difficult to master. It creates a highly-leveraged position that can either yield substantial profits, or create large losses. Regulatory policy vis-à-vis margin training during the early twentieth century was lax. Margin requirements were low; essentially, anyone with some money could invest on margin, albeit their risk tolerance, suitability, or knowledge of the margin process. This enabled financial consumer of all income brackets to control large amounts of publicly traded securities with a very small amount of capital. Without effective guidance from their investment advisors (commission man or stockbroker), that should have advised many financial consumers against investing on margin, investors took advantage of these lax policies by purchasing large amounts of stock on margin. Between 1921 and 1929, the Dow Jones Industrial Average (a leading index of 30 industrial stocks) increased more than six times its value. However, when global economic conditions deteriorated in the latter half of 1929, global stock markets also crashed, prompting massive margin calls, and subsequently, leaving for broke millions of financial consumers that bore far too much risk by investing on margin.
The stock market crash of 1929 marks the beginning of The Great Depression, a period characterized by excessive unemployment; a drop in personal income, tax revenue, and corporate profits; and significant decreases in international trade. Moreover, crop prices dropped, which affected the farming, mining, and lumber industries worldwide. In response to the 1929 stock market crash and The Great Depression, the government (taking cues from the Progressive Era) intervened by creating new regulatory policies and agencies. Congress created the Federal Deposit Insurance Company (FDIC), the President established the Securities and Exchange Commission (SEC), and regulators developed the National Association of Securities Dealers (NASD), the Securities Act of 1933, and the Securities Exchange Act of 1934. Collectively known as the New Deal, regulators also passed the Investment Company Act of 1940, which established requirements for the registration of investment advisors and investment firms.
Before the 1929 stock market crash, there were no registration requirements for investment advisers. The establishment of registration requirements for investment advisers indicates recognition by the government for the need to keep investment professionals in-line with public interest. While the change in status quo from one of limited regulation (pre-1907) to one of strong regulation (post-1929) may have been a step in the right direction, policymakers missed many opportunities to establish effective registration requirements for stockbrokers. For example, in March 1933, FDR introduced the New Deal, which created the SEC, and led to the implementation of IAA. This would have been an appropriate time to establish minimum educational parameters for individuals that actively advise clients and mange client assets. Yet, according to IAA, Section 203 (c)(1), an investment adviser (or any person that intends on becoming an investment adviser), may satisfy the registration requirement by filing an application with the SEC, and providing the following information: (a) employers name and type of organization; (b) the name of the State where the adviser will register (including office location, principal place of business, names and addresses of partners, officers, directors, and persons performing similar functions, and the number of employees; and (c) the education, business affiliations for the past ten years, and present business affiliations of each investment adviser, partner, officer, director, and other employees persons performing similar functions. Put differently, the SEC requires that an individual informs them of his or her educational qualifications, but places no limitations or requirements for such education. The only stipulation required by current legislature (which was established in 1940) is a high school diploma. Thus, deficiencies in the regulatory registration requirements for investment advisers remains a major weakness of IAA (and subsequent legislature that pertains to investment advisers and financial consumers); one that fails to ensure that the individuals managing clients’ money possess the core competencies and skills needed to understand and effectively manage the complexities of portfolio and investment management. My thesis argues that these competencies and skills are typically developed and tested through a rigorous education that is attained from an accredited college or university.
Regulation through the 1980s
Both during and after the Great Depression, John Maynard Keynes (1883-1946) gained fame for his arguments concerning laissez faire policies. Keynes argued for government intervention in the economy, suggesting that too little intervention before 1929 contributed to the Great Depression. During the Saving and Loan Crisis of the 1980s, the topic of study was not laissez faire policies, but rather, corporate behavior and government policies that created excessive risk in the U.S. economy. During this period, Congress was more concerned with regulating the mortgage and housing industries rather than the stock market. The Congressional record shows that between 1980 and 1989, the 97th through the 101st Congress introduced, passed, voted on, or amended 882 bills and legislature that dealt with issues ranging from urban development reform (Department of Housing and Urban Development Reform Act of 1989) and veterans benefits (Veterans’ Benefits Amendments of 1989) to reverse mortgage insurance (Reverse Mortgage Insurance for Older Americans Act of 1990) and tax credits for homeowners (Residential Housing Tax Incentives Act of 1981). During the same period, Congress passed, voted on, or amended 22 bills and legislature that dealt with investment advisors, none of which concerned registration requirements. Opportunities to amend existing legislature appeared in the Investment Adviser Self-Regulation Act of 1989 (proposed by Senator Christopher Dodd and cosponsored by Senator John Heinz); the Financial Modernization Act of 1988 (proposed by Representative John LaFlace); the Financial Services Regulatory Efficiency Act of 1987 (proposed by Senator E.J. Garn); or the Fair Trade in Financial Services Act of 1990 (proposed by Senator Donald W. Riegle, Jr, and cosponsored by 10 others.). These Acts amend the Investment Advisors Act of 1940, focusing on issues such as ethics, fair trade, foreign applications, consumer rights, self-regulatory authorities, and exemptions for investment advisors. Absent from the governments agenda is attention to the professional qualifications of investment advisors. At no time does Congress or the Senate introduced the idea of reviewing the skills and core competencies of investment advisers as a means of improving the quality of the financial service industry.
Regulation Through the 1990s
The period between 1990 and 2000 ushered in new and innovative methods for investors to buy and sell securities via the Internet. As online trading increased, and discount, online investment firms such as Charles Schwab, E-Trade, and Ameritrade emerged; financial consumers were exposed to an affordable and convenient method for investing in the securities markets. Accordingly, they were also exposed to new levels of risk, as day-trading (buy and selling the same security on the same day) became popular. Combined with new, speculative securities known as dot-com’s (Internet-based companies that either traded at excessively high multiples to their earnings, or had negative earnings), both day traders and regular investors alike yielded short-term profits for several years until the dot-com bubble, or information technology bubble, peaked in March, 2000, sending stocks tumbling nearly 10% in one day, and leading to a protracted sell-off on the NASDAQ. During this period, Congressional actively for the financial industry increased from the previous decade, as government regulators, struggling with the melt-down in technology stocks, introduced, passed, voted on, or amended 32 bills and legislature that dealt with investment advisors. As with the previous decade, regulators missed the opportunity to amend existing policies or create new ones that would have imposed (or at least examined) educational requirements on investment advisers. Instead, Congress focused on amending the Banking Act of 1933(Glass-Steagall Act) as it pertained to lending, insurance, securities transactions, financial operations abroad, and continuing education for financial consumers; (Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act, proposed by Representative James Leach and cosponsored by 12 others); and new methods for collecting fees from existing investment advisors (Investment Adviser Regulatory Enhancement and Disclosure Act of 1993). The latter, in particular, represented an ideal opportunity for regulators to propose (at the very least) the notion of imposing minimum educational prerequisites on individuals that aspired to a career in investment management.
Notably, the Investment Adviser Regulatory Enhancement and Disclosure Act of 1993 (proposed by Representative Rick Boucher of Virginia) amends the Investment Advisors Act of 1940 as follows: it (1) sets forth a sliding scale fee schedule for investment advisers; (2) authorizes the SEC to suspend the registration of any investment advisor for failing to pay the requisite fees; (3) authorizes the SEC to conduct periodic exams of advisers and discipline them for non-compliance; (4) prohibits certain transactions by investment advisers that are deemed unsuitable for a clients financial situation and experience; (5) directs the SEC to promulgate investor protection rules by setting bond requirements for certain investment advisers that commit larceny or embezzlement; (6) prohibits a person convicted of a felony within the last ten years from registering as an investment adviser, and (7) prohibits an investment adviser from disclosing confidential client information. The goal of the abovementioned enhancements lean towards preventing investment advisors from providing advice that is not suitable for financial consumers, charging them additional fees, and punishing them for committing serious crimes. This was the ideal opportunity to include an educational requirement for investment advisers. Doing so would have made sense, given the broad regulatory changes that were designed to improve financial security.
The Global Financial Crisis of 2008
With the exception of the dot-com bubble, which does not classify as a financial crisis, but rather as a serious market correction, between the end of the 1980s and 2008, the economy was relatively stable (as evidenced by the absence of excessive macroeconomic fluctuations), succumbing to only mild-recessions that lasted no more than 8 months each. However, the terrorist attacks on September 11, 2001 marked the beginning of a series of significant political, economic, and psychological events that resulted in a serious threat to U.S. financial public interest. In response to the attacks on New York City and Washington, D.C., the Federal Reserve adopted a monetary policy that lowered interest rates, thus making it easier for U.S. citizens to borrow money. By 2003, key interest rates were at 1%, the lowest since the end of World War II. Low rates created a robust supply and demand environment between U.S. financial consumers that wanted to purchase a home, and financial organizations that accommodated these needs through the creation (or modification) of financial products such as sub-prime mortgages. During this period, thousands of mortgage brokers sold high-risk mortgages to unsuspecting would-be homeowners in order to earn a higher commission. Essentially, a mortgage broker earns a lower commission on a 30- or 15- year fixed mortgage than he or she does on a 5/25 adjustable mortgage. Accordingly, between 2003 and 2007, sub-prime mortgage applications increased 292%, from $332 billion to $1.3 trillion. However, in late 2006, the U.S. housing market peaked, and by 2007 home owners experienced a sharp decline in the value of their property. According to the National Bureau of Economic Research (NBER), this boom and bust in the housing market triggered a recession that began in June 2007 and ended in December 2009. Sometimes referred to as the Great Recession, financial public interest was seriously damaged by the above-mentioned events, as evidenced by a 115% increase in seasonally adjusted unemployment, a 45% (on average) drop in housing prices, and a 13.21% decrease of household net worth.
The threat to financial security and public interest increased two-fold in September 2008 when investment banks Lehman Brothers and Bear Stearns filed for bankruptcy protection, citing massive losses that originated from their sub-prime mortgage business operations. Within a few weeks, dozens of other large financial institutions and publicly-traded corporations such as General Motors and AIG also filed for bankruptcy. These events triggered a massive sell-off in the global equity markets, and prompted massive layoffs for millions of workers. Consequently, between September 2008 and August 2011 the seasonally adjusted unemployment rate in the U.S. increased 46.77%. In August 2011, U.S. unemployment peaked at 9.5%. Comparatively, between 1948 and present, the average non-accelerating rate of unemployment (NAIRU) is 5.6%. Placing this into perspective, the annual rate of unemployment in August 2011 was 61.97% higher than the 64 year average annual rate of unemployment. This indicates a failure in regulatory policy, of which there are several possible causes: (1) aggressive movements by the Fed to lower interest rates; (2) failure by policymakers to address concerns surrounding moral hazard; and (3) issues that arise when the government allows investment or commercial banks to begin offering products of which they have little prior expertise.
The U.S. economy was already in a recession when the above-mentioned corporate failures occurred. In response, the government adopted a series of stabilization policies that included the Troubled Assets Relief Program (TARP), a taxpayer-funded $700 billion bailout designed to prevent businesses from completely failing. Notably, at the beginning of the recession (June 2007), the rate of U.S. unemployment was 4.6%, and it remained below or at NAIRU (the natural or non-accelerating rate of unemployment) until August 2008. However, after September 2008 unemployment increased well-above NAIRU, household net worth dropped, and taxpayers money that the government might have used for social programs or national defense was given to failing corporations. Each of these events (a rise in unemployment, a drop in household net worth, and the utilization of tax payer’s money) increased risk to the financial consumer, and negatively affected financial public interest, as evidenced by large reductions in personal and household net worth, and a significant increase in unemployment. During the Global Economic Crisis of 2008, regulators contended more with restoring confidence than with recovery. Accordingly, the House cleared bill H.R.4173 – Wall Street Reform and Consumer Protection Act of 2009; and the Senate introduced bill S.3217 – Restoring American Financial Stability Act of 2010. In addition, President Obama increased FDIC protection from $100,000 to $250,000; approved a massive financial bailout (TARP); and, introduced several regulatory proposals targeting consumer protection, executive pay, capital requirements for banks, enhanced authority for the Federal Reserve, and an expansion of the regulations concerning derivatives.
During this period (2000 to 2010), policymakers shifted their attention to matters concerning the management of hedge funds, 401k retirement funds, transparency within the private sector, independent investment advisers, investor protection (in general), and military personnel protection (specifically). Through the introduction and amendment of 45 bills and pieces of legislature, regulatory policy designed to change IAA was put in front of Congress that would negate the exemption rule for all investment advisers, regardless of occupation or AUM, (Hedge Fund Adviser Registration Act of 2009); require all advisers to maintain a readily accessible electronic process for responding to inquirers (Broker Accountability through Enhanced Transparency Act of 2003); disclose any fees received by a company for any publication, analysis, or report regarding said company over its securities (Broker Accountability through Enhanced Transparency Act of 2003); and protect members of the Armed Forces from dishonest and predatory insurance sales practices while on a U.S. military installation (Military Personnel Financial Services Protection Act).
