January 29, 2015
Authored by: Dan Wheeler
Have you thought about offering your customers wealth management services? The fee opportunities are attractive and the regulatory issues are more manageable than you might think.
Why should a bank’s board directors consider entering the wealth management business? For one, several of your competitors are already doing so. Wells Fargo already employs over 15,000 financial advisors and is looking to serve an even broader swath of the mass market than it already does. And, according to the American Banker, approximately 25% of all banks plan to offer wealth management services by the end of 2016, according to a survey conducted by that publication. If that survey data is representative across the banking industry, your board would not be in the leading edge if you are not considering the risks and rewards of building or acquiring a wealth management division.
This article assumes that U.S. community banks are not looking to compete directly with the largest private banks in advising billionaires on anything from buying a private jet to investments in complex derivatives. Instead, most community banks will offer basic wealth management services, including administering retirement assets held in 401(k) plans and IRAs, advice in setting up educational and health savings plans and perhaps basic trust services to assist in administering family trusts. Other service offerings, such as insurance, securities custody, securities lending, securities clearing and settlement, are sometimes considered part of wealth management or trust services, but this article does not discuss those other services because they are generally not a good fit for community banks, at least in the early stages of launching a wealth management division. Basic wealth management services are, at least in theory, a natural complement to the business of offering deposit services and loans to wealthier bank customers.
Your bank should determine whether it needs trust power from its chartering state in order to operate its particular wealth management division. State laws determine what activities constitute fiduciary or trust powers; it is not controlling whether the bank labels its activities as a “trust” or “fiduciary” in nature. A bank should consult counsel to understand whether it needs to apply for trust powers under state law and/or for FDIC consent to exercise those trust powers. Generally, FDIC consent is not required for a bank to start or acquire an investment adviser subsidiary.
The business of managing assets and, in appropriate cases, acting as fiduciary for high net worth customers is one at which community banks should excel. After all, community banks emphasize better service, local presence and personal relationships. However, the biggest banks dominate this business. Industry research indicates that the top 10 trust companies hold 60% of all trust assets. Despite this current dominance by big banks, most customers, other than the wealthiest, receive less than satisfactory services from the big banks.
The attractions of the asset management business for a community bank are straightforward.
- Stable revenue. There is much lower volatility to a revenue stream that depends only on the amount of assets under management. Fluctuations in interest rates and the credit quality of your customers have little or no effect on your asset management business.
- Stable and increasing profitability. Assets can be increased dramatically but the supporting infrastructure can expand much more slowly. Generally, private banks earn revenues of about 1% of the assets they manage, although banks in the U.S. earn a bit less. According to McKinsey, such fees leave banks with a margin of about 0.35% of their clients’ money under management.
- Low capital requirements. S. banks are not required to hold regulatory capital against assets under management for clients nor are there any bonding requirements.
- High demand. Many experts believe that, with the decline in private and public pension plans, younger generations have no choice but to ensure growth of their retirement assets. New households and individuals needing wealth management services emerge constantly.
- Wide open market. A community bank can, by offering a simplified suite of services, afford to take on customers that the larger banks and asset managers cannot.
There are several challenges to overcome in a bank’s launch of a wealth management division.
- Achieving adequate scale. Obviously, too few assets make a wealth management division with its fixed costs, a money loser. Across the industry, $40 million in assets under management is considered the minimum to break even. Many banks report that natural cross-selling to their largest depositors produced the most immediate and significant returns. Simple referral fee arrangements can be designed to incentivize bank staff to refer appropriate customers to the wealth management division. Other ways to achieve critical size are purchasing an asset management firm or acqui-hiring one or more local boutique wealth management practices to quickly assemble a book of business and achieve profitability. Banks that exit the wealth management business usually do so because they failed to achieve adequate scale in time or did not realize that success in the business requires a long-term commitment. It can take 5-10 years to achieve profitability when starting from scratch. However, today’s technology and customers’ comfort with it allows small banks to profitably serve smaller accounts than ever before, which helps shorten the time to profitability.
