Two headlines this week caught my eye and suggest that at least some reforms in the financial industry may not improve the lot of individual investors.
Earlier this week, the Wall Street Journal carried a story, “Stock Research Reform to Die,” which discussed the end of the requirement of Wall Street firm’s to carry independent research. The general tone of the piece was to highlight how little it was used by clients and advisors, citing for example a statistic that showed only 11.5% of financial advisors were using the non-proprietary research at least occassionally. The analysis misses the actual importance of the research — given that the vast majority of financial advisors are no longer stock-pickers and use managed money instead, that 11.5% likely represents a very high percentage (half?) of advisors who actually select individual equities. There is a legitimate argument that could question the cost-effectiveness of this reform, but individual clients and their advisors will be worse off as the requirement expires and several firms stop providing the research. Kudos to Morgan Stanley Smith Barney for continuing the practice despite the cost.
On another front, in today’s Wall Street Journal comes news that the administration will be addressing compensation structure throughout the financial services industry. To the administration’s credit, these will be issued as “best practice” guidelines rather than inflexible rules (at least for those firms not encumbered with TARP). According to the article, the administration will focus on guidance that bonuses be largely structured as restricted stock in an attempt to align employee and shareholder interests. While I sympathize with those who see flaws in the bonus structure (see, for example, my op-ed in the Boston Globe from March), restricted stock awards carry their own problems.
Requiring a heavy emphasis on restricted stock has been favored by many academics. In some cases, these are even some of the same people who proposed the unsuccessful executive pay reforms in 1993 that actually contributed to the current problems. Focusing on restricted stock awards may be an effective strategy for many industries, but is ill-suited for a financial service industry that has an ethical and often legal responsibility to it’s customers.
In a meeting I attended over 20 years ago, Joe Grano, then the head of PaineWebber’s private client group, shared wisdom that has stayed with me: “In our industry, everything we do has to be a fair balance between our responsibilities to the client, to employees and to shareholders.” Skewing compensation further to restricted stock can place an undue weight on shareholder interests to the detriment of client needs. At a previous employer with a strong (forced) orientation to employee share ownership, I saw this at work first hand. In the ethical election poll, the vote for employee compensation now gets aligned with the vote for the shareholders, with the client left in a lurch. Over the years this surely contributed to Wall Street’s past sins of proprietary product pushes and research tainted by investment banking profits. This is an industry, after all, which often thinks of its financial advisors as “distribution,” serving the needs of the “production” created by investment banking and product creation groups.
Setting aside the adverse consequences for the clients of these firms, I do not believe the restricted stock requirement will even have the desired effect of reducing systemic risk. This is really a game theory question and a variation on the famous “Prisoner’s Dilemma,” where suboptimal results are driven by individual perspectives. The Wall Street traders who helped create the systemic risk didn’t intend to destroy their firms, after all. It would be easy, from the perspective of an individual trader, to assume that any colleagues are simply trying to maximize their own bonuses and taking on firmwide risk, so they might as well get what they can, while they can. Essentially, the thought process will be: “I can’t control the share price or overall firm performance, all I can do is maximize my own bonus whether it is paid in cash or stock.” In terms of risk taking, that puts us right where the industry has been all along, only now there’s an additional rationale to overlook the client interests.
It’s important that our financial industry’s systemic risk issues be addressed, but the burdens of the necessary reforms shouldn’t be carried by the clients of the industry, the individual investors.