As noted above, members of Congress have introduced, voted on, or amended existing legislature that protects financial consumers in a variety of ways. Notably, since the early 1980s, the notion of enhancing and funding programs for consumer education stands out as an example of the government’s belief that financial education can positively affect financial security. For instance, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009 calls for (a) the funding of education incentives to help consumers protect themselves against violations by advisers; (b) requires the Office of Financial Literacy of the Bureau of Consumer Financial Protection to provide educational materials and training to seniors to increase awareness and understanding of misleading or fraudulent marketing; (c) requires the Office of Financial Education to develop a strategy for improving financial literacy of consumers; (d) instructs the Comptroller to study effective methods, tools, and strategies intended to educate and empower consumers about personal financial management; (e) amends the Housing and Economic Recovery Act of 2008 to include economically vulnerable individuals and families among the groups targeted for financial education and counseling; (f) authorizes the Secretary to implement measures or programs designed to expand access to financial literacy and educational opportunities for individuals that obtain loans, (g) including counseling services, educational courses, or wealth building programs; and, (h) requires the Director to use specific funds to conduct foreclosure rescue education programs, with an emphasis on retirement and low-income minority communities. Indeed, Congress supports the notion that education (1) can help financial consumers; and (2) the government ought to fund it. Moreover, in 2010, Senator Christopher Dodd of CT introduced the Restoring American Financial Stability Act of 2010, which specifically identifies minimum educational requirements for qualified risk managers engaged in the business of insurance. The bill defines a qualified risk manager, with respect to a policyholder of commercial insurance, as a person that has a bachelor’s degree or higher from an accredited college or university in risk management, business administration, finance, economics, or any other field determined by a State insurance commissioner or other State regulatory official or gentility to demonstrate minimum competence in risk management. From a legislative perspective, it is a positive development that policymakers find value in establishing minimum educational requirements for any financial services occupation, even if it comes 80 years and three financial crises too late. It is also positive that they hold a favorable view on the benefits of financial education. The fact that regulatory policy supports the notion of financial education, combined with the fact that recent proposed legislature identifies minimum educational prerequisites for a financial industry-based career leaves open the possibility of further minimum requirements for investment advisors.
Notwithstanding the potential benefits of financial education programs for consumers, there are at least two primary problems with the current Congressional proposals. First, by directing educational policy at financial consumers, policymakers suggest that individual investors must master some rather dense and complicated information in order to prevent fraud, identify manipulative practices, and understand complex investment vehicles and investment strategies. Second, by imposing minimum educational requirements for risk managers but not for investment advisers, it leaves investors susceptible to the same problems they have been experiencing for decades. It makes no sense to place the burden of education solely on the financial consumer, given that there is no way to ensure that they are (1) capable of understanding abstract investment theories sufficient to prevent significant loss of capital, or (2) willing to devote enough time to learn it. A better solution, one that Congress should consider, is to (1) maintain a basic, government-funded financial educational program for consumers (such as those already in place), and (2) refuse registration for any individual investment adviser that does not meet the same criteria as those established for risk managers. Doing so would be a step towards the development of a more stable investment industry.
As it pertains to the financial markets, the majority of academic research that focuses on the benefits of education (which Congress often refers to as financial literacy) is concerned with educating individual consumers, while none addresses the benefits of formal higher education for investment professionals. There is currently no literature or statistical study suggesting that the government should establish minimum educational requirements for investment professionals as a means of improving financial security. Yet, a substantial amount of theoretical hypotheses and statistical evidence points to a strong, positive correlation between higher education and improved occupational performance. By definition, occupational performance (as it pertains to investment advisers) includes the core competencies and skills, knowledge, social and cognitive abilities, and moral judgment capabilities needed to function effectively within the financial markets, and service clients in a manner consistent with public interest.
For consumers, the purpose of financial markets is to improve the efficiency of resource allocation, and enable them to create mutually beneficial exchanges by providing information and liquidity. For businesses, financial markets provide capital to companies that need to develop economic value that is available both now and in the future. Thus, theories that focus on financial crisis and/or how to prevent them from occurring again should focus on either information and/or liquidity provided by financial markets to the consumer (which is provided by many different sources, including investment advisers), and/or the economic value such markets provide to businesses. Whether such theories take an economic, political, or social approach, or if their focus lies on either consumers or businesses (or both), theories regarding financial crisis must be concerned with protecting financial consumers against exposure to excessive levels of risk because (as previously mentioned) financial security is the underlying public interest issue for the financial industry. This thesis focuses on the information provided by investment professionals to consumers by arguing for government established, formal educational requirements for investment advisers as a means of improving financial security for both consumers and businesses. Existing theories and statistical studies (discussed below) on the benefits of education support my hypothesis.
The Benefits of a Formal Education
A society comprised of individuals that have received a formal education from an accredited college or university derives many social, economic, and legal benefits. Education can help transform people’s lives, and it enables them to sustain themselves and their communities when facing daily stresses and strains. Higher education, in particular, can lead to better career opportunities, higher lifetime earnings, a more thoughtful understanding of society, and enhanced capabilities to accept other cultures. Higher education is also positively correlated to GDP; lower rate of unemployment; and lower incidence and prevalence of violent crime. Moreover, a college education increases the predictability of moral judgment as compared to individuals that spend no years in college. The decision facing most people about whether to attend college almost always includes measuring the cost of pursing an education against expected returns. For individuals, the correlation between education and wages shows an increase of approximately 10% per additional year of schooling. For businesses (particularly those that provide professional services), hiring individuals that posses the optimal level of higher education for a specific job enhances brand, builds reputation, and reduces risk. For those who decide that the cost is worth it, they can usually expect to realize higher lifetime earnings by completing a college degree program as compared to individuals that did not go to college. Thus, it is appropriate to review existing theories that strive to explain which type(s) of pedagogical methods might provide the optimal level of education for investment advisers.
Signaling Theory vs. Human Capital Theory
There are two prevailing theories that strive to explain the causal relationship between education, earnings, and productivity. On the one hand, human capital theory suggests that education awards an individual with productivity-enhancing human capital, and that this increased productivity results in increased earnings. By definition, human capital refers to core competencies, knowledge, social and personality attributes, including creativity and cognitive abilities. Thus, human capital theory asserts that when individuals obtain a college education, their productivity will increase because their competencies, knowledge, and social skills are enhanced, and their cognitive abilities are improved. On the other hand, signaling theory argues that education only reflects inherent human capital. This school of thought suggests that individuals already possess human capital, and education merely reflects it. When applying these theories to the qualifications of investment advisers, perhaps the most important questions that require answering are: which measures of productivity (human capital) are vital to the occupation, and which ones are most beneficial to financial security.
To begin, I start with an overview of the requirements needed to function effectively as an investment adviser. The Bureau of Labor and Statistics (BLS) asserts that investment advisers require mathematical, problem solving, computer, and analytical skills. In order to present complex financial concepts and strategies in an easy-to-understand format (both orally and in writing), investment advisors must also possess excellent communication skills, knowledge of accounting principles and financial analysis, a broad perspective of financial and business markets, knowledge of investment analysis, financial modeling, and an understanding of company and industry trends. FINRA also requires adherence to strict ethical practices and standards, knowledge of client’s accounts, and traits that are specific to the investment industry, such as margin trading, derivatives, product knowledge, and risk. Self-confidence, maturity, and the ability to work independently are important as well. Proponents of behavioral finance assert that investment advisers also need a keen understanding of the psychological factors that affect the decision-making process of financial consumers each time they buy or sell a publicly traded security. BLS asserts that college-level knowledge is important for investment advisers, and while businesses may prefer to hire financial analysts with a college degree that includes coursework in statistics, economics, business, corporate budgeting, and financial analysis methods, there is no such requirement for investment advisers. Instead, “many employers consider interpersonal skills and sales ability more important than academic training.” (Bureau of Labor and Statistics) Nevertheless, BLS also indicates that college for investment advisers is recommended because financial advisers must understand economic theory, market conditions, and trends. They suggest liberal arts or business administration as appropriate academic concentrations for investment advisers.
The above-mentioned information suggests that investment advisers require a depth and breadth of knowledge (human capital, or measures of productivity) that is typically obtained through a formal college education. Coursework in economics, finance, accounting, basic and social psychology, strategy, business communications, mathematics, statistics, and ethics are commonly found in many college programs. It is improbable to suggest that a sufficient number of individuals (that are interested in investment management as a career) possess inherent knowledge of these topics sufficient to negate the need for a formal education. Yet, that is exactly what regulatory policy suggests by not requiring investment advisers to obtain such an education. (As I discuss later, current financial regulatory policy is entirely signal-centric.) As previously mentioned, the only official educational requirements for investment advisers is to (1) earn a high school diploma; and (2) pass a standardized test. Thus, for the purpose of my thesis, human capital theory supports the premise that policymakers should establish minimum educational requirements for investment advisers. Doing so would be consistent with the tenets of public interest, as it would allow financial consumers to select from a large pool of investment professionals with well-developed productivity-enhanced human capital; and thus,
provide advice that is deemed suitable by regulatory standards.
Notwithstanding the above-mentioned benefits of formal education, human capital theory alone does not explain other specific aspects that are important to function effectively as an investment adviser, such as those required by FINRA and the SEC, and obtained through standardized testing and occupational licensing. For example, knowledge of clients’ accounts, technical aspects and risks of margin trading, derivative analysis, industry regulations, asset allocation modeling, financial status and tax analyses, and suitability are not typically taught in college programs. Rather, individuals are tested on these topics through a series of standardized examinations administered by FINRA. When an individual passes one of these standardized exams, it sends a signal to investment firms that they are legally qualified to work in the field. Thus, signaling, not human capital, is correlated with occupational licensing because the financial industry bases its hiring on such signals. Put differently, a individual cannot legally work as an investment adviser without successfully passing a standardized test. Employers view these tests as a signal to help them determine who is legally qualified and who is not. However, these signals are being misinterpreted by employers as confirmation of productivity-enhanced human capital. Consequently, millions of financial consumers are receiving (and paying for) advice from investment professionals, many of whom do not possess the human capital needed to provide such advice. I argue that requirements for investment advisers should include (1) a formal education (which would develop their human capital); and (2) occupational licensing (which would enhance specific skills, and qualify them legally). Doing so would be consistent with what is expected of investment professionals by FINRA, SEC, their employer, and perhaps most importantly, by financial consumers.
Ethics and Moral Judgment
As noted above, the investment industry uses signals, not human capital, to determine who is qualified to manage other people’s money. This creates an immediate problem, both for employers and financial consumers, because it indicates that investment advisers might be accomplished sales people, but not necessarily highly educated. Research indicates a positive correlation between higher education and moral judgment. While signaling and human capital theories provide a basis from which to understand certain requirements for investment professionals, and which types of teaching and/or educational methods could help achieve them, there are other requirements that also deserve attention. For example, FINRA requires adherence to strict ethical practices and standards by all investment professionals. Moreover, many Congressional bills and proposed legislature, including Dodd-Frank, indentify poor ethics as one of the causes of the Global Financial Crisis of 2008. Therefore, it is necessary to understand how higher education can improve the ethical and moral decision-making capabilities that investment advisers must make regularly.
Many academic studies show that education is consistently a strong correlate of moral judgment. A 20-year longitudinal study by Colby, Kohlberg, Gibbs, and Lieberman (1983), shows that formal education in 4,500 adults correlated .53 and .60 with a Harvard group’s measure of moral judgment. Other studies show that formal education accounted for 53% of variance regarding moral judgment, whereas only 0.2% of this variance is attributed to gender. A comparison of two groups, one comprised of low-education individuals (2-years or less of college) and the other comprised of high-education individuals (3-years or more of college) demonstrates that in the years following high school, young people that continued their formal education in college are far more likely to make better moral decisions than those with little or no college. Multiple regression analyses indicate that the number of years people spend in college significantly adds to the predictability of moral judgment. While these studies establish an empirical relationship between moral judgment and formal education, it does not necessarily clarify its theoretical significance because there are several possible cause and effect explanations. These explanations suggest that increases in moral judgment during college may be the result of socializing with students from other cultures and backgrounds; that some students might study specific philosophical or ethics-based courses in college while others may not; that some students have different exposures to moral thinking before they attend college; and that college students are predisposed to seek intellectual stimulation, are motivate to develop their cognitive capabilities, and find more pleasure in working on complex problems. Considering that the investment industry relies on employing individuals that possess superior moral judgment-making skills; FINRA requires that all investment advisers adhere to a strict code of ethics and standards; and Congress has repeatedly indentified low ethics and lack of moral judgment as causes of financial crisis, it would make sense for policymakers to establish minimum formal educational requirements for the individuals that provide ongoing advise to financial about how to invest their money.
