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«Working Paper Nr. 39 Februar 2005 THE REGULATORY BURDEN IN THE SWISS WEALTH MANAGEMENT INDUSTRY _ Christian Buehrer Institut für schweizerisches ...»

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Universität Zürich

Institut für schweizerisches Bankwesen

Working Paper Nr. 39

Februar 2005




Christian Buehrer

Institut für schweizerisches Bankwesen

Universität Zürich

Plattenstrasse 14

8032 Zürich

Telefon: +41 1 634 4583 Email: buehrer@isb.unizh.ch Ivo Hubli Im Maiacher 2 8804 Au Telefon: +41 1 781 3348 Email: ivo.hubli@gmx.ch Eliane Marti Universitätsstrasse 57 8006 Zürich Telefon: +41 1 361 0351 Email: elianemarti@freesurf.ch




Christian Bührer, buehrer@isb.unizh.ch; Ivo Hubli, ivo.hubli@gmx.ch; Eliane Marti, elianemarti@freesurf.ch.

Swiss Banking Institute, University of Zurich, Plattenstrasse 14, 8032 Zurich, Switzerland.

1 Introduction In the recent past, regulatory costs have received a great deal of attention within the Swiss wealth management industry. On the one hand, financial institutions are intensifying their focus on cost management in general, due to the plunge of fees and commissions since the bubble burst on global equity markets. On the other hand, wealth management institutes are faced with rapidly increasing regulatory requirements, leading to a significant rise in their regulatory costs.

Neither in theory nor in practice is there any doubt regarding the economic rationale and the necessity for regulation in the financial industry. Basically, bank regulation is justified as a means of preventing potential market failures in the financial sector[1], in order to protect depositors and the financial system as a whole:[2] the characteristics of the wealth management business, such as agency problems and asymmetric information, may lead to risky behaviour on the part of wealth management institutes and potential losses for depositors and investors.[3] A crisis in a single financial institute may easily lead to a crisis of confidence in the whole sector, with harmful consequences on monetary transactions and other industries within an economy.[4] Additionally, regulators and supervisors are paying to attract attention to protecting the reputation of the financial industry and financial centres. The prevention of activities such as money laundering and the financing of terrorism is of paramount importance within this context.[5] Yet, despite the positive effects of these regulatory interventions, their cost has to be considered, too. In fact, it is only if the overall benefits of regulation exceed its cost that regulation ultimately yields a profit. Attempts to quantify the cost of regulation can be found in the U.S. and the U.K. In Switzerland, however, there is still a lack of information on the regulatory burden of financial institutions.

2 Review of the Literature Theoretical aspects of regulation in general, as well as the specific regulation of the financial system, are widely covered in the literature. Furthermore, several articles in both academic and practical journals discuss the optimum extent of regulation and the advantages and drawbacks of regulatory systems. Nevertheless, there have been only a few attempts in the literature to quantify regulatory costs, most likely owing to the difficulty of assessing them quantitatively.

ELLIEHAUSEN’s review paper provides an interesting overview of 15 U.S. studies from 1976 to 1994 regarding regulatory costs. It questions the statistical significance of many of the results, but still provides a valuable insight into the quantitative world of regulatory costs.

In 1998, FRANKS, SCHAEFER STAUNTON investigated the regulatory burden of British AND brokers and investment management firms. Among other results, they quantified the regulatory burden as GBP 2’135 and GBP 2’690 per capita, respectively.

In 2003, a study by EUROPE ECONOMICS analysed the cost of the British regulatory system and showed that the prevention of money laundering accounts for the greater part of the total regulatory burden.

The Swiss Federal Banking Commission (SFBC) annually surveys the auditing costs of Swiss financial institutes. The results show a clear trend of continuously increasing regulatory costs for auditing issues and strong economies of scale.

3 Methodology

In the autumn of 2003, the Swiss Banking Institute of the University of Zurich (ISB) initiated a series of studies[6] on the regulatory burden of Swiss wealth management institutes for the year

2002. The primary aim of these studies was to compare the impact of regulation on the costs of different regulatory frameworks applicable to the provision of wealth management services. The empirical measurement of these expenses is based on a framework set up by the British Financial Services Authority (FSA). The FSA is obliged to assess the economic costs and benefits of each proposed policy, by carrying out a Cost Benefit Analysis (CBA).[7] Thus, it tries to avoid the implementation of regulations whose additional benefits are offset by supplementary costs.[8] In contrast to such a CBA, the studies conducted by the ISB clearly focus on the assessment of regulatory costs, while benefits are not quantified. The participants in the survey were merely asked to rank the different fields of regulation according to their importance for the Swiss financial industry, in order to assess their relative benefits.

The cost categories in the ISB studies follow the CBA framework of the FSA, which distinguishes between direct, compliance and indirect costs.

Direct costs comprise the resources needed within the body of the financial regulator to design, monitor and enforce regulations. In the U.K., costs for ongoing supervision are incurred by the FSA and are regarded as direct costs. In Switzerland, however, a certain degree of supervisory responsibility is delegated to designated auditing companies. The ISB studies define these costs as a new cost category called incremental auditing costs, since the Swiss “dual supervision system” forces external auditors to fulfil ongoing supervisory functions. According to the SFBC, this bucket includes external and internal incremental auditing costs, whereas incremental costs only comprise costs which would not have been incurred in the absence of regulation.

Compliance costs are the costs incurred by financial institutes as a result of activities required by regulators.[9] Again, the focus lies on the incremental part of the costs, which of course is a subjective and often difficult quantity to delimit.

