Financial advisors’ conflicts of interest may merely be shifted
06/06/2023
Does a Ban on Inducements Improve Financial Advice?
Nic Schaub / Simon Straumann - June 6, 2023
Many households rely on financial advice. For instance, a quarter of people polled in a survey published by the Deutsches Aktieninstitut considered financial advice of “high” or “very high” importance when making investment decisions. However, this can present a problem, as financial advisors are often subject to conflicts of interest: On the one hand, they should act in the best interest of their clients and steer them toward the products that are best suited for them. On the other hand, they also have to act in the interest of their employer, directing their clients toward products that maximize the company’s profits.
Such conflicts of interest are particularly prevalent in commissions-based financial advice. With this format, the advisors are not paid directly by the customers for the advice they provide, but rather are paid indirectly through commissions from product providers when selling their products to customers. It is all too common that advisors, when in doubt, recommend products that maximize commissions.
It is against this backdrop that the European Commission spent several months discussing a total ban on inducements paid to financial advisors. However, the effectiveness of such a ban is still subject to debate, and the European Commission ultimately decided to toss the idea out.
A new study from WHU turns to Switzerland to see how such a ban affects individual investors. The study focuses on a Federal Supreme Court ruling in 2012 that prohibited banks from earning commissions from product providers when clients delegate the management of their portfolio to the bank.
A look at the Swiss data showed that the portfolio share of own-bank mutual funds and own-bank structured products increased significantly after inducements were banned. However, own-bank products often have inferior returns when compared to other products available on the market. For example, during the investigation period, the average risk-adjusted return of own-bank mutual funds was below that of other available mutual funds. As a result, the ban on commissions had a negative impact on the risk-adjusted portfolio returns of individual investors.
In the end, the ban on inducements in Switzerland did not succeed in preventing conflicts of interest of financial advisors. It merely pushed the problem elsewhere. This is neither in the interest of customers nor of policymakers and should be taken into account when deciding for or against undertaking such measures in the future.
Tips for practitioners
- Clients should be cautious when interacting with their financial advisor. They need to understand why advisors may recommend one product over another and be sure that advisors act in their best interest.
- It often makes sense to get a second opinion from another financial advisor. Advisors who charge a flat fee do not rely on payments from product providers and therefore their advice should be rather unbiased.
- Individual investors should try to understand as much of the subject as possible so that they and their advisor are on equal footing. This will allow them to pose targeted questions.
- When imposing a ban on inducements paid to financial advisors, policymakers should focus on both intended and potential unintended effects.
Literature reference and methodology
In their research paper “How Does a Ban on Kickbacks Affect Individual Investors?” Professor Nic Schaub and Professor Simon Straumann of WHU – Otto Beisheim School of Management investigate the effects that a ban on commissions in financial advice can have on individual investors. To do so, they focus on a ruling made by the Swiss Federal Supreme Court in 2012 that prohibited banks from earning commissions from product providers when clients delegate the management of their portfolio to the bank. The researchers analyzed over 20,000 securities portfolios from more than 10,000 different bank customers in Switzerland between 2010 and 2020.
- Schaub, N./Straumann, S. (2023): How Does a Ban on Kickbacks Affect Individual Investors?, Working paper.
Co-Autoren
Professor Nic Schaub
Nic Schaub is a professor of household finance at WHU – Otto Beisheim School of Management. His research interests are in household finance, behavioral finance, and asset pricing.
Assistant Professor Simon Straumann
Simon Straumann is an assistant professor of finance at WHU – Otto Beisheim School of Management. His research focuses on household finance, financial intermediation, as well as asset pricing.