- Regulatory and compliance issues. As a stand-alone business, asset managers have traditionally enjoyed a light regulatory environment. This is changing somewhat, due to the bank regulators’ interest in what they call the “shadow banking” sector, a category into which they place asset managers, at least the largest ones. This concern is discussed in the Financial Stability Board’s publication, Strengthening Oversight and Regulation of Shadow Banking: An Overview of Policy Recommendations. However, as a general matter and particularly for a bank, the additional regulatory burden of a wealth management division remain manageable. And, to be clear, Regulation Y specifically allows banks to provide investment advisory services.
- Adviser registration not required for an in-house wealth management division. Banks and bank holding companies are specifically excluded from the definition of “investment adviser” under the Investment Advisers Act of 1940 unless the bank acts in an unusual capacity as an investment adviser to a mutual fund, closed-end fund or unit investment trust. Thus, community banks can avoid the SEC’s requirements to register as an investment adviser if they keep the adviser activities within the bank. If that business is spun off into a subsidiary or a sister company, then that entity would have to register with the SEC and be subject to SEC examination. In addition, states generally exclude banks from investment adviser registration under their version of the Uniform Securities Act. Putting wealth management into a separate entity can have perceived value in isolating associated liabilities away from the bank. But, in practice, those benefits are outweighed by significant compliance cost savings when the division is part of the bank and the bank’s insurance coverage can be adjusted to cover any additional liability risks. It is not necessary that a bank offer both investment advisory and trust services. A bank can offer either independently. If a bank wishes to offer trust services, then doing so as part of the bank reduces compliance burdens. In some jurisdictions, a non-bank entity that operates a trust business must obtain deposit insurance even if the entity does not act as depository.
- Adequate audit program, controls, policies and procedures. Bank regulators examine investment advisory activities of banks with a focus on the adequacy of audit programs and the prevention of self-dealing and improper conflicts. Community banks can minimize their compliance burden by (1) using an unaffiliated third party custodian to hold customer assets, (2) not setting up or advising a mutual fund or other proprietary investment company and (3) keeping the wealth management division as part of the bank, and not a separate subsidiary or affiliate. A bank that avoids those three problem areas can focus on the tasks of educating its board on its oversight role, designing a compliant internal referral fee process and the other necessary policies and procedures, obtaining good pricing from, and supervision of, its securities custodian and third party service providers and auditors.
- Avoiding broker-dealer registration. Depending on the exact nature of the activities the bank intends to engage in as part of its wealth management division, the bank may need to organize the division into a separate entity and register it with FINRA as a broker-dealer. This can be avoided by ensuring that transactions in securities are effected through a third party broker-dealer, as is typical for investment advisers, and that personnel in the wealth management division (or elsewhere in the bank) do not engage in market making, securities underwriting, capital raising and similar activities.
- Acquiring the right staff. The task of appropriately staffing a wealth management division may be the most significant challenge, according to banks already in the business. In an American Banker survey, 29% of banks say that they rotate wealth management advisers through the bank’s branches, 17% use full time advisers and 24% concentrate the advisors in a private banking office. For community banks, the most fertile source of candidates are talent at big bank wealth management divisions who are frustrated with the bureaucracy and are looking to better serve their clients in a small bank environment. A key role is a dedicated compliance officer with training and skills specific to wealth management in the bank environment.
- Technology, systems and controls. Fortunately, there are several service providers who specialize in providing the technology platform for investment advisers. This is not something your bank has to invent or build on its own. However, banks must carefully manage such vendors and service providers as they do in other areas in line with detailed regulatory guidance in this area.
Entering the wealth management business is primarily a matter of careful strategy and execution and secondarily a capital investment. Your bank has handled more complex tasks. You can do this if you decide it is the right strategy for your bank.
This article was originally published on the Western Independent Bankers Directors Directors Digest.