Rules are Made to be… Changed?

Recently the Federal Reserve announced that the so-called Volcker Rule would be amended, effective immediately. The rule, named after former Federal Reserve Chairman Paul Volcker, was part of the massive financial regulations package known as Dodd-Frank that was passed in the wake of the last financial crisis. These regulations were ostensibly put into place to prevent a similar crisis from ever occurring again, but the full efficacy of these rules has not yet been tested. Despite these good intentions there were many questions surrounding many of these regulations almost immediately - the Volcker Rule in particular.

Questions arose not only from the standpoint of whether these types of rules are effective, but also whether they are even necessary. One oft cited criticism is that the Volcker Rule specifically prevented banks from entering speculative investments. What is considered speculative versus what is considered an acceptable and normal investment of capital was never fully made clear despite the 900+ page girth of the rule.

There are aspects of the Dodd-Frank regulations that even those who lent their names to the legislation disagree with. The rules have proven to be difficult to comply with and a burden, in terms of both time and effort, for those entities subject to them – the Volcker Rule being one prominent example.

Last week, the Federal Reserve decided to roll back the Volcker Rule – kind of.  Going forward the rule may or may not apply in part, fully or not at all based on bank assets. In this adaptation of the rule, banks with more than $10 billion in assets would continue to be subject to the rule as written, with no changes going forward. Banks that find themselves in the second tier, those with less than $10 billion in assets but more than $1 billion, will be subject to “reduced compliance requirements,” while smaller banks with less than $1 billion will not be subject to the Volcker Rule at all.

This seemingly arbitrary application of rules based on bank size begs the question whether the rules are effective or necessary at all. If compliance with such rules is an important requirement for the continued functioning of markets why would only some banks be subject to it and not others? Of course, the main argument is “too big to fail” banks need to be more regulated than those which are not too big, but wouldn’t the failure of ten $1B banks be just as bad as one $10B bank failure?

What other aspects of society have different laws for different sized entities? Things are either necessary or they are not. Stop lights are not optional for small cars and required for large trucks.

A much simpler solution to this problem than a 900-page rule, if indeed it is a problem in the first place, is to make banks responsible for their own actions. If a bank fails due to poor investment choices that bank, and its management, should be left to deal with the consequences. Having a government backstop to excess risk taking is never the answer. One extreme is attempting to regulate banking transactions, the other extreme is allowing speculation and providing a bailout when things go south. In both cases the bank is excused from responsibility from its actions and that is where the problem lies.

The roll back of the Volcker Rule is a step in the right direction, although admittedly a very small one. The role of government should be to make conducting business easy, not more difficult, and that includes letting poorly run banks fail. It is not the task of regulators to play the doting parent of a child learning to ride a bike. The best lessons are learned the hard way and too much interference in the day-to-day operations of any business often has the opposite of the desired effect. The ability to determine an acceptable risk level will never be learned by banks so long as the doting regulators allow no risk to be taken or conversely allow imprudent risks to be taken but the consequences not felt.

The Volcker Rule is not the only regulatory issue in the news lately. While it may not get as much media coverage there is another, lesser-known rule that is much more likely to impact the average investor in a meaningful way.

The Fiduciary Rule, issued by the Department of Labor (DOL), had only just begun to go into effect piece by piece. The rule itself, as most regulatory rules are, was far too long and far too complicated to get into all aspects (and exceptions) in this space. However, we will focus on one area that should be of particular interest to business owners and investors who have retirement plans.

The rule effectively would have made any advisor working with a retirement plan, like a 410(k), a fiduciary. A fiduciary is a very specific legal term. Anyone who works in a fiduciary capacity is required to work in the best interest of their clients, even if it is to their own detriment. It may surprise many people that financial advisors are not all held to this fiduciary, or best interest, standard. Some are, most are not.

The reason this is such an important distinction is that the other standard advisors can be held to, the suitability standard, is far weaker and far worse for investors. Not only does is allow for overcharging for services, and therefore worse investment returns over time, it also makes it much more difficult to prove wrongdoing should a dispute end up in court.

When the Fiduciary Rule was originally being presented the amount of push-back from the investment advisory industry was incredible. For anyone paying attention it became crystal clear that many of the best know, and largest, investment advice providers in the country were against the rule because it would result in stricter standards and lower profits. In other words, they would actually have to work for the money they earned and be held to account for the advice they provide – a novel idea!

Following some last minute legal wrangling, the details of which are too dull to include here, the Fiduciary Rule is all but neutered at this point. What was a decent, albeit far too complicated, step towards consumer protection, ended up being a worthless waste of time, money and resources, the end result of which makes investors no better off than they would have been otherwise.

As is usually the case, however, it did not need to be this way. A short, one-page, or even one-paragraph, maybe even one-sentence rule could have achieved more and been less prone to gutting via appeal and political dealings.

Simply, call a spade a spade. The whole argument over fiduciary vs. suitability standards largely boils down to the role being played. An advisor, in the truest sense of the word, one who advises, is held to a fiduciary standard. They pick investments that are, in their estimation, the best for that particular client, and that particular scenario.

Someone who adheres to the suitability standard, need only pick an investment that is suitable, not necessarily the best, not necessarily even good, just suitable. They are not advising, they are selling. It should come as no surprise that, more often than not, the deciding factor by which investments are chosen under this standard comes down to how much the ‘advisor’ stands to earn from selling that investment vs. another.

People are confused about advisors, their different standards, what to expect from an advisor and investing in general. The rules are currently written such that there is almost no telling who it is you are dealing with and in what capacity they are serving your needs (or maybe their own needs).

The failed Fiduciary Rule just another case of regulators trying to do more when less would have been more effective. A rule that simply required truth in advertising would have been much simpler and a much more elegant solution.

A rule that simply stated that one must disclose whether they are an advisor or a sales person and the standard to which they are held to, fiduciary or suitability, should be a part, and a prominent one at that, of every investment advisory contract. That would itself solve the obfuscation that is so prominent in the investment advice business today.

Current rules further complicate matters by allowing nearly anyone to call themselves an advisor, qualifications and motivations be damned. It is the equivalent of a sales person at a car dealership calling themselves a mechanic and promising to fix your car. Can this person fix your engine problem? The nametag suggests they can, but reality suggests otherwise. What they can do though, is sell you something, and when it doesn’t fix the issue, well, there is no recourse because they’re just a salesperson and not held to any responsibility for the efficacy of their work. As far as they, and their dealership, are concerned, the job was done because the profits were directed into their pockets. As the client, however, you likely have a different opinion and are left with a still faulty vehicle and less money to show for your efforts.

There is an old saying that goes something like, “He who rules least, rules best.” This is something that regulators and law makers should carefully consider. Over-broad regulations become not only burdensome to businesses but also a target for lawsuits on all kinds of legal grounds – some legitimate, many not. Simple, well-written and direct rules would be much more effective than something broad and overarching that ultimately is difficult to comply with a rife with opportunities for being overturned.

The result of all these years that has been spent writing, amending and re-writing the Fiduciary Rule has been wasted. Advisors and Brokers have spent untold time and money trying to fight or understand or undermine the rule – ultimately seeing it dissolve. The costs they bore will now be passed on to the very investors the rule was seeking to protect from among other things, high fees.

Incidentally, with the gutting of the Fiduciary Rule, investors are no more protected than they were beforehand and will likely continue to work with ‘advisors’ who are little more than salespeople while not realizing the risks and costs they are opening themselves up to.