RELC - Textbook

REGULATORY ENVIRONMENT & COMPLIANCES (GLOBAL) Approved courseware for the Certified Financial Planner CM certification education programme in India\" Published by 'International College of Financial Planning Ltd.' \"Every effort has been made to avoid any errors or omission in this book. Inspite of these errors may creep in. Any mistake, error or discrepancy noted may be brought to our notice, which, shall be taken care of in the next printing. It is notified that neither the publisher nor the author or seller will be responsible for any damage or loss of action to anyone of any kind, in any manner, there from. No part of this book may be reproduced or copied in any form or by any means or reproduced on any disc, tape, perforated media or other information storage device, etc. without the written permission of the publisher. Breach of this condition is liable for legal action. All disputes are subject to Delhi jurisdiction only.\"

Regulatory Environment & Compliances – Global & India Published by the International College of Financial Planning Ltd. © International College of Financial Planning Limited 2003 This subject material is issued by the International College of Financial Planning Ltd. on the understanding that: 1. International College of Financial Planning Ltd., its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortuous, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. 2. The International College of Financial Planning Ltd. expressly disclaims all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this subject material. 3. No person should act on the basis of the material contained in the publication without considering and taking professional advice. 4. No correspondence will be entered into in relation to this publication by the distributors, publisher, editor(s)or author(s) or any other person on their behalf or otherwise. Author Sanjiv Bajaj CFPCM, MBA (Finance), International Certificate for Financial Advisors (CII – London) Revised By: Madhu Sinha CFPCM, CIWM Author (“Financial Planning A Ready Reckoner”. Easy strategies for all, Campus Director, International College of Financial Planning, Mumbai Former Director , FPSB India. Revised By: Dinesh Gupta CFPCM from FPSB, IRDA and AMFI Certified. Associate in Insurance from Insurance Institute of India. \"Unless otherwise stated, copyright and all intellectual property rights in all course material(s) provided, is the property of the College. Any copying, duplication of the course material either directly, and or indirectly for use other than for the purpose provided shall tantamount to infringement and shall be strongly defended and pursued, to the fullest extent permitted by law.\"

TABLE OF CONTENT 1 17 REGULATORY ENVIRONMENT & COMPLIANCES - GLOBAL 23 47 1. Chapter 1: Introduction to Regulatory Environment 63 2. Chapter 2: Legislated “Client Best Interest” Requirements 71 3. Chapter 3: Economic Environment & Financial Advice 4. Chapter 4: Social & Political Environments 5. Chapter 5: Compliance & Implications 6. Chapter 6: Anti-Money Laundering REGULATORY ENVIRONMENT & COMPLIANCES – INDIA SPECIFIC 89 1. Chapter 1: Regulatory System & Environment 91 2. Chapter 2: Role of Regulators 97 3. Chapter 3: Acts Relevant to Corporate Entities, Securities & External Trade 105 4. Chapter 4: Consumer Grievances Redressal 119 5. Chapter 5: Acts, Statutes & Regulations Relevant to Financial Consumers 125 6. Chapter 6: Regulation of Market Intermediaries in Financial Products 129



Chapter 1: Introduction to Regulatory Environment You will learn the various aspects of compliances, laws, regulatory, economic and political environment in relation to financial services, their functions and impacts. Financial regulation is a form of regulation that subjects financial institutions to certain conditions, restrictions and guidelines with the goal of preserving the financial system’s stability and integrity. Financial regulation has also affected the banking sector structure by increasing the range of available financial products. Consider the following from The Fundamental Principles of Financial Regulation: “What is needed is, first, a restatement of the basic objectives of financial regulation and, then, an assessment of whether the current regulatory framework is well-structured to attain such objectives, and, if not, to explore what can be done to restructure such regulation so that it does.” “So let us start by asking what should be the purposes of regulation. Traditional economic theory suggests that there are three main purposes: 1. To constrain the use of monopoly power and the prevention of serious distortions to competition and the maintenance of market integrity; 2. To protect the essential needs of ordinary people in cases where information is hard or costly to obtain, and mistakes could devastate welfare; and 3. Where there are sufficient externalities that the social, and overall, costs of market failure exceed both the private costs of failure and the extra costs of regulation.” (Markus Brunner Meier, 2009) Financial institutions are public or private organizations that accept funds from the public or other institutions and invest them in various financial assets, and that provide various types offinancial services to their clients. The Financial Times provides the following definition for financial regulation: “Laws andrules that govern what financial institutions such as banks, brokers and investmentcompanies can do”. These rules are generally circulated by government regulators orinternational groups to protect investors, maintain orderly markets and promote financialstability. The range of regulatory activities can include setting minimum standards for capital andconduct, making regular inspections, and investigating andprosecuting misconduct (Financial Times, 2017). CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 1

The International Monetary Fund website provides a paper addressing a framework for financial regulation (White, 1999) that identifies a three-way classification of regulation: Economic, Safety and Information. The objective that distinguishes financial regulation from other kinds of regulation is that of safeguarding the economy against systemic risk. Concerns regarding systemic risk focus largely on banks, which traditionally have been considered to have a special role in the economy. The safety nets that have been rigged to protect banks from systemic risk have succeeded in preventing banking panics, but at the cost of distorting incentives for risk taking. Regulators have a variety of options to correct this distortion, but none can be relied upon to produce an optimal solution. Goals of Regulation Financial regulation is primarily intended to achieve the following underlying policy outcomes:  Market Efficiency and Integrity: Regulators are to ensure that markets operateefficiently and that market participants have confidence in the market’s integrity.Liquidity, low costs, the presence of many buyers and sellers, the availability ofinformation, and a lack of excessive volatility are examples of the characteristicsof an efficient market. Regulation can also improve market efficiency byaddressing market failures, such as principal-agent problems, asymmetric information, and moral hazard.Regulators contribute to market integrity byensuring that activities are transparent, contracts can be enforced, and the “rulesof the game” they set are enforced. Integrity generally leads to greater efficiency.  Consumer and Investor Protection: Regulators are to ensure that consumers orinvestors do not suffer from fraud, discrimination, manipulation, and theft.Regulators try to prevent exploitative or abusive practices intended to takeadvantage of unwitting consumers or investors. In some cases, protection islimited to enabling consumers and investors to understand the inherent riskswhen they enter into a contract. In other cases, protection is based on theprinciple of suitability—efforts to ensure that more risky products or productfeatures are only accessible to financially sophisticated or secure consumers andinvestors.  Capital Formation and Access to Credit: Regulators are to ensure that firmsand consumers are able to access credit and capital to meet their needs such thatcredit and economic activity can grow at a healthy rate. Regulators try to ensurethat capital and credit are available to all worthy borrowers, regardless ofpersonal characteristics, such as race, gender, and location.  Illicit Activity Prevention: Regulators are to ensure that the financial systemcannot be used to support criminal and terrorist activity. Examples are policies toprevent money laundering, tax evasion, terrorism financing, and thecontravention of financial sanctions.  Taxpayer Protection: Regulators are to ensure that losses or failures in financialmarkets do not result in federal government payouts or the assumption ofliabilities that are ultimately borne CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 2

by taxpayers. Only certain types of financialactivity are explicitly backed by the federal government or by regulator-runinsurance schemes that are backed by the federal government, such as theDeposit Insurance Fund (DIF) run by the Federal Deposit Insurance Corporation (FDIC). Such schemes are self-financed by the insured firms through premiumpayments, unless the losses exceed the insurance fund, and then taxpayer moneyis used temporarily or permanently to fill the gap. In the case of a financial crisis,the government may decide that the “least bad” option is to provide funds inways not explicitly promised or previously contemplated to restore stability.“Bailouts” of large failing firms in 2008 are the most well- known examples. Inthis sense, there may be implicit taxpayer backing of parts or all of the financialsystem.  Financial Stability: Financial regulation is to maintain financial stability throughpreventative and palliative measures that mitigate systemic risk. At times,financial markets stop functioning well—markets freeze, participants panic,credit becomes unavailable, and multiple firms fail. Financial instability can belocalized (to a specific market or activity) or more general. Sometimes instabilitycan be contained and quelled through market actions or policy intervention; atother times, instability metastasizes and does broader damage to the realeconomy. The most recent example of the latter was the financial crisis of 2007-2009. Traditionally, financial stability concerns have centered on banking, but therecent crisis illustrates the potential for systemic risk to arise in other parts of thefinancial system as well. These regulatory goals are sometimes complementary, but at other times conflict with each other.For example, without an adequate level of consumer and investor protections, fewer individualsmay be willing to participate in financial markets, and efficiency and capital formation couldsuffer. But, at some point, too many consumer and investor safeguards and protections couldmake credit and capital prohibitively expensive, reducing market efficiency and capital formation.Regulation generally aims to seek a middle ground between these two extremes, where regulatoryburden is as small as possible and regulatory benefits are as large as possible. As a result, whentaking any action, regulators balance the tradeoffs between their various goals. Types of Regulation The various types of regulation applicable to market participants are varied and differ by regulator, but canbe grouped in a few categories: Prudential: The purpose of prudential regulation is to ensure an institution’ssafety and soundness. It focuses on risk management and risk mitigation. Examples are capital requirements for banks. Prudential regulation may bepursued to achieve the goals of taxpayer protection (e.g., to ensure that bankfailures do not drain the DIF), consumer protection (e.g., to ensure that insurancefirms are able to honor policyholders’ claims), or financial stability (e.g., toensure that firm failures do not lead to bank runs). CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 3

Disclosure and Reporting: Disclosure and reporting requirements are meant toensure that all relevant financial information is accurate and available to thepublic and regulators so that the former can make well-informed financialdecisions and the latter can effectively monitor activities. For example, publiclyheld companies must file disclosure reports, such as 10-Ks. Disclosure is used toachieve the goals of consumer and investor protection, as well as marketefficiency and integrity. Standard Setting: Regulators prescribe standards for products, markets, andprofessional conduct. Regulators set permissible activities and behavior formarket participants. Standard setting is used to achieve a number of policy goals. For example, (1) for market integrity, policies governing conflicts of interest,such as insider trading; (2) for taxpayer protection, limits on risky activities; (3)for consumer protection, fair lending requirements to prevent discrimination; and(4) for suitability, limits on the sale of certain sophisticated financial products toaccredited investors and verification that borrowers have the ability to repaymortgages. Competition: Regulators ensure that firms do not exercise undue monopolypower, engage in collusion or price fixing, or corner specific markets (i.e., take adominant position to manipulate prices). Examples include antitrust policy (which is not unique to finance), anti-manipulation policies, concentration limits,and the approval of takeovers and mergers. Regulators promote competitivemarkets to support the goals of market efficiency and integrity and consumer andinvestor protections. Within this area, a special policy concern related to financialstability is ensuring that no firm is “too big to fail.” Price and Rate Regulations: Regulators set maximum or minimum prices, fees,premiums, or interest rates. Although price and rate regulation is relatively rare infederal regulation, it is more common in state regulation. An example at thefederal level is the Durbin Amendment, which caps debit interchange fees forlarge banks. Economic Financial regulation governs one of the most important systems in an economy—the financial system. The primary purpose of financial regulation is to improve the functioning of that system. The design of financial regulation is thus ultimately an exercise in economics—applying the analytic tools of economics to determine the legal and regulatory framework best suited to correcting the failures of a financial system. The starting point of economic regulation is “if it isn’t broken, don’t fix it.” In other words, if there is no clear evidence of a failure of markets, do not interfere with them. To understand why, consider the “welfare properties” of competitive markets. The invisible hand of competition guides participants in well-functioning market economies to allocate resources in ways that achieve economically efficient CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 4

