garp switzerland chapter meeting - garp - global association of

Investment Suitability and Product ClassificationDr. Marc Ryser

GARP Switzerland Chapter Meeting14. January 2010

Investment Suitability and Product Classification

Ryser, Alessandro Lana

GARP Switzerland Chapter Meeting

January 2010

Investment Suitability – Press Review

«Financial crisis: Who pays the price and what happens next?»

Press Review

«Handing out the product‘s term sheet is not sufficient when advising clients lacking in financial experience.»

EU directive

„EU aims to set up new rules for

investor‘s protection“

January 2010

Agenda

1. What is Investment Suitability?

2. Investment Suitability Regulation and the Situation in Switzerland

3. Key Risk Areas and Lessons learned

4. Suitability Framework and examples of solution concepts

► Product classification: are downside risk and complexity independent dimensions?

► How to classify product complexity

5. Complexity Analysis of the Swiss

Investment Suitability Regulation and the Situation in Switzerland

Key Risk Areas and Lessons learned

Suitability Framework and examples of solution concepts

Product classification: are downside risk and complexity

complexity?

Swiss Structured Products Market

January 2010

What is investment suitability?Mis-selling and associated risks

Regulatory, legal & reputation risk is essential – How does regulation cope with investment suitability?

Mis-selling is generally referred to a situationin which a firm solicits a financial instrumentto a client that is not suitable for him orsuitability is not assessed adequately

Mis-Selling

ScopeWhen recommendation concerning an investment is made to a client

ObligationDetermine whether product /

service is suitable for a particular client

Fair, clear, not misleading, and considering client

sophisticationInformation to client

Considering financial situation, investment objectives, knowledge and experienceSuitability assessment

Elements ofInvestment Suitability

What is investment suitability?

How does regulation cope with investment suitability?

Associated risk categories

RegulatoryRisk

LegalRisk

ReputationRisk

Exposure to regulatory sanctions arising from non-compliance with applicable rules & regulations

Exposure to legal cases and related financial losses arising from disputes and legal proceedings

Impairment of reputation arising from business activities which negatively impact the bank’s trust, image and brand

January 2010

RegulatoryTrend

Worldwide regulatory trend towards assessing suitability at product levelto suitability within the context of an investment portfolio required

Switzerland

§ Fiduciary obligation may emerge under certain circumstances

§Potential obligation to warn client of risks and provide recommendation if a relationship of mutual trust has developed

§Dec 09 EFD/SNB/FINMA Financial market policy: topic of strategicimportance

Europe

§MiFID requires firms to assess the suitability of a service or transaction when providing advice to clients

§Comprehensive disclosure requirements(e.g. risks, inducements, conflicts of interest)

Regions

Trends

Suitability

Misadvise

Point ofSale Disclosure

How is investment suitability regulated?Overview of regulatory initiatives

Is investment suitability a topic in Switzerland as well?

Worldwide regulatory trend towards assessing suitability at product level (e.g. EEA, USA, Hong Kong) in addition to suitability within the context of an investment portfolio required to meet converging regulations

requires firms to assess the suitability of a service or transaction when providing advice to

disclosure requirements(e.g. risks, inducements, conflicts of interest)

Americas

Example: USA

§Reasonable grounds for suitability for specific product (e.g. non-deposit investment product) recommended to particular customers (e.g. retail customers)

§Comprehensive disclosure requirements

Asia

Example:Hong Kong

§Recommendations provided to clients need to be assessed at product level

§Q&A SFC is equivalent to MiFID suitability regime

How is investment suitability regulated?

Is investment suitability a topic in Switzerland as well?

January 2010

Market observations? Which are the identified key risk areas?

Is investment suitability a topic in Switzerland?Relevant Federal Court Decisions & current market developments

BGE 4C.68/2007

BGE 133 III 97

BGE 4C.385/2006

► Defines information and warning duties► Investment adviser must ► Information must correspond with ► Investment adviser ensures having the

► Defines information and warning duties► Information must consider

internet banking, warning that suitability was not assessed► Warning to client in specific cases

► Defines threshold for concentrations ► In situations of mutual trust (fiduciary relationship) the

risks, e.g. concentration risk► Considered as excessive

Fede

ral C

ourt

Dec

isio

nsTr

ends

in M

arke

t P

ract

ice

Current Developments

► Despite missing explicit CH regulation, we observe the investment suitability processes

► In absence of explicit regulations, international regulations

► Internationally active institutes, exposed to multitudes of local regulations and specific requirements, tend to consolidate approaches “minimal requirements” to a “maximal requirements” perspective

Market observations? Which are the identified key risk areas?

