The Market For Financial Adviser Misconduct
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University of Chicago; University of Minnesota Carlson School of Management
University of Chicago – Booth School of Business
University of Chicago – Booth School of Business
February 29, 2016
We construct a novel database containing the universe of financial advisers in the United States from 2005 to 2015, representing approximately 10% of employment of the finance and insurance sector. Roughly 7% of advisers have misconduct records. Prior offenders are five times as likely to engage in new misconduct as the average financial adviser. Firms discipline misconduct: approximately half of financial advisers lose their job after misconduct. The labor market partially undoes firm-level discipline: of these advisers, 44% are reemployed in the financial services industry within a year. Reemployment is not costless. Following misconduct, advisers face longer unemployment spells, and move to less reputable firms, with a 10% reduction in compensation. Additionally, firms that hire these advisers also have higher rates of prior misconduct themselves. We find similar results for advisers of dissolved firms, in which all advisers are forced to find new employment independent of past misconduct or performance. Firms that persistently engage in misconduct coexist with firms that have clean records. We show that differences in consumer sophistication may be partially responsible for this phenomenon: misconduct is concentrated in firms with retail customers and in counties with low education, elderly populations, and high incomes. Our findings suggest that some firms “specialize” in misconduct and cater to unsophisticated consumers, while others use their reputation to attract sophisticated consumers.
The Market For Financial Adviser Misconduct – Introduction
American households rely on financial advisers for financial planning and transaction services. Over 650,000 registered financial advisers1 in the United States help manage over $30 trillion of investible assets, and represent approximately 10% of total employment of the finance and insurance sector (NAICS 52). As of 2010, 56% of all American households sought advice from a financial professional (Survey of Consumer Finances, 2010). Despite the prevalence and importance of financial advisers, financial advisers are often perceived as dishonest and consistently rank among the least trustworthy professionals (e.g., Edelman Trust Barometer 2015, Wall Street Journal “Brokers are Trusted Less than Uber Drivers, Survey Finds”).
The view is best summarized by Luigi Zingales in his American Finance Association presidential address: “I fear that in the financial sector fraud has become a feature and not a bug” (Zingales, 2015). This perception has been shaped by highly publicized scandals that have rocked the industry over the past decade. While it is clear that egregious fraud does occur in the financial industry, the extent of misconduct in the industry as a whole has not been systematically documented. Moreover, given that every industry may have some bad apples, it is important to know how well financial industry deals with misconduct. In this paper we attempt to provide the first large-scale study that documents the economy-wide extent of misconduct among financial advisers and financial advisory firms. We examine the labor market consequences of misconduct for financial advisers, and study adviser allocation across firms following misconduct. Last, we provide some evidence that firms “specialize” in misconduct and cater to unsophisticated consumers, while others use their reputation to attract sophisticated consumers, allowing misconduct to persist in equilibrium.
More broadly, studying financial advisers provides a lens into markets in which sellers are experts relative to their customers. For example, it is difficult for consumers to ascertain the value of services provided by such professionals as doctors, attorneys, accountants, car mechanics, and plumbers. In these markets, trust and reputation are supposed to prevent the supply of poor services. Disclosure of financial advisers’ misconduct is public, providing a “market mechanism” that should prevent and punish misconduct. One would imagine that in markets with less disclosure, misconduct may be even more difficult to eradicate through competition alone.
To study misconduct by financial advisers, we construct a novel panel database of all financial advisers (about 1.2 million) registered in the United States from 2005 to 2015, representing approximately 10% of total employment of the finance and insurance sector. The data set contains the employment history of each adviser. We collect all customer disputes, disciplinary events, and financial matters from advisers’ disclosure statements during that period. The disciplinary events include civil, criminal, and regulatory events, and disclosed investigations.
We find that financial adviser misconduct is broader than a few heavily publicized scandals. One in thirteen financial advisers have a misconduct-related disclosure on their record. Adviser misconduct results in substantial costs; the median settlement paid to consumers is $40,000, and the 75th percentile exceeds $120,000. Misconduct is too concentrated among advisers to be driven by random mistakes. Approximately one-third of advisers with misconduct records are repeat offenders. Past offenders are five times more likely to engage in misconduct than the average adviser, even compared with other advisers in the same firm at the same point in time. The large presence of repeat offenders suggests that consumers could avoid a substantial amount of misconduct by avoiding advisers with misconduct records. Furthermore, this result implies that neither market forces nor regulators fully prevent such advisers from providing services in the future.
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