outcomes. Market participants use information on prices to determine where and when to sell their products and where and when to purchase their inputs. Market participants make employment decisions on the basis of wages and salaries and investment decisions in relation to the cost and returns on different forms of capital. Open market based economies run on the basis of markets that determine prices, wages, interest rates and cost of finance on the basis of decisions made by a large number of individuals and institutions (John Armour, 2016). An economic regulation system should result in a financial services sector that is: open to entrants; to new ideas about products and services; and to a competitive process that permits the better ideas and the more efficient organizations to flourish and spread their benefits throughout the economy. Concerns about safety and about information adequacy should be addressed directly through safety/prudential regulation and information regulation, and not through inefficient economic regulation. Safety Prudential regulation can be defined as the type of financial regulation that requires financial firms to control risks and hold adequate capital as defined by capital requirements (in contrast to consumer protection rules that are also part of financial regulation). With respect to banks and other depository institutions, insurance companies and defined benefit pension plans, prudential regulation should be vigorous, since widespread insolvencies among these institutions can be disruptive and undermine the confidence of savers and investors in an economy. (Prudential regulation aims to ensure the safe and sound operation of financial institutions for the overall benefit of financial markets.) The components of a vigorous and sensible prudential regulatory system include: Minimum Capital Requirements Capital is both a direct buffer against insolvency and an indirect protection, since higher capital levels mean that the financial institution has more to lose from risk taking and should thereby be less inclined to undertake it. Minimum capital requirements should be commensurate with the risks undertaken by a financial institution and should be forward-looking. They should be based on an accounting framework that emphasizes current values for assets and liabilities rather than the historical values that are the basis for existing accounting frameworks. Where possible, a layer of subordinated debt should be part of the capital requirement (e.g., for banks). This will bring supplementary market discipline and scrutiny to aid the regulatory process, since the holders of the subordinated debt will have similar interests in curbing the excessive risk taking of the financial institution. Restrictions on Activities All activities that are \"examinable and supervisable\"—that regulators can comprehend sufficiently to be able to set appropriate capital requirements and to judge the competency with which they are being conducted—should be permitted within the financial institution. Any activities that are not examinable and supervisable should not be allowed to be conducted by the financial institution but CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 5

should be permitted for a separately capitalized affiliate, so long as transactions (e.g., loans) between the two entities are tightly scrutinized. Honesty and Competency The honesty and competency of a financial institution’s principal owners and senior management must be continuously scrutinized. Prompt Corrective Action When a financial institution’s capital level drops below the regulatory minimum level, regulatory scrutiny should increase and restrictions should tighten. When a financial institution becomes insolvent, it should be promptly disposed of; the former owners' rights should be eliminated and senior managers removed, and new owners should be found or the financial institution should be liquidated. Market Value Accounting Since adequate capital is crucial for safety regulation, it must be measured appropriately. As was mentioned above, the standard measurement frameworks that apply to financial institutions are inadequate, in part, because they are backward-looking and are slow to recognize current values. The necessary accounting framework must rely on current—i.e., market-based—values. Lender of Last Resort A reliable lender of last resort, that is prepared to lend to otherwise solvent banks that are subject to depositor runs, is an important means of dealing with the instability problems of banks. A lender of last resort is an institution (usually a territory's central bank) that offers loans to banks or other eligible institutions that are experiencing financial difficulty or considered highly risky or near collapse. A reliable lender of last resort may choose to lend to an otherwise solvent institution to avoid such risks as a “bank run” by depositors and plays a vital role in dealing with instability problems faced by banks. To reassure itself that it is lending to solvent institutions, it is critical that the lender of last resort have the same information available to bank regulators, as this provides further support for the financial system. Deposit Insurance Prudential regulation addresses the inability of a bank's depositors to adequately monitor the bank's behavior. Deposit insurance provides an extra layer of assurance for depositors against regulatory failures. The need to provide this kind of assurance to depositors is so critical to the banking system that over the past few decades, whenever faced with bank insolvencies, governments have invariably kept depositors whole, regardless of whether formal deposit insurance arrangements were in place. A better policy would be to make such arrangements explicit beforehand, rather than creating ex CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 6

ante uncertainty and ex post \"bailouts.” Like all efficiently priced insurance, of course, the premiums should be risk-based. Personnel Good laws and regulations are not by themselves adequate. They need to be interpreted and enforced. They require a regulatory team that is well-staffed, well-trained and well-paid. Corporate Governance and Securities Regulation A territory’s regulatory environment around corporate governance and securities regulation are properly considered to be a form of safety regulation. Though this type of government regulation doesn’t necessarily affect the basic economic/financial risks that are inherently part of securities markets, it does provide a basic framework of reliance and assurance for creditors and investors. These provisions should include the specification of creditor and stockholder rights, including minority stockholder protections and a bankruptcy code. The important long-run considerations—that lenders will be more willing to lend when they have greater information and greater assurances that they will be repaid—should be kept in focus in the design of such systems. These provisions include a system of fiduciary obligations on the part of intermediaries, such as stockbrokers and dealers (and other financial facilitators), and limits on manipulation in thin markets. Information Requirements for timely, periodic issuances of information by publicly traded companies are an important \"lubricant\" for securities markets. Though such issuances are an inherent part of a corporate governance system, they are also an essential form of information regulation. The issuance of financial information should be standardized (so that lenders and investors can more easily make comparisons among enterprises) and, for example, use an accounting system that stresses standardization and transparency. Again, as is true for prudential regulation, the enforcement of information regulation (as well as corporate governance, bankruptcy and securities regulation) must be from a regulatory team that is well-staffed, well-trained and well-paid. Financial regulation requires laws (legislation and regulations) to govern the financial environment and regulators to oversee, explain and comment on the regulations. Regulators Every territory that has a financial marketplace also has financial services regulations and regulators. As we are primarily concerned with investment-related regulations, we can begin exploring regulators by looking at the International Organization of Securities Commissions—IOSCO. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 7

IOSCO is the international body that brings together the world’s securities regulators and is recognized as the global standard setter for the securities sector. IOSCO develops, implements and promotes adherence to internationally recognized standards for securities regulation. IOSCO was established in 1983. Its membership regulates more than 95% of the world’s securities markets in more than 115 jurisdictions. The IOSCO Objectives and Principles of Securities Regulation have been endorsed by both the G20 and the Financial Stability Board (FSB) as the relevant standards in this area. They are the overarching core principles that guide IOSCO in the development and implementation of internationally recognized and consistent standards of regulation, oversight and enforcement. They form the basis for the evaluation of the securities sector for the Financial Sector Assessment Programs (FSAPs) of the International Monetary Fund (IMF) and the World Bank. IOSCO Objectives IOSCO members have resolved:  To cooperate in developing, implementing and promoting adherence to internationally recognized and consistent standards of regulation, oversight and enforcement to protect investors, maintain fair, efficient and transparent markets, and seek to address systemic risks;  To enhance investor protection and promote investor confidence in the integrity of securities markets, through strengthened information exchange and cooperation in enforcement against misconduct and in supervision of markets and market intermediaries; and  To exchange information at both global and regional levels on their respective experiences to assist the development of markets, strengthen market infrastructure and implement appropriate regulation. The insurance industry has a similar organization to IOSCO: Established in 1994, the International Association of Insurance Supervisors (IAIS)is a voluntary Member-driven, non-profit organization of insurance supervisors and regulators formed under Article 60 of the Swiss Civil Code. With over 210 Members (accounting for nearly 100% of worldwide premium volume), the IAIS isthe international standard-setting body responsible for developing and supportingthe implementation of principles, standards and guidance for the supervision of theinsurance sector. The IAIS is guided by the following mission statement: “The IAIS mission is to promote effective and globally consistent supervision of the insurance industry in order to develop and maintain fair, safe and stable insurance markets for the benefit and protection of policyholders, and to contribute to global financial stability”. IAIS aims to do for the insurance industry what IOSCO is doing in the securities arena. IAIS developed a five-year plan for the years 2015-2019, highlighting seven high-level goals: CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 8

1. Assessing and responding to insurance sector vulnerabilities As the recognized thought leader in insurance supervision, the IAIS proactively identifies risks and developments in the general economy and the financial sector that may affect the insurance sector, its business, insurance regulation and supervision as a basis for subsequently timely developing appropriate forward-looking policy responses. 2. The IAIS as the global standard setter for insurance The IAIS is well-established and unequivocally recognized by all relevant stakeholders as the independent global standard setter in insurance through the development of sound principles and standards for globally consistent micro-prudential, macro-prudential and conduct of business supervision of the insurance sector. 3. Contributing to financial stability in the insurance sector The IAIS plays a key role in assessing and identifying global systemically important insurers (G-SIIs) and promotes supervisory measures applying to G-SIIs. 4. Enhancing effective supervision IAIS Members apply best practices for effective insurance supervision and supervisory cooperation. 5. Enhancing implementation and observance of Insurance Core Principles (ICPs) Based on a robust program for monitoring implementation, the IAIS is promoting the observance of the ICPs by all Members, and coordinating and facilitating initiatives that meet the capacity-building needs of the Members of less-developed jurisdictions. 6. Effective stakeholder outreach and external interaction Through transparent and robust processes, the IAIS effectively promotes its interests with its stakeholders and the production of high-quality deliverables by collecting input from stakeholders while maintaining its independence. The IAIS develops and maintains a close partnership with key external partners. 7. Effective and efficient organization and operations The IAIS is an independent and highly efficient association with sound governance, an effective and efficient operational and working party structure, and a Secretariat that provides high-quality support and advice. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 9

Each of the high-level goals has several strategic points to help achieve their goals. Even a brief view of the IAIS goals shows that they have similar concerns as IOSCO. They want to improve the insurance sector’s standards and financial strength, and protect consumers by improving guidelines and supervision. We highlight the role and goals of IOSCO and the IAIS to help financial advisors understand that territorial regulations do not occur in a vacuum. This is not to say that all territories move in lock-step with IOSCO, IAIS or with each other, or that there are no regulatory differences among territories. It does, however, point to the consistent overarching goals and alignment of regulatory bodies around the globe. When financial advisors consider the nature of existing or pending regulations in their territory, it can be helpful to understand global trends in regulation. You can find more detail about financial regulators by territory on the internet. Note that some territories have a single regulatory body while others have more than one, usually focused on a sector or a region. For example, the UK lists five bodies, Australia three, Canada 11, China three, and the European Union five, while territories such as Greece, Honduras, Iceland and Israel each have one main regulatory body for financial services. Additionally, some territories may have state, regional or other jurisdictional regulatory bodies. Much of regulators’ work is focused on financial services firms and other large financial intermediaries. The expectation is that the firms will pass down, through senior management and corporate boards, rules and regulations that the regulators have mandated for employees to support. That said, many of the regulations apply directly to independent financial advisors who do not work with financial firms. We will cover legislation and regulation as a whole, rather than differentiate between items that are targeted to large firms and those that also directly impact independent practitioners operating in financial markets. Example 1 What are the three goals or purposes of IOSCO’s regulatory approach/resolution? Solution: 1. To cooperate in developing, implementing and promoting adherence to internationally recognized and consistent standards of regulation, oversight and enforcement to protect investors, maintain fair, efficient and transparent markets, and seek to address systemic risks; 2. To enhance investor protection and promote investor confidence in the integrity of securities markets, through strengthened information exchange and cooperation in enforcement against misconduct and in supervision of markets and market intermediaries; and 3. To exchange information at both global and regional levels on their respective experiences to assist the development of markets, strengthen market infrastructure and implement appropriate regulation. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 10

