How can retail finance customers avoid being ripped off?

A condition for any market to work well is that consumers have enough information to make good decisions. This is rarely the case with services such as finance.


Theory, backed up by a lot of practical evidence, suggests that markets are a good way of organising many economic activities. But for markets to work, consumers need to have a pretty good idea of what they’re looking for, and to be able to judge the competing products. This is fine with TVs, cars and less complex services. I can tell whether I like the TV picture or find the car enjoyable to drive. I don’t know everything about the product but I’m in fairly good position to shop around. If there are also lots of competing products then there’s a good chance the market solution is a good one: I get a decent product that I’m happy with, at a price that is as low as it could be.

The Internet has further improved consumer information by telling me about services I haven’t consumed but others have e.g. restaurants, hotels and shops. Customer feedback overcomes the problem that I need to buy the service to try it. But these services are generally one-off experiences so that even if I make a mistake, it’s annoying rather than disastrous.

But in more complex services such as financial advice, the stakes are much higher (if I make an error I may be poor in retirement) and it is far harder to judge the quality of the provider. The problem is one of asymmetric information: I lack the information (and many people also lack the expertise to judge the information, even if they had it). This is a problem with complex and important services such as medicine, law and finance.

Solutions to asymmetric information

Two solutions exist. One is professionalisation, meaning that the suppliers are (self)organised into a profession with standards, barriers to admission and some form of continuing quality control. This works reasonably well for medicine, law and accounting. But finance is not a profession – there is no agreed body of knowledge and no qualification that guarantees a minimum standard.

So in finance we rely on the second solution: regulation. Wholesale finance is largely unregulated because it is assumed that the buyers have the expertise to judge the service they’re being offered. But retail financial services are heavily regulated in most countries. The regulation typically includes some form of exam for practitioners to prove they have at least basic technical knowledge, rules on advertising and methods of compensation for those who the regulator judges to have been exploited.

But this is not enough. All existing retail brokers are regulated but that doesn’t mean they’re all honest, competent and efficient. An interesting new blog from the University of Chicago Stigler Centre provides fascinating and rather alarming data on US retail brokerages. These are all regulated by FINRA (the Financial Industry Regulatory Authority, which is a private corporation that provides self-regulation under the authorisation of the SEC. Sometimes brokers are found guilty of breaking FINRA’s rules. But previously that data has been hard to find and analyse (perhaps unsurprisingly). Chicago researchers have made that information easily accessible and published a league table of the 30 brokers with the worst disciplinary records. And the results are quite shocking.

The worst broker is Oppenheimer & Co, with 19.6% of its 2,275 advisers having been in trouble with FINRA. Famous names fill the list: Wells Fargo is 3rd (15.3%), UBS is 4th (15.1%), Morgan Stanley is 11th (13.1%). Merrill Lynch, the largest and possibly most famous of US retail brokerages, is “only” 29th with 8.5% of its advisers having been disciplined.

Can you imagine going to a doctor or even a car mechanic where 8% of the employees had been in trouble with the regulator? And how can a firm with one in five of its advisor being disciplined stay in business?

The obvious answer is that people don’t know; this data has in theory been in the public domain but is only now accessible and useful because the University of Chicago made it so. The data also reveal that misconduct is more common in California and Florida, states with a higher proportion of older, retired investors. It’s consistent with earlier research that the retail financial advisory industry is segmented according to the sophistication of the customer, with more misconduct in districts with less sophisticated customers. In other words, systematic ripping off (my words, not those of the University of Chicago).

The paradox of markets needing a non-market agent to help

There is an irony here for those who know the history of economic ideas. Chicago is the traditional home of free market economics, the bastion of those who believe that markets, left to themselves, will mostly deliver the best outcomes. Winner of the Nobel memorial prize for economics in 1982, George Stigler, after whom the centre is named, was a leading exponent of this view and a deep sceptic about government intervention.  But the blog authors make clear that the act of publishing this information is not a profitable one. They are producing a public good – a service that is valuable to many people but not commercially profitable to supply. This is a well known form of what economists call market failure which creates a case for state intervention.

It is a kind of paradox long known to economists that markets can indeed function well but sometimes need outside help from the state or some other non-profit seeking entity. In this case, the provision of the information could make the market work much better. One would like to think that Oppenheimer might come under some competitive pressure to improve the performance of its advisers if the public knew about their record.

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