Prof. Eugene Kandel from Tel Aviv University: The current proposal of separation of Mutual and Provident Funds from Banks will not yield an educated retail clientele.
I am sure that the authors of this report had good intentions, and perhaps good things will come out of it, but I am doubtful that we will get all what we are promised from this reform. I do not want to sound negative, so given the 15 minutes I have, I would like to mention a positive aspect of the committee suggestions, and then to point out some problems with the reasoning in a couple of areas.
But first, I would like to comment on the process. It would be inconceivable in the US that several government officials, as talented and committed to market reforms as they are, would come up with such a major reform in the capital market without engaging in a serious open debate regarding its consequences. In the US such proposal would have been first analyzed by the Council of Economic Advisors (a group of prominent academics), and would then be open for comments from various communities; which usually draws much input from the academia. Before being brought to Congress, the Congressional Budget Office would go over it as well. Unfortunately, Israel has neither CEA nor CBO, so a reasonable step would have been to include academics in the committee. The current outcome shows that certain issues were not completely thought through.
The large banks in Israel are involved in so many activities, that they compete wit themselves in practically every initiative. This fact has two negative effects: first, most of the decision-making regarding the allocation of capital in the country is made by a few people. This is not optimal, given the rapid changes in the market place and the importance of the opinion diversity as the source of innovation. Second, banks have little incentives to introduce financial innovation, in fear of cannibalizing their existing lines of business. So if the separation of the Mutual Funds and of the Provident Funds creates new decision making centers, and financial powerhouses that advance innovation – then it is an important step. Indeed, it may make the banks more innovative as well. This goal is not found in Bachar's report, but it may be a very important side effect.
What the report does stress is that the separation will solve many conflicts of interests that banks have vis-à-vis their clients. The report outlines several sources of Conflicts of Interests associated with the bank's multiple activities – I add my comments:
Banks are debtors and underwriters at the same time, thus may have an incentive to underwrite firms that owe them money and to provide biased information to the investors in an IPO. The first part was never documented in empirical studies that looked at this question. The second part is endemic everywhere– the underwriter has an incentive in a positive demand, thus tend to exaggerate the quality of the issue. It has been shown that the market adjusts for that. This is not a serious issue.
Banks are underwriters as well as money managers – the former have captive demand for their IPOs. This has been shown to exist in the early 1990's – banks tended to use their money management arms to buy the IPOs that were underwritten by them. It is not clear whether this is a problem for competition in the money management market, or the IPO market. However, since the introduction of the independent directors into the money management affiliates of the banks, such actions would be very hard to pass in the board.
Banks as debtors and money managers – will direct investments to firms that owe bank money. This is also a very problematic action – the board will not agree, just as in 2.
Banks are service providers and money managers – the latter buy more expensive services from the former. The tendency of investment managers to churn the portfolio can be added here. This practice will undoubtedly hurt the returns, so if the competition for the money management services (mutual and provident funds) exists, then the extent of this problem is limited.
Banks are investment advisors and money managers – provide biased advice to retail clients. I consider this the most serious issue, and would like to focus on it.
In particular I would like to focus my remarks on the question of Advice versus
Marketing, as well as on the merits of greater competition, which is so hailed in the report.
Advice – the report paints a somewhat idyllic picture in which banks, free of conflicts of interest, will provide an independent advice to retail clients and will get compensated by commissions, just as it does in the case of stocks. Unlike stocks, mutual and provident funds are savings instruments that are used by the majority of the population. Some of them are in direct competition with the banks' own programs. Moreover, to provide independent and unbiased advice on financial products that are appropriate for the client, the financial advisor must spend time studying the clients' needs, her attitudes to risk, and her current portfolio, and only then recommend a combination of instruments. This will require a much more competent staff than is currently available, better support systems, but most of all – time. The commission is supposed to cover these costs.
Competition. At the same time the report jubilantly announces that competition among advisors, as well as with the marketers will drive the costs to their competitive levels. What is the competitive level of commissions? Recall that a Marketer of a product (who does not pretend to give unbiased advice, just sells his products) is allowed to get paid by the fund, while the Advisor is not. This means that the Marketer will always be able to charge a lower commission than an Advisor, who has higher costs. This cannot be equilibrium. In fact, this problem had been known in economics for at least 25 years:[1] it is classical case of a free riding on service – service provision as a part of price competition does not work very well- at the end the service disappears, or becomes a separately priced item in various form. In the US financial advisors act like Marketers, but sell funds that charge loads, from which the marketers are paid. I am not aware of any financial advisors that are paid commissions in the US or in Europe.
Can we price advice separately? Probably not. Recently a large firm hired a respected pension consulting firm to provide advice for its workers. They were able to get a full inspection of their pension and life insurance needs by an expert for only 300 NIS, which is far below the costs. Out of 4000 people working for the company less than 30 were willing to pay this price; and gave up on advice that may save tens of thousands of shekels over their lifetime. Other advice venues that rank performance of investment managers get very limited interest from the retail investors. This is in a stark contrast with the US and Europe, where professional evaluation services, e.g. Morningstar, get millions of paid subscribers, and funds use these rankings in advertising.
This leaves me with an uneasy feeling about the upcoming equilibrium in the advice market. In my opinion the outcome will be that the retail investors will be completely in the dark about what they need, and which providers offer better products.
Given this conclusion, let us move to competition among the money managers, which is strongly encouraged by the Ministry of Finance. My Ph.D. is from the University of Chicago, and I am very much in favor of competition. Unfortunately, many times people overllok the simple fact that the competition is a good tool, and not a goal by itself. This tool works well only when certain conditions are met. One of the most important conditions is that consumers know what they want, how to evaluate the quality of a product, and can compare products. This is not the case with financial services. Nor is it a case with legal and medical advice, insurance services, and pharmaceuticals. All these have an uncertain (and noisy) future outcome, which a layman cannot predict with any degree of precision. Thus, price competition in these services never works very well – no matter what we do. Today's cheaper advice may translate into tomorrow's very expensive fiasco. While Mrs. Cohen from Hadera does not choose her own medicines (she is even not allowed to in some cases) does not represent herself in court, for some reason she feels capable of choosing her pension plan or a provident fund.
We have established that retail clients do not know how to choose financial products, and get very poor advice. So how do our clueless retail clients evaluate and choose financial products? By the most recent return, of course. They get this message from the media, which keeps publishing the most recent darling (last month, last quarter, and last year in the best case), ignoring the risks, and the possibility of manipulations. They also get this message from the Ministry of Finance, which stresses performance and wants the funds to report it daily. ong message from the media, This leads to two very dangerous phenomena:
Consumers "chase performance", thus on average choose more manipulative and high-risk funds. It is a losing proposition for them.
Given (1) the funds become more prone to manipulations, and to risk taking – this is really the main problem. In fact I was shocked, when I saw late last year an ad of a pension fund stating that it is the best choice for pension savings, because its returns over the last 3 months were the highest among its peers. If the they do not see the danger in this phenomenon, then the future pensioner are in trouble.
To summarize: in my opinion, the current proposal of separation of Mutual and Provident Funds from Banks will not yield an educated retail clientele. Education of the population is the only way to make the competition work, and the Bachar report is completely silent on this. Without this, there is a danger that competition among many small funds exacerbates the problem of manipulations and risk taking. More thought is required on this issue.
Remarks
[1] Recall the absence of the academic economists in the committee.