Legislation and Regulation Most of the current financial regulationsare a direct consequence of the 2007 and 2008 global economic crisis. While these two years could be a reasonable timeline for the crisis, several territories, agencies and organizations are still suffering the effects of the economic downturn. It’s not that there was no regulation prior to the collapse. Rather, policymakers and regulators around the world recognized that many of those regulations did not serve to avert the economic catastrophe and needed to be revised, updated and strengthened. Regulations are often seen by those who work in the financial services sector as intrusive or unnecessary, but the aim of regulation is to encourage and facilitate territorial and global economic well-being and development. Only a cursory analysis of the factors causing economic instability and crisis would indicate that a certain amount of regulation is important and vital for effective economic growth at least. Within this context, safety issues have become more relevant. It includes not only protection for individual investors but also applies to the security and stability of the entire financial system, requiring sufficient capital rates from financial institutions. In addition to capital standards, regulators have called for financial services companies to implement appropriate (i.e. reliable and clear) accounting processes and procedures. These help to establish that capital is maintained, risk is managed and companies operate according to best practices. Regulators need timely and reliable financial information reporting to encourage and facilitate a transparent and competitive financial market. They must be clearly written and freely circulated to interested individuals and organisations, including regulators. Similar rules differ by region, as said, even though the details that should be included in such reports can be seen as a global consensus. Every jurisdiction has its own laws and regulations on financial services provision. Although some are more advanced than others, in most jurisdictions general concepts and realistic standards can be found, except for those without any financial market. The European Union has established one of the most detailed sets of financial market and financial advice regulations. Although the rules only apply to Europe, it is worth looking at them as a good example. In 2008, the European Union (EU) put into force the Markets in Financial Instruments Directive (MiFID: Directive 2004/39/EC). Its purpose was to improve the EU financial markets’ competitiveness by creating a single market for investment services and activities. It was also designed to ensure a high degree of harmonized protection for investors in financial instruments. MiFID was reformed to become MiFID II. The revised regulations were adopted in May 2014 and MiFID II went into effect in January 2018. MiFID II creates rules that apply to all investment firms and specific rules for the provision of investment advice. Some of the key rules require: CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 11

1. All investment firms to act honestly, fairly and professionally in accordance with the best interests of their clients; 2. Investment firms that provide advice on an independent basis to: i. Assess a range of financial instruments available on the market which must be sufficiently diverse with regard to their type and issuers or product providers to ensure that the client’s investment objectives can be suitably met and must not be limited to financial instruments issued or provided by the investment firm itself or by entities having close links with the investment firm; or by other entities with which the investment firm has such close legal or economic relationships, such as contractual relationships, as to pose a risk of impairing the independent basis of the advice provided; ii. Not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients. Minor non-monetary benefits that are capable of enhancing the quality of service provided to a client and are of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client must be clearly disclosed and are excluded from this point. 3. Investment firms to ensure that staff giving investment advice or information about financial instruments, investment services or ancillary services to clients on behalf of the investment firm possess the necessary knowledge and competence to fulfil their obligations; 4. Investment firms when providing investment advice to 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 investment 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. The European Securities and Markets Authority (ESMA) was charged with the responsibility of suggesting detailed rules for MiFID II. ESMA has already produced a number of detailed rules and is continuing to do so. As a key part of this process, in 2015, ESMA released guidelines specifying criteria for the assessment of knowledge and competence of investment firms’ personnel, effective as of 3 January 2017. The ESMA Guidelines directly affect investment advisors in the EU, and may indirectly provide guidance for investment advisors in other territories. The MiFID II rules and the ESMA Guidelines create a detailed regulation framework for the regulation of investment advice, and it will help to understand how such a regime works by looking at some of the detail. As such, we will quote directly from the Guidelines. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 12

ESMA Guidelines Criteria for knowledge and competence for staff giving information about investment products, investment services or ancillary services Firms should ensure that staff giving information about investment products, investment services or ancillary services that are available through the firm have the necessary knowledge and competence to: 1. Understand the key characteristics, risk and features of those investment products available through the firm, including any general tax implications and costs to be incurred by the client in the context of transactions. Particular care should be taken when giving information with respect to products characterized by higher levels of complexity; 2. Understand the total amount of costs and charges to be incurred by the client in the context of transactions in an investment product, or investment services or ancillary services; 3. Understand the characteristics and scope of investment services or ancillary services; 4. Understand how financial markets function and how they affect the value and pricing of investment products on which they provide information to clients; 1. Understand the impact of economic figures, national/regional/global events on markets and on the value of investment products on which they provide information; 2. Understand the difference between past performance and future performance scenarios as well as the limits of predictive forecasting; 3. Understand issues relating to market abuse and anti-money laundering; 4. Assess data relevant to the investment products on which they provide information to clients such as Key Investor Information Documents, prospectuses, financial statements or financial data; 5. Understand specific market structures for the investment products on which they provide information to clients and, where relevant, their trading venues or the existence of any secondary markets; 6. Have a basic knowledge of valuation principles for the type of investment products in relation to which the information is provided. Criteria for knowledge and competence for staff giving investment advice Firms should ensure that staff giving investment advice has the necessary knowledge and competence to: 1. Understand the key characteristics, risk and features of the investment products being offered or recommended, including any general tax implications to be incurred by the client in the context of transactions. Particular care should be taken when providing advice with respect to products characterized by higher levels of complexity; 2. Understand the total costs and charges to be incurred by the client in the context of the type of investment product being offered or recommended and the costs related to the provision of the advice and any other related services being provided; CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 13

3. Fulfill the obligations required by firms in relation to suitability requirements including the obligations as set out in the Guidelines on certain aspects of the MiFID suitability requirements; 4. Understand how the type of investment product provided by the firm may not be suitable for the client, having assessed the relevant information provided by the client against potential changes that may have occurred since the relevant information was gathered; 5. Understand how financial markets function and how they affect the value and pricing investment products offered or recommended to clients; 6. Understand the impact of economic figures, national/regional/global events on markets and on the value of investment products being offered or recommended to clients; 7. Understand the difference between past performance and future performance scenarios as well as the limits of predictive forecasting; 8. Understand issues relating to market abuse and anti-money laundering; 9. Assess data relevant to the type of investment products offered or recommended to clients such as Key Investor Information Documents, prospectuses, financial statements or financial data; 10. Understand specific market structures for the type investment products offered or recommended to clients and where relevant their trading venues or the existence of any secondary markets; 11. Have a basic knowledge of valuation principles for the type of investment products offered or recommended to clients; 12. Understand the fundamentals of managing a portfolio, including being able to understand the implications of diversification regarding individual investment alternatives. Organizational requirements for assessment, maintenance and updating of knowledge and competence 1. Firms should set out the responsibilities of staff and ensure that, where relevant, in accordance with the services provided by the firm and its internal organization, there is a clear distinction in the description of responsibilities between the roles of giving advice and giving information. 2. Firms should: i. Ensure that staff providing relevant services to clients are assessed through the successful completion of an appropriate qualification and having gained appropriate experience in the provision of relevant services to clients; 3. Carry out an internal or external review, on at least an annual basis, of staff members’ development and experience needs, assess regulatory developments and take action necessary to comply with these requirements. This review should also ensure that staff possess an appropriate qualification and maintain and update their knowledge and competence by undertaking continuous professional development or training for the appropriate qualification as well as specific training required in advance of any new investment products being offered by the firm; 4. Ensure that they submit to their Competent Authority (CA), on request, records concerning knowledge and competence of staff providing relevant services to clients. These records shall contain information that enables the CA to assess and verify compliance with these guidelines; CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 14

5. Ensure that when a member of staff has not acquired the necessary knowledge and competence in the provision of the relevant services, this staff member cannot provide the relevant services. However, where this member of staff has not acquired the appropriate qualification or the appropriate experience to provide the relevant services or both, this staff member can only provide the relevant services under supervision. The level and intensity of supervision should reflect the relevant qualification and experience of the staff member being supervised and this could include, where appropriate, supervision during clients meeting and other forms of communication such as telephone calls and e-mails; 6. Ensure that, in situations under letter d., the staff member supervising other staff has the necessary knowledge and competence required by these guidelines and the necessary skills and resources to act as a competent supervisor; 7. Ensure that the supervision provided is tailored to the services to be provided by that staff member and cover the requirements of these guidelines relevant to those services; 8. Ensure that the supervisor takes responsibility for the provision of the relevant services when the staff member under supervision is providing relevant services to a client, as if the supervisor is providing the relevant services to the client, including signing-off the suitability report where advice is being provided; 9. Ensure that the staff member, who has not acquired the necessary knowledge or competence in the provision of the relevant services, cannot provide those relevant services under supervision for a period exceeding four years (or shorter if required by the CA). We can make a few comments on the preceding that may help clarify understanding. Section V.IV is targeted to financial firms, while sections V.II and V.III focus on those interacting with clients. Notice the differentiation between V.II and V.III. The first (V.II) provides guidance for staff providing information about investment products, investment services or ancillary services. The second (V.III) lists criteria for knowledge and competence for staff giving investment advice. There is, here and elsewhere, a recognized differentiation between those who provide information and those who take the information and use it to provide advice. If we were to compare the two sections, one thing would be clear: Investment advisors must understand risk-related components of the investments they discuss with, and recommend to, clients. Investment advisors must ensure suitability of the product solutions and (as important) recognize when a given investment product may not be suitable. In both sections, the regulations require understanding of the broader financial markets and the economy. There is also the requirement to understand all fees and costs, with the assumption that these will be explained to the client. There is also an expectation that both categories of financial staff (those who provide information and those who provide advice) will understand investment performance criteria as well as limits related to forecasting. All of this is in keeping with the goal of transparency and competency. The ESMA document also requires awareness of anti-money laundering issues, which will be covered later in this course. In the European insurance sector, The European Insurance and Occupational Pensions Authority (EIOPA) oversee Europe’s insurance industry. EIOPA’s main goals are: CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 15