Occupational Licensing vs. Formal Education
Given that regulatory policy has failed to prevent financial crisis from occurring again, the signals sent by standardized testing raises important concerns about the effectiveness of occupational licensing as a stand-alone solution for the investment industry. At its core, the occupation formally known as customer’s men (stockbroker) has evolved from a sales position to a consulting position. While it used to require that a person only possess superior sales and interpersonal skills (and it still does), it now also requires that a person have mastered the aforesaid academic topics, display impeccable moral judgment, adhere to strict government regulations, and provide prudent advice to each client based on numerous individual factors. Perhaps, if the only function required by investment advisers was to pick a few stocks now and then, and hope that they are profitable, it might negate the need for formal education. However, the investment process is much more complicated than many people realize. Individuals that seek professional advice on their investable assets require (and deserve) the same level of competence they expect when they require medical advice or treatment from their physician. Thus, an important question that requires clarification is: can occupational licensing alone be viewed as a sufficient measurement of knowledge and competence.
As demonstrated above, statistical and theoretical evidence both support the notion that it would benefit public interest if investment advisers were required to complete a college degree before qualifying to take the standardized tests administered by FINRA. Does this indicate that the government should discontinue licensing requirements in lieu of formal educational requirements? Shapiro analyzes occupational licensing as an input of regulation that requires minimum levels of human capital investment by professionals. Shapiro argues that licensing alleviates moral hazard, and benefits public interest by enhancing consumer protection. Although any type of formal education is beneficial to public interest, there are a few problems with Shapiro’s study. First, he studies licensing from an economic perspective, not from one that considers the benefits of licensing on society. Since the economy is only one component of society, one could argue that Shapiro’s findings might not truly represent how occupational licensing fits into the broader scope of public interest. However, the notion that occupational licensing enhances consumer protection is sustained (to a degree) by a well-functioning arbitration system implemented by FIRNA (discussed below). Phillips asserts that, “sometimes [occupational licensing] does serve the public interest—most importantly, perhaps, by protecting consumers against incompetent or unethical practitioners. While it is difficult to state with any certainty that occupational licensing for investment professionals either increases competence or significantly impacts ethical behavior, financial consumers certainly derive other benefits from licensing. For example, licensing allows for continued regulation of investment professionals by FIRNA and the SEC, which includes prescreening of all individuals working in the investment industry for felonies and other criminal activity. In addition, financial consumers can request background information about any investment professional, view their employment history, and if necessary’ file a complaint against them or their employer through FINRA’s arbitration system. In the absence of licensing requirements, consumers would not be able to verify an advisers credentials or background, nor would they be able to file a complaint and try to recoup losses without hiring (and paying for) a private attorney.
Occupational licensing is a profitable business for the government. In 2012, FINRA reported net income of $10.2 million, with 3,400 employees, or $2,941.17 net income/employee. Placing this into perspective, if FINRA were a publicly traded company, it would rank higher (in terms of per-employee profitability) than many well-known publicly traded companies, such as Amazon.com, Toshiba, Waste Management, YUM! Brands, Safeway, T-Mobile, Wendy’s, Starbucks, Avis, and Bon Ton Stores. For the same period, SEC net income was even higher. There are currently 42 different licenses offered by FINRA. FINRA is the independent regulator responsible for registering and regulating industry participants. FINRA also writes and enforces rules; informs and educates the investing public; provides trade reporting and other industry utilities; and administers the largest dispute resolution forum for investors and registered firms. According to FINRA, the only non-educational requirement needed to earn a Series 7 (General Securities Representative License) is that an individual, “must be associated with and sponsored by a FINRA member firm.” In addition, there are no internship or residency requirements needed before an individual can get paid for managing other people’s money.
Table 2 displays a comprehensive list of all financial licenses available for individuals working in a non-managerial capacity (managing investor money, but not managing other investment professionals), whereas Table 3 shows all licenses for those who actively manage investment professionals.
Table 2 – Non-managerial licenses for investment management professionals
|Series 3||National Commodity Futures Exam|
|Series 5||Interest Rate Options Exam|
|Series 6||Investment Company and Variable Contracts Exam|
|Series 7||General Securities Representative Exam|
|Series 11||Assistant Representative Order Processing|
|Series 15||Foreign Currency Options Exam|
|Series 17||Limited Representative|
|Series 22||Direct Participation Exam|
|Series 30||Futures Branch Office Manager Exam|
|Series 31||Futures Managed Funds Exam|
|Series 42||Registered Options Representative Exam|
|Series 44||NYSE Arca Options Market Maker Exam|
|Series 52||Municipal Securities Representative Exam|
|Series 55||Equity Trader Limited Representative Exam|
|Series 56||Proprietary Trader Qualification Exam|
|Series 62||Corporate Securities Limited Representative Exam|
|Series 63||Uniform Securities Agent State Law Exam|
|Series 65||Uniform Registered Investment Adviser Law Exam|
|Series 66||Uniform Investment Adviser Combined State Exam|
|Series 72||Government Securities Limited Representative|
|Series 79||Investment Banking Exam|
|Series 82||Private Securities Offerings Limited Representative|
|Series 86||Research Analyst Securities Analysis|
|Series 87||Research Analyst Regulations|
|Series 99||Operations Professional|
Source: Financial Industry Regulatory Authority
Table 3 – Licenses for financial professionals that manage other financial professionals
|Series 4||Registered Options Principal Exam|
|Series 9||NYSE General Securities Sales Supervisor Exam Options|
|Series 10||NYSE General Securities Sales Supervisor Exam|
|Series 12||NYSE Branch Manager|
|Series 14||NYSE Compliance Officer|
|Series 16||NYSE Supervisory Analyst|
|Series 23||General Securities Principal|
|Series 24||General Securities Principal Exam|
|Series 26||Investment Company Principal Exam|
|Series 27||Financial and Operations Principal Exam|
|Series 28||Financial Operations Principal Introducing Broker Exam|
|Series 39||Direct Participation Programs Principal Exam|
|Series 51||Municipal Fund Securities Limited Principal|
|Series 53||Municipal Securities Principal Exam|
Source: Financial Industry Regulatory Authority
Table’s 2 and 3 display thirty-nine different securities licenses that embodies the entire educational requirements for investment professionals that make the investment, managerial, compliance, and operations decisions for hundreds of investment firms that manage trillions of dollars of money for financial consumers and businesses in the U.S. Regulators created these licenses in order to provide financial consumers with a pool of investment professionals that have demonstrated a certain level of competence in financial-specific topics. By doing so, regulators have embedded a signal within the regulatory process that tells both investment firms and financial consumers that the person they hire is qualified. Inadvertently, this has created an environment within the investment industry characterized by strong regulatory oversight and subject knowledge, but weak human capital.
Unlike other professional occupations such as medical doctor, nurse, attorney, college professor, or certified public accountant, all of which require an extensive formal education before an individual can even be considered for licensing, anyone (with the exception of convicted felons) with a high school diploma can earn a securities license. In addition, candidates for FINRA securities exams need to earn a passing score of only 72%; the equivalent of a C- in most colleges. In general, a grade of C- is deemed minimally acceptable by most colleges and universities, and only one level above unsatisfactory in terms of knowledge and core competencies. Moreover, investment firms are not obligated to hire individuals with a minimum level of formal education. In essence, an individual could, quite literally, graduate from high school at the bottom of his or her class, study for a securities license, and within a few months time, manage unlimited amounts of money. With the proper sales skills (a trait that is often inherent for some personality types) he or she could persuade extremely high-net worth clients and businesses to hire them as their adviser. For example, almost none of the more than 1,000 registered stockbrokers working for defunct brokerage firm Stratton Oakmont went to college. While the owner of the firm, Jordan Belfort, allegedly graduated from American University with a degree in biology, he hired individuals that excelled in sales, but lacked the moral fiber needed to effectively work in investment management. In 1998, Stratton Oakmont was convicted of fraud and stock manipulation by the SEC after regulators learned of investor losses totaling more than $200 million. Belfort perfected a scheme known as “pump and dump”, which involves artificially inflating the market price of high-risk penny stocks through misleading statements. Over the years, financial consumers have lost billions of dollars to pump and dump schemes and other types of unethical behavior at the hands of unscrupulous investment advisors that clearly lacked moral judgment. Yet, average earnings for investment advisers in 2009 exceeded six-figures as compared to non-financial jobs, where average income was slightly less than $60,000 per year. Many advisers earn seven figures or more. The above-mentioned facts suggest that if investment advisers were required to earn a college degree before they earned their securities license, fewer financial consumers would be exposed to the type of behavior commonly exhibited by rouge investment firms. In addition, it exemplifies that weak and ineffective regulatory policy that fails to address educational requirements for investment professionals possess a serious threat to financial security and public interest.
The government does not provide any assurance that the individuals managing investor capital has ever completed a college degree, internship, or residency. Thus, there is no assurance that investment advisers have developed their human capital to a level that is sufficient to effectively perform the functions of their job. In addition, investment firms are free to place a significant amount of money into the hands of their employees that might not necessarily display the core competencies and skills normally acquired in a four-year college degree program. This flaw in regulatory policy exposes financial consumers to additional risk above that which exists in the investment products themselves. Investors rely on their advisors to provide critical analysis of the financial markets, an accurate assessment of their investment goals, objectives, and risk tolerance, and advice that is suitable for their individual needs. Given that the U.S. financial markets are worth several trillion dollars; that the U.S. economy has experience three major financial crisis between 1929 and 2008; and that the majority of consumers are neither aware of the policies that dictate their investments, nor professionally qualified to analyze and understand complex investments and strategies, it would be logical for the government to impose minimum educational requirements on the individuals that are entrusted with managing it (and allowed to profit from it).
Mix Messages from Policymakers
While individual investment firms can, and sometimes do, impose additional requirements on its employees, I argue that it is inconsistent with the tenets of public interest to let the private sector ultimately determine educational requirements for the employees that manage other people’s money because the consequences of mismanagement (or incompetent management) often harms financial security. One of the goals of regulatory policy is to protect public interest. As it pertains to the investment industry, the requirement to protect public interest manifests in financial security; thus, responsibility to ensure that consumers are protected falls on the government, not the private sector. Allowing the private sector to determine the educational requirements for investment professionals fails to create a standard by which financial consumers can be reasonably assured that, regardless of which firm they hire, the advisers working for those firms will meet acceptable minimum requirements of human capital. Moreover, recent legislature (Dodd-Frank) identifies, “dramatic failures of corporate governance and risk management at many systemically important financial institutions” as one of the causes of the Global Financial Crisis of 2008. Thus, on the one hand, regulators leave it up to employers to determine the minimum requirements needed to work as an investment adviser (excluding occupational licensing requirements), yet on the other hand, they indicate that many of these same employers (important financial institutions) exhibited, “dramatic failures of corporate governance and risk management” throughout the years leading up to the worse financial crisis since the Great Depression. Put differently, Congress leaves minimal requirements standards for investment managers up to corporations they deem incompetent.
While some firms may decide not to hire individuals that do not possess at least a four-year college degree, all firms rely on assets under management (AUM) as a gauge for employment. In other words, if an investment professional currently manages millions of dollars of client assets, many firms will hire them simply to gain control of the assets, albeit the financial advisor’s level of education. Still other firms, such as Goldman Sachs, claim that, “we actively seek to recruit talented people from all academic backgrounds into our university programs and entry level positions.” For experienced investment managers, Goldman Sachs lists no educational criteria at all. Put differently, they would consider hiring an individual with a degree in fashion design or English literature, for example, to manage client assets. This fact is problematic, and potentially dangerous for the clients, given that Goldman’s minimum to open a retail investing account is $5 million.
The Bureau of Labor Statistics, a different division of the government, recommends higher education for investment advisers; yet, neither Congress nor the Senate has ever recommended such action. Moreover, in response to each financial crisis, Congress typically identifies numerous corporate failures as the cause of said crisis, but then recommends financial consumer educational programs as a solution that will prevent future crises, thus suggesting that consumers are somehow to blame for the crisis. In addition, the previously-mentioned exemption clause is of particular interest. It asserts that if a person works as an lawyer, accountant, engineer, or teacher (professions that require a college degree) whose performance of such services is solely incidental to the practice of his or her profession, they are qualified (as based solely on their educational backgrounds) to provide investment advice and collect a fee for such services. Again, this sends a mixed message vis-à-vis competency requirements for investment advisers. On the one hand, current regulatory policy exempts college-educated individuals from occupational licensing requirements; yet, on the other hand, they indicate that a person without such an education needs only to pass a standardize exam in order to qualify. In so doing, it sends the message that if a high school graduate passes a 130 question, multiple-choice exam, they acquire the same amount of knowledge, skills, core competencies, social and interpersonal skills, and moral reasoning capabilities as they would through the successful completion of a four-year degree program from an accredited college or university. These mixed signals create problems for financial consumers, most of whom are unaware of the policies that regulate the markets and industries in which they invest their hard earned money and lifetime savings, and thus require exceptional professional advice.
