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The letter and the spirit of the law

How ticking every compliance box can still fall foul of the regulation

There’s perhaps no word that more reliably follows ‘regulatory’ than ‘burden’. And when they’re found together, it’s a good bet that ‘increasing’ will not be far behind. This is not only unwelcome to those that have to shoulder the burden, but it’s also unnecessary.

There are two sides to any set of laws: the words themselves, and the intentions (or spirit) behind them. When we focus on the former, we risk overlooking the latter, which leads to poorer client outcomes, and - because of that - additional burdens to bear.

The spirit of financial advisory regulations is clear: to protect clients from bad investments, from unscrupulous salesmen, and from themselves. They aim to increase a client’s comfort and confidence with investing – to arm them with a greater understanding of what they’re investing in, and why. This principles-based regulation has many advantages, but it’s not without issues. Because if the intentions of the rules are not being met, then the answer (assuming adequate law enforcement) becomes… more rules! Each bit of bolted-on regulatory refinement may be well-meaning, but it’s still another form for a firm to fill in, or box for a client to tick.

Comfort and confidence are emotional states, triggered by internal traits colliding with external circumstances. And you don’t manage that by looking through a limited, letter-of-the-law lens. A focus on the letter of the law can leave advisers feeling like they’re playing a constant game of catch-up. To make matters worse, a focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being followed at the expense of meeting the very outputs the laws are there to produce. You get what you incentivise.

Client comfort and confidence starts with client engagement

Think first of first impressions. A first impression could be the difference between a client engaging with the very concept of investing, or turning off, from the off, becoming forever dependent and vulnerable. Compliance at the start of an investment is vital. But trying to get everything out of the way as soon as possible is counterproductive. Moreover, understanding of both the client and how they interact with their investments naturally grows over time, built by the ongoing feedback loop fed by each adviser-client and client-investment interaction.

Understanding is not helped by haste or volume, or by failing to highlight a clear link between a request and its ultimate importance for the requestee. A risk and financial personality assessment should have clear consequential prescriptions. Requests feel less demanding when the end purpose is clear. An emotionally understood investor is an engaged investor.

Think second of trust. The adviser-client relationship, and therefore a huge element of client comfort, relies on trust; and it’s eroded when the tools designed to help feel like a hindrance.

Overlooking the spirit of the laws is easy, but dangerous, because it’s the spirit that will always be the final judge of whether a course of action is suitable or not. Recall, for example, the FCA’s 2011 guidance which stated that they’d “reviewed 11 risk-profiling tools and were concerned to find that nine tools had weaknesses which could, in certain circumstances, lead to flawed outputs.”

Consider too the ability to take risk. The spotlight is now turning on risk-capacity calculations, because they’re commonly not calculations at all. Instead, capacity assessments are often based on qualitative statements or workarounds, which are not designed for the purpose of quantifying affordability over a lifetime in the context of fluid and uncertain circumstances.

Time horizon is perhaps the classic example of the potential for unintended consequences. It’s entirely sound that an investor’s time horizons are considered. But the plural is important. ‘What is your investment horizon?’ is a meaningless question, usually with options - like ‘3, 5, or 7 years’ - that are simultaneously leading and misleading. Investment time horizons are, by definition, spread across competing, and flexible, goals. Reducing this to a single tick in a box or a mark on a line often forces investors to state a horizon that is shorter than their true goals, which runs counter to all good advice on investing as a long-term activity.

Outputs also decay: suitability is an ongoing process, so snapshot assessments are insufficient. Of the main elements of suitability, only risk tolerance is broadly stable across time. Comprehensive compliance therefore must be as dynamic as the investment journey it supports. Confirming the right level of investment risk for a client prior to investing is non-negotiable. But that right level is subject to change: the assessment needs to keep pace.

Concentrating on the ultimate intention of the regulations also helps reduce confusion caused by trying to measure the suitability of a portfolio across different levels, i.e. tied to a specific goal, general goals, an individual, or a family unit. Zoom out and assessing suitability becomes much clearer. Suitability is a system that needs to function with a clear understanding of the whole set of assets and liabilities to be included as being ‘suitable’, and which beneficial owner, or set of beneficial owners this set of assets is suitable for.

The hidden dangers of hiding behind boxes

It could be argued that all talk of ‘spirit’ is a bit unscientific, and no defence against a regulatory judge. This would be wrong. It is far more dangerous to rely on blind box-ticking with evidence only of the answer, not the process, or the reason, or what the question was, or why it was being asked. When it comes to assessing suitability, the message you send about what is being invested in is less important than the one the client receives.

The focus should be much less on acquiring client knowledge for the purposes of ticking boxes, and much more on how we use this knowledge in coherent suitability frameworks that reflect an understanding of what truly matters to investors. And profiling shouldn’t stop when investment starts. It should be married to, not divorced from, the ongoing client relationship, dynamically adjusting to meet changing circumstances.

Regulations are getting more rigorous, but their pattern is predictable. And reacting to regulatory changes is less efficient than anticipating them. A focus on the spirit of the laws should ensure that regulatory requirements are met as a side-effect of following processes designed for other purposes.


Greg B Davies, PhD - Head of Behavioural Science, Oxford Risk

Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing.

He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade.

In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions.

Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioral Investment Management.

Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.


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