 Better protecting consumers and rebuilding trust in the financial system.  Ensuring a high, effective and consistent level of regulation and supervision taking account of the varying interests of all Member States and the different nature of financial institutions.  Greater harmonization and coherent application of rules for financial institutions and markets across the European Union.  Strengthening oversight of cross-border groups.  Promote coordinated European Union supervisory response. Although we have focused on the regulatory environment in the EU, we could easily expand the discussion to the rest of the world. The EU probably has invested more time codifying a unified regulatory approach across territories, but regulatory bodies are undertaking similar harmonization efforts through global bodies like IAIS and IOSCO. Additionally, most territories also have nongovernment or quasi-governmental organizations working to improve and implement higher standards among members. Financial Planning Standards Board (FPSB) fits into this broad category and has a focus on developing and delivering high-level professional standards for financial advisors and financial planners among its Member organizations. You can get a sense of FPSB’s approach as you study the Personal and Professional Ethics course. Review Questions 1. What are the areas the IMF identifies as the three-way framework for classification of regulation? 2. How would you describe the underlying desire of regulators regarding regulatory actions? 3. How would you summarize the ESMA Guidelines as presented in the text? If you are not part of the European Union, what is their significance to you? Associated Websites  https://en.wikipedia.org/wiki/List_of_financial_regulatory_authorities_by_territory  World Stock Exchanges/Regulators: http://world-stock-exchanges.net/regulators.html  FCA: https://www.fca.org.uk  Prudential Regulation Authority: http://www.bankofengland.co.uk/pra/Pages/default.aspx  https://www.ftadvisor.com  https://www.imf.org/external/pubs/ft/seminar/1999/reforms/white.htm http://www.imf.org/exte rnal/  https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial- markets/securities-markets_en  http://europa.eu/rapid/press-release_MEMO-14-305_en.htm  https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir  https://www.cfainstitute.org/ethics/Documents/MiFID%20II%20Policy%20Brief.pdf  https://www.esma.europa.eu/sites/default/files/library/2015-1886_- _final_report_on_guidelines_for_the_assessment_of_knowledge_and_competence.pdf CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 16

Chapter 2: Legislated “Client Best Interest” Requirements You will learn legal framework within which financial advisors operate with a legal, social and ethical responsibility to protect their client’s interest. As referenced in the section on Legislation and Regulation, ESMA released guidelines specifying criteria for the assessment of knowledge and competence of investment firms’ personnel, effective January 2017. MiFID II and the ESMA Guidelines directly affect investment advisors in the European Union, and may indirectly provide guidance for advisors in other territories. Consequently, we will refer directly to ESMA and MiFID II guidelines in this section. As described above, the MiFID rules, as amplified by the ESMA Guidelines, require firms and investment advisors to act in the best interest of the client (ESMA, p.35). They also require investment advisors to select products that are best suited to the client profile (ESMA, p.42). In its Code of Ethics and Professional Responsibility, Financial Planning Standards Board lists as its first Principle the requirement that financial planners and financial advisors place the client’s interest first. There is a consistency among territories and professional bodies in identifying this overarching principle. As a result, it would seem that this would not require much, if any, clarification. However, this is not the case. Specifically, there is the question of what it means for an investment advisor, a financial advisor or a financial planner to act in the client’s best interest. Must the advisor simply make recommendations that are “suitable” for the customer (meaning that the recommendations meet a client's defined needs and objectives), or does the requirement go deeper? Does the financial advisor need to adhere to a more significant standard, identified as a “client first” standard or, in Anglo-Saxon countries, referred to as a fiduciary, or fiduciary-like, standard? The Fiduciary Standard The fiduciary responsibility under the U.S. legal system is a legal concept defining the relationship between two parties, which allows one to behave exclusively in the interests of the other. The appointed fiduciary is responsible for the ethical responsibility of a principal and careful care is taken to ensure that there is no conflict of interest between the fiduciary and the principal. A fiduciary obligation exists whenever the relationship with the client involves a special trust, confidence, and reliance on the fiduciary to exercise his discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his expertise and discretion CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 17

to act on the client's behalf. In most cases, no profit is to be made from the relationship unless explicit consent is granted when the relationship begins. Breaches in Fiduciary Duty Case law says that breaches of fiduciary obligation typically take place when a binding fiduciary relationship is established and actions that violate or act against the interests of a particular customer are taken. Typically, actions are often taken to benefit the interests of the fiduciary or of a third party rather than the interests of the customer. A breach can also stem from a failure to provide important information to a client that may lead to misunderstandings, misinterpretations, or misguided advice. Identification or disclosure of any potential conflicts of interest is usually important in fiduciary relationships because all types of conflicts can be a source for undesired intentions. Elements of a Breach of Fiduciary Duty Claim As is expected with most all case law, certain precedents and elements have been established in the legal industry to help govern against fiduciary breaches and to protect those who have been harmed by unlawful actions. Each jurisdiction may have different elements, but in general, the following four elements are essential in helping a plaintiff to prevail in a breach of fiduciary duty claim. Duty: The plaintiff will prove that there was a fiduciary obligation. In several situations, fiduciary duty can be required so that the legality of the fiduciary duty is most important. Breach: The plaintiff must show that breach of the fiduciary duty occurred. The type of breach can vary in each case depending on the actions taken by a defending fiduciary. Examples of a breach may include failed disclosure of important information causing misinterpretation, negligence, or unlawful use of funds. Damages: The plaintiff must show that damages occurred from the breach. Without damages there is typically no basis for a breach of fiduciary duty case. Causation: Causation is usually also an element associated with a breach of fiduciary duty cases. Causation shows that any damages incurred by the plaintiff were in direct association with the breach of fiduciary duty actions taken by the defendant. Although the legal concept of fiduciary varies from territory to territory, the concept can be readily understood. A fiduciary obligation describes a relationship with the client that involves a level of trust, confidence and reliance on the fiduciary to exercise his or her discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his or her expertise and discretion to act on the client's behalf. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 18

At its core, the definition of “fiduciary” states that the financial advisor must act with undivided loyalty to the client. In other words, act in the best interest of the client. One professional organization identifies that being a fiduciary encompasses three basic requirements: trust, loyalty and disclosure. They illustrate their position by asking three questions:  Trust: Someone who does not completely trust their financial advisor can never be fully confident that they are receiving the best possible advice from the best possible advisor. Without trust, can client confidence be achieved?  Loyalty: A financial advisor who is loyal to their clients will not be swayed by outside forces to recommend investments with higher commissions or payouts. Without loyalty, can clients be sure their own interests are being looked after?  Disclosure: Clients must know, and understand, how their financial advisor is being compensated for the advice they are providing and whether any conflicts exist that may cause a problem with that advisor’s ability to provide truly independent advice. Without disclosure, can the financial advisor provide prudent advice? From these questions some common themes emerge that are in line with those presented by MiFID and ESMA. Within the EU, MiFID has established a set of rules to support financial markets. The rules state that investment advice should be:  Fair  Transparent  Efficient  Integrated Though the terms differ, they describe the same operating standards. Add the statement from ESMA that their document creates guidelines to assist firms in meeting their obligations to act in the best interest of their clients, and you can see the consistent focus on “client first” across all the guidance. Don’t most people in the financial services arena recognize the requirement to put the client’s interest first? Unfortunately, practice doesn’t always support the concept. Although you might find general agreement with the concept, you will recognize deep differences in its application. The question for us then becomes, in what ways is it important for the financial advisor to act in the best interest of the client, and what difficulties might be present? Let’s consider fiduciary duty and suitability in this context. Fiduciary Duty and the Duty of Suitability A critical aspect of a client-first or fiduciary standard arises when there is a conflict or potential conflict of interest between a fiduciary and the client for whom he or she is acting. For example, a financial advisor preparing an investment recommendation for a client might be considering two options, one of which will involve a payment to the fiduciary from the issuer of the investment and one that does not. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 19

Both may be “suitable” for the client in the sense that they fit the needs the client has expressed. A client-first or fiduciary standard requires the financial advisor to choose the investment which is in the best interests of the client. If this is the investment with no payment, then the financial advisor should recommend that one and not allow the benefit to the financial advisor to influence the advice. If it happens to be the one involving a payment to the financial advisor, the financial advisor must fully disclose that fact before the client makes the investment decision. In other words, the duty of loyalty requires the financial advisor to put the client’s interest ahead of his or her interest; and the duty of disclosure requires the financial advisor to fully disclose the conflict and make sure the client understands that before making the decision.  While there are not many financial advisors who will openly declare that the client’s interests are secondary and financial advisors should look out for their own self-interests (commercial or otherwise) over those of clients, the potential for conflicted interests is present. What does putting the client’s interest first really mean? How should a financial advisor apply the principle in today’s financial marketplace? Even where “fiduciary” represents a legal concept in a territory, there are disagreements on the application of the principle. Part of the difficulty can be traced to the word “legal.” When principles such as those around client interests are set in law, individual behaviors may be distorted as interpretations of the law and common practice may differ. It is important for financial advisors to know and understand the legal requirements relevant to their country or territory. For example, in the United States, financial advisors providing advice and recommendations on retirement pensions and financial products must comply with the Employee Retirement Income Security Act (ERISA), which includes specific fiduciary requirements. Failure to comply with this Act can result in large monetary fines and imprisonment. Financial advisors subject to fiduciary requirements of a specific nature (such as ERISA) should be clear about legal requirements and expectations, and comply accordingly. In situations where legal requirements are less clear, financial advisors should choose to operate on the basis of putting the client first. In the absence of specific regulations defining regulatory expectations on the fiduciary conduct of a financial advisor, how should a financial advisor determine best practice in this area? The answer comes down to defining what it means to act in the best interest of the client and apply the principle in all professional advisor/client relationships. Generally speaking, we can say that acting in the client’s best interest means, to borrow from the Latin phrase premium non nocere—first, do no harm. Many physicians subscribe to a similar concept by agreeing to abstain from whatever will harm the patient, and to do what will be beneficial. This concept serves as a good foundation for abiding by the client-first/fiduciary mandate. As financial advisors begin to move beyond this basic foundation, it can become more difficult to apply the dictum. This is where cooperating with the management team and compliance specialists in the financial services firm can be helpful. Shared wisdom can often illuminate a path forward and best practice when there is a question about the way to meet the fiduciary standard. From a practical perspective, CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 20

documentation of client meetings and decisions will often go a long way toward showing the financial advisor’s intent (and client’s agreement) to put the client’s interest first. Not every professional organization or territory has a fiduciary requirement. In fact, some territories’ legal systems do not include the concept of being a fiduciary. Those territories and organizations will often hold to a suitability standard. This brings us back to the ESMA and MiFID requirement that recommendations are suitable for the client. Suitability is to be determined following an assessment of client requirements. A careful look at the two concepts—fiduciary and suitability—appears to show little difference in application. However, it is widely recognized that a client-first—or fiduciary— requirement is the greater while suitability is the lesser. Why is this so? In the broadest sense, you might consider the two to be more-or-less equal. The financial advisor is putting the client’s interest first by ensuring a recommendation is suitable, based on the assessment of client requirements, such as the client’s objectives, needs and financial situation. The difference between the two is subtle, but significant. Here’s how an ERISA attorney described the difference: \"With regard to the standard of care under current securities laws, a broker-dealer needs only to determine that an investment is suitable for the client. However, the fiduciary standard of care requires that the financial advisor take into account a number of considerations, such as whether the fees are reasonable, whether the investments are adequately diversified, whether there are conflicts of interest, whether the investments are consistent with the provisions of the trust or other governing document, and so on. Furthermore, the process that the financial advisor uses in developing the recommendation is measured by a prudent and reasonable hypothetical person who is knowledgeable about investments, about portfolio concepts and about the purpose of the investments.\" Suitability requires that a financial advisor determine that a particular type of investment is suitable for the client. Under the suitability standard, the financial advisor could equally recommend an investment option that pays more commission, or one that pays less. Suitability does not require choosing the lower-cost option. However, as a fiduciary, if a lower-cost option is available, and the investment provides the same benefits, the financial advisor should recommend the lower-cost alternative. This does not mean that the financial advisor cannot earn a living. It does mean, that in placing the client’s interest before his or her own, the financial advisor will recommend the lower-cost option, all else being equal. There is a larger context at play. Is it better to operate from a rules-based perspective or one that is principles-based? Rules-based standards tend to focus more on specific suitability requirements, while those that are principles-based lean toward the higher “client first” standard. If a financial advisor embraces the principles-based client-first standard, the advisor will in every reasonable way do his best to support the client’s goals and objectives by doing what he believes to be in the client’s interest. The financial advisor will put the needs of the client first, before his own. Following this type of standard will move someone a long way on the path toward greater professionalism. You can find additional coverage in the Personal and Professional Ethics course content, which focuses on professional standards. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 21