Is investment suitability a topic in Switzerland?Relevant Federal Court Decisions & current market developments

information and warning duties when providing investment adviceInvestment adviser must inform in a fair and non-misleading mannerInformation must correspond with knowledge and experience of clientInvestment adviser ensures having the respective client information

information and warning duties for execution only transactionsInformation must consider knowledge and experience of client. Practical examples: internet banking, warning that suitability was not assessed

in specific cases

concentrations in a client’s portfolioIn situations of mutual trust (fiduciary relationship) the client must be warned of specific risks, e.g. concentration riskConsidered as excessive concentration: 40% of asset class „shares“, 13% of total portfolio

Despite missing explicit CH regulation, we observe the general tendency for enhanced investment suitability processes and pre-trade requirementsIn absence of explicit regulations, market practice currently focuses on alignment with international regulations in particular when Cross-Border activities are involvedInternationally active institutes, exposed to multitudes of local regulations and specific

consolidate approaches . This implies a radical move from a to a “maximal requirements” perspective

January 2010

What are the key risk areas?Main risk areas observed by leading private banks

► Ernst & Young serves leading global wealth managers and private banks

► Experience from current investment suitability projects in Europe and Asia

► Outcome of Workshops with C-level participants of major private banks

► COOs and Heads of Compliance of leadingprivate banks confirm the following risk areas related to mis-selling as crucial

Market participants agree on need to actively manage key risk areas

Basis for our conclusion

What are the key risk areas?Main risk areas observed by leading private banks

► Sales process not considering client and product classification

► Deviations from client profile / investment strategy and Concentrations in client portfolio

► Misleading product information andinadequate risk disclosure

► Lack of evidence

► Inappropriate sales staff training

Market participants agree on need to actively manage key risk areas – What are the lessons learned?

Key risk areas observed in the market

January 2010

Overall: Need for an end-to-end investment suitability framework

What are the lessons learned? Industry practice related to key risk areas observed

► Monitoring of concentrations and related escalation processDeviations and Concentrations

► Early integration of client and product characteristics in sales processSales process

► Knowledge health checks for client facing staff and certificationSales Staff Training

► Legally enforceable client waivers in specific cases for selected productsEvidence

► Governed disclosure process covering product complexity / downside riskProduct information and risk disclosure

► Complexity and downside risk based product classification to match client profile, segment or classProduct Classification

► Client classification by sophistication level in addition to other criteria Client Classification

end investment suitability framework – How to structure?

What are the lessons learned? Industry practice related to key risk areas observed

Monitoring of concentrations and related escalation process

Early integration of client and product characteristics in sales process

Knowledge health checks for client facing staff and certification

Legally enforceable client waivers in specific cases for selected products

Governed disclosure process covering product complexity / downside risk

Complexity and downside risk based product classification to match client profile, segment or class

Client classification by sophistication level in addition to other criteria

January 2010

Client

High NetWorth

Individuals

PrivateBankingClients

AffluentClients

RetailClients

Product Pull

Sales Process

Deviations from

Investment Strategy and

Concentrations in C

lient Portfolios

Front (RM)

Client Classification

SalesProcess

RiskDisclosure

Evidence

How to structure those elements?End-to-end investment suitability framework

Investment suitability framework to reduce risk of mis

Sales StaffTraining

Provider Selection

Product Push

Sales Process

Product

Product Assessment

Product Classification

ProductSales

Platforms

Product Information

How to structure those elements?end investment suitability framework

Providers

AssetManagement

Investment Banking

Other

Mutual Funds

Investment suitability framework to reduce risk of mis-selling – Examples of solution concepts?

January 2010

Common Suitability Definition (Joint Forum Study)For each transaction involving investment advice or portfolio management, suitability is based on three Client factors: Risk Profile, Knowledge and Experience, Investment Objectives.

Assessments of Financial situation (Risk Ability) and Risk Tolerance build a complete Risk Profile.

Risk ProfileA reasonable understanding of the mechanisms driving a product payoff and an adequate investment experience in financial products are unavoidable inputs for a suitable advise at product level

Knowledge & Experience

Knowledge &Experience

Risk profile

Investment objectives & constraints(e.g. Time horizon, reference currency, liquidity requirements, diversification to professional occupation)

Client View

Translating Common Suitability Definition into Product Suitability Dimensions

Examples of solution concepts?Industry’s understanding of suitability

How to link client and product specific suitability factors?

Definition (Joint Forum Study)involving investment advice or portfolio management, a firm must assess suitability. The assessment of a transaction’s

Risk Profile, Knowledge and Experience, Investment Objectives.

