Friday, October 21, 2016

SEC to Rely on FINRA to Monitor Brokerages

"Daddy, read me the story of the self-regulating market again"
If your daddy didn't read you this fairy tale when you were young, maybe your "Uncle" Milton told it to you at university.  Or a kindly professor relayed the Uncle's wisdom to you. 

If this didn't happen, here's a quick recap. 

Even if each businessman single-mindedly pursues his or her own profit to the exclusion of all other concerns, where there is intense competition of the "free" market (note that requirement) salutary outcomes result:
  1. individual or overall market excesses are magically curbed 
  2. firms offer the best service and prices, eventually competing profits away to zero unless, of course, they make improvements to products.  [Because profits never go to zero (except in bankruptcy) this no doubt proves the creative power of free markets to constantly improve products.]
  3. those firms that do not lower their prices or improve their products are forced out of business
Since by definition, the market in the USA is not only "free" but "intensely" competitive, then with such miraculous powers there is little if any need for government regulation.  In fact by interfering with the market, governments are liable to do more harm then good as this quote attributed to Mitt Romney demonstrates. 

The invisible hand of the market always moves faster and better than the heavy hand of government.

This theory seems to be the rationale for this recent SEC decision reported this Monday by Reuters.

The Securities and Exchange Commission is leaning more heavily on partner regulator the Financial Industry Regulatory Authority to monitor brokerages as it devotes extra staff to oversee the rapid growth of independent financial advisers, a top regulator said Monday
What could possibly be a reasonable objection to FINRA taking over SEC duties?

Simply put, FINRA is an industry group and therefore has an inherent conflict of interest. 

Does this mean that it is certain that they will fail to do a proper job or that they have failed in the past?  No.  What it does mean is that a conflict could cause them to fail.

What are some of the potential trouble "spots"?

  1. Setting professional qualification standards too low.  FINRA doesn't report the pass rates on its qualification exams (Series 7, etc).  The pass rates for the CFA, CFP, FRM are all reported and suggest these certifications are difficult to obtain.  Why is that?   
  2. Restricting information on actions against brokers.  If you'll recall a while back, FINRA was criticized for failing to provide enough information in its Broker Check (BC) tool to allow investors to determine whether to work with a particular broker.  FINRA announced some improvements but just recently the  Public Investors Arbitration Bar Association found those improvements lacking and criticized FINRA because BC doesn't include reasons for a broker's termination by a firm, information about bankruptcies, tax liens and scores on relevant industry examinations.  PIABA noted that some of this information is provided by state security regulators (government agencies) which suggests (but does not prove) that legal liability issues did not motivate these omissions.  
  3. Applying a light touch on penalties when perhaps a heavier one is justified.  In the past the maximum fine was $15,000 per "offense" in the NASD days. (FINRA is the combination of the "old" NASD and NYSE separate self-regulatory bodies).   This has changed. Fee levels have increased.   In 2016 FINRA is set for a record year of estimated fines of some $160 million due to some "supersized" fines.  ("Supersized" is defined as a fine $1 million or more).  The estimated 2016 total fines is less than the fines levied against Wells Fargo by government regulators for the "fake accounts" scandal. The last time I looked FINRA's largest 2016 fine was some $25 million against Met Life (2015 revenues $70 billion net income $5 billion).  See the analysis of these "ginormous" fines by Sutherland Asbill and Brennan here.  And here for K&L Gates' analysis of 2015 fines in which it's noted that most FINRA actions are resolved for less than $50,000.  It should be noted that FINRA fines individuals as well as firms and that many of the firms in the industry are minnows alongside the major brokerage firms so $50,000 could be a firm threatening fee. 
Just to be clear, I am not accusing FINRA of improper behavior.  I am merely pointing out a conflict of interest.

During his illustrious career, AA has seen a lot of conflicts of interest turn into conflicts of action. 

Here's one "sweet" story - not witnessed by AA.


Early warning signals of the coronary heart disease (CHD) risk of sugar (sucrose) emerged in the 1950s. We examined Sugar Research Foundation (SRF) internal documents, historical reports, and statements relevant to early debates about the dietary causes of CHD and assembled findings chronologically into a narrative case study. The SRF sponsored its first CHD research project in 1965, a literature review published in the New England Journal of Medicine, which singled out fat and cholesterol as the dietary causes of CHD and downplayed evidence that sucrose consumption was also a risk factor. The SRF set the review’s objective, contributed articles for inclusion, and received drafts. The SRF’s funding and role was not disclosed. Together with other recent analyses of sugar industry documents, our findings suggest the industry sponsored a research program in the 1960s and 1970s that successfully cast doubt about the hazards of sucrose while promoting fat as the dietary culprit in CHD. Policymaking committees should consider giving less weight to food industry–funded studies and include mechanistic and animal studies as well as studies appraising the effect of added sugars on multiple CHD biomarkers and disease development


Why take a risk with this conflict of interest? 

FINRA has a role to play.  

But should the SEC cede what is properly a government responsibility?


1 comment:

Abu 'Arqala said...

Adam Smith is often cited as a source for the intellectual underpinning of free markets, intense competition, and thus the self-regulating nature of the market.

A lot of this is based on selective reading of Wealth of Nations. Here's AA's favorite selection.

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible, indeed, to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary.

http://www.gutenberg.org/files/3300/3300-h/3300-h.htm