Example 1 What are some key differences between a suitability standard and a fiduciary standard? Solution: 1. Suitability requires that a financial advisor determine that a particular type of investment is suitable for the client. Under the suitability standard, the financial advisor could equally recommend an investment option that pays more commission, or one that pays less. Suitability does not require choosing the lower-cost option. However, as a fiduciary, if a lower-cost option is available, and the investment provides the same benefits, the financial advisor should recommend the lower-cost alternative. This does not mean that the financial advisor cannot earn a living. It does mean, that in placing the client’s interest before his or her own, the financial advisor will choose the lower-cost option. 2. Rules-based standards tend to focus more on specific suitability requirements, while those that are principles-based lean toward the higher “client first” standard. If a financial advisor embraces the principles-based client-first standard, the advisor will in every reasonable way do his best to support the client’s goals and objectives by doing what he believes to be in the client’s interest. The financial advisor will put the needs of the client first, before his own. Chapter Review Review Questions Whether your territory recognizes the legal concept of fiduciary, you should be able to understand and describe its implications. How would you describe the concept of operating as a fiduciary? Associated Websites  https://www.esma.europa.eu/press-news/esma-news/esma-publishes-final-report-mifid-ii- guidelines-assessment-and-knowledge  http://www.esma.europa.eu/system/files/2012-387.pdf)  http://www.napfa.org/consumer/DefinitionofFiduciary.asp  http://www.401khelpcenter.com/401k/chamberlain_401k_suitability_fiduciary.html)  http://www.cfp.net/for-cfp-professionals/professional-standards-enforcement/standards-of- professional-conduct) CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 22

Chapter 3: Economic Environment & Financial Advice You will learn the how various micro & macro-economic environment factors, economic indicators impact financial planning & financial advice to your clients. It’s safe to say that no financial advisor can accurately predict the future. Even though a financial advisor has used the most up-to-date, quality information to develop a client’s recommendation or strategy, over time, the economic environment is sure to change enough that the initial assumptions are no longer correct. The economy is the environment in which we live. It encompasses far more than finances and impacts much of what financial advisors do. Decades ago, it might have been appropriate to only address the domestic economic environment, but this is no longer possible. We live in a global economic environment and must plan accordingly. Monetary and Fiscal Policy Governments are understandably interested in establishing and maintaining a positive economic environment in their territories. When the economy is stable and flourishing, citizens generally are happier and the territory more prosperous. However, in times when the economic environment is less stable, and perhaps declining, the overall atmosphere may take on a gloomier aspect and social or political unrest may ensue. As a result, a government generally does what it can to support a thriving economic environment. Governments focus on using two primary tools to impact their economy: monetary policy and fiscal policy. Monetary policy is the domain of a territory’s central bank, while fiscal policy is more directly tied to the federal government’s budgetary process. Monetary Policy Economic growth, exchange rate stability and price stability are the objectives of monetary policy and to achieve these objectives there are certain targets such as interest rates, supply of money or bankcredit which are vital to be altered through instruments of monetary policy to realize these objectives.Reserve requirements variation, bank rates and interest rates change, currency supply adjustment, selective credit control and open market operations are certain instruments of monetary policy toachieve these targets. The monetary policy must move in parity with economic policy because it is one instrument of overall economic policy. The objectives of monetary policy are: maintenance economic growth, CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 23

rupeeexchange rate stability with foreign currencies, inflation control or stability in prices, full employmentand balance of payments. A central bank will often use monetary policy either to stimulate or slow down economic growth. In simplest terms, at least in theory, monetary policy can encourage either spending or saving, depending on whether the central bank wants to speed up or slow down economic growth. The central bank has three main tools to accomplish its monetary policy objectives: open market operations, the discount (interest) rate and reserve requirements. Open Market Operations The purchase and sale of securities by the central bank in the money market is known as open market operations. The securities are sold by the central bank, when there is an increase in the prices and acontrol is required. The commercial banks are not in a position to lend more to borrowers andbusiness community because their reserves are reduced. As a result price rise is checked due todiscouraged investment. Thus, the central bank uses open market operations as a primary tool to impact the supply of bank reserves (the amount of funds banks must hold against deposits in bank accounts). When the central bank wants to increase the supply of money in the economy, it will buy government bonds, thereby infusing additional cash into the system. Conversely, when the central bank wants to remove money from the economic system, it will sell government bonds, taking in cash and reducing the available money supply. Discount Rate Discount rate is the standard term used to identify interest rates. Bank Rate is the rate at which the central bank lends money to the commercial banks and is alsocalled discount rate.It can be used either in the context of the rate charged to borrow money or the rate applied as earnings on savings or investments. When applied by a central bank, the discount rate is the interest rate the bank charges commercial banks to borrow money. When the central bank wants to tighten monetary policy, it will increase rates, while a rate decrease indicates the bank wants to ease policy. Actions by the central bank in this area have the additional indirect effect of impacting all other interest rates in the economy. Further, although it seldom has an immediate impact, central bank adjustments to the discount rate affect inflation. Increasing money supply will ultimately lead to increased prices for goods and inflation whereas a reduction in money supply is likely to reduce consumer demand and the prices of goods and inflation. Since a core central bank objective generally is to control inflation, it employs the discount rate tool carefully. To show how far-reaching changes to monetary policy can be, changes in discount rates may also affect exchange rates, which in turn can influence export prices and overseas demand for a territory’s goods. Import prices can also be impacted, which also can affect inflation. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 24

Reserve Requirements Banks are required to maintain certain reserve levels to help assure soundness and the ability to function as anticipated by the public and required by the government. The central bank periodically adjusts the required amount banks must keep in reserve as a tool to increase or decrease money supply. When the central bank wants to decrease money supply it will increase its reserve requirement. This means banks must hold on to greater amounts of deposits to maintain required reserves. Conversely, when the central bank wants to put more money into circulation (i.e., increase money supply) it will reduce reserve requirements. This allows banks to lend more (increase credit), thereby facilitating consumer and business spending. Money supply will also be affected by global, voluntary regulatory frameworks, such as Basel III, which affects a bank’s capital adequacy requirements. These requirements mean that a bank will need to retain more capital assets to meet minimum requirements. Fiscal Policy Where monetary policy is largely set by the central bank, fiscal policy is determined and implemented directly by the government. It is the modification of government spending or taxation with the objective to help achieve a more positive economic environment. Fiscal policy impacts aggregate demand, which represents the total spending on goods and services produced and consumed in the economy at a given time and price level. The government policy related to public debt, public expenditure and taxation is called Fiscal Policy. Fiscal Policy is the aggregate demand curve shift due to tax uses, government transfers or goods and services purchases by government. As per Keynes in the thirties through fiscal measures thegovernment can influence business activities. Fiscal Policy or Budgetary Policy is the most importantinstruments through which government intervenes in the economy. This is an important tool to combatrecession, inflation and to accelerate the economic growth. There are alterations in taxation andspending policies of the government through the legislation. There are two approaches to fiscal policy: discretionary policy and automatic stabilization. Discretionary policies are those that are implemented by making a singular (i.e., one-off) policy change. Automatic stabilization uses either fiscal drag or fiscal boost to stabilize the economy. Fiscal drag uses a progressive tax policy to enforce higher tax rates on higher income levels, reducing disposable income. A fiscal boost can be provided by lowering tax rates with the resulting increase in more available income. Economists also use the terms expansionary and contractionary to identify policies designed either to stimulate or slow down economic growth. Expansionary Fiscal Policy is the Fiscal Policy when aggregate demand is increased by thegovernment through tax cuts to increase disposable income of consumers and it is used in the time ofrecession. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 25

Contractionary Fiscal Policy is the Fiscal Policy when there are efforts of the government todecrease aggregate demand by decrease of disposable income of consumers and taxes are increased tocombat inflation. Spending by the government can also have an impact on the economy. Governments can spend money in all areas, but typically will do so primarily for pensions and salaries, subsidies, health care, education and infrastructure. At the same time, when governments spend in such areas, they typically increase their budget deficit. The spending may have an initial positive impact, but increased deficits can ultimately have a negative impact on the overall economy. As a result, the desire to stimulate the economy must be tempered with the reality of debt, tax revenue, and the broad economic impact. Objectives of Fiscal Policy The governments all over the world formulate the fiscal policy to attain the following objectives:  welfare state establishment  foreign trade promotion  full employment achievement  promotion of investments which are socially desirable  to achieve rapid economic development and  Income inequality reduction. Economics, according to Professor Bill Robinson (University of Nevada, Las Vegas), is about scarcity (Robinson, 2011). According to Robinson, economics is the study of how people, businesses and governments deal with the problem of scarcity, which means, the excess of human wants over what can actually be produced to fulfill these wants. The dictionary defines economics as a social science dealing with the production, distribution and consumption of goods and services (Merriam-Webster, Inc 2004). Nothing about money. So why consider economics in a text on financial advice? To start, financial advice is not primarily about money, either. Instead, financial advice attempts to assist clients in managing their financial affairs to meet life goals and objectives. As a result, money is involved, but the real aim is to help clients achieve goals. In just about every case, an individual’s goals include consumption of goods and services, and those individuals would not normally come to a financial advisor if there were no scarcity involved. As you can see, then, financial advice is integrally involved with economics. Economic Indicators People—both personally and professionally—are keen to know how future events will unfold. Will the market go up or down? Will I get into an auto accident, or will my health fail? Is the government going to run out of money, raise my taxes, or cut benefits? Why do people want to know these things? Simply, to plan for the best possible outcome in that future. Knowing what is likely to happen in the future makes it easier to make plans and be prepared. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 26