Since the implementation of the Investment Advisors Act of 1940, the assumption has been that standardized testing provides a sufficient method for vetting individuals that choose investment management as a career. This assumption is based on (1) the premise that investment advisors only require knowledge of financial markets, investment products, account management, and to a slightly lesser degree, awareness of ethical practices; and (2) the signals that are inadvertently created by regulatory policy, which are heavily weighted towards licensing, yet do not even consider the benefits of formal education for investment professionals. Thus, signaling theory explains current regulatory policy for the investment industry, while the human capital hypothesis provides theoretical and statistical support for the argument that a new policy prescription is needed within the investment industry.
Current Occupational Licensing for Investment Advisers
Questions found on FINRA examinations test candidates for knowledge of trade execution, margin trading, account management, and other administrative issues, and to a lesser degree, economics and finance. FIRNA does not include questions pertaining to behavioral finance or psychological conditions that affect (and determine) how financial consumers make investment decisions. Some FINRA exams include questions about ethical practices, compliance, and regulation. For example, the Series 7 exam (the most comprehensive examination according to FIRNA), is segmented by major job function. Candidates for the Series 7 licensing exam are tested on topics such as (1) rules about acquiring clients; (2) regulations concerning the evaluation of securities held in client’s accounts; (3) different types of accounts; (4) maintaining records; (5) suitability; (6) risk tolerance; and (7) regulations concerning order verification for clients. Risk tolerance is an extremely important component of the investment process, one that FINRA considers vital when determining investment product suitability, or appropriateness. Risk tolerance is a psychological condition commonly shared by all financial consumers. It pertains to an individual’s ability to withstand degrees of variability in investment returns. While FINRA asserts that investors should have a realistic understanding of the risks they face, and of their ability and willingness to tolerate changes in the value of their investments, they do not test investment advisers on the psychological conditions associated with investor behavior. Questions regarding suitability comprise 28% of the Series 7 exam (the largest of all categories), thus indicating that the concepts associated with investor suitability are extremely important.
Occupational licensing should remain an important component of the minimum educational requirements for investment advisers. Nevertheless, FIRNA should review and revise said exams for the following reasons. First, these exams are offered in a multiple-choice format, which creates several immediate concerns about the depth and breadth of knowledge of the individuals that successfully pass them. Multiple-choice testing, in general, as compared to essay style testing, permits students to guess on answers they do not know; only allows for right or wrong scenarios; and often encourages surface learning. By contrast, essay questions test high cognitive skills; allows students to demonstrate depth of knowledge; and requires students to express a broad understanding of a topic. Second, these exams are more beneficial to FINRA than they are to public interest. Multiple-choice exams are cost-effective, time-efficient, easier to monitor against plagiarism, and allows for quick computerized scoring. While these features are advantageous to FINRA because they help reduce administrate fees and extra labor costs, they provide a disservice to public interest and financial security because standardized, multiple-choice testing does not determine if the individual taking the exam meets the previously-mentioned qualifications for investment advisors. It is likely that financial consumers care more about the quality of advisers available, and less about whether the government has to spend more money to filter and sort them through better testing methods. Figure 5 compares the pros and cons of multiple-choice testing.
Figure 5. Pros and cons of multiple-choice testing
|Easier to monitor against plagiarism||Feedback to student can be limited|
|Cost-effective||May encourage surface learning only|
|Time-efficient||Possibly measures students’ test-taking abilities vs. content knowledge and understanding|
|Facilitates rapid feedback through ease of scoring||Questions may be misinterpreted|
|Broad coverage of content||May involve testing for low level knowledge only|
|Constructing high quality test questions may be difficult|
|General reliability and validity of tests are unknown|
|Relies on publishers’ databases and test banks|
Third, the number of law suits filed by financial consumers indicates flaws in the current content of standardized testing for investment advisers, particularly as it pertains to issues involving suitability, unauthorized trading, churning, and other unethical practices. FIRNA reports that a number of cases filed annually by financial consumers involve suitability. In fact, between 2010 and 2013, FINRA reports 6,190 instances where investors cited unsuitable advice as a reason to file an arbitration. This accounts for 33.6% of all cases filed during this period, (see figure 6).
Figure 6. Unsuitability as a percentage of total cases filed: 2010 to 2013
Source: Financial Industry Regulatory Authority: Dispute Resolutions
Figure 7 shows all topics that FINRA considers when arbitrators review claims of financial mismanagement. The data shows that in addition to unsuitability, financial consumers complain about margin calls (which forces a cash deposit requirement, or liquidation of securities, in their account when the value of their investment portfolio drop quickly); churning (which is a highly unethical practice designed to generate commissions for the adviser quickly, and usually results in financial loss for the consumer); and unauthorized trading (which is done to hide investment transactions, usually for the purpose of generating extra commissions). Other areas of concern, such as negligence, omission of facts, breach of contract, breach of fiduciary responsibility, and misrepresentation are somewhat more vague, and could involve a number of different transgressions, many of which might be more subjective than those concerning suitability, churning, margin trading, or unauthorized trading. All of these topics are of great concern, and pose a threat to financial security because they suggest intent on the part of the investment adviser to steer his or her client towards an investment, or investment strategy, that is inconsistent with said clients risk tolerance, goals and/or objectives. As discussed below, intent, not product failure, determines the difference between safety and security. These case filings indicate damage to financial security, but not necessarily to safety. Put differently, in 2013, if every investor in the United States owned U.S. treasury bonds, but 260 of them complained about unauthorized trading, and filed an arbitration stating that their advisers purchased those bonds without their knowledge, all of the investors are equally safe because U.S. treasuries are guaranteed. However, 260 of them are not secure because the manner in which they came to own those bonds violates FIRNA and SEC rules.
Figure 7. Arbitration cases served by controversy involved: 2010-2013
When compared to other service-oriented industries (that have higher educational standards for their employees), the investment industry exhibits a higher and accelerating rate of legal actions. For instance, according to the Civil Justice Resource Group, in 2008, the number of hospital patients that become victims of malpractice decreased by 4% from the previous year. By contrast, in 2008, FINRA reports a 43% increase in arbitrations filed. A large percentage of these cases involve suitability, thus indicating that the advice consumers have been receiving from their financial advisors is not in their best interest. Those who subscribe to the human capital theory might argue that the decrease in malpractice cases is due to the high academic standards required by the medical field, whereas the increase in legal action taken against investment firms is due to low educational standards for investment professionals. This further suggests that the standardized test format currently used by FINRA does not sufficiently provide the depth or breadth of knowledge needed for investment professionals to advice clients in a manner consistent with their financial goals and objectives. Put differently, the fact that there are so many suitability cases and arbitrations filed each year indicates that many investment advisers are not proficient in providing advice that meets minimum expectations. My thesis argues that this level of proficiency can be increased through formal education. If current licensing exams were sufficient, it would stand to logic that the number of cases would be lower.
Safety vs. Security: Clarification and Application
In 2010, as part of Dodd-Frank, policymakers established the Consumer Financial Protection Bureau (CFPB), an independent agency of the government responsible for consumer protection in the financial sector. CFPB’s jurisdiction includes debt collectors, payday lenders, mortgage companies, credit unions, and securities firms, and focuses primarily on credit cards, mortgages, and retirement investments. CFPB’s core functions include writing rules; supervising companies, and enforcing federal consumer financial protection laws; restricting unfair, deceptive, or abusive acts or practices; taking consumer complaints; promoting financial education; researching consumer behavior; monitoring financial markets for new risks to consumers; and enforcing laws that outlaw discrimination and other unfair treatment in consumer finance. It is unclear what precise role CFPB holds in the regulation of securities firms, or the monitoring of retirement investments accounts, as these areas are already regulated by SEC and FINRA. Nevertheless, the formation of CFPB is based on the premise that some financial products may be unsafe for financial consumers; and thus require regulation. According to Carpenter, Grimmer, and Lomazoff, the notion of product safety regulation for finance makes sense. Carpenter et al. argues that safety regulation induces a form of consumer confidence by sending a message to consumers that a specific product has undergone pre-market preview. The quantity and quality of the information made available through said preview would be, “far greater than would be provided in an unregulated marketplace.” As mentioned above, my thesis concentrates on the quality of advice that financial consumers receive from investment advisers regarding publicly traded securities; thus, it would not be beyond the scope of my thesis to comment on the feasibility of any organization that regulates and/or analyzes financial products such as credit cards or mortgages. As it pertains to the regulation of retirement investment accounts (which are most certainly comprised of publicly traded securities), it remains to be seen if CFBP will actually affect positive change in preventing fraud. However, throughout the body of literature that exits regarding the protection of financial consumers, there is confusion about the concept of safety, and how it differs from security. As it pertains to public interest, the goal of policy is to support financial security, not necessarily to regulate alleged safety issues of investment products. The different between safety and security is intent. I provide the following hypothetical scenario to explain this difference. Assume that an individual is walking across a wet tile floor. The probability that he or she will slip and fall increases because the floor is wet. Thus, he or she is less safe than if they walk across a dry tile floor. The question that requires answering is: how did the water end up on the floor. If it was placed there intentionally, then there is both a safety and a security issue. By contrast, if the water dripped from a broken pipe in the ceiling, there is still a safety issue, but there is no security issue. The former indicates that someone intentionally placed the water on the floor, hoping that whoever walked across it would fall and succumb to an injury; the latter was merely an act of nature. Relating this to financial products (particularly those that are publicly traded), if a financial consumer purchases a stock, he or she is no less safe than all of the other people that purchased the same stock. However, if an investment firm or adviser recommends said stock (an intentional act) either through deceptive marketing, direct contact, or any other form of communication, it may or may not create a security issue for the consumer. Whether an investment product creates a security threat to the consumer is determined by suitability, not product failure. Another example includes the subprime mortgage crisis, which I discussed in detail earlier. When thousands of mortgage brokers sold subprime mortgages to consumers between 2001 and 2006, the product itself was not the problem. Indeed, the product (subprime mortgages) is suitable for some consumers, albeit a very small percentage. Rather, the security problem was created intentionally when mortgage brokers sold subprime mortgages to consumers because they earned a higher commission (YSP) by selling a 5-25 Adjustable Rate Mortgage (ARM) than they did by selling a 30-year fixed mortgage. Thus, contrary to the assertions made by CFPB, the problems with financial security lie not in the financial products themselves, but rather in determining if those products are suitable for the consumer. I argue that the most effective way to ensure suitability is by improving the quality of advice provided to financial consumers by the investment industry.
As it pertains to product quality, within the financial industry, premarket approval mechanisms for publicly traded securities have been in place for decades. For example, when a company first goes public, it issues an Initial Public Offering (IPO). During this premarket period, SEC requires that all companies issue a first, or preliminary, prospectus (also referred to as a red herring) as part of its public offering. The name red-herring comes from the color of the front page, which is either red, or includes a red bar along the binding designed to alert investors that it is a preliminary document. SEC requires that a red herring prospectus include the purpose of the issues; discloser of any option agreement; underwriters commissions and discounts; promotion expenses; net proceeds to the issuing company; balance sheet; earning statements for the past three years; names and address of company officers, directors, underwriters, and stockholders with 10% or more of the current outstanding stock; underwriters agreement; legal opinion on the issue; and articles of incorporation. If CFPB determines that pre-market approval for publicly traded securities should include additional information beyond that which is currently required by SEC (and provided during the red-herring phase), it is difficult to imagine what information it would include. In all likelihood, it would have to include a method for determining the level of risk facing consumers based on psychological factors that affect the investment-decision making process; all macroeconomic and political externalities that affect both the consumer and the product; and perhaps most challenging, it would have to predict how that product will perform. In other words, it would need to accurately foretell the future.
The Efficient Market Theory and Premarket Testing
The efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient.” Also referred to as the joint hypothesis problem, EMH further suggests that it is not possible to achieve results (profits) consistently in excess of average market returns on a risk-adjusted basis because the information available at the time the investment is made provides all publicly known information about the investment. EMH is a well-known theory subscribed to by many financial analysts. Is the theory behind pre-market safety regulation merely EMH reinvented? What types of information would be available in the premarket testing phase that is not available in the post market that would indicate that a product is either safe or not safe? The answer to this question falls outside the scope of my thesis; however, it remains unclear what type of real information (as opposed to simulated) premarket testing would reveal about a financial product.
