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The Small, Generalist Broker-Dealer: R.I.P.? Who Will Survive

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On July 18,  the House Committee on Oversight and Government Reform held a hearing regarding “Regulatory Burdens: The Impact of Dodd Frank on Community Banks.” In her testimony, Wake Forest University Professor Tanya Marsh discussed how “Dodd-Frank builds on decades of ‘one-size-fits-all’ regulation of financial institutions, an ill-conceived regulatory framework that puts community banks at a competitive disadvantage to their larger, more complex competitors.” 

In her testimony, Marsh argued that “The imposition of regulatory burdens on community banks without attendant benefits ultimately harms both consumers and the economy by: 1) forcing community banks to consolidate or go out of business, furthering the concentration of assets in a small number of mega-financial institutions, and 2) encouraging standardization of financial products, leaving millions of vulnerable borrowers without meaningful access to credit.”  

She could have been speaking about small broker-dealers. 

Sound Familiar?

As a broker-dealer recruiter, I find Professor Marsh’s description eerily similar to the struggles facing the small broker-dealer. Throughout much of her testimony, you could have replaced the term “community bank” with “small broker-dealer” and the story would still hold true. 

In her testimony, Professor Marsh continued that “with respect to compliance, community banks are at a disadvantage because they do not have their larger competitors’ sophisticated legal and compliance staffs to interpret the new rules and regulations and look for effective ways to comply with those regulations without compromising their ability to serve customers and earn profits.”   

A study released in 2012 by the Federal Deposit Insurance Corp. reinforces the detrimental effect of increased regulation on small community banks. According to that study, “The facts of bank consolidation are striking. From 1984 to 2011, the number of small banks — those with assets of less than $25 million — declined 96%.” Meanwhile, the number of banks insured by the FDIC has shrunk, while large banks have significantly grown their share of total bank assets.

We know from long experience that smaller businesses are disproportionally impacted by regulatory costs. The Office of Advocacy of the U.S. Small Business Administration (SBA) has been studying the cost to small businesses of regulation since 1995. A 2010 SBA study concluded that small businesses “bear the largest burden of federal regulations. As of 2008, small businesses face an annual regulatory cost of $10,585 per employee, which is 36% higher than the regulatory cost facing large firms.” That was before Dodd-Frank. 

The Decline of Small Broker-Dealers

While I’m not saying that Dodd Frank is placing our industry in the same dire straits as what we are seeing with community banks, we’re not in much better fiscal shape. The Financial Industry Regulatory Authority classifies small broker-dealers as those with less than 150 reps. As a recruiting firm we agree with this segmentation, provided that average production per rep runs around $100,000 or less, which would make $15 million of revenue or less a better litmus for categorizing a firm as small.  

Like community banks, the number of broker-dealers continues to decline, with the lion’s share being small broker-dealers that closed or merged.  It’s also important to note that the broker dealer decline is not rep-driven; the number of reps since 2005 has dropped by only 3.11%, according to Fishbowl Strategies, a marketing firm that provides trending information about the broker-dealer and RIA arena.

Broker-Dealers in the Marketplace

Offsetting some of these broker-dealer closures or mergers are new broker-dealer formations. However, as Fishbowl Strategies points out, these are also in decline.

New Broker-Dealer Formations

The Federal Reserve Bank of Minneapolis quantified the cost of financial regulation and found a disproportionate effect of regulation on small banks by showing how the costs of hiring just two additional compliance personnel could reverse the profitability of one-third of the smallest banks.  Small and some midsize broker-dealers face the same dilemma. One firm shared with us their desire to hire a product person to help reps with education and product selection. Instead, this firm was forced to hire an additional compliance officer to cover additional supervision and tracking dictated by Dodd Frank. 

Which Small BDs Will Survive?

While there appears to be a future of doom and gloom for the smaller BDs, those that specialize are best positioned to overcome the obstacles presented by ever increasing regulation. The smaller firms that we see growing at a healthy clip with consistent profitability include those that have a niche in which they excel, which gives them the upper hand. Those broker-dealer specializations we see flourishing include:

  • Alternative Investment Focus It’s all about due diligence, proper education and allocation on alts to keep this model from blowing up
  • IMO Broker-Dealers Firms that have their own insurance marketing organization are less reliant on securities production for profits, and thus tend to offer a low-cost structure that is especially attractive to reps who produce less than $100,000. 
  • Institutional Business This focus helps to lower risk and make earnings less cyclical 
  • Transaction Orientation This model can work if the BD weeds out reps who are churners and have multiple disclosure events
  • CPAs/Enrolled Agents, 403(b) and 457 Plans
  • Overseas Clients­ This will become a growing niche as we become more global
  • The Faith-Based Christian broker-dealers will be able to attract like-minded representatives
  • 100% RIA Model In this model, the BD only makes money on the commission side, so cost controls are important (no frills)
  • Advisory Reporting using Orion or Black Diamond software, with low administration fees on rep-directed platforms (5 bps or less or a flat fee) 

In the second part of this posting, we look at those broker-dealers that are most at risk of failing.


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