Since we cannot really know the future, the next best thing is having good information about likely trends, especially if the information comes from a reliable source, in a timely manner. Statistical information about the economy, in the form of economic indicators, often provides just the information needed to allow for some type of planning. Each territory has its own key economic indicators, but there are similarities. Among the key indicators are (Baumohl, 2008): • Employment • Consumer spending (and consumer sentiment) • Gross domestic product (production and inventories) • Housing • Central bank • Foreign trade • Wages and prices Individually, the listed indicators can have an impact on personal and professional financial choices. Collectively, given the right situation, they can move markets and have a major impact on the territory, regional or global economic environment. The various indicators have different degrees of applicability when it comes to predicting economic changes. As an example, advance orders for durable goods indicate future manufacturing activity. If factories don’t receive orders for goods, those who sell such goods have too much inventory and/or are not seeing demand from people who want to buy those goods. This may indicate a slowdown or continued economic malaise. Increases in orders, especially significant increases, indicate a more robust sales environment, which would be a positive economic indicator. For an economic indicator to have real value, it must be accurate. Quite a bit of economic data released by governments gets revised later. Sometimes this is because of how the government gathers and projects information (i.e., some projected data is not fully compiled for a month or more after its initial release). Statisticians will analyze released data and find adjustments that need to be made. The adjusted information then becomes a revised report. This is one reason why it’s important not to base too many decisions on only one economic report. Normally, it is better to view a series of reports for a more accurate sense of what is likely happening. Unfortunately, some data sources have a reputation for being less than accurate. There may be many reasons for this inaccuracy, some of it political in nature, but in any case, it’s difficult to make plans with information that is likely to be inaccurate. Researching multiple information sources may help increase accuracy. However, if the data is bad, it will be bad regardless of the amount of research you do. Thankfully, there is sufficient incentive for accurate data that researchers can usually have a reasonable level of comfort. Some of an economic indicator’s value depends on the business cycle. For example, if the economic environment is recessionary, few people care about inflation data (there have been a few times in CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 27

history when recession was, in fact, accompanied by inflation. Deflation information may be interesting, but inflation is usually of little concern in such an environment, because people have less money (often due to lack of jobs), so businesses cannot raise prices if they hope to sell their goods or services. When the business cycle is in full growth mode, inflation is very much on people’s minds. Business Cycle The Theory of Business Cycles was initially put forward by Joseph Schumpeter in his work,Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process in1939.Initially, this theory did not generate the interest it deserved. Perhaps, that was due to the factthat J.M. Keynes’s General Theory that had preceded it occupied centre stage in the macroeconomic discourse at that time. Business cycles imply repeated ups and downs in the level of economic activity usually measuredby the GDP of the concerned economy. This is somewhat akin to the phases of the moon or seasonalfluctuations in agricultural output. Based on the cyclical pattern observed in the past, futureexpected movements in economic activity may be predicted. For instance, the movement ofimportant macroeconomic variables such as inflation, growth and unemployment tend to be linkedto business cycles. Dornbusch, Fisher and Startz (2013) provide the following definition: “Business Cycles are moreor less regular pattern of expansion (recovery) and contraction (recession) in economic activityaround the path of trend growth”. The broad pattern of a typical business cycle is as follows: 1. A cycle contains an expansionary phase, known as an economic boom or upswing in which economic activity flourishes. The highest point or peak of the upturn in economic activity is shown in Figure 1. 2. This tends to be followed by the onset of recessionary conditions in which economic activity slows down and starts declining. 3. The lowest level to which economic activity dips is known as a slump or trough (see Figure 1). During this phase, the rate of economic growth turns negative. 4. A revival or an upturn follows the recessionary phase which may then lead into another business cycle. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 28

Figure 1: Business Cycle A quick word about recessions. A recession is a period of economic decline. Exactly when a recession begins and ends, or even what specifically defines a recession, is up to some debate. Recessions typically are reported well after they have begun, because no one knows how long a period of decline will last until it happens. Once in a recognized recession, the economy does not officially shift back into growth mode until sometime after it has actually been in that mode (for the same reason, it’s practically impossible to identify a trend until you’re well into one). By some definitions, a recession exists after at least two consecutive quarters of economic contraction (Business Dictionary, 2013). Recessions are typified by low growth, low output (i.e., GDP), low wages, high unemployment and general economic stagnation. Thankfully, most recessionary periods do not last much longer than a year, but some periods have lasted for several years. Causes of Business Cycles There is no single cause or set of causes that may result in a business cycle. According toSchumpeter, each cycle is unique and unlike the others preceding it. To find the actual cause leadingto it therefore, each cycle has to be analyzed separately. In fact Schumpeter compares businesscycles to humans. Each individual is different from others and there is no single cause that couldexplain, e.g., why humans die. As such, the question why business cycles occur, has been exploredby many, but there is still no definitive answer to it. There are two kinds of economic factors that are considered in any economic analysis: internal andexternal. Simply put, the factors that act from within a firm or business are called internal factors while those that act from outside are called external factors. The focus of most economic CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 29

analysesremains confined to the internal factors and by and large external factors are treated as given. Sothe role of external fluctuations is often ignored. Yet, it is the external factors and the economicfluctuations they cause that are the subject matter of the theory of business cycles. In fact it is changes in the external factors that are believed to largely account for cyclicalfluctuations. These external factors could be economic, such as change in tax rates or in interestrates; or they could be non-economic, such as wars or natural calamities. It is valuable to look at the economic environment on both a long-term and a short-term basis. The business cycle focuses on the short-term. It is a recurring pattern in the economy consisting first of growth, followed by weakness and downturn (recession), and finally by recovery and a resumption of growth (Baumohl, 2008, p. 11). The business cycle reflects a territory’s output and unemployment picture. Output is the term used for real gross domestic product (GDP). Unemployment is simply the percentage of the available labor force that does not have jobs (Ball, 2009, pp. 344-345). We indicated that the business cycle reflects short-term movements. Output and unemployment have a long-term normal or average level. In the short term, output and unemployment variables fluctuate around the longer-term norms. Long-term output is called potential output, and long-term unemployment is called the natural rate. Over a long period, short-term fluctuations tend to revert to the more normal levels. Potential output and the natural rate of unemployment tend to change gradually. However, real output and unemployment (i.e., the business cycle) can be erratic. The environment when actual output (i.e., short term) exceeds potential output (i.e., the long-term average) is known as an economic boom. Conversely, a recession is the environment in which actual output is less than potential output. Similarly, unemployment is below the natural rate during good economic times, and above the natural rate in a recessionary environment. The business cycle has essentially remained the same for all current history. Periodically, pundits suggest that the cycle has shifted or is no longer valid, but it consistently proves otherwise. Let’s briefly look at each of the four business-cycle sections represented in the preceding figure: expansion, downturn, recession/depression, and recovery. Expansion There are four primary areas of spending (Ip, 2010, pp. 34-35, 45), otherwise known as gross domestic product (GDP): 1. Consumer spending and housing 2. Business investment 3. Government spending 4. Exports CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 30

Consumer spending, including housing, may also be called consumption. “Consumption is reflective of all the money people spend on goods and services” (Conway, 2009, p. 72). In developed (i.e., wealthy) territories, consumer spending has been, by far, the largest component of GDP. Most consumer spending is a relatively short-term matter. Housing, which really fits into its own subcategory, is long term. Some other purchases, such as major appliances or cars, may also be considered longer-term spending. Business investment tends to have a relatively long-term focus. Businesses invest money in things like factories and buildings, major equipment, perhaps other businesses, and additional areas designed to help businesses grow. Government spending is what you would suppose—what territorial governments spend on goods and services. The amount of GDP accounted for by government spending varies greatly by territory and jurisdiction. As a matter of policy, some governments spend larger amounts of money on things like national health care and other benefits for citizens. Additionally, increasing government spending is one approach for moving an economy from recession to expansion (i.e., Keynesian economics). As the expansion takes hold, it is often difficult for the government to cut back on putting money into the economy. Exports can be greater or lesser than imports. Few territories make and keep all the goods they need. As a result, most territories purchase goods from other territories (imports). The goods sent from one territory to another are said to be exported by the sending territory. A territory’s exports minus its imports is called net exports. Net exports can be either a positive or negative number. Ideally, a healthy expanding economy would cause the net exports to be positive. When imports exceed exports, the territory is said to have a trade deficit. One implication of a trade deficit is that the territory is living beyond its means (Conway, 2009, p. 99). When the economy is expanding, each of the primary areas is most likely growing. Much of the reason for this is confidence. As the economy improves, consumer and business confidence also improves. As a result, spending and investment increase. This, in turn, provides the government with greater revenue as tax receipts increase. Governments usually find ways to spend the additional money, so this, too, adds to ongoing economic expansion. Finally, as companies manufacture more goods, the territory may be able to export more and import less (it helps if the receiving territories are also going through economic expansion). Gradual, sustainable expansion is a good thing. However, when expansion grows too quickly, it can create problems. An economy that is expanding too rapidly is said to be booming. A boom is a period of rapid economic expansion resulting in higher GDP, lower unemployment and rising asset prices (Pettinger, 2013). Inflation is one likely result of a booming, or overheating, economy, as consumers have enough money to purchase what they want, supplies become somewhat limited, and suppliers can increase prices because of increased demand. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 31

Bubbles A boom may result in a bubble—that is, consumer confidence skyrockets, with the result that they are more than willing to pay ever-higher prices for the goods they desire. Bubbles most often occur in the investment area. In several territories, the housing market attained bubble status as individuals, investors and corporations continued to pay higher and higher prices for houses and other buildings. The assumption was that the market would keep going up (it never does; markets always go through rising and falling periods). If the market is going to continue rising, why not pay whatever price is asked, knowing you can soon sell the property at a higher price? The problem with bubbles is they eventually pop. The housing bubble eventually popped, and those who had made purchases at unsupported (i.e., too high) prices learned the answer to their question of why not keep paying more. When a bubble pops, prices tend to drop precipitously. In the most recent U.S. housing bubble, many areas experienced a drop in real estate values of around 30% (from peak to trough) (The Business Journals, PR Newswire, 2013). Bubbles are not new. One of the earliest bubbles occurred in 17th century Holland, and involved tulips (Mackay, 1852). The 1600s in Holland saw the tulip receiving extraordinary interest, so much so that even those with very low incomes “invested” in tulips, sure they were making a guaranteed investment. One tulip variety (Admiral Liefken) was valued at 4400 florins. To put that into perspective, at the time, four fat oxen were valued at 480 florins, 1,000 pounds of cheese was valued at 120 florins, and a suit of clothes was worth 80 florins. Other tulip varieties were similarly priced. In 1636 a division for tulips was developed for the Dutch stock exchange (and subsequently spread to exchanges in London and Paris). Tulip gambling became rampant and, shortly thereafter, the bubble burst, with many speculators losing all their money. Before moving on, let’s make two points about financial markets and bubbles. First, it is not easy to identify a bubble, or to know where it is in its cycle. Second, it can be difficult to bring a bubble back under control (Conway, 2009, p. 138). Downturn and Contraction As happened with Dutch tulips in the 1600s, all bubbles eventually come to an end, sometimes with disastrous economic results. As an example, several economists include the popping of the mid-2000s housing bubble in the United States as a key factor in the ensuing global economic meltdown. A popping bubble is one way for the business cycle to move into a downturn, but the truth is all periods of expansion are followed by periods of contraction. Why can’t expansion continue indefinitely? The simple answer is, eventually, people get all the stuff they want and stop making purchases. That’s a bit too simplistic, but it’s correct as far as it goes. Here’s what often happens: CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 32