Compared to the FSA framework, the ISB studies do not quantify the least obvious, hard-tomeasure indirect costs. Indirect costs are opportunity costs and arise from missed income, reduced competition and loss of business to other, less regulated countries.[10] Consequently, the ISB studies distinguish between the following cost categories: (1) direct costs, (2) incremental auditing costs and (3) compliance costs.

4 Data

The data used were gathered through questionnaires. The drawbacks of this approach, such as potential misunderstanding of the questions, were mitigated by intense consultation of experts during the design and realisation phases. The results are based on responses from 48 Swiss wealth management institutes, comprising 17 members of the Association of Swiss Commercial and Investment Banks (ASCB), 10 members of the Association of Swiss Private Bankers (ASPB) and 21 Securities Dealers (SD). The information about Independent Asset Managers (IAM) is based on 371 responses and estimates of their regulatory burden. Table 1 shows the number, the average headcount and the range of headcounts within the institutes described.

Table 1: Number of providers and average headcount of the different regulatory frameworks Regulatory Framework Number of Providers Sample Average Headcount Headcount: Range

–  –  –

Sources: ASPB, Bührer 2004, Hubli 2004, Marti 2004, SAAM, SFBC 2004b, SNB 2004.

From a statistical point of view, the size of the sample is rather too small to assign reliability to the results. In addition, the difficulty of estimating the cost of regulation, and especially of delimiting the incremental part, was a very likely source of data bias. The quality of the data was therefore assessed carefully.

In the first place, several control questions were incorporated into the questionnaires in order to allow quality as well as consistency checks. Secondly, a large number of consistency tests were carried out in order to uncover potential bias and distortions of the sample data (e.g. through outliers); the outcomes of these tests confirmed the scale of the findings.[11] Finally, the results were compared with findings from other studies, such as the SFBC survey on the auditing costs of Swiss financial institutes, which again confirm the scale of the results.[12] The conclusion of the quality assessment is that the quality of the data is satisfactory, and that the data are able to reveal both the basic characteristics and the scale of the regulatory burden of the wealth management firms analysed.

Within the scope of the ISB studies, the ASCB Banks, Private Bankers and SDs questioned were invited to assess the costs and benefits of seven regulatory fields in a qualitative manner.

Table 2 illustrates the cost-benefit ranking and the resulting ranking differences for the specific regulatory fields.

Table 2: Cost-benefit ranking for different regulatory fields

–  –  –

Sources: Hubli 2004, Marti 2004.

The greatest costs arise in those regulatory fields where the benefits seem to be highest. This is shown by the above rank correlation coefficients. The largest gap between costs and benefits is exhibited by the regulatory field of equity/liquidity/accounting, and is especially pronounced for SDs.

5 The four Regulatory Frameworks in Wealth Management

In Switzerland, wealth management can be conducted through various regulatory frameworks:

Wealth Management Banks, Private Bankers, Security Dealers (SD) and Independent Asset Managers (IAM).

Banks are subject to the strictest regulation and supervision, based on the Federal Banking Act (FBA), the ordinance to the Federal Banking Act (FBO), the guidelines of the SFBC, and self-regulation. The law basically sees a bank as an enterprise which operates in the classic business of interest margins; thus, the regulatory concept for banks is directed primarily at commercial banking and the limitation of inherent risks. In Switzerland, the system of universal banks prevails. This allows banks – if they so wish - to participate in all banking businesses.

Nevertheless, there are many banks which focus on particular business opportunities. The 30 ASCB Banks are mainly active in wealth management, are organised as stock corporations and have a securities dealer’s license. On average, these banks have 280 employees.

The Private Banker status is regulated by the FBA. The legal status of such institutes covers sole ownership, registered partnership, limited partnership and limited partnership with shares.

The specific status of Private Bankers is characterised by the presence of at least one partner with unlimited liability for the bank's commitments. Based on the unlimited and joint liability of the participators, they benefit from certain regulatory privileges and thus wear a somewhat looser regulatory corset than other banks. Private Bankers who do not advertise publicly enjoy a certain relief with regard to their capital surplus accumulation and are not obliged to publish their balance sheet and income statement. Their civil law responsibility is regulated in the Swiss code of obligations (CO), and is thus different from that which applies to stock corporation banks.

Private Bankers are not subject to double taxation as stock corporations are, but face disadvantages in the area of income tax and social security contributions: the total earnings of partnership companies - even if reinvested - are subject to income tax and to pension and public social security payments. Social security contributions are deducted not only from salaries, but also from total earnings.[13] In Switzerland, there exist 15 Private Bankers employing an average of 240 persons each.

Securities Dealers (SD) are regulated through the Federal Act on Securities Exchanges and Securities Trading (SESTA). The associated ordinance and a circular drawn up by the SFBC define five categories of SD: own-account dealers, issuing houses, derivative houses, market makers and client dealers, the last-named being predominately active in the wealth management business. The regulation of the SDs is very similar to bank directives and is the same for all categories. Whereas SDs are allowed to make loans (e.g. lombard credits) and keep deposits and custody accounts, only banks are allowed to offer interest on clients’ accounts. Thus, SDs are not allowed to operate in the interest margin business. The auditing rules and licensing regulations are equally applicable to SDs and banks; an important difference, however, concerns the minimum capital prerequisites, since SDs have to raise at least CHF 1.5 millions, compared to a CHF 10 millions requirement for banks. Regarding special regulatory rules[14], which are particularly relevant in wealth management, there are no major differences between the regimes of SDs and banks. In Switzerland, there are 65 SDs without banking licenses, with an average headcount of 26.

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