Swiss regulation on client risk-profiling

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Financial advisors in many countries are now required to offer financial products adapted to their client’s risk profile. Switzerland is no exception and is progressively aligning with European regulation to maintain the competitiveness of its financial services industry.


why client risk-profiling?

Following the financial crises in the 2000s, financial regulators strengthened investor protection policies. In particular, regulated firms providing investment advice are now obligated to make suitability checks on behalf of the investor. Financial Advisors should know their clients, in order to recommend them products that are suitable for their investor profile. In Switzerland, client suitability assessment is regulated at several levels, but the 2015 Federal Financial Services Act creates a new common basis for stricter regulation, in part driven by the need to harmonize with MiFID II.

How is risk-profiling regulated?

Risk-profiling is regulated at three different levels in Switzerland:

  • Self-regulation, that is to say that institutions abide by rules of conduct determined by professional organizations such as the Swiss Bankers Association (SBA) or the Swiss Association of Asset Managers (SAAM);
  • Guidelines issued by the regulator, i.e the Federal Financial Markets Authority (FINMA);
  • Since 2015, at the federal level by the Federal Financial Services Act (FINSA).

Regarding cross-border financial services providers operating in the European Union, European regulation already applies de facto.

The evolution of regulation in Switzerland is driven by two main factors:

  • A need for stronger investor protection measures;
  • Progressive harmonization with EU regulation to maintain the competitiveness of the Swiss financial services industry.

what does the law say exactly?

Under FINSA, investment firms are asked, in certain cases, to run suitability tests by checking their client’s:

  • Appropriateness: Financial experience and knowledge;
  • Financial situation;
  • Investment objectives.

Under FINSA, investment firms can be required to perform the full suitability test, only the appropriateness test, or no test at all depending on the kind of service provided:

  • No check is required in case of execution-only transactions on a reverse solicitation basis (demanded by the client);
  • The appropriateness check is required when providing investment advice regarding a specific transaction;
  • The full suitability check is required when providing investment advice on the client’s whole portfolio or when providing portfolio management services.

In addition, while investment firms are required to perform these checks as set out above, the law does not prevent firms from providing the service when judging that a product is unsuitable or inappropriate, or even if it cannot gather the information required to carry out the suitability check. In these cases, the client will simply be warned of the advisor’s opinion or that the check will not be performed for lack of information.

Below is a summary of the main differences between FINSA and MiFID II:

Service provided MiFID II FINSA
Execution-only (non-complex) Appropriateness No check
Execution-only (complex) Suitability No check
Specific investment advice Suitability Appropriateness
Investment advice on portfolio Suitability Suitability
Portfolio management Suitability Suitability

Therefore, while the law constitutes great progress in the process to harmonize Swiss and EU regulation, it leaves the finer details to the regulator.

what is the regulator’s take on the subject?

The Swiss Financial Markets Authority (FINMA) issued a set of Guidelines for the recognition of self-regulation in asset management as a minimum standard in 2009.

As mentioned above, the investment services industry in Switzerland is largely self-regulated, by way of professional organizations. These guidelines simply state the minimum standard self-regulation must attain in order to be recognized by the regulator.

These guidelines clearly state the need for client risk-profiling. Investment firms should:

  • Draw up a risk profile outlining the client’s risk tolerance and risk capacity, taking into consideration the client’s experience and knowledge;
  • Define the investment strategy based on the client’s risk-profile, financial situation and investment restrictions;
  • Ensure that the investments are always in line with the risk profile and the designated investment objectives and restrictions;
  • Review the investment strategies employed on a periodical basis and assess whether the clients’ risk profile is in line with their current financial circumstances. If this is not the case, clients are to be made aware of this and it must be made in writing.

These guidelines establish strong requirements for self-regulation and are re-stated in official documents by the main professional organizations:

  • The Swiss Bankers Association’s Portfolio Management Guidelines (2013): “The bank draws up a risk profile that is in keeping with the client’s risk appetite and risk capacity, while reflecting his/her financial situation, investment objectives, knowledge and experience”;
  • The Swiss Association of Asset Managers’ Code of Conduct for Independent Asset Management: “the asset manager must obtain information from the client with regards to his investment requirements, appetite and tolerance for risk to establish a risk profile. The asset manager shall produce a risk profile on the basis of the gathered information and carry out periodic reviews as to its accuracy or whenever changes occur”;
  • The Swiss Funds and Asset Management Association’s Guidelines on the Distribution of Collective Investment Schemes: “In the case of distribution to non-qualified investors, and to qualified investors as defined in Art. 10 para. 3bis CISA (high-net-worth individuals) who do not waive advice, the Distributor must take the investor’s individual needs into account, in particular their risk tolerance and risk capacity.”;
  • The Association Romande des Intermédiaires Financiers’ Code of Deontology Concerning the Exercise of the Profession of Independent Asset Manager: “They must question the client in order to determine his/her experience and knowledge of finance, and his/her (subjective) propensity to take risks and his/her (objective) capacity to bear them and must record them in writing. After having defined the client’s risk profile, the asset manager and the investment adviser determine with him/her the investment strategy, that is, the investment objectives and the asset allocation, as well as the investment restrictions”.