The expansion period is often (usually) typified by increasing inflation. Suppliers know they can raise prices and still sell goods, so they do. Unemployment is low, and finding (and keeping) good employees gets a bit harder. As a result, employees demand higher salaries, and employers start increasing wages. They can do so because they know they can recapture the additional expense (i.e., cost of goods sold) by increasing the price of their goods and services. For a time, this process aids economic expansion, but eventually it contributes to a slowdown. Prices can only go so high before people determine they are too high. At this point, consumers begin to decide to delay or eliminate a potential purchase, because the price is not justifiable. As more and more people do this, inventories start to increase. Any well-run business tries to match inventories and purchases, so businesses reduce orders for goods. Reduced orders cause factories to start cutting back on production. As the process of contraction continues, manufacturers and sellers do not need to retain their workforce at current levels, so they start layoffs. As the number of out-of-work people grows, the supply of qualified workers increases. This allows employers the option of lowering wages and benefits for existing employees, and hiring new employees at lower wages. Lower wages mean less money available for discretionary spending, so the cycle of fewer people purchasing fewer goods continues. Suppliers can only cut their workforce and other expenses so far before they are at a tipping point. Somewhere in the process, sellers start to lower prices. Lower prices usually mean lower profits, so some companies may get to the place where they can no longer remain in business, and they close. Additionally, lower corporate values and decreased profits affect the stock market. This often has the impact of further souring sentiment and increasing caution. Government intervention is another potential cause of an economic slowdown. The two primary, interrelated factors are: 1. A decrease in government spending 2. Intervention by the central bank to adjust money supply and interest rates A government will sometimes try to help its economy grow. To do this, the government may try to create jobs by developing infrastructure projects (e.g., building roads and bridges) or by finding ways to provide funding for employers to hire more people. Sometimes the spending goes to create education benefits so out-of-work individuals can get the training necessary to find a new job. The government has other means by which it can try to help its economy, but almost all methods involve increasing its debt. Just as is true for many consumers, the government borrows money so it can carry out its plans. Eventually, however, the debt load can get so high that the government must start cutting back and start repaying the debt if it wants to regain some semblance of a balanced budget. If a territory’s economy has been sustained primarily through government intervention, and the government starts to cut back on its spending, there is a good likelihood that the economy will start to contract. Contraction is less certain if the territory’s economy is sustainable on its own, and not dependent on continued government support. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 33

A territory’s central bank can also contribute to an economic slowdown. Central banks primarily do four things: (1) clear private bank payments (e.g., checks and electronic payments); (2) lend to private banks to support liquidity in times of difficulty; (3) control money supply; and (4) regulate the territory’s private banks (Ball, 2009, pp. 46, 47). The latter two activities can significantly impact a territory’s economy (i.e., monetary policy). Some people consider inflation to be harmful to an economy’s health. Actually, inflation is not necessarily bad; too much inflation is the problem. Interestingly, so is too much deflation. As such, most central banks have an ideal inflation target they try to maintain. The central banks attempt to influence inflation by adjusting their territories’ money supply. Central banks attempt to keep their territories’ economies growing, but not too rapidly. If the central bank moves to lower interest rates, it is likely attempting to help the economy to grow. Unfortunately, sometimes the economy does just that, and does it well. Too well. When this happens, the central bank’s job shifts, and it moves to raise interest rates. Generally, higher interest rates tend to cool down an overheating economy. As you might imagine, maintain the inflation rate at its target is not an easy job for the central bank, and often seems to be an act more in the domain of art than science. Central banks impact interest rates (and inflation) by lending to, or borrowing money from, eligible banks. This has the effect of increasing or reducing money supply in a given economy. When consumers have more money (so the thinking goes), they will spend more, thereby stimulating the economy. Interestingly, if consumers spend enough that the economy is overly stimulated, prices start to rise and inflation begins to increase. Before long, the central bank, in an attempt to keep inflation within its target range, will act again by reducing money supply and raising interest rates. Part of this process can include the amount of reserves a territory’s central bank requires commercial banks to maintain. When the central bank increases the reserve requirement, less money is available for the banks to lend. This normally means interest rates will increase. Increases in reserve requirements impact a bank’s liquidity, and can become a problem for banks with nominal reserves. Largely because of potential liquidity problems, most central banks use caution when considering a change in reserve requirements. As a counterpoint, some central banks use reserve requirements more aggressively as a tool to tame inflation (Bloomberg News, 2012). Sometimes, actions by the central bank, along with other government intervention, can delay or reverse economic decline. Often, however, it seems that what will be, will be, and the economy continues its downward path. When this happens, the business cycle moves into a period of recession or depression. Recession and Depression When all the preceding factors combine to cause a continued economic decline, the business cycle will evolve into a recession or depression, depending on the severity of the contraction. At some point, the contraction will reach a low point or trough. From there, things start to get better, but first, people must endure hard times. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 34

What is the difference between a recession and a depression? There is no absolute answer. A depression is usually defined as being a bad recession, but there is no explicit definition. Again, one way to identify a recession is two consecutive quarters of a decline in GDP. Other methods exist, but all point to an ongoing decrease in economic strength. When the economy experiences an unusually long and strong downward turn, the term “depression” may start to appear in conversation. As an example, some people define a depression as a contraction in economic activity of at least 10% or lasting at least three years (or more than two years) (Ip 2010, 29-30). In other words, it is a really bad recession. Thankfully, most economies do not normally experience depressions. In the U.S. and elsewhere, the period known as the “Great Depression” lasted for around 12 years, from 1929 through approximately 1941. Some would say that period actually included two depression periods, but the result was the same—approximately 12 years of a very bad economic environment. More recently, the global economic great recession (or depression, if you prefer) began, arguably, in the U.S. in late 2007, and spread throughout most of the rest of the world. The recession/depression officially ended in the U.S. in mid-2009. However, recovery is continuing somewhat slowly in some areas. When economic recovery is weak, relapse into recession is a constant concern. Today, in many parts of the world, concerns about heading back into a recessionary period continue. Recovery Not all economic recoveries are weak. Many times, the business cycle moves from a period of recession into an increasingly strong recovery period. Recoveries are typified by increases in demand for goods and services. People become more optimistic and often begin making purchases they delayed during the recession. Prices are generally still low, but that condition doesn’t remain for long. Supplies are normally low after a recession (although some inventories may remain high for a time), and businesses increase production slowly. When production begins to increase, manufacturers usually must start hiring. Wages may start at the low end, but as the economy continues to grow, so, too, do wages (usually). More money often means increased demand, which, until supplies outpace demand, causes prices to rise. To a point, consumers are willing to pay the increased prices because they are working, making money, and optimistic. Stock market returns usually grow during this period, too. The recovery period leads seamlessly into ongoing expansion, and the business cycle continues. Example 1: How would you determine the potential impact of an economic downturn on your clients’ financial plans? a. What are action steps you can take to mitigate some of that impact? b. Does the current stage of the business cycle make any difference in this situation? If so, in what ways? If not, why not? CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 35

Solution: 1. What are action steps you can take to mitigate some of that impact?  Begin by asking questions such as have some goals become unachievable, or perhaps need to be delayed; how can you prioritize goals; are there ways to apply resources to more than one goal; can the client increase resources and/or reduce liabilities? 2. Does the current stage of the business cycle make any difference in this situation? If so, in what ways. If not, why not?  Interest (discount) rates are likely to fall, which means investments will take longer to grow.  Inflation may make goods and services costlier, requiring greater amounts of assets (thereby delaying ultimate goal achievement).  Clients should remake/adjust their budget and perhaps restructure goals to be more in line with current returns and expenses.  If possible, clients should delay taking significant financial actions that might further deplete assets.  An economic downturn will likely be experienced during a downturn or recession/depression part of the business cycle. If possible, this would be the time to make additional investments into a well-balanced portfolio, knowing that recovery and expansion will probably increase their value. Economic Indicators Revisited Previously, several key economic indicators are listed below:  Employment  Consumer spending (and consumer sentiment)  Gross domestic product (production and inventories)  Housing  Central bank  Foreign trade  Wages and prices We said that at least part of the indicators’ value depends on the business cycle. After discussing the cycle, you can probably see why this is so. Depending on the broader economic cycle, there may be more concern about deflation than inflation. In a recession, consumer spending indicators shift from how much consumers are spending, and their overall level of optimism, to the cloud of pessimism causing consumer spending to spiral downward. Likewise, in expansion, GDP is a sign of increasing growth. In recession, it points to the depth of recession. Economic indicators may be leading or lagging. In other words, they either predict or confirm current economic conditions. Some of the following list may be more or less applicable in a given territory (and CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 36

may have somewhat different names), but all may be useful in reading current economic conditions. The following list is presented in Secrets of Economic Indicators (Baumohl 2008, 171-174). Leading Indicators  Average hourly workweek in manufacturing  A sustained rise or fall in the number of hours worked may predict the hiring or firing environment.  Average weekly initial claims for unemployment  Initial claims for unemployment benefits climb when the economic climate deteriorates; the number of claims falls when the economy gets stronger.  Manufacturers’ new orders for consumer goods and materials  A measure of how comfortable manufacturers are with current inventory levels and projections of future consumer demand.  Vendor performance, or delivery times index  If it takes longer to deliver products to customers, this suggests that orders are flooding in so quickly that they are creating bottlenecks and products can’t be shipped as fast. On the other hand, quicker deliveries are more closely associated with an economic slowdown.  Manufacturers’ new orders for non-defense capital goods  Companies are less likely to spend on new capital equipment and goods if they suspect a business slowdown is looming.  Building permits for new private homes  Tracking changes in the number of permits is a good indicator of future building activity.  Stock prices  The stock market has been a good leading indicator, based on what investors believe the economy will do in the future.  Money supply in real (inflation-adjusted) terms (e.g., M2)  M2 includes currency, demand deposits, savings accounts and bank certificates of deposits. M2 growth that does not keep pace with inflation indicates a weakening economy.  Interest rate spread between government bonds and central bank funds rate (e.g., 10-year Treasury bond and the federal funds rate)  The difference between long and short-term rates. Higher long-term rates indicate a growing economy. Conversely, higher short-term rates (i.e., a narrowing spread) indicate a contracting economy. This is especially true when the yield curve is inverted (i.e., short-term rates are higher than long-term). Lagging Indicators  Average duration of unemployment  As more economic evidence becomes available, companies get a clearer picture of the business cycle and whether they should be hiring or firing.  Inventories and sales ratio, manufacturing and trade CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 37