Financial and Business Simulators
Carpenter et al suggests that new product simulators might help regulators identify the safety of financial products. By simulating economic conditions of varying adversity, ranging from systemic shocks to cyclical declines, regulators would have at their disposal information sufficient to veto the approval of said products that fail to meet certain standards. Simulators do indeed provide unique perspectives on financial markets, and many investment firms currently use them to help understand possible outcomes based on specific inputs. However, as demonstrated above, economic conditions alone do not determine financial market conditions. The terrorist attacks of September 11, 2001 are a good example of this. Before the attacks, the idea that terrorists would commandeer two commercial airplanes and fly them into the World Trade Center was never even considered. That these two airplanes would bring the twin towers down to the ground was even less feasible. Thus, while simulators have potential when it comes to new product testing, economic conditions alone are not sufficient. Indeed, the terrorist attacks on September 11 are not solely an economic event, and financial markets are also dependent upon global and domestic politics, consumer psychology, corporate behavior, and many other internal and external factors. Thus, new product simulations that included only economic conditions would likely produce incomprehensive results. Carpenter et al asserts that there would likely be many potential problems with this type of simulation, and notes that there may even be some confusion about determining what a financial product is. To be clear, a financial product is not necessarily an investment product; but an investment product is most certainly a financial product. And, neither investment nor financial products (both of which are intangible products) should be compared to tangible products (such as medical devices or pharmaceutical products). Doing so can lead to misinterpretations of the data that studies of this nature might produce. The manner in which intangible products (such as mutual funds, annuities, or exchange traded funds) are marketed, advertised, regulated, and understood by the public differs vastly from tangible products. Moreover, one of the primary differences between investment products and other types of products (such as medical or pharmaceutical) is that with investment products, the goal is not to eliminate risk; but rather, to manage it effectively and prevent financial consumers from unknowingly being exposed to excessive levels of risk. Without risk, there can be no profit. By contrast, the complete elimination of risk for pharmaceutical or medical products would be ideal. Thus, where risk is undesirable, safety tests may provide some benefit.
Perhaps a better type of simulator would be directed towards investment advisers, rather than investment products. Considering that many investors rely on the advice of investment firms and their employees, a simulator that helps investment professionals understand their client’s investment goals and objectives, and requires them to make decisions based on ethics and standards, rather than on the amount of commissions they might earn, would likely benefit the financial consumers.
Education as a Filter and Sorting System
Within the past few years, FINRA has developed online educational programs for financial consumers, the goal of which is to provide, “underserved Americans with the knowledge, skills and tools necessary for financial success throughout life.”  These new educational programs are the product of both necessity and technology. The advent of advanced web-based technologies allows FINRA to delivered content to any computer with Internet access. Offering courses online in multiple-choice format makes it affordable. These programs have been in existence for only a few years; thus, it is not possible to determine their effectiveness. However, there are no prerequisites for taking FINRA’s online courses. Moreover, human capital theory suggests that if the participants taking these courses have not graduated from college, they may be less capable of grasping the information provided. FINRA has no way of knowing if the participants graduated from high school, college, or graduate school; therefore, it is not logical to assume that such programs will provide financial consumers with the level of financial literacy needed to understand the complexities of the financial markets, and the intricacies of the products in which they invest their money. While the notion of enhancing financial literacy for consumers makes sense, and funding for these programs is backed by approved legislature, it would make more sense if the government were to establish minimum educational requirements for investment professionals. The previously mentioned data indicates that when individuals pursue higher education, they develop core competencies and skills, and demonstrate they type of critical thinking needed for many types of occupations. Professions such as medical doctor, attorney, or certified public accountant (CPA) require between six and twelve years of formal education from an accredited college, a relevant internship and/or residency, and a passing grade on a comprehensive qualifying examination. By focusing its efforts on consumer financial education, and not establishing minimum requirements for investment professionals, regulatory policy fails to reduce the type of excessive risks still facing financial consumers.
Regulatory policymakers can reduce this level of risk by working with investment firms and banks to review the educational requirements needed to manage investor capital, and increase the standards by requiring that all investment professionals earn at least a relevant, four-year college degree from an accredited college or university. Regulators can further increase these standards by requiring that all investment professionals that work in an advisory capacity complete a relevant internship or residency with a registered investment firm before actually working with client assets. Theory and statistical data supports the premise that doing so would likely improve the type of advice provided to financial consumers that rely on their advisors to guide them on their investment capital. It would also vet individuals that lack the level of moral judgment and ethics needed to manage other people’s money.
The above-mentioned theories create a base from which policymakers could propose legislature in favor of establishing minimum education requirements for investment advisers. However, it is useful to examine other theories that strive to explain the cause(s) of financial crisis; doing so provides a deeper understanding of financial market failures, and how my hypothesis fits into the broader body of existing literature.
While it is certain that many mistakes have been made vis-à-vis the regulation of the financial markets between 1929 and 2008, the origin of those mistakes is less certain. Concerning the Global Economic Crisis of 2008, for instance, some blame former Federal Reserve Chairman Alan Greenspan. Gross argues that Greenspan is responsible for market turbulence, suggesting that his policies placed the American economy at risk. Margin suggests that U.S. Presidents Carter, Reagan, Clinton, and Bush, and other regulators, created ineffective policies and failed to mange those policies in a manner that was beneficial to both the public and the private sectors. Others blame such factors as dishonest mortgage lenders; increasing greed among hedge funds; or the inaccuracy of rating agencies such as Standard and Poor’s or Moody’s. Still others believe that the cause can be found through the tenets of behavioral finance, which suggests that bias, overconfidence, and aversion to ambiguity caused individual investors to assume too much risk, and thus, make imprudent decisions regarding their own money.
Although it is natural to point blame at a group of individuals or specific leaders when markets collapse, doing so is not prudent because it can lead decision-makers away from developing viable solutions to the problem. Regulators face many problems when trying to create and implement regulatory policies after a financial crisis has occurred. On the one hand, they must implement policies that will rebuild public confidence in the economy sufficient to evoke normal consumer investment and spending. In order for the public to believe that their investment capital will not be subject to fraud, misrepresentation, or omission of facts, several conditions must be met. At the very least: (1) regulators must create effective polices that assert realistic goals; (2) regulatory agencies must be able to enforce them; and (3) the private sector must operate within the confines of moral hazard (the belief among financial organizations that the government will bail them out when their actions result in large monetary losses to the financial consumer). When one or more of these conditions are not met, financial and economic risk typically increases, often to unacceptable levels. When risk is too high, financial consumers usually lose money, lose trust in the banking system and lose confidence in the regulatory agencies charged with implementing regulatory policy. By contrast, if risk is too low, neither investors nor businesses that are willing to assume a higher level of risk in exchange for a better-than-average return will be able to do so.
On the other hand, policymakers must also create policies that allow the private sector to earn a profit. Hood et al. suggests that, in principle, it is, “possible for risk management to be pursued at both the level of individual organizations and the ’systemic’ or social-system level without contradiction.” Garten argues that regulatory policies, “simply will not work if they interfere with the industry’s pursuit of profits.” While a key goal of regulatory policy is to accomplish a stable, economic environment that benefits all members of society, private and public alike, policymakers have been largely ineffective at meeting that goal. There are many factors that interfere with the process of effective policy implementation; thus, policymakers should rely on regulatory theories and research that originate from academia when seeking effective policy prescriptions. However, regulatory theories also have their own obstacles. A key challenge facing regulatory theory is to account for the linkages among the different components of regimes. According to Hood et al., the, “behaviour-modification dimension of regulation,” which is shaped by strategies that include standard-setting and information gathering, often results in a breakdown of relations within the regime itself, thus suggesting that controversial bills proposed within the House might only add to further division between political parties.
The division between political parties within the U.S., and the results of that division, is an example of the breakdown that Hood et al. cites as the cause of ineffective policy implementation. U.S. history is plagued with a division of political beliefs, particularly when it deals with racial issues. In 1858, Abraham Lincoln expressed concern over the division between the North and the South, which eventually contributed to policy failures towards the topic of slavery, and ultimately characterized the Civil War. More recently, racial inequalities represent an area of policy failure within the U.S. that still plagues minorities. In their book, Still a House Divided: Race and Politics in Obama’s America, Desmond S. King and Roger M. Smith hypothesize why American politics have failed to reduce racial inequalities. King et al. indicates that while President Obama’s political approach to race might encourage unity and progress, America’s enduring division of racial politics and conflicts have been shaped by distinct political alliances and their competing race policies. Public interest issues such as housing, employment, criminal justice, immigration, voting in majority-minority districts, and school vouchers represent areas of racial significance that require regulatory attention.
But, how does racial discrimination and inequality correlate to the investment advisory process? An analysis of recent housing anti-discrimination bills proposed by the House supports the notion that, “evolving systems of opposed racial policy alliances,” which are comprised of, “color-blind and race-conscious alliances” have shaped American politics into a two-party system with opposing economic goals and ideologies. On June 28, 2007, H.R. 2926 was introduced to the House, the purpose of which was to develop a program that would prevent housing discrimination by (1) detecting and documenting differences in the treatment of individuals seeking to rent or purchase housing, or obtain or refinance a mortgage; (2) measuring patterns of adverse treatment based on the race, color, religion, sex, familial status, disability status, or national origin of a renter, home buyer, or borrower; and (3) measuring the prevalence of such discriminatory practices across housing and mortgage lending markets. H.R. 2926 was strongly favored by 59 Democratic members of Congress, and by 1 Republican member – Representative Jim Walsh of New York’s 25th District. When H.R. 2926 was proposed, its cosponsors (members of Congress who endorse a bill for consideration) asserted that it would establish, design, and maintain a national education and outreach program for the development and dissemination of the fair housing rights of individuals that seek to rent, purchase, sell, or facilitate the sale of a home; (2) use all appropriated funds for such program; and (3) disseminate regulations on the fair housing obligations of each recipient of federal housing funds to affirmatively further fair housing.
H.R. 2926 also called for the implementation of a competitive matching grant program to assist private nonprofit organizations in: (1) conducting comprehensive studies of specified aspects of the causes and effects of housing discrimination and segregation; and (2) implementing pilot projects that test solutions to help prevent or alleviate housing discrimination and segregation. Notwithstanding the logic behind H.R. 2926, which would have benefited financial consumers and public interest in general, and also provided useful statistical data that could have supported academic research and the development of analytics tools (such as those recommended by Bozeman), it stood dormant until January 15, 2013 where it was reintroduced as H.R. 285. Thus far, H.R. 285 has received only 19 Democratic cosponsors; no Republican cosponsors and a, 3% chance of getting past through to the Committee.
Racial discrimination is evident in several areas of the financial markets; most notably within lending. As previously noted, African-Americans and low to moderate income minorities received lower quality, higher interest rate mortgages during the months and years preceding each major financial crisis beginning with the Great Depression. Most recently, lenders started paying a bonus (YSP) to advisers and brokers for placing (or steering) a borrower (usually low-income minorities) into a higher cost loan than that which the borrower qualifies. As with other situations that pertain to the regulation of the financial markets, Congress has had ample opportunity to implement policies that would reduce discriminatory practices within the banking and financial sectors. While the implementation of additional legislature (such as HR 285) may improve some of the problems facing low-income minorities within the financial and housing markets, it will not change the quality of advice that they receive from investment professionals. Until Congress passes legislature establishing minimum education requirements for investment professionals, financial security will remain at risk for low-income minorities.
While some theories focus on policy failure in general, others attempt to explain specific events. For example, Faridul, Saleheen and Matiur argue that the cause of the 1929 crash is not due to margin trading, (as previously mentioned), because a causal connection between volatility and margin has not been clearly established. According to Faridul et al, volatility is, “known to be serially correlated.” By serial correlation (also referred to as autocorrelation), Faridul et al. refer to the relationship between a given variable and itself over various time intervals. Serial correlations exist (typically) in patterns of repetition, when the level of a specific variable affects its future level (or in this case, its future value). In terms of finance, serial correlations are used frequently in technical analysis as a means of determining how well the previous price history of a security predicts its future price. Thus, Faridul et al. suggests that the serial correlation between volatility and margin did not cause the 1929 Stock Market Crash. Instead, they explain market volatility by suggesting that (1) investors reduce the holding period for stocks in order to release more funds after their initial borrowing limit is reached; (2) margin borrowing does not influence NASDAQ index itself, but it does affect investor behavior; and (3) the “dynamic feedback among NASDAQ Price, holding period, and margin borrowing.”
There are several problems with Faridul et al.’s theory. First, this analysis focuses on the NASDAQ (which was not even established until 1971) yet, they argue that margin trading analyzed on the NASDAQ was not responsible for the 1929 Stock Market Crash. It is not logical to compare data derived from NASDAQ trading (which is an electronic market) to the NYSE, which did not fully accommodate electronic trading until 1995. Second, they suggest that margin borrowing does not influence the NASDAQ, but it does influence the behavior of the investors that trade stocks on the NASDAQ. In essence, Faridul et al. disconnects the stock market from its investors; yet, it is impossible to do so because the only factor that truly affects the current price of stocks is when financial consumers buy or sell publicly traded securities. It is not logical to suggest that a market or an index is not influenced by the buying and selling (investor behavior) that creates the value of the market or the index itself. Third, Faridul et al. suggests that the holding period (the amount of time between when an investor purchases a security and when that security clears in his or her account) somehow affects volatility. Again, Faridul et al. are using contemporary data, where the holding period is three business days, as compared to 1929, when the holding period was five business days. In other words, the short holding period that Faridul et al. cite as one of the reasons why the market crashed in 1929 did not exist until the early 1990s. In short, Faridul et al.’s theory about why the stock market crashed in 1929 is unsubstantiated because the data they used in their study is inconsistent with their hypothesis.