How does Swiss regulation relate to MiFID II?

The evolution of Swiss regulation in recent years has mainly been driven by the development of similar regulation in the EU, notably the MiF II Directive. A large part of the Swiss asset management industry thrives on cross-border business.

MiFID II requires third countries to guarantee that the level of investor protection is equivalent to EU provisions, making MiFID II provisions indirectly applicable to Swiss investment services providers offering their services in the European Economic Area. Failure to comply with these requirements will result in a refusal by the European Securities and Markets Authority (“ESMA”) to issue its so-called “equivalence decision” to enable Swiss financial institutions to be registered with ESMA and provide services to EU-based Eligible Counterparties and Per Se Professional Clients.

Therefore, it is a matter of competitiveness for the Swiss investment services industry to comply with MiFID II, and EU regulation is progressively becoming best practice for the industry in Switzerland.

Below is a summary of when and how MiFID II applies to Swiss investment firms:

Service model Booking Center Advisor Client MiFID II relevance
1- Onshore CH CH CH CH None
2- Cross-border CH-EU CH CH EU Indirect
3- Shared relation CH-EU/EU-CH CH/EU CH/EU EU Direct
4- Onshore EU (incl. Passport) EU EU EU Direct
5- Cross-border
/Shared relation CH-Non-EU
CH CH/Non-EU Non-EU None
6- Cross-border EU-Non-EU EU EU Non-EU Direct

In short, Swiss companies offering exclusively on-shore services (1), or services to non-EEA third countries (5) are not affected by MiFID II, while those having cross-border business with EEA-based clients are concerned indirectly (2) and those operating partially or completely in the EEA (3) are concerned directly.

what do EU provisions say exactly?

Under the European MiFIDII, investment firms are asked to run suitability tests by checking their client’s:

1) Appropriateness: Financial experience and knowledge;

2) Financial situation;

3) Risk profile. Client’s risk profile often includes investment objectives, time horizon, risk tolerance and ability to bear losses.

Under the European MiFIDII, the whole client suitability assessment is only compulsory for portfolio management and investment advice. For other investment services, only appropriateness assessment is most of the time required[1]. (DIRECTIVE 2014/65/EU (25)(2)(3)(4)).

In order to ease the implementation of these new requirements, the European Regulator has published additional guidelines and technical advice intended to help with the construction of compliant risk-profiling tools.

Below is a summary of technical advice by ESMA (MiFIDII) in 2014 (ESMA/2014/1569):

  • Consistency control: Financial intermediaries should take appropriate steps to control the coherence and consistency of their client’s risk profile with other client’s information.
  • Loss aversion assessment. Putting more weight on the level of loss rather than risk that the client is willing to take.
  • Recording and updating of client’s information at a relevant frequency.
  • Simple language. The investment firm should ensure that questions are likely to be understood by the client.

On top of 2014 technical advice, it is useful to recall some complementary guidelines by ESMA on MiFID in 2012[2]:

  • Using concrete examples. For instance, instead of asking a client whether he feels comfortable with risk-taking, the client can be asked his level of loss over a given period of time he would be willing to accept, either in the individual investment or his portfolio. ESMA gives the following example: ‘’ How would you cope with permanently losing 10000 euros on your 50000 euros investments?’’
  • Avoiding the dissimulation of risk-profiling scoring. Information disclosed to the client should not include the way risk profile is established.
  • Tailor-made questionnaires. ”When questionnaires are used, they should, when and as they deem appropriate and also to the extent possible in terms of costs, be tailor-made.” Esma guidelines, 2012.
  • Taking demographic data into account, such as age, marital status, family situation (number of children), employment situation or need for liquidity.

what are the institutions targeted by these obligations?

