Bro­kers be­hav­ing badly

The Pak Banker - - OPIN­ION - Barry Ritholtz

BAD bro­kers don't leave the busi­ness; they just move on to a dif­fer­ent firm. That is one of the key find­ings of a study of bro­ker mis­con­duct by pro­fes­sors at the busi­ness schools of the Univer­sity of Chicago and Univer­sity of Min­nesota. The study, ti­tled "The Mar­ket for Fi­nan­cial Ad­viser Mis­con­duct," re­viewed bro­ker dis­ci­plinary records from 2005 to 2015 stored in the Fi­nan­cial In­dus­try Reg­u­la­tory Author­ity's Bro­kerCheck data­base, cov­er­ing al­most 4,000 se­cu­ri­ties firms em­ploy­ing about 640,000 bro­kers.

There is an enor­mous wealth of in­for­ma­tion that is pub­licly avail­able about bro­kers who vi­o­late the suit­abil­ity rules and other stan­dards of con­duct. What the study found was that mis­con­duct that re­sulted in dis­ci­plinary ac­tion was wide­spread, with one in 13 bro­kers hav­ing a mis­con­duct-re­lated dis­clo­sure in their Finra files.

There is no other way to put this: That's just as­ton­ish­ing. To their credit, many bro­ker­ages try to take ap­pro­pri­ate ac­tion. As Bloomberg News re­ported yes­ter­day, "Mis­con­duct isn't left unchecked by fi­nan­cial firms. About half of ad­vis­ers found to have com­mit­ted mis­con­duct are fired."

My col­league Michael Bat­nick plowed through the 60-page re­port to pull more data from the study. He found that: About a third of bro­kers with mis­con­duct records are re­peat of­fend­ers. Past of­fend­ers are five times more likely to en­gage in mis­con­duct than the av­er­age ad­viser, even com­pared with other ad­vis­ers in the same firm at the same point in time.

Bro­kers work­ing for firms whose ex­ec­u­tives and of­fi­cers have records of mis­con­duct are more than twice as likely to en­gage in mis­con­duct.

Al­most half of the bro­kers who en­gage in mis­con­duct in a given year don't keep their jobs into the next year. How­ever, al­most half of the bro­kers (44 per­cent) who lost their jobs due to mis­con­duct found em­ploy­ment in the in­dus­try within a year.

Among cur­rently reg­is­tered bro­kers, 7.56 per­cent en­gaged in mis­con­duct at least once. Of those, 38 per­cent are re­peat of­fend­ers.

Per­haps most dispir­it­ing of all is that mis­con­duct is even more com­mon in coun­ties filled with wealthy, el­derly peo­ple. For ex­am­ple, the study found that of the "5,278 ad­vis­ers in Palm Beach, Florida, 18.11% have en­gaged in mis­con­duct."

Th­ese num­bers be­come even more as­tound­ing once you un­der­stand the stan­dards of con­duct for bro­kers. Finra, the in­dus­try­fi­nanced self-reg­u­lat­ing au­thor­ity, only re­quires that bro­kers ad­here to a so-called suit­abil­ity stan­dard -- mean­ing that they make rec­om­men­da­tions that are sup­posed to be ap­pro­pri­ate to the cus­tomer. It also hap­pens to mean that it's fine to rec­om­mend the prod­ucts that are most re­ward­ing for the bro­ker. The tougher, bet­ter bench­mark is the fidu­ciary stan­dard, which re­quires some­one to put the client's in­ter­ests ahead of their own. That makes me imag­ine what would hap­pen if the fidu­ciary stan­dard were ap­plied to all bro­kers, as it will be later this year for those bro­kers deal­ing with re­tire­ment ac­counts. If that were the case, I think the rate of bad be­hav­ior would be shown to be even higher than it is in this re­port.

How is it pos­si­ble that de­spite all of this read­ily avail­able pub­lic in­for­ma­tion about bad bro­ker be­hav­ior, in­vestors con­tinue to get abused? Two pos­si­ble an­swers are that the in­for­ma­tion is much less eas­ily ac­ces­si­ble than we imag­ined, and that the mar­ket­place for fi­nan­cial ad­vice is ter­ri­bly in­ef­fi­cient.

This isn't a mi­nor con­cern. Bad bro­kers cost in­vestors bil­lions of dol­lars a year, and much of the losses are never re­cov­ered be­cause of the fi­nan­cial in­dus­try's pri­vate jus­tice sys­tem. ( For more on this see this and this.)

Just how much in­vestor money is lost due to bro­ker mis­con­duct is, sadly, un­known. But we do have some idea of how much eth­i­cally du­bi­ous but le­gal be­hav­ior -such as con­flicts of in­ter­est -- costs in­vestors: about $ 17 bil­lion each year, ac­cord­ing to a re­cent White House re­port.

One of the cen­tral rules of eco­nom­ics is that in­cen­tives mat­ter. One way we can im­prove the be­hav­ior of bro­kers and oth­ers is to al­ter the in­cen­tives by sim­pli­fy­ing the rules they must fol­low, and by rais­ing the stan­dards of con­duct. The fidu­ciary stan­dard ac­com­plishes both and should be the guid­ing cri­te­rion for the in­dus­try.

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