Academic debate runs high over the causes of regulatory policy failure and systemic crises, and the above-mentioned theory is one of many that attempt to identify the cause of the 1929 stock market crash. Galbraith argues that margin loans were, in fact, at the center of the 1929 stock market crash because declines in stock prices were caused by heavy borrowing on margin, which in turn increased prices beyond intrinsic value. Other theories suggest that an unfavorable decision by the Massachusetts Department of Public Utilities on October 15, 1929, which would have promoted a federal investigation of Boston Edison’s (a Massachusetts-based utility company) rates, promoted the sell-off in the stock market after investors heard the news. Benton E. Gup, former visiting scholar at the Office of Comptroller of the Currency (OCC) in Washington, D.C., suggests that financial crisis is caused by a failure by regulators to consider all of the relevant interests in decision-making; a lack of responsiveness to the interests of the public; a failure to remain current with a changing economy; and a failure to link significant policies from one organization to other governmental agencies. Still other theories take a more traditional view of financial crises. Financial fragility, which is an essential part of the business cycle; may have worsened already weak economic conditions and result in bank panics. According to the International Monetary Fund (IMF), financial crises are often contagious; they tend to spread rapidly, display no apparent vulnerability, and prompt calls for swift policy responses. The IMF cites unsustainable macroeconomic policies, excessive credit booms, large capital inflows, balance sheet discrepancies, and political and economic restraints. While it is unlikely that any one, single factor caused the stock market crash in 1929, these theories represent a small sample of a large body of literature that attempts to explain it. Furthermore, it exemplifies that much of the existing theories focus on the cause of financial crisis, but few are concerned with identifying methods or recommending policy prescriptions that might prevent it from occurring again. Any such methods should focus on how to improve the quality of advice the investment industry provides to financial consumers, and if said advice is in line with the rules governing suitability.
Suitability, as both a concept and as a tenet of public interest, is not specific only to the financial industry. In financial services, it refers to the quality of advice that investment professionals provide to financial consumers. In other industries, suitability has a more well-developed application. In the medical field, for instance, suitability refers to both the quality of service that medical professionals provide to health care consumers, and it also determines whether a medical student is suitable to practice medicine and care for patients. The education industry has taken the lead on determining suitability for medical students. For instance, the College of Physicians and Surgeons at Columbia University grant medical degrees only to students that have demonstrated, “dedication to acquiring knowledge, skills, both cognitive and non-cognitive, and attitudes necessary to provide competent medical care.” Medical students are expected to demonstrate a level of dedication to providing competent medical service that shows respect and compassion for human dignity. Students must always, “maintain the dignity of the person, including respect for the patient’s modesty and privacy.” Students are also expected to demonstrate honesty and integrity, and act respectfully and ethically in interactions with patients. In essence, this means that an individual cannot become a physician without first completing a rigorous (and very specific) education at an accredited college that develops not only individual human capital, but also evaluates their moral judgment capabilities. Investment professionals have no such requirements. In other words, suitability for investment professionals refers only to the advice that they provide, but not to the qualifications of the individuals providing it; for medical professionals, it applies to both. It is logical to suggest that if a person is deemed suitable in all areas (knowledge, core skills, ethics, and honesty), he or she is more likely to provide suitable advice for the consumer, regardless of the product that he or she is recommending. Thus, FINRA should review its current stance on suitability, and include minimum requirements for investment professionals, not only for the advice they provide. Doing so would be likely provide financial consumers with a higher quality of investor professionals from which to choose.
Data and Analysis
As previously mentioned, between 1929 and 2008, the United States succumbed to three major financial crises, and at least fifteen different recessions lasting between eight and forty-three months. Put differently, over the past eighty years, the U.S. economy has been in a state of recession for fourteen of those years, or 17.5% of the time. Figure 8 shows that the U.S. economy has been in a recessionary state more than one-third (35%) of the time. Given that the average life span in the U.S. is approximately eighty years, this means that the average U.S. citizen lives approximately one-fifth of his or her life under the economic hardships typically associated with a recession, such as high unemployment, inflation, and uncertainty about the safety of the money and investments that they entrust to financial institutions, many of which fail during severe financial crises.
Figure 8 – Recessions in the United States: 1797 – 2011
Source: National Bureau of Economic Research
During this same period, tens of thousands of banks failed, thus indicating a failure in regulatory policy consistent with rate of failure mentioned above. (Figure 9) The data suggests an urgent need for policymakers to reduce the rate of failure; doing so would be consistent with the aforementioned goals of regulatory policy, which is to reduce systemic crisis, and improve financial security.
Figure 9: Annual bank failures in the United States: 1934-2011
But, how can policymakers reduce the rate of bank failure? Some academic studies suggest that an increase in the rate of failure is caused by guarantees (moral hazard) within the private sector. For instance, Kohn argues that creditors have little reason to monitor an organization if their liabilities are guaranteed. Thus, executives working for said organization can assume greater risk without penalty. Kohn suggests that doing so, “increases the rate of failure and, ultimately, can bankrupt the guarantor.” Gup suggests that policymakers should attempt to avoid the mistakes associated with moral hazard, such as, “incentive incompatible safety nets” and concentrate on the cause of, “losses to depositors in bank insolvencies and depositor runs on banks.” Gup argues that formulating a policy that addresses these issues would (1) reduce (and possibly eliminate) the behavior exhibited by banks that is consistent with moral behavior; and (2) align the goals of all parties involved in financial transactions. The solution to moral hazard, according to Gup, is to reduce a banks incentive to engage in moral hazard behavior by (1) requiring sufficient private capital; and (2) imposing a series of sanctions that would prompt, “early intervention or prompt corrective action on troubled banks.”An early intervention system that can help banks in distress is a novel idea, and, according to the survey I conducted specifically for my thesis, the majority of financial consumers (68%) strongly favor a system that will pause the financial markets during times of extreme volatility in order to allow both the private and the public sectors a chance to evaluate their next move.
About the Survey
When trying to explain why financial consumers need professional advice when they invest in the financial or housing markets, it is useful to understand the public’s awareness of the policies that affect their financial security. As previously-mentioned, in the wake of a financial crisis, regulatory policymakers must create and implement policies that (1) prevent the housing and financial markets from crumbling again; (2) restore consumer confidence and bring people back to the markets when the structure of the industry had failed them; and (3) support the efforts of the private sector that need to earn a profit in order to remain in business. To accommodate these goals, government regulators must decide when (and if) to intervene, how much intervention is needed, and if their goals are in line with what is needed to restore consumer confidence. But, how aware are financial consumers of the policies that affect the value of their investments, and the decisions they make that prompt them to invest their capital. To understand the consumer decision-making process better, my thesis includes the results and analysis of a survey written specifically to address (a) policy awareness, (b) assignment of blame, (c) the bearing of risk, (d) government intervention and action and (e) public interest.
The survey was disseminated through a variety of social media websites and direct email marketing. The results help to explain consumer policy awareness, investment product knowledge, and overall understanding of the role of government during a financial crisis. Respondents were pre-screened for the following criteria: (1) at least 18 years of age; (2) a home owner (vs. someone who rented their home); and (3) someone that was either solely (or at least partially) responsible for making the major financial decisions in their household. The survey also recorded IP addresses as a means of preventing duplicate entries, thus permitted only one household to participate in the study. The number of total survey applicants equaled 1,484, while total respondents after initial screening and prequalification equaled 891.
Financial Consumer Survey Questions
Respondents were asked questions about why they made large investment decisions (both in the financial and housing markets) between 2001 and 2011; who they primarily blame for the Global Economic Crisis of 2008; who should bear the risk when a major financial crisis occurs; which measures the government should take to calm markets, stabilize the economy, and restore consumer confidence during times of severe financial crisis; and the role of government, banks, corporations, and themselves as it pertains to public interest. The survey intentionally excludes non-homeowners because (1) people that rent would most likely have less reason to be aware of regulatory policies that affect homeowners; and (2) non-homeowners do not fully contribute to the household net worth data provided by the government. For instance, at the end of the third quarter, 2012, the value of real estate in the U.S had increased approximately $370 billion as compared to the previous quarter, whereas the value of equities and mutual funds had expanded approximately $800 billion over the same period. While 62% are homeowners, more than 74% invest in the financial markets (either directly in the form of stocks and mutual funds, or indirectly through 401k, 403b, and other types of retirement plans). Thus, for the purpose of my thesis, it makes sense to exclude non-home owners that may have accumulated substantial net worth that originates from securities holdings and other intangible investments, yet are excluded from an analysis of household net worth reported by the Federal Governments Flow of Funds report.
The survey also looks at specific psychological conditions that all investors face when making financial decisions by asking respondents to identify reasons why they either made large investments in the housing or equity markets between 2001 and 2011, or refrained from doing so. For instance, if a respondent indicated that they purchased a primary residence between 2001 and 2011, or invested in the stock market outside their 401k or 403b company-sponsored retirement plans, they were prompted to answer questions regarding the reasons for their decision.
Survey question #1
Respondents were asked to identify which major investment decisions they made between 2001-2011. Those that invested in either the stock or housing markets were asked to identify their reasons for doing so. By contrast, those that did not invest in either the stock or housing markets were asked to identify their reasons for not doing so.
|Question||Which major investment decisions did you make between 2001-2011?||Results (%)|
|Options||Invested in growth stocks or funds||57|
|Invested in tax-free bonds||4|
|Invested in high-yield bonds||18|
|Invested in international stocks or bonds||29|
|Purchased a house as a primary residence||47|
|Purchased an investment property||14|
|I did not invest in the stock or bond markets between 2001 and 2011||16|
|I did not purchase a home between 2001 and 2011||8|
Survey question #2
To gain a better understanding of the factors that affected their decision to buy a home between 2001 and 2011, respondents were asked which of the following influenced their decision to purchase their primary residence?
|Question||Which of the following influenced your decision to purchase your primary residence? (select all that apply)||Results (%)|
|Options||Prices kept going up, and I was concerned that if I did not buy soon I would be priced out of the market.||18|
|Financing rates were historically low at the time, and seemed like they might go up.||22|
|The mortgage interest deduction lowered the cost of the loan.||8|
|Stories and reports from the news media suggested that it was the right time to buy.||42|
|Things that politicians said made it seem like it was the right thing to do.||18|
|I was able to receive state or federal assistance to purchase a home.||9|
Survey Question #3
In order to understand some of the reasons that prevented consumers from purchasing a home between 2001 and 2011, respondents were asked to identify specific factors.
|Question||I did not purchase a home as my primary residence between 2001 and 2011 because I (select all that apply)||Results (%)|
|Options||was required to make a 20% down payment.||43|
|was unable to get an adjustable rate mortgage with a low initial rate.||22|
|was forced to rigorously document my income and net worth.||4|
|was unable to get an FHA (Federal Housing Authority) backed loan.||6|
|the federal mortgage interest tax deduction had been repealed prior to my purchase.||5|
|had not received federal or state assistance to purchase the home.||17|
|had not received the federal housing tax credit from the 2009 Stimulus Bill.||15|
|own my home and I am happy with it.||21|
|could not afford it.||39|
Survey question #4
Respondents that purchased stocks and/or bonds between 2001 and 2001 were asked to identify which factors influenced their decision.
|Question||Which of the following influenced your decision to invest in stocks and/or bonds between 2001 and 2011?||Results (%)|
|Options||I read a stop tip on a financial blog or newsletter that stocks were the highest performing investment over the long run.||30|
|I saw other people making money, and felt I was being left out.||14|
|I had hoped to realize long term capital gains to benefit from favorable tax treatment.||17|
|I felt that I could pick winning stocks even if the overall market went down.||12|
|I did not know where else to invest my money.||11|
|I followed the advice of my financial advisor.||28|
Survey question #5
|Question||I did not invest in stocks or bonds between 2001 and 2011 because (select all that apply)||Results (%)|
|Options||I lost money during the stock market bubble of the 1990’s||27|
|I do not typically invest in the stock, bond or mutual fund markets except though my 401k||27|
|the money that I would have invested was put towards purchasing a home||13|
|I could not afford it||33|
Survey question #6
To test policy awareness, respondents were asked to identify which policies that affect the housing markets they support.
