As the fiduciary debate rages on, suitability changes are already here. New guidelines have just been announced that increase sanctions for violations of the Financial Idustry Regulatory Authority’s suitability rule 2111 from a one-year suspension to two years. In the worst cases, offenders can be barred for life. When suitability violations involve a firm, the sanctions mandate a 90-day suspension of business activities and can even result in permanent expulsion.
These new rules have elevated the importance of risk profiling and risk tolerance, which are often lost in the shuffle. This is unfortunate — and surprising — given that risk profiling deficiencies have been shown to be the leading cause of suitability failures.
These guidelines should also be a warning sign to RIAs as stricter regulatory standards governing investment advice are all but guaranteed, especially now that the White House and Department of Labor (DOL) have entered the fray. There is even talk on the need to harmonize FINRA and Securities and Exchange Commission rules.
Risk Profiling Tool Concerns
Let’s look at the experience in the U.K., which has led global investment suitability regulation. Following the 2008-’09 financial crisis, British regulators conducted a study to uncover factors that led to unsuitable advice. The subsequent report concluded a majority of cases that failed suitability requirements “did so because the investment selection did not meet the customer’s attitude to risk.” In fact, 9 out of the 11 risk profiling tools evaluated by the regulators were deemed “not fit for purpose.”
A similar pattern has emerged in the U.S. where the number of FINRA arbitration cases rose 62% following the Internet bubble, and more than doubled after the global financial crisis in 2008. “Taking too much risk” has been an oft-cited reason for these cases. It seems bear markets are marvelous at verifying the worthiness of reliable risk profiling tools and weeding out unreliable ones that fail to deliver at arguably the most crucial time in the client-advisor relationship.