A reasonable understanding of the mechanisms driving a product payoff and an adequate investment experience in financial products are unavoidable inputs

suitable advise at product level.

Knowledge & Experience

Further client’s specific needs and investment constraints have to be considered and suitability tested prior to each transaction.

Investment Objectives

Complexity

Downside risk

Further product characteristics (e.g. term, currencies risk exposure, liquidity rating, sectors exclusion)

Product View

Translating Common Suitability Definition into Product Suitability Dimensions

Examples of solution concepts?Industry’s understanding of suitability

How to link client and product specific suitability factors?

January 2010


Risk profile

Investment objectives & constraints

Client View

Client and Product Suitability Dimensions

How to link client and product suitability factors?Market practice of institutes in MiFiD

How to consider products complexity level within product types?Should downside risk be assessed at product or at portfolio level?

Multivariate matching of dimensions

► Multivariate matching of all dimensions is the most elaborated approach. A statistical model allows for an enhanced automation level when performing the suitability check.

► Financial industry has decades of experience in applying multivariate statistical models, especially in credit rating analysis.

► E.g. recent but concrete regulatory suggestion Italy MiFiDLevel III : CONSOB 9019104 March 2009.

Complexity

Downside risk

Further product characteristics

Product View


How to link client and product suitability factors?MiFiD area: focus on product suitability

How to consider products complexity level within product types?Should downside risk be assessed at product or at portfolio level?

Dimension by dimension matching► The most common approach implemented by banks in the

MiFiD area is dimension by dimension matching of clients profile to products. The large majority supports RMs in this task with classification schemes of clients and products types.

► The observation of market practice in MiFiD area generates few spontaneous key questions:- should risk be assessed at product or at portfolio level?- should the assessment of knowledge and experience be based on product types /classes (e.g. Equities, structured derivatives) or on products complexity level?

January 2010

Are risk and complexity orthogonal dimensions?


Risk profile

Investment objectives & constraints

Client View

Complexity

Downside risk


Product View


How to link client and product suitability factors?Suggested target model

Automated check at portfolio level (when diversification and time horizon are adequate) supported by portfolio risk monitoring tools

Manual check at product level

Automated check at product level supported by adequate complexity classification and knowledge and experience rating of clients

Are risk and complexity orthogonal dimensions?

Complexity


How to link client and product suitability factors?

Automated check at portfolio level (when diversification and time Missing: Complexity Classification

► Risk classifications of products (e.g. SVSP VaR rating for structured derivatives) or portfolio risk monitoring tools have been available for a while already

► The most urgent need for action derived from the recent financial crises is the development of a complexity classification of products

January 2010

Are risk and complexity orthogonal Some examples

Product

A. Equity Warrant; Clariden Leu

B. Barrier Reverse Convertible;

Vontobel

C. Capital Protected with

Coupon; Dresdner Kleinwort

VaR

Risk Level 6

Risk Level 2

Risk Level 1

Characteristics

Call Warrant on Valora Holding AG, Option Style American .

13.20% Multi Defender on Nestle, Novartis, Roche. Barriers at 50% of the issued price. Potential scenario with delivery of worst of in basket.

DJ EuroSTOXX 50 Shark-Autocall-Certifcate. Barrier event at 135%.

Bonus when triggered at 6%.

• Downside Risk Classification(Swiss Structured Products Association SVSP, provided by Derivative Partners): VaR 99% 10 days, based on historical simulation

• Complexity Classification (Ernst & Young / Derivative Partners ): scoring model based on 27 complexity factors at product type and product level

Focus on “Products Complexity”. Appropriate classification approaches?

orthogonal dimensions?

Complexity

Moderate

Very High

Very High

Level 6

Level 2

Level 1

Downside risk

A

B

Cmedium enhanced highlow

1

2

3

4

5

moderate

Complexity

(Swiss Structured Products Association SVSP, provided by Derivative Partners):

(Ernst & Young / Derivative Partners ): scoring model based on 27 complexity factors

6

very high

Focus on “Products Complexity”. Appropriate classification approaches?

How to classify products according to complexity?Classification methods

January 2010

Downside Risk


Classification Methods ?

Decision Tree/Binary Questions


How to classify products according to complexity?

Complexity


Classification Methods ?

Scoring Model

Factors Weighting

Distribution of products

0

2

4

6

8

10

12

0 20 40 60 80 100Score (0 to 100 points)

Calibration / Class Building

• Factor 1

• Factor 2

• Factor 3

• Factor 4

• Factor 5

• Factor 6

• Factor 7

• …….