|Question||Over the years the government enacted a number of different housing policies that were supposed to support the markets, provide greater access to mortgage loans, and/or provide tax breaks for homeowners. Given your current situation, which of the following did you, or would you, support?||Results (%)|
|Options||Community Reinvestment Act of 1977||2|
|Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010||12|
|The Home Affordable Modification Program (HAMP)||9|
|Tax Reform Act of 1986||5|
|I’m not familiar with any of these policies.||71|
Survey Question #7
To understand who they blame for the Global Financial Crisis of 2008, and the for millions of foreclosures on low-income minorities, questions 5 and 6 asked respondents were asked if they blame the government, the private sector, the public sector, or some combination of the above.
|Question||Some people blame government regulators for failing to control the housing crisis, others blame the banks for offering loans without regard to the consequences. Still others believe that the consumer is responsible for their own financial mistakes. Whom do you blame for the global economic crisis? (select all the apply)||Results (%)|
|Options||Myself (and other consumers) for making a bad financial decision.||19|
|The news media for barraging people with messages to buy more than they could afford.||12|
|Banks for pushing people to take on more debt than they could afford.||68|
|Regulators for failing to prevent the banks from making predatory loans.||54|
|The federal government for creating programs to encourage people who couldn’t afford houses to buy them anyway, thus raising prices for everyone.||14|
|The federal reserve for keeping interest rates too low for too long during the middle of the last decade.||9|
Survey question #8
|Question||During the housing boom, subprime lending was concentrated in low-income, and especially minority communities. All things being equal, this meant that minorities were far more likely to get higher-price loans. According to a study conducted by the Joint Center for Housing Studies at Harvard University, housing markets result in racial/ethnic segregation of residential areas. Consequently, it was minority neighborhoods that were hit hardest by risky nonprime lending, which resulted in the concentration of foreclosures in these communities. Who do you think is primarily to blame for these foreclosures?||Results (%)|
|Options||the consumers (home owners)||0|
|the government regulators||19|
|the banks and financial institutions||49|
|the banks and the government||32|
|the banks and the consumers||0|
|the consumers and the government||0|
Survey question #9
To understand better if financial consumers placed less value on home ownership after the housing market crash, respondents were asked to identify how they feel about owning a home as an important part of their personal wealth.
|Question||Over the past several decades the percentage of people that own their home has varied. While some people believe that homeownership is a very important part of building personal wealth, others think that its less important. Which of the following view best describes how you feel?||Results (%)|
|Options||I favor home ownership because it reduces personal income taxes, reinforces family stability, responsibility, asset-building and self-esteem.||79|
|I think that homeownership gives families a “stake” in a community, and thus, builds stronger communities.||0|
|Home ownership helps communities with public benefits such as increased tax revenues, greater private investment, and stronger and safer neighborhoods.||0|
|Homeownership creates economic impacts for transaction related jobs, sales taxes and property tax revenues.||0|
|I don’t find much value in owning a home. It might be better to rent.||15|
|I don’t like owning a home because there are a lot of hidden expenses and maintaining it takes a lot of my free time.||6|
Survey question #10
To gain a better understand of who financial consumers think ought to bear the risk during an economic crisis, questions 9 and 10 asked respondents to choose between banks, the government, or themselves.
|Question||There has been some debate over who should bear the most risk during an economic crisis: individuals, banks, or the government. Keeping in mind the well-being of the general public or community, which of the following best represents your views?||Results (%)|
|Options||The risk should be shared equally between all parties.||10|
|The government should bear all of the risk.||33|
|Banks should bear all of the risk.||55|
|Individuals should bear all of the risk.||2|
Survey question #11
|Question||Some people think that during times of severe financial conditions (such as the recent collapse of the housing market that began in June 2007) the government, corporations and investors (consumers) should equally bear the risk of interest rate and market fluctuations. Other believe that these risks should be disproportionately shared. Which of the following best describes your views?||Results (%)|
|Options||Risk should be shared by all parties because they all had a hand in the events that occurred.||10|
|Government should bear the full risk.||33|
|Corporations and banks should bear the full risk.||56|
|Consumers should bear the full risk.||0|
|Corporations and the government should share the risk, but not the consumer.||1|
Survey question #12
What should the government do when a financial crisis occurs? Respondents were asked to identify which types of actions the policymakers could use to restore consumer confidence.
|Question||What measures should the government take in order to calm markets, and restore the economy and consumer confidence during times of severe financial crisis?||Results (%)|
|Options||Bail out failed businesses in order to help the economy get back on track.||14|
|Invigorate the economy by reducing taxes so that people have more money to spend.||69|
|Make money more available by printing currency.||4|
|Make borrowing money more affordable by reducing interest rates.||55|
|Control prices of specific items, such as food, utilities, medicine and gasoline.||0|
|Government should slow down the pace of automatic loan approve during times of extreme market volatility.||34|
Survey question #13
Do financial consumers think they have any influence over public interest. Respondents were asked to express their opinion about who they think plays a role in shaping the conditions that contribute to the society in which they live.
|Question||In general, the term ’public interest’ refers to that which emphasize the well-being or general welfare for all members of society. Keeping this in mind, and given the recent events in the housing markets that led to the global financial crisis, which of the following describes best how you feel about the role of government, banks and corporations and your own decisions.||Results (%)|
|Options||I believe that the public interest in created by everyone: industry, the government and all citizens.||2|
|I don’t really think that I personally have much influence on the public interest overall.||46|
|I think that government policy shapes the public interest.||6|
|I think that banks and businesses determine the public interest.||17|
|I think that the government and industry, but not the citizens themselves, shape public interest.||29|
Survey question #14
Questions 14 through 16 focus on possible solutions to prevent another financial crisis. Respondents were asked how they feel about moral hazard; if they would approve of a circuit-breaker that would pause the financial markets during times of extreme volatility; and overall, what should the government do to prevent the next financial crisis.
|Question||The term ’Moral Hazard’ refers to the belief among financial organizations that the government will bail them out with tax payers money when their actions result in large monetary losses to the financial consumer. Some people believe that the government could prevent future financial crisis by eliminating moral hazard. Other believe that it would be impossible to eliminate it because the government ultimately has no choice but to intervene during a crisis. Which of the following best describes how you feel about this topic?||Results (%)|
|Options||I think the government ought to eliminate moral hazard and stop spending my tax money to bail out failed banks.||79|
|I think if a business fails, it should be allowed to fail without the government getting involved.||12|
|I think the government has a responsibility to our nation to bail out banks when they fail.||6|
|I do not think the government has the right to use my tax money to bail out failed businesses of any kind.||3|
Survey question #15
|Question||In response to extreme market fluctuations in October 1987 and October 1989 the New York Stock Exchange instituted circuit breakers to reduce volatility and promote investor confidence. By implementing a pause in trading, investors are given time to assimilate incoming information and the ability to make informed choices during periods of high market volatility.||Results (%)|
|Do not favor||7|
Survey question #16
|Question||Overall, what do think the government should do to avoid a financial crisis?||Results (%)|
|Options||Intervene by increasing regulation on banks and corporations.||30|
|Not intervene by allowing markets to operate and businesses to fail.||46|
|Intervene by decreasing regulations on banks and corporations.||15|
|Intervene by imposing stricter requirements on financial consumers.||9|
Financial Consumer Survey: Analyzing the Results
Economic decisions are not made strictly on economic data. During all major financial crises, consumers are subject to a variety of psychological factors and conditions that influence their decisions before the crisis occurs, such as greed, bias, social conformity, and social comparison. Thus, this survey is an appropriate method for determining some of the attitudes and preferences of financial consumers at it pertains to the financial and housing markets.
The results of my survey indicate that a large percentage of financial consumers invested in the stock and/or housing markets during between 2001 and 2011, while only 16% did not invest in stocks or bonds, and only 8% did not purchase a home. Of those that did purchase a home, a large percentage did so because interest rates were historically low. This supports the arguments made by Foleyin (2007) and Gross (2000), which suggest that excessive rate cuts by the Federal Reserve in the years following the terrorist attacks on September 11, 2001 created a high-risk environment for consumers that purchased low-rate, low-quality loans created by banks and investment firms. Of those that did not purchase a home, the majority either could not afford the 20% down payment, and/or did not qualify for an adjustable rate mortgage with a low initial rate.
Social-psychological factors such as social conformity and social comparison cause people to follow the lead of others when they are unable to, “clearly and concretely measure their own opinion.” This is partly why financial consumers are heavily influenced by stock market tips and news. Brehm et al. suggests that this may be particularly true when markets are volatile, and somewhat less true during periods of relative stability. Brehm et al. asserts that news, tips and suggestions influence people sufficiently to affect their decisions regarding investments and real estate.
The results of my financial survey (Question #4) supports this assertion. For instance, 57% of respondents indicated that they invested in domestic stocks between 2001 and 2011. When asked why they made this decision, 11% said that they did not know where else to invest their money; 14% saw other people making money and felt they were being left out; 17% hoped to realize long-term capital gains; 28% followed the advice of their financial advisor; and 30% had read a stock tip on a financial blog or newsletter that stocks were the highest performing investment over the long run.
Financial consumers are equally influenced by interest rates, housing prices, and home-owner tax policy. For example, when asked why they purchased a primary residence between 2001 and 2011, 18% of respondents said that prices kept going up and they were concerned that if they did not buy soon they would be priced out of the market; 18% indicated that the things that politicians said made it seem like it was the right thing to do; 22% said that financing rates were historically low at the time and seemed like they might go up; and, 42% said that stories and reports from the news media suggested that it was the right time to buy. That 30% of respondents purchased stocks, and 42% purchased a home, because of a tip or news article they read on a news blog supports a basic assertion of behavioral finance: financial consumers are strongly influenced by tips and news.
Among those individuals that did not invest in the stock market between 2001 and 2011, 13% said the money that they would have invested was put towards purchasing a home; 27% said that they do not typically invest in the stock, bond or mutual fund markets except though their 401k; 27% said that they lost money during the stock market bubble of the 1990’s; and 33% said that they could not afford it. In addition, among those consumers that did not purchase a home between 2001 and 2011, 14% said they were required to make a 20% down payment but could not afford to do so; 18% said they were forced to rigorously document their income and net worth, which prevented them from begin approved for a mortgage; 20% were unable to get an adjustable rate mortgage with a low initial rate; 22% were unable to get an FHA (Federal Housing Authority) backed loan; while 26% own their home and were am happy with it. These data suggest that without sufficient government assistance, effective regulatory policy, and administrative management, a large percentage of financial consumers that cannot afford to save for their retirement or purchase a home would be unable to do so.
Another factor affecting the consumer economic decision-making process is psychological commitments. As it pertains to economic decision-making, psychological commitments are analogous to financial anchors (a preconceived rate-of-return on a given investment). Psychological commitments often end in entrapment, a behavioral condition that occurs when investors are deceived by their own initial commitments, and attempt to justify or salvage existing investments despite changes in macroeconomic conditions or corporate earnings. Collectively, these psychological factors both influence and direct the behavior of the financial consumer. While financial consumers should be able to act prudently and avoid investment products that they either do not understand or cannot truly afford, they often behave irrationally, and invest blindly, with no regard of the consequences. The determinant is based on numerous external influences, including news and tips from the media, economic transparency from the private sector, knowledge of the products in which they invest, and an understanding of the regulatory policies that affect those products. Considering that so many financial consumers have incurred significant financial losses over the past 100 years, and taking into consideration that many are subject to the psychological conditions that prevent them from making rational decisions about their investments, it is logical to suggest that they need unbiased, prudent advice from the investment industry that addresses the factors and consequences of risk, takes into consideration their clients goals and objectives, and remains consistent with FINRA’s rules on suitability.
Testing for Policy Awareness
Policy awareness indicates awareness of the future, which in turn implies sense of direction, or goal. Put differently, in order to plan effectively for future events, and achieve future goals, it is important to have knowledge of the regulatory policies that could obstruct (or advance) those goals. Public policy often assumes two basic facts: (1) that the public is generally in possession of sufficient information vis-à-vis the various policy alternatives of the moment to make a rational choice among them; and (2) that an election presents the voters with recognizable alternatives through which it can express its policy preferences. To further test financial consumers’ awareness of the regulatory policies that affect their investment capital, my survey looked at a specific and controversial piece of legislature: the Glass-Steagall Act. In 1999, Congress approved the repeal of the Glass–Steagall Act, which effectively removed the separation between investment banks and depository banks in the United States that had existed since the Great Depression. Doing so created a situation similar to the one that existing during the 1980s Savings and Loan debacle, when government intervention permitted thrifts to offer additional products to consumers in order to remain competitive. The Glass–Steagall Act allows certain types of financial institutions to offer products to financial consumers that they were previously unable to offer. When Congress replaced the Glass-Steagall Act with the Gramm-Leach-Bliley Act, it (1) eliminated restrictions against affiliations between commercial and investment banks; and (2) allowed banking institutions to provide a broader range of services, including underwriting and other dealing activities.
