One Compliance Tale in Time of Covid

As we all struggle to understand the new compliance challenges forced upon us by covid, today I pass along an example relayed to me by a compliance officer working in financial services. From nitty-gritty issues of policy and procedure, to substantive questions about risk assessment, my friend told quite the thought-provoking tale. 

We’ll call my compliance officer friend Frank. He works at a wealth management firm with more than $50 billion in assets under management — so, a wealth management firm of respectable size, but not huge. His firm works with financial advisers, providing capital and financial planning services to those advisers as they work with their clients, who tend to be high-net worth individuals. 

All of last week, Frank told me, he was inundated with calls from those financial advisers seeking approval for loans so they could invest into the markets. 

Yes, you read that correctly: Frank’s advisers want money so their high-net worth clients can lever up and invest in the markets today. Apparently the advisers believe that assets are at fire sale prices right now, so they want more money to scoop up those assets and then make a killing when the market rebounds. 

That’s what these advisers are telling Frank, at least. He called around to other compliance officers he knows, and his peers all told him they’re seeing the same frenzied requests for leverage. 

How much demand? Roughly five times the usual requests for any given month, Frank says — and 70 percent of that higher demand came last week.

Frank isn’t sure how many high-net worth investors truly are seeking leveraged loans so they can bet big on a market rebound. It’s also possible that panicky financial advisers are trying to drum up leveraged loans as an investment strategy, and then they’ll pitch that idea to their clients no matter how hare-brained it might actually be. “There will be a certain percentage trying to do that,” Frank says.

Here’s the tricky part: leveraged loans can be a reasonable part of financial planning, even amid today’s turmoil. But broker-dealers, financial advisers, and wealth management firms have a duty of care to understand when those loans are appropriate for clients. 

So how can Frank make that determination in these chaotic times? As he told me: “The assessment of risk is completely different now.”

A Changed Risk Landscape

Typically, Frank’s firm checks a litany of items about a client before approving a loan: the client’s existing retirement plan, his or her assets, liabilities, net worth, income, age, and so forth. The goal is to understand whether more leverage is a reasonable risk for the client. 

Covid casts those standard assessments aside. Now the question is whether extending leverage to the client is reasonable in our greater macro-economic world.

That is, in normal times, any high-net worth client with a relatively strong personal balance sheet could ask for more leverage, and probably get it. Today Frank has to consider a much larger picture. For example, if that high-net worth client is a restaurateur, now Frank has to wonder whether that client will survive the next six to 12 months. Ditto for wealthy owners of travel, tourism, retail, or entertainment businesses.

The client’s wealth is no longer the deciding factor. The client’s line of business is. Frank has to assess how covid might affect that variable.

“I have to look at this now with a completely different eye,” Frank said. “These are the things we have to scramble and put together, and what this looks like in a new world order.” 

Theoretically, Frank’s board would be offering guidance on the firm’s risk tolerance — and the board has been supportive, he stresses. Its message has been that all clients get thorough due diligence in this risky period. No client gets a free pass no matter how large his or her portfolio, or how much the financial adviser is clamoring for a quick answer. 

Still, assessing that risk is incredibly difficult. Frank admitted he has no formula to assess potential exposure, no standard metrics he considers reliable. “We don’t really know,” he said. “So we have to look at everyone as an individual” and try to get the firm’s financial advisers to take the issue seriously. 

Renewed Focus on Procedures

In other words, for Frank’s firm to meet its duty-of-care obligations, the financial advisers must take a risk-based approach to each request for leverage, one client at a time. They need to immerse themselves into each client’s financial particulars and document their thought processes, to demonstrate to Frank that, yes, leverage really is a feasible move for the client in question. 

I’m sure all financial firms say they do this as a matter of course. Most probably even mean it. But I harbor no illusions that at least some financial advisers try to skate by with a more cookie-cutter approach to analyzing their clients’ financial position. 

Well, that’s a stupendously risky thing to do in our covid world. So perhaps this lesson is a bit self-evident, but I’ll say it anyway — 

As the world’s risk landscape changes fundamentally, compliance officers will need to pay much more heed to substantive due diligence that yields the best answer, rather than pro forma procedures that obey regulatory rules.

So now Frank is looking much more closely at where a client’s income comes from — “a second, third, and fourth look at the question” —  and whether that’s sustainable in our current economic climate. 

He’s calling advisers, asking them to explain exactly what conversations they’ve had with clients requesting loans. Yes, those advisers pass along notes to Frank’s compliance team for review, but those notes don’t always tell the full story. “Especially if it’s two band-aids and an elastic for notes,” Frank quipped tartly. 

On some occasions, Frank even knocked a few advisers seeking loans for clients who historically are quite risk averse. “Like, how did they even let the conversation get that far?” he said. 

Bigger Lessons? You Tell Me

What can compliance and risk officers in other professions take away from Frank’s experience? 

First, that when the world changes, you do need to question fundamental assumptions about risk that your firm might have used for many years. (Like, say, a wealthy restaurateur is a safe bet for lending money.)  

And second, when those assumptions change, you need to be ready to go beyond policy and procedure to find the truth. In Frank’s case, even if financial advisers submit all the documentation that would pass regulatory compliance muster — um, so what? What good is being in compliance if those procedures still misjudge risk, and leave your firm looking at huge losses six months from now? Which is the true risk Frank’s faces from covid.

All that said — Frank readily admits he and his team are doing the best they can without a roadmap. If other compliance officers have advice for him, he’s eager to hear it. If you have similar tales of new compliance challenges in our covid world, I’m eager to hear it. Email me at [email protected] or find me on Skype at MattKellyCompliance, and let me know.

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