Posted by: Uma Shashikant on Thu, May 3rd, 2012
Nurturing Financial Advisors - Part 1 - Defining their Role and Revenue Model
In this three part series, I am summarizing the views I presented in a paper to Sebi when comments were invited on the discussion paper on distributors in October 2011. Sebi has been discussing with various stake holders and one expects regulatory action on this issue soon.
Defining the Advisor
An all encompassing definition of a financial advisor would be one whose primary task is advising a household on how to choose and use financial products. The primary entity, whose interest is sought to be protected by regulatory agencies, is the household, which consumes a range of financial products from bank deposits, credit cards and loans, to securities, insurance products and pension products. Since the household may not possess the expertise to make decisions that impact its long-term financial health, or be able to expertly compare the risk and return of competing financial products, it may seek the services of a financial advisor.
A financial advisor is therefore an expert in personal finance, who is able to provide strategic and tactical advice that enables a household to manage its balance sheet efficiently, taking into account its specific objectives and constraints. This function cannot be oversimplified to mean distribution of financial products, financial planning or risk profiling.
The certification examination to become a financial advisor needs to be much more rigorous than a “gate-keeping” certification that is being commonly implemented currently by financial regulators.
It is a professional expertise that requires a level of rigour as required for fund management, portfolio management or corporate financial management. It is pertinent that qualifications for all the above mentioned roles are not specified by regulators. They have been developed by the industry and then adapted as the rigorous standard. There is the urgent need to define and develop professional certifications in wealth management on the lines of the CFA mark, which is well accepted globally, for portfolio managers. This is a task CIEL is currently engaged with.
Regulation of financial advisors should enable creating and fostering such expertise in the market place to enable households to access professional advice in personal finance.
Revenue Models for Advisory Business
Various revenue structures for financial products across the world provide three distinct models for financial intermediaries, including manufacturers and distributors.
The first is a capital-based model, mostly used by banks where equity capital is used primarily to fund geographic expansion and technology investments. Borrowed capital is used to create a risky asset portfolio that generates a rate of return that is higher than the cost of borrowing. The profitability of banks depends critically on quality of assets, which in turn impacts costs of borrowing and return on equity. Most banks focus on growth in size, which enables them to manage these three ends efficiently.
The second is the advice-based model, where the focus is not financial capital, but on reputational capital. Credit rating agencies, investment bankers, accounting firms, legal and tax advisors, venture capitalists and private equity managers, fund and portfolio managers use this model. They lend their expertise in enabling few specialized but critical activities, which result in tangible benefits to their clients. They compete with one another to win client mandates, but tend to grow their business based on their track record of performance. They are able to charge a fixed fee or a variable fee from their clients, but the largest firms in most of these businesses earn a variable fee, linked to the economic value of the object of, or outcome of, their advice.
The third is the transaction-based model, where the focus is on completing a defined set of activities, using standard procedures and processes and earning a fee for doing so. Stock brokers, depositories, distribution agents, direct sales agents, insurance agents and deposit mobilisers are all such “transaction-only” entities, who complete a set of activities and earn a fee for doing so. Many of them may automate their processes, resulting in higher volumes and lower costs (example: stock brokers). The fee they charge is linked to the volume of business they generate. They do not bring in any product structuring expertise as does the first group above, or offer specialist expertise as the second group.
Financial advisors clearly fit in category two above. The distinction between the advisor and the distributing agent is critical due to the difference in their functions and therefore the different economic incentives needed to encourage their growth.
In our view, the malpractices in the financial distribution space occurred due to the lack of recognition of this distinction, which enabled mere agents to earn the revenues (such as the trail commission) otherwise due to an expert advisor.
(Part 2 of this series will be published on May 04, 2012).
rajendra prasad verma purnea bihar on Sat, May 5th, 2012 1:33:31 pm
allways ur fan
Amit Bivalkar on Sat, May 5th, 2012 1:08:40 pm
Very well written article mam, i have some views on the same, In case of Credit rating agencies, the client wants his company rated, in case of Investment bankers the client wants money from others, in case of tax consultants the clients wants to save tax ,Private equity and venture capitalists the clients want money again.So at all given points of time the so called entity does what the client WANTS of the client is identified In case of Financial Advisors the problem is they dont analyse the difference between what the Client WANTS and what he actually NEEDS. Payment for such services therefore becomes very difficult as no VALUE ADD is presented. If you try to take a analogy , even a guy who drives a BMW or a Jaguar in India goes to the petrol bunk for filling FREE AIR and does not wish to go to a Authorised Tyre shop and pay 10 Rs . Sad but true.
prakash praharaj on Sat, May 5th, 2012 10:04:15 am
Excellent clarity on models.Please let me know on your certification project.Awaiting for the next part!