Indeed, the new regulatory provisions put forth by Glass-Steagall, which are similar, in principle, to the policies enacted by the government that allowed thrifts to compete with commercial banks, are of great concern to financial consumers because they allow organizations that were previously inexperienced with certain investment products to suddenly start selling them to consumers that are, as mentioned above, expecting expert advice and knowledge from their investment professionals. Thus, financial consumers should be aware of the regulatory policies that have the potential of affecting their household network, investment principle, and financial security. Yet, respondents to the survey had little knowledge of this (or other) policies that impact their investments. The results of the survey indicate an overwhelming percentage of respondents (71%) indicated that they were not familiar with any of these policies, while only 4% were familiar with Dodd-Frank, and 7% with Gramm-Leach-Bliley.
The survey provides important insight about the depth and breadth of awareness among financial consumers that invest their capital in the financial and/or housing markets. At its core, it indicates a low-level of awareness by a majority of consumers about the regulatory policies that affect their money. This supports that notion that many financial consumers require help from investment professionals that can sort through the media rhetoric and policy jargon, and provide non-biased advice that is suitable for their risk tolerance.
Measuring Public Interest
A majority of financial consumers and homeowners are unaware of the policies that govern their mortgages, investment and retirement accounts, and bank accounts. This suggests that both policymakers and the financial industry should be doing more to help financial consumers understand how these policies affect the value of their investment portfolios. As discussed throughout my thesis, when regulatory policy is not implemented correctly, public interest is often damaged. But, how can society measure when public interest has been damaged? One possible way (as it pertains to financial security) is to quantify monetary losses of financial consumers, and how such losses have affected the financial security of those consumers. Measuring those losses can be accomplished by reviewing the volume of legal action (arbitration cases filed) against investment advisers. FINRA oversees 4,345 brokerage firms, 163,410 branch offices, and 635, 140 registered securities representatives. Their chief role is to protect investors by maintaining the fairness of the U.S. capital markets. This is no small task considering that the abovementioned firms and registered representatives collectively trade, manage, and advise tens of millions of investors on several trillion dollars worth of publicly traded securities. One of FINRA’s many responsibilities includes the provision and management of a dispute resolution system that allows investors to file a complaint against their investment advisor after they suffer losses in the financial markets. While FINRA does not track the average arbitration amount, according to Kenneth L. Andrichik, Senior Vice President of Dispute Resolution at FINRA, the range of claim sizes is very broad, and claims range from hundreds to billions of dollars.
FINRA permits investors to file a claim against their advisor for any amount of loss, and they do not perform any administrate screening regarding the potential merits of a claim. Nevertheless, as it pertains to financial security, it is appropriate to consider the following: if an individual with a net worth equal to one million dollars files an arbitration for a monetary loss of $10,000, it might not necessarily constitute a threat to that persons financial security. By contrast, if a person with a net worth of $20,000 files a claim for $10,000, it would indicate that he or she has lost a substantial percentage of their net worth. The former equals a loss of one-percent of net worth (which is not necessarily considered a threat to financial security), while the latter amounts to fifty percent (an amount that is most certainly considered a threat to an individual’s financial security.) When financial consumers have suffered a loss, arbitration can resolve disputes, and avoid time-consuming litigation. When a case goes to arbitration, an independent third party (the arbitrator) reviews the facts and circumstances of the complaint, and issues a ruling to resolve it. FINRA’s arbitration system remains a cost-effective method for the public to potentially recoup their losses due to financial mismanagement.
In addition to providing an effective method for financial consumers to file a complaint against an investment adviser, the FINRA dispute resolution and arbitration system can also be used as an indicator of the health of financial public interest and financial security. When the percentage of arbitration cases filed increases annually, it indicates that a larger number of people (as compared to the previous year) lost money as a result of mismanagement by their investment advisor. In turn, when financial consumers lose large amounts of money due to mismanagement, financial security is threatened and public interest is damaged. Thus, there is a connection between financial security and total number of arbitration cases filed.
It is important to note that when a consumer files a complaint with FINRA, he or she is alleging that they lost money because of intentional actions on the part of their investment adviser. There certainly are situations where investors have lost money by their own doing, and there are also situations when firms are forced to sell stocks or bonds in an investors account (always at a loss to the client) due to margin calls. However, FINRA provides arbitration services only for investors that have lost money because an investment adviser acted inappropriately, and/or provided unsuitable advice. Thus, the following case information points directly to situations where consumers lost money through unscrupulous behavior and/or unsuitable advice by investment advisers.
Between 1999 and 2013, financial consumers filed 87,398 arbitration cases, with an average of 5826.53 arbitrations cases filed annually (median 5608). (see figure 10)
Figure 10- Number of arbitrations filed annually by inventors: 1999-2013
Source: Financial Industry Regulatory Authority
The data show annual fluctuations for arbitrations, with case filings peaking in 2003 and 2009. These peaks in case filings are strongly correlated (.72) to market risk, as measured by the VIX, (see figure 12). Although FINRA does not provide total dollar amount or average claim amount with its dispute data, the American Bar Association estimates that FINRA claims typically range between $25,000 to over $500,000. And, as noted above, some claims exceed one billion dollars. Therefore, between 1999 and 2013, financial consumers may have lost between $2,184,950,000 and $43,699,000,000. Placing this into perspective, during The Great Depression, consumers lost $1,337 billion, and during the Savings and Loan Scandal, they lost $88 billion. Put differently, the amount of money lost by financial consumers over the past century has increased with each financial crisis, despite significant efforts by policymakers to reduce consumer losses.
According to FINRA, a large number of cases involve violations of rule 2111, which deals with issues pertaining to suitability, (see figure 6). Rule 2111 asserts that all financial advisors or financial consultants must deal fairly with the public. Investment advisors and consultants must have a reasonable basis to believe that a transaction or investment strategy that they recommend is suitable for the customer. This reasonable basis must be based on information that a firm or representative gathers about the client. It includes age, other investments, financial situation and needs, annual income and liquid net worth; tax status, marginal tax rate; investment objectives (which include generating income, funding retirement, buying a home, preserving wealth or market speculation); investment experience; investment time horizon, liquidity needs; and risk tolerance (a customer’s willingness to risk losing some or all of the original investment in exchange for greater potential returns). Rule 2111 places an obligation on a firm and associated person to seek information from customers before making any recommendations. In accordance with Rule 2111, advisers must manage their clients’ portfolios on a daily basis; understand both the political and economic externalities (domestic and international) that continually shape the financial markets; analyze and recommend individual securities (stocks, bonds, mutual funds, commodities, annuities and derivatives); and provide many other account and client services that firms promise. As demonstrated throughout my thesis, human capital theory and statistical data indicate that the level of core skills, knowledge, competencies, and moral judgment needed to effectively assess each client, and provide prudent advice based on each clients risk tolerance, financial goals, and investment objectives, is not consistent with the level of education a person receives by earning only a high school diploma.
Interpreting FINRA Arbitration Case Filing Data
Financial consumers face many types of risk, including credit, foreign investment, liquidity, market, operational, and interest-rate, all of which contribute to market volatility. Thus, the risk facing financial consumers (and the possible causes of financial loss) are both wide and varied. This thesis looks at the type of risk facing financial consumers that originates from unscrupulous behavior by investment advisers that seek higher-than-average commissions through intentional acts that are both illegal and unethical. An analysis of arbitration cases filed by consumers through FINRA’s dispute resolution system shows that case filings declined between 2003 and 2007; and again between 2009 and 2013. This decline coincides with market volatility (as determined by the S&P Volatility Index). During these same periods, market volatility reached 40.65 on September 19, 2002, and 81.48 on November 20, 2008, (see figure 11 below). Average Daily Volatility between January 2, 1985 and March 20, 2014 is 20.14.
Figure 11. Relation of market volatility to case filings: 1999-2013
Source: Yahoo Finance Historical Quotes Database
Figure 11 shows a strong correlation between market volatility and case filings. By comparing the change between these two variables, it reveals a 72% (.72) correlation between a change in the VIX and a change in cases filed, (see figure 12).
Figure 12. Market risk to financial consumer complaints: 2000-2012
To date, there are no academic studies addressing this correlation; yet, the data indicates a 12-month (on average) lag period between the date that the VIX reaches an annual high or low (for a given year), and a proportional increase/decrease in the number of people that file a complaint against his or her investment adviser in the following year. There are many possible ways to view this correlation. For instance, when the VIX (which is a widely used measurement of market risk) increases, it might be viewed as more than an indicator of market risk; it might be viewed as a indication that the advice financial consumers have received from their investment advisers is inconsistent with their risk tolerance levels. In turn, this would indicate that financial security is also at risk. This could lead to a better understanding, and perhaps even the development of, a quantitative method for measuring public interest. Indexes and benchmarks are frequently utilized for determining the condition of a publicly traded security; it stands to reason that such data could also be used to understand when the financial consumers that trade those securities are at risk. Doing so might provide some guidance for policymakers that strive to increase financial security, and prevent another financial crisis from occurring.
How Much Money is at Stake?
Financial consumers hire investment advisers for many reasons. Consumers with less than $100,000 in investable assets typically seek portfolio growth; those with between $100,000 and $1 million often seek a combination of growth and income; and, those with more than $1 million often have special tax and philanthropic needs that include charitable giving, estate and trust planning, and wealth transition from one generation to the next. There are approximately 241.8 million U.S. citizens over the age of 18 (the legal age to invest without requiring a custodian). As of 2011, 54% (or approximately 130.5 millions) of Americans invested in the U.S. stock market. In 2013, Q4 total Household Net Worth (HNW) in the U.S. was $80.7 trillion (approximately 4.8 times the value of U.S. GDP, which was $16.7 trillion for the same period). As a percentage of HNW, 2013 Q4 total financial assets equaled $43.71 trillion, or 46.3% of HNW. The types of investment products that are considered financial assets include stocks, bonds, mutual funds, certificates of deposit, life insurance, and mortgages (but not the value of real estate). As of June, 2011, there were 4,135 brokerage firms in the U.S.; the top 40 firms had $3.9 trillion AUM. As a general rule, investment advisers charge a 1% fee on AUM. As mentioned above, there are no minimum educational requirements for financial advisers; only 30.4% of U.S. adults (or approximately 8.2 million) have earned a bachelor’s degree; and, a large percentage of consumers are unaware of the policies governing the financial industry and investment products in which they invest their money. Placing all this into perspective, this means that financial advisers (some of whom have never attended college) collectively earn $437.1 billion annually by providing advice to financial consumers (most of whom have never attended college) that own $43.71 trillion dollars worth of assets.
Since the end of the Great Depression, the financial assets to HNW ratio have increased steadily, (see figure 12).
Figure 12. Percentage of financial assets to household net worth: 1945-2013
This suggests that (1) an increasing number of people will rely on investment advisers to provide prudent advice on their financial assets throughout their lives; and (2) as more U.S. citizens build wealth in financial assets, it is likely that the severity of financial crises will also increase, given the extreme levels of volatility that remain. This also indicates that the quality of advice provided by the investment industry must improve to a level where financial consumers can be reasonable assured that their investment adviser possesses the human capital required to provide prudent advice that is suitable with their risk tolerance.
Summary and Conclusions
Ultimately, this study reveals significant reasons for establishing minimum formal educational requirements for investment advisers. Statistical evidence as it relates to education theory points to a strong, positive correlation between higher education and moral judgment, which is a significant requirement for investment advisers. Essentially, the number of years spent in college is related to individual ability to determine right from wrong, and thus make better decisions. In addition, human capital theory supports the notion that the core competencies and skills, knowledge, and social and cognitive abilities needed to function effectively within the financial industry, and service clients in a manner consistent with public interest, is developed through higher education.
Regulatory policy since the Investment Advisers Act of 1940 has increased regulatory oversight of investment firms and corporations through the creation of new regulatory agencies; implemented and/or revised regulatory policies; and established financial literacy programs for consumers as a means of preventing another financial crisis from occurring again. Nevertheless, financial consumers still face high levels of risk, as demonstrated by numerous recessions and financial collapses science the Great Depression. Policymakers need to look at alternative methods for improving financial security by proposing legislature in Congress that would prerequisite a four-year college degree program from an accredited school or university for anyone that seeks licensing through FINRA. In addition, FINRA (along with Congress and the SEC) needs to move away from current occupational licensing standards, which is comprised entirely of multiple choice testing, and move towards a blended approach that includes essay-style examinations. Doing so would improve the signal that investment firms receive from candidates that successfully complete FINRA exams and seek employment in investment management. FINRA should also consider enhancing its suitability requirements to include not only the advice that investment advisers provide, but also the human capital of the advisers themselves. FINRA should take cues from the medical community, and work with accredited colleges and universities to establish such suitability requirements.
This study also identifies a relationship between market volatility and FINRA arbitrations filed by financial consumers. Additional research is needed to determine if this relationship may be significant. The relationship between volatility and risk ought not be overlooked. The notion of potentially developing new methods that might help policymakers and scholar’s measure public interest is compelling, and holds significant implications for financial security. Further research is needed in this area.
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