Banks’ Products Distribution Strategies: Three Lawyerly Remarks on a recent Econometric Research by the Bank of Italy
A very interesting paper from Danilo Liberati and Francesco Vercelli of the Bank of Italy came out yesterday. The paper is called As long as the bank gains: expanding the retail distribution activity and looks at the distribution strategy of banks and in particular at the determinants and profitability of the various investment products distributed.
The Authors focus on three asset classes: mutual funds, individually managed portfolios and insurance products.
Leaving aside the econometric analysis (which I must admit completely escapes my understanding), the Authors reach a number of conclusions. For example they confirm that, quite predictably I would say, “banks with larger amounts of bad loans relative to capital have distributed more [asset management instruments], an activity that does not absorb equity; […]. Moreover banks which devote more resources to lending are less interested in expanding other banking activities, such as the distribution of [asset management instruments], or they are less equipped to do it.
I want to focus here on a specific line of argument opened by the paper, though. The Authors have found that “fees from individually managed portfolios distribution have contributed to bank profitability more than those from mutual funds”. Furthermore, the Authors have also found that the distribution of individually managed portfolios (and in particular those issued by third party intermediaries) is more profitable for the bank than that of mutual funds and insurance contracts.
These findings spark three comments from, my own, legal practitioner’s, perspective.
Firstly, I think it would be very interesting to expand the analysis by digging into the distinction among the insurance products between “class I” and “class III” (unit-linked) products.
Class III products are in many respects akin to an individually managed portfolio. Investors in both class III products and individual portfolios bear the investment risk, i.e. the risk that the payoff to the investor may be lower than the capital invested and both products offer exposure to an underlying portfolio of assets managed by a professional intermediary.
An economist would probably say they are substitutes. Bankers actually use a more mundane term to express the same concept: class III products were also known in the past as “wrappers”, to hint at the idea that such products may in effect be individually managed portfolios packaged — “wrapped”, indeed — into an insurance contract (the driver behind that being the different treatment from a tax, asset protection and inheritance law). That was more common in the good old days, though, before the legislator, the tax authorities and the Italian Courts started looking into some of these products and questioning their characterization as insurance products.
Class I products, to the contrary, entail a capital guarantee plus a return and as such are significantly more conservative products compared to class III products. Mutual funds do not entail a capital guarantee but they are by design low risk products and as such they are more akin to class I products. This is of course true of UCITS funds (as opposed to hedge, private equity, or other alternative investment funds), which I expect to comprise the overwhelming majority of the products generating the data set analyzed.
By diving deep into the aforesaid distinction, therefore, I think one could verify whether class III insurance products provide greater returns to the bank than class I products and, if this is the case, whether the profitability for the bank of class I and class III products mimics that of, respectively, mutual funds and individually managed portfolios.
Secondly, the Authors have looked at a data set which distinguishes between maintenance fees (paid for as long as the investment sits within the portfolio of the client) and placement fees (paid upfront as of the time of the investment) only for individually managed portfolios issued by third party intermediaries. With respect to mutual funds, instead, the data analyzed include information only on maintenance fees, while the Authors have only been able to define an estimate of the placement fees pertaining to mutual funds (see footnote 8). The Authors however correctly note in such respect that maintenance commissions represent the largest fraction of distributors’ compensation (but see below for an important qualification to such statement).
It would be interesting to look at if and to what extent the recent evolution of regulation may change such dynamic.
As it is known, MiFID II has arguably introduced more stringent requirements for the legality of retrocessions to banks, in comparison to the rules set out under MiFID I (which applied during the years covered by the data set analyzed in the study).
Despite all the hype on the increased protection afforded by MiFID II’s rules on inducements, however, I would be quite surprised if any significant decrease of the rebates paid were to be found. As I have argued elsewhere, rules on inducements are very difficult to enforce due to the heavily facts-specific nature of the assessment required to demonstrate a breach and therefore they have very limited bite.
Thirdly, it is not clear to me whether the data set analyzed includes, for mutual funds, also the fees which the bank may earn in consideration for the MiFID advisory investment service provided to the client, i.e. the recommendation to buy a specific fund. Unless I am mistaken, such fees are not included in the data set. Business models on the market vary in shape and form. However, a material number of banks offer distribution services combined with advisory services (also as a result from moral suasionand enforcement initiatives by Consob). That is, the bank recommends an instrument and then, should the client agree to buy the product, also provides the execution service. It is thus fairly common that banks earn two commissions from the placement of a fund: The fee for the advisory, paid by the client, plus the retrocessions from the asset manager (banks using a “fee only” business model will only receive the advisory fee though). I think factoring also such component into the analysis might shed additional light on the dynamics of banks’ choices in choosing among the various types of investments, as such fees might indeed reduce the gap between mutual funds and individually managed portfolios in terms of contribution to the bank’s profitability.