These requirements apply to a broad range of institutions:

  • Banks;
  • Securities dealers;
  • Fund management companies
  • Custodian banks;
  • Asset Managers Collective Investment Schemes (CIS);
  • Distributors;
  • Representatives of foreign CISs;
  • Other intermediaries regulated by the Collective Investment Schemes Act.

how Are client’s risk profiles assessed today?

To comply with regulation, Financial Intermediaries often opt for a paper questionnaire with few explicit questions. 85% of them are designed in-house[3] and their diversity is huge. In our analysis of 504 of these risk-profiling questionnaires from 50 different countries including Switzerland (52% from European Union), the number of questions varies from 1 to 25. 49% of them evaluated risk tolerance directly with the question: “What is your risk attitude?” or “Which option best describes your risk attitude?”. Only 54% took loss aversion into account.

Why are regulators and scholars concerned about risk-profiling today?

Over the past decade, many academic and official reports, especially in Europe, have pointed out the lack of compliance and scientific validity of investor-profiling questionnaires.

In an analysis run by UK-FSA in 2011, 54% were judged unsuitable because of their failure to measure risk attitude.

In another report by AMF in 2011, “one third of the audited questionnaires have an overall explanatory power that exceeds 25% (with a maximum of 37.6%), while another third fall short of 10%. (…) Ten of the 14 questionnaires deal with risk‐taking preferences but often in a superficial manner. Only 8 questionnaires attempt to quantify preferences regarding risk taking and the questions asked are often too vague to be of any real help for ensuring that clients are sold suitable products.”

Similar conclusions have been drawn from studies run by other European Member States[4]:

  • The definition of risk is not clearly separated from the notion of loss;
  • Questionnaires do not integrate the basics of psychometrics, econometrics and behavioral economics to properly assess customer risk profile;
  • The scoring method of the questionnaire is often too simple and displayed to the client;
  • Most questions are judged either oversimplified or too technical or ambiguous;
  • There is a huge heterogeneity in the number of questions from one questionnaire to the other;
  • The consistency of answers is not controlled;
  • Firms do not make the effort to gather sufficient information about the client, especially his investment objectives and financial situation (education, profession…);
  • Firms over-rely on client’s self-assessment;
  • Firms attempt to evade their responsibility to give suitable advice by giving the impression that it is the client who decides on the suitability of an investment;
  • Data recording on the suitability process is poor;
  • Firms over-rely on poorly designed risk-profiling and asset-allocation tools.

A few years after the publication of these reports, regulators still have concerns about risk-profiling compliance (FCA, 2014).

Why does risk-profiling implementation turn out to be so difficult for financial intermediaries?

Following these alarming reports on investor profiling by financial intermediaries, regulators have consulted practitioners to better identify the difficulties of directive implementation[5]. Some factors are listed below:

  • The notion of risk is difficult to apprehend;
  • Clients hold such questionnaires as intrusive, boring and time-consuming;
  • Financial advisers had implemented, in a formal or informal way, such client suitability procedures before and do not understand why they should spend money and time to change them;
  • Responsibilities in product choice based on the answers of the questionnaire are ambiguous;
  • Front Officers are not trained in the basics of psychometrics, econometrics and Behavioral Economics which makes it hard for them to build a compliant and scientific tool;

Behavioral Finance as a solution to client suitability assessment burden

Recent reports by both regulators and academic scholars have promoted the use of behavioral finance findings to solve the issue of client suitability assessment for financial intermediaries. Behavioral Finance includes in its models psychological factors which highly impact investment decisions, contrary to what is held by conventional finance. Popularized by Nobel-Prize winners Kahneman and Tversky in the 1970s, behavioral economics have been very successful in the academic world for their application in finance, law and economics. However, behavioral economics have had limited applications in the field of business so far. Reports below highlight the benefits of using these theories to help financial advisors better understand their client’s psychology and needs.

Neuroprofiler: Turning Client suitability into a science

Based on the last advances of behavioral finance, Neuroprofiler is a user-friendly solution to Client Suitability Assessment burden. Some of the application assets are listed below:

  • Concrete and simple investment scenarios in plain-English;
  • User-friendly interface which makes suitability assessment entertaining for the client.
  • Based on the last advances of behavioral finance and machine learning;
  • Consistency control of client’s answers;
  • Loss aversion assessment;
  • Complex risk-profiling scoring which makes the test hard-to-cheat both for the client and the financial advisor;
  • Adaptive and tailor-made questionnaire generated by a machine-learning algorithm.
  • Integration of demographic data, such as age, marital status, family situation (number of children) or employment situation.
  • Recording of data through a user-friendly, online and responsive platform. Both clients and financial advisors have access to their test history on their personal device.
  • Easy updating of client information. Financial advisors simply have to send a web link to their clients in order to update theirs risk profiles.
  • E-Training to help financial advisors to better understand the psychology of their clients and better address their needs.

