Law Institute

Behavioural Findings and Financial Market Regulation

AIIFL, Hong Kong February 2, 2015

Prof. Dr. Rolf H. Weber

Chair Professor, Law Faculty, University of Zurich

Visiting Professor, Law Faculty, University of Hong Kong

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suitability

heuristics and biases e.g. loss aversion

Client

ban vs.disclosure

conflicts of interestse.g. retrocessions

Advisor

prospectusregulation

advertising vs. disclosuree.g. past performance

Producer

Potential causes of misconductPotential causes of misconduct

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Often no focus on maximizing profits

Behavioural researchBehavioural research

Decisions influenced by emotions

Past performance orientation (immoderate expectations)

2 February 2015 Behavioural Findings and Financial Market Regulation. Prof. Dr. Rolf H. Weber

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Absoluterationalbehaviour

Utility maximization

Perfectinformation

Stablepreferences

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Homo oeconomicusHomo oeconomicus

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Rational choice challengesRational choice challenges

Behaviour of a homo oeconomicus

Efficient market hypothesis

Limits of rationality assumption

Emotion, inertia, reference biases,overconfidence

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probability misjudgement

selective perception

herding

Perception

cognitive

emotional

anchoringmental accounting

overconfidence

reflection effect

Processing& validation

self-attributionhindsight bias

endowment effectsoptimism bias

Decision

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European perspectiveEuropean perspective

MiFID I and II

ESMA

Implementation of systems and controls

Effectiveness and importance of the compliance function

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MiFID I and IIMiFID I and II

Appropriateness & suitability test

MiFID I

Transparency (executed documentation)

2 February 2015 Behavioural Findings and Financial Market Regulation. Prof. Dr. Rolf H. Weber

Risk tolerance

MiFID II

Mitigation of conflicts of interest

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MiFID Guidelines 06/07/2012MiFID Guidelines 06/07/2012

Greater convergence in the interpretation + supervision

Investment firms must obtain the necessary information to be able to understand the essential facts about the client in order to assess the suitability of any investment for that client (client’s investment objectives, financial situation, knowledge, experience)

Assessment:Is the specific transaction suitable ?

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(82): When providing investment advice, the investment firm should specifyin a written statement on suitability how the advice given meets thepreferences, needs and other characteristics of the retail client. […]

Art. 25 (2):When providing investment advice or portfolio management the investment firm shall obtain the necessary information regarding the client's or potential client's knowledge and experience in the investment field relevant to the specific type of product or service, that person’s financial situation including his ability to bear losses, and his investment objectives including his risk tolerance so as to enable the firm to recommend to the client or potential client the investment services and financial instruments that are suitable for him and, in particular, are in accordance with his risk tolerance and ability to bear losses

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MiFID IIMiFID II

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(77): To further protect consumers, it is also appropriate to ensure investmentfirms do not remunerate or assess the performance of their own staff in away that conflicts with the firm's duty to act in the best interests of theirclients, for example through remuneration, sales targets or otherwise whichprovide an incentive for recommending or selling a particular financialinstrument when another product may better meet the client’s needs.

Art. 24 (10):An investment firm which provides investment services to clients shall ensure that it does not remunerate or assess the performance of its staff in a way that conflicts with its duty to act in the best interests of its clients. In particular, it shall not make any arrangement by way of remuneration, sales targets or otherwise that could provide an incentive to its staff to recommend a particular financial instrument to a retail client when the investment firm could offer a different financial instrument which would better meet that client’s needs.

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MiFID IIMiFID II

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(104) The financial crisis has shown limits in the ability of non-retailclients to appreciate the risk of their investments. While it should beconfirmed that conduct of business rules should be enforced inrespect of those investors most in need of protection, it isappropriate to better calibrate the requirements applicable todifferent categories of clients. […]

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MiFID IIMiFID II

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Specific regulatory elementsSpecific regulatory elements

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Experience and knowledge

Risk absorbing capacity

Investment objectives

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Experience and knowledgeExperience and knowledge

• Product experience

• Transaction experience

• Education

• Profession

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Risk absorbing capacityRisk absorbing capacity

• Source and extent of income

• Liquid assets, investments

• Real property

• Financial commitments

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Investment objectivesInvestment objectives

• Investment period

• Risk preferences

• Risk profile

• Investment purpose

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ESMA findingsESMA findings

Failure to ask clients the right questions

Failure to recommend a suitable investment

Failure to collect the necessary and relevant information

Failure to interpret correctly the information provided by the client

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Risk assessmentRisk assessment

Embracement of risk preferences

Methods for risk assessment

Approaches to risk assessment

Restrictions and limitations

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Regulatory approaches in Hong KongRegulatory approaches in Hong Kong

HKMA Circular 12 Jun 2012

SFC Code of Conduct 5.2

SFC Q & A on suitability obligations

Internal study

SFC Consultation Conclusions 5 Sep 2014

New Clause in clients agreements

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Perform a mandatory suitability test

Combat conflicts of interests

Optimize the documentation for financial products

Code of conductCode of conduct

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Limits to investor protectionLimits to investor protection

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OutlookOutlook

Need of considering behavioural findings

Biases require more than disclosures

Hard law versus soft law