There is no doubt that the fallout from the market meltdown is far-reaching. Reactions from the financial services industry have ranged from new credit policies to in-depth reviews of risk management and compliance procedures. Next up will be a stringent review of the regulations that govern every aspect of the industry, and it is certain that this review will result in changes that will have a long-lasting impact on the financial planning sector.

As world governments sort out these new rules and regulations, risk management will certainly be in the spotlight. While many will assume that risk management is heavily weighted toward large institutional clients, the truth is that an important piece of the risk-management puzzle is the retail relationship — particularly the connection between the front-line financial professional and the client. That’s because the client/advisor relationship is one of the highest risk points in the financial services industry. It’s where things go off the rails most often, and where liability is most likely. The advisor is the primary link among products, markets, clients and the firm. When that link breaks, risk escalates.

The pressure on the client/advisor/firm relationship was not always this intense. In the past, most of the industry and its regulations were focused on a world driven by institutional investors, straightforward financial products and transaction fees. This all changed when the markets, fuelled by deregulation, opened up the late 1980s. Today, it is a very different market, a retail dominated market. The role of the advisor has shifted, increasing the risk inherent in the client/advisor dynamic. Driving this increased risk are two systemic factors: the shift to advice and the growing complexity of products.

In response to the new risks created by this shift, the industry has increased its focus on two compliance principles: “know your client” and “know your product” are taking on greater significance as we recover from the financial crisis. For the advisor, understanding the importance of these concepts and how they influence risk management can go a long way toward helping financial firms minimize their risk exposure.

Providing high-quality, customized financial advice is an integral part of the value model in the client/advisor relationship, and it is the benchmark of differentiation among the many service providers. This increased focus on providing advice also introduces a higher element of risk into the relationship with the client. As a result, the KYC principles and practices — the backbone of risk management — move to a whole new level. If a broker or financial planner is in an advi-sory relationship with a client, as opposed to simply taking “buy” and “sell” orders, the onus of responsibility to the client increases. To what degree is an area of debate in Canada and the U.S., but there is the potential that the relationship can develop into a fiduciary one in some circumstances. This higher standard of care also increases the risk that advisors may be liable to their clients if advisors breach their professional duties to their clients.

Adding to the risk profile is the industry shift toward wealth management. In this arena, the complexity of advice and services is growing. Wealthy clients have diverse needs that require a new type of advisor to service them. Concentration on traditional investments is not enough for this group. They are looking for holistic advice relating to complex problems requiring complex solutions. This is the Holy Grail for Canadian investment firms in search of financial strength and profitability.

But as the relationship becomes more complex, the associated risk also increases. The more advisors can educate themselves on KYC and apply it as a risk-management tool, the stronger their practices will be.

The second risk factor is the growing complexity of products. Financial engineering and instantaneous, interlinked markets have increased the volume of new products. Advisors are confronted with increasingly complex investment options, ranging from life insurance to asset-backed securities.

The increased demand for customized advice, combined with an ever-growing list of products and services, is a formula that has the potential to go wrong quickly — with expensive results. The Portus Alternative Asset Management Inc. crisis is an example of what can go wrong when there is a lack of product knowledge on the part of both advisors and clients.

@page_break@What seemed self-evident and basic in the past is not so any longer; today, regulators are talking more and more about KYP. Recently, the Investment Industry Regulatory Organization of Canada announced new rules around KYP, and CSI Global Education Inc. has responded with a new compliance course focusing on KYP.

In fact, education and training plays a pivotal role in addressing escalating risk. Education helps provide checks and balances to keep risk under control. It builds knowledge and offers a tool kit to help advisors and brokers ask the appropriate due-diligence questions when confronted with new products or in dealing with new clients.

In today’s economic environment, discretionary education around KYC and KYP may be viewed as an additional cost for already heavily burdened advisors. But this is not so. Ultimately, getting ahead of any proposed regulatory changes and adopting best practices for KYC and KYP provides advisors and their firms with a critical risk-management strategy and a competitive advantage. IE



Roberta Wilton is president and CEO of CSI Global Education Inc., a national educator of financial services professionals in Canada.