Development of a Complexity ClassificationCollaboration between Derivative Partners and Ernst & Young

January 2010

► Approximately 85’000 products analyzed, issued between January 2007 and mid November 2009 (Source of data: Derivative Partners)

► 40 potential complexity factors have been considered. The currenton 27 factors, respectively 5 at product type and 22 at product level

► Factors at product type level capture complexity of the payoff structure (e.g. number of strikes, number of strikes of different nature)

► Factors at product level capture complexity derived from further characteristics and features (e.g. asset class, underlying composition, variable coupons, managed )

► The approach is based on a scoring model, for each product a “complexity score” is calculated

► The number of complexity classes has been fixed to 6 according to the number of classes introduced in 2009 by the Swiss Structured Products Association (SVSP)

Complexity Classification: Prototype developed in collaboration with Derivative Partners

How did we proceed for the development of the classification?

Development of a Complexity ClassificationCollaboration between Derivative Partners and Ernst & Young

Approximately 85’000 products analyzed, issued between January 2007 and mid November 2009 (Source of data: Derivative Partners)

40 potential complexity factors have been considered. The current prototype is based 27 factors, respectively 5 at product type and 22 at product level

Factors at product type level capture complexity of the payoff structure (e.g. number of strikes, number of strikes of different nature)

at product level capture complexity derived from further characteristics and asset class, underlying composition, variable coupons, lookback, active

The approach is based on a scoring model, for each product a “complexity score” is

The number of complexity classes has been fixed to 6 according to the number of VaRin 2009 by the Swiss Structured Products Association (SVSP)

Complexity Classification: Prototype developed in collaboration with Derivative Partners

How did we proceed for the development of the classification?

Development of a Complexity ClassificationFocus on complexity and time invariant classification

January 2010

How are products distributed among the 6 complexity classes?

Structured Derivatives Database

► A scoring model easily allows for the inclusion of further product features (e.g. COSI in 2009) that the industry could develop in the future

► Based on this classification approach, Derivative Partners process and offer a real time (daily calculation)classification for all listed products

Maintenance of a scoring model based classification

Complexity Factors

Uncorrelated

Expert based (*) selection of complexity factors. Principal selection criteria:• Time invariant (static classification)• Complexity factors only , where

possible

Correlation and principal components analysis in order to reduce the selection of factors to non redundant information

(*) Joined Derivative Partners / Ernst & Young expertise

Development of a Complexity ClassificationFocus on complexity and time invariant classification

How are products distributed among the 6 complexity classes?

A scoring model easily allows for the inclusion of further product features (e.g. COSI in 2009) that

Derivative Partners will potentially be able to automate the process and offer a real time (daily calculation)classification for all listed products


Weighting

Complexity

Correlation and principal components analysis in order to reduce the selection of factors to non redundant information

Expert based (*) determination of weights for each single factors, though mostly uniform weighting

0.0

0.1

0.2

0.3

0.4

0.5

Per

cent

age

1_Low 3_Medium 5_High

(*) Joined Derivative Partners / Ernst & Young expertise

Distribution of products within 6 complexity classesWarrants dominate relative weights

January 2010

For further analysis see contact details (next slide)

► Moderate complexity class, which dominates with more than 50% of the issued products, contains Warrants which usually differ only by the type of underlying

► Derivative Partners will have the opportunity to further fineof classes, while adapting the prototype to a final version


0.0

0.1

0.2

0.3

0.4

0.5

Complexity class

Per

cent

age

1_Low 2_Moderate 3_Medium

Low Moderate Medium EnhancedProducts 18,939 44,114 6,654Percentage 22% 52% 8%

Distribution of products within 6 complexity classesWarrants dominate relative weights

For further analysis see contact details (next slide)

Moderate complexity class, which dominates with more than 50% of the issued products, contains Warrants which usually differ only by the type of underlying

Derivative Partners will have the opportunity to further fine-tune score thresholds for the definition of classes, while adapting the prototype to a final version


Complexity class

4_Enhanced 5_High 6_Very high

Enhanced High Very high Total6,133 1,585 7,910 85,335

7% 2% 9% 100%

January 2010

Ernst & Young - Contacts

Dr. Marc RyserPartner

Tel +41 58 286 49 03Mobile +41 58 289 49 03Fax +41 58 286 42 33Email [email protected]

Alessandro LanaManager

Tel +41 58 286 42 71Mobile +41 58 289 42 71Fax +41 58 286 42 33Email [email protected]

mailto:[email protected]

mailto:[email protected]

garp switzerland chapter meeting - garp - global association of

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