 

BIBLIOGRAPHY

 

ARIF, Code of Deontology Concerning the Exercise of the Profession of Independent Asset Manager

Commission directive 2006/73/EC. Official Journal of the European Union.

Conseil Fédéral (2015). Message concernant la loi sur les services financiers (LSFin) et la loi sur les établissements financiers (LEFin)

DELMAS-MARSALET, J. (2005). Rapport relatif à la commercialisation des produits financiers. La documentation francaise.

Département Fédéral des Finances. Analyse d’impact de la loi sur les services financiers (LSFin) et de la loi sur les établissements financiers (LEFin)

Directive 2004/39/EC. Official Journal of the European Union.

Directive 2006/73/EC. Official Journal of the European Union.

Directive 2008/10/EC. Official Journal of the European Union.

Directive 2014/65/EU. Official Journal of the European Union.

Doncel, L. M., Reinhart, W., & Sainz, J. (2008). A behavioral approach to MiFID. Banks and Bank Systems, Volume 3, Issue 1.

ESMA. (2010). Public hearing on the “Review of the Markets in Financial Instruments Directive (MiFID)”. Brussels.

ESMA. (2014). Consultation Paper on MiFID II/MiFIR.

ESMA. (2014). Investor Protection Aspects of the Consultation Paper on MiFID II and MiFIR.

ESMA. (2014). Response form to the MiFID II/MiFID Consultation Paper.

ESMA. (2012). Final report: Guidelines on certain aspects of the MIFID requirements.

European Commission. (2011). Consumer market study on advice within the area of retail investment services. Final Report. http://ec.europa.eu/consumers/rights/docs/investment_advice_study_en.pdf.

EY (2012), MiFID II: Need for Action for Swiss Investment Firms

EY (2016), Swiss Regulatory Update Banking 2016

FINMA (2009). Circular 2009/1 Guidelines on asset management Guidelines for the recognition of self-regulation in asset management as minimum standard

FINMA (2012). Regulation of the production and distribution of financial products (FINMA position paper on distribution rules)

European Commssion. (2011). Consultation on the review of the MIFID.

Faff R.W., H. T. (2004). An empirical investigation of personal financial risk tolerance. Financial Services Review, 13(1): 57-78.

Ferber, M. (2012). Review of the Markets in Financial Instruments Directive Questionnaire on MiFID/MiFIR 2. MEP.

FSA. (2006). Levels of Financial Capability in the UK. Results of a baseline survey. http://www.fsa.gov.uk/pubs/consumer-research/crpr47.pdf.

FSA. (2011). Assessing suitability: establishing the risk a customer is willing and able to take and making a suitable investment selection. UK.

Hübner, G., & Plunus, S. (2013). Accommodating profile dynamism in MIFIDII. Revue Bancaire et Financière.

Jung, E. a. (2008). Anforderungen an Finanzvermittler. German Consumer Affairs Ministry.

Marinetti, N. M. (2012). Risk Profiling and Current Suitability Practices: What Can Be Learned from a Sample of Italian Householders. Research paper.

Mazzoli, C., & Marinelli, N. (2011). An Insight Into the Suitability Practice: The Standard Questionnaire Dilemma. research paper.

Mazzoli, C., & Marinelli, N. (2014). Determinants of Risk-suitable Investment Portfolios: Evidence from a Sample of Italian Householders. International Journal of Finance and Banking.

McGoldrick, S. (2012). Making Sense of MiFID. FIXGlobal.

N.Linciano, & Soccorso, P. (2012). Assessing investor’s risk tolerance through questionnaire. CONSOB.

Open hearing on MIFIDII. Paris. (2014).

Palma, A. d., & Picard, N. (2011). Evaluation of MIFID questionnaires in France. AMF.

Swiss Association of Asset Managers (2013). Swiss Code of Conduct for Independent Asset Management

[1] See 25(4) for exceptions

[2] Guidelines on certain aspects of the MiFID suitability requirements, Final Report, ESMA, July 2012

[3] Global Private Banking and Wealth Management Survey, PwC, 2014

[4] Evaluation of MiFID questionnaires in France, AMF, 2010.

Assessing investor’s risk tolerance through a questionnaire, Consob, 2012.

Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection, FSA, 2011.

[5] Guidelines on certain aspects of the MiFID suitability requirements, Final Report, ESMA, July 2012

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