 Historically, the inventory-to-sales ratio reaches its cyclical peak in the middle of a recession and then falls at the start of a recovery as sales pick up more rapidly than inventories.  Change in labor cost-per-unit of output  Labor costs increase when productivity fails to keep pace with compensation growth. Unit labor costs usually reach a high point during the recession as output per hour drops faster than compensation (which does, eventually, tend to drop as well).  Average prime rate charged by banks  The prime rate is what banks charge their best corporate customers to borrow money. Changes in the prime tend to trail broader changes in the economy.  Commercial and industrial loans outstanding  Business debt normally peaks after a recession has started; when profits are slowing and debt service remains high.  Changes in Consumer Price Index (CPI) for services  Service inflation usually peaks several months after the onset of recession and declines once the recovery has started.  Ratio of consumer installment credit outstanding to personal income  Prolonged drops in household income require a larger percentage of income to service debt. This usually causes a commensurate cutback in consumer spending (especially through use of credit) as people become more cautious. After economic conditions improve, consumers tend to shift back to spending and borrowing on a more normal basis. Example 2: What is the main difference between leading and lagging economic indicators? Solution:  Economic indicators may be leading or lagging. In other words, they either predict or confirm current economic conditions.  Leading indicators predict, while lagging indicators confirm. Economics Overview Now that we have looked at the business cycle and economic indicators, let’s turn our attention to taking a broader look at economics. Economics can generally be divided between microeconomics and macroeconomics. Microeconomics is a study of how supply and demand interact in individual markets for goods and services. Macroeconomics is a study of the economic big picture and how the overall economy works. It covers at things such as GDP, employment and inflation (Rodrigo, 2012). Issues such as unemployment, inflation, GDP growth rate and exchange rate are commonly usedin the day to day conversation of policy makers, media persons and even the common man. Theseare related to macro aspects of the economy. The branch of economics that deals with the study ofthese aspects is known as Macroeconomics. Unlike the micro aspects that deal with analysis ofthe behavior of a single CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 38

entity such as a firm, a consumer, a worker or an investor,macroeconomic variables capture the aggregate behavior of all agents (households, firms andgovernment) in an economy. For instance, the aggregate consumption function is based on totalplanned consumption expenditure of all the agents and its relation with aggregate income in aneconomy. Similarly, the investment function is based on total planned investment of all the firmsin an economy. Thus, microeconomic analyses focus on the performance of a single unit in an economy. While,the macroeconomic analyses tries to capture the performance of all units in an economy and studytheir implications. As may be obvious to you, while we the study the behavior of a single unit, alarge number of other things are kept constant. For instance, in microeconomics while studyingthe law of demand, you may have read the assumption of ceteris paribus, which means all otherfactors apart from price of the commodity are assumed constant. However, in macroeconomicsthe behavior of a lot of interlinked variables have to be considered simultaneously to understandhow aggregate variables are determined in an economy. When we began to look at the topic of economics, we said that economics is about scarcity. Let’s refine that to say, according to British economist Lionel Robbins, “Economics is the study of the use of scarce resources which have alternative uses” (Sowell 2011, 2-3). This means that economics is not only about scarce resources, but also about the decisions made concerning those scarce resources. Even more specifically, economics concerns itself with the consequences of the decisions made. In an economic context, scarcity refers to the limited resources. These resources are the inputs ofproduction: land, labor and capital. The basic economic problem arises because people andsociety have unlimited wants but resources of the economy are limited. And thus the variouseconomic decisions must be made to ensure efficient allocation of resources. These decisionsbasically involve giving up or trading off one want to satisfy another. Thus, the economy has tochoose the way it use its resources. You can understand the application of economics and the scarcity of resources concept to providing financial advice. The financial advisor’s job is to help individuals achieve their goals and objectives, and this may have to be done with scarce resources, which often have alternative uses. Questions that need to be answered include:  Which goals are achievable, and in what order?  What resources can be applied to achieve those goals?  Are some goals unachievable, and if so, how do you determine which is the most important?  How much of a resource should be applied to a given goal or need?  Are there ways to apply resources to more than one goal?  Are there ways to increase resources and/or reduce liabilities? These microeconomic considerations are also applicable on a macroeconomic basis when looking at territories and global economies. When territories are making these choices, the decisions can impact not only the financial wellbeing of citizens, but also of the entire nation. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 39

Economic Systems Economic system refers to the framework concerned with the allocation of resources for the purpose of production and distribution of goods & services in a society/ country within the prescribed rules governing ownership and administration. According to Loucks, “Economic system consists of those institutions which a given people or nation or group of nations has chosen or accepted as the means through which resources are utilized for the satisfaction of human wants. In the words of Gruchy, “Economic system is an evolving pattern or complex of human relations which is concerned with the disposal of scarce resources for the purchase of satisfying various private and public needs for goods and services”. Two major types of economic systems exist within nations: government-controlled and market- controlled. Throughout history, both systems have been applied with greater or lesser success. Economically, the main difference between the two is who, or what, controls production and consumption. In a government-controlled economy, the state determines what should be produced, in what quantity, and with what availability. This means the government must determine resource needs and production requirements. However, without proper data, these tasks can take place without any real understanding of consumer need (i.e., demand), production costs and efficiencies to determine the cost of goods sold, or many other production constraints. The process often results in an overabundance of some goods and not enough of others. Lack of efficiencies often leads to higher production costs. Higher production costs lead to increased scarcity, prompting a reevaluation of government-mandated production quotas . . . and the cycle continues. In contrast, market-controlled economies are more generally based on decisions made by individuals and firms. Households decide how much labor and other factors to supply and what goods to consume. Firms decide what goods to produce and what factors to employ based on consumer demand. Demand is greatly influenced by the price of goods available for consumption and the price paid for the supply of labor (wages). The more desirable a given resource, and the greater its scarcity, the higher its price is likely to be. This means, among other things, a limited number of people will be able to own and use the resource. Basic Economics uses the example of those who would like to live in a beachfront home (Sowell 2011, 14). Many who might otherwise want to live in a beachfront home do not do so because the cost is so high. Understand, the price does not determine the scarcity. The scarcity of beachfront properties determines the price—supply and demand. When many people want a thing that is scarce, the price rises. If consumers determine that same item is no longer desirable, the price is likely to fall. To consider a different example, many people want and use computers. This high demand should lead to high prices. However, there is no lack of supply, because so many companies produce computers. As a result, the market determines that prices should fall. This may mean that some manufacturers are not able to compete, because of the low-price levels. At that point, they have some choices. They can improve production efficiencies, improve the products and charge higher prices. Or they can close CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 40

down. These examples, among many that could have been chosen, show how prices in a market-driven economy guide both consumers and producers. At the same time, prices are determined, in large part, by supply and demand. Unfortunately, even market-driven economies can be sabotaged by various forms of price controls. Prices normally fluctuate freely in a free-market economy. Sometimes, though, a government, consortium, cabal or some other group may act to artificially control prices. This has been accomplished by limiting supply, thereby increasing prices. Diamonds are a good example of this. The number of diamonds on the market at any given time is pretty closely controlled by mining and distribution companies. This, in turn, keeps diamond prices within a narrow, fairly high price. A government may create policies that encourage farmers not to grow certain crops with an eye to controlling prices. Sometimes this same desire to control prices can result not in limiting production, but in limiting availability. For example, agricultural price supports have led to overwhelming storage of produce, rather than distribution, because full distribution would lower prices significantly. Not always, but often, price controls result in artificial shortages and can lead to frustration among the population at large. Price controls can also encourage certain people to develop black markets to make desirable products more widely available; at a price, of course. Macroeconomic Schools of Thought Several economic schools of thought have emerged throughout history. Some of these have disappeared over time, while others have been revisited and revised as new information becomes available. Following is a brief listing of some major economic schools of thought. Classical Economics The study of economics—though not necessarily by that name—is ancient. Xenophon, a student of Socrates, analyzed Athenian economic policies. Thomas Aquinas later explored the moral aspects of economics. Others have done related studies over time, but several key individuals stand out, among them, Adam Smith. Adam Smith’s work, The Wealth of Nations, published in 1776, is considered the foundation of classical economics. Smith refuted the work of the Mercantilists, who proposed a system whereby a nation could ensure greater exports than imports, with the difference measured in gold. Gold, to the Mercantilists, was wealth. Not so with Smith. To Smith, wealth consisted of the goods and services that impacted the nation’s standard of living. Further, the nation was made up of all people living in it. The market economy was one of Adam Smith’s central ideas. That is, a change in supply will eventually be balanced by a change in demand. Smith downplayed any economic value provided by government, and strongly suggested government leave things alone. Smith conceived the idea of the invisible hand. This is the concept that, in a free-market economy, participants will act out of self-interest. Further, interactions with others will automatically produce the most productive and efficient environment for CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 41

goods and services. David Ricardo was a follower of Adam Smith who did much to advance classical economics. Another, who is held in somewhat less regard, is Jean Baptiste Say, a French economist. Say’s Law essentially said that “supply creates its own demand.” That is, people will buy whatever is available. When goods are produced, income is produced. Income is used to buy the goods. The money can then be used to produce (and buy) more goods. Say’s Law suggests that there will never be a surplus. All goods that are produced will be purchased. History has very definitively disproved this notion. Thomas Malthus was another classical economist in the late 1700s. Malthus suggested that a territory’s population would grow faster than its ability to support them. One major implication is that jobs will always be scarce, and therefore the job market will be very competitive. Relatively low wages, resulting from high competition for jobs, is another implication of this concept. Another implication is that the population will be limited by the means to support it (e.g., low food supplies will limit the number of people, and increasing food, housing, etc., will cause a commensurate increase in population). Keynesian Economics John Maynard Keynes is probably the most well-known proponent of the school of thought that bears his name. Keynes, a British economist living in the late 1800s and early 1900s, wrote The General Theory of Employment, Interest and Money. Keynes was concerned not just about supply and demand, but those situations in which a nation’s resources were not being used at all—as was true in the 1930s Great Depression. While classical economics suggested that interest rates would determine business investment rates (i.e., when interest rates were low enough, businesses would make capital investments for the future), Keynes argued that there were times when it did not matter how low interest rates fell. Businesses would not invest in the future because the outlook was too grim. Keynesian economics supports the idea that aggregate demand (i.e., total economic output at a given price) will be influenced by many public and private decisions. Keynes and his supporters felt that this process, rather than being reasonable and systematic, could behave in quite irrational ways. Keynes also believed that, unlike in classical economics, wages and prices have limited (rather than unlimited) flexibility or elasticity. Also, unlike most classical economists, Keynes believed the government could (and should) positively impact a nation’s economy by investing in it (rather than letting the economy adjust on its own). Keynes acknowledged that there was a trade-off between government intervention (e.g., to produce full employment) and inflation, but judged the results to be worth the trade-off. One follower of Keynesian economics, A. W. Phillips, developed what has become known as the Phillips Curve, to flesh out the full-employment/inflation trade-off. Phillips, an Australian economist with the London School of Economics, drew the curve to show, for example, a decrease in aggregate demand will increase unemployment and lower inflation. Conversely, an aggregate demand increase will decrease unemployment and increase inflation, as shown in Figure 2 (Economics Online, 2017). CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 42

Figure 2: Phillips Curve The above figure establishes an inverse relationship between the rate of unemployment and the rate of inflation. If one falls the other rises and vice versa. In figure (2) above, suppose unemployment is low, workers will demand a high nominal wage as they have more bargaining power. Firmsincrease the price level in response to an increase in nominal wage. Thus, low unemploymentcauses inflation to rise The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960s was that a fiscal stimulus, and increase in aggregate demand, would trigger the following sequence of responses: 1. An increase in the demand for labor as government spending generates growth 2. The pool of unemployed will fall 3. Firms must compete for fewer workers by raising nominal wages 4. Workers have greater bargaining power to seek out increases in nominal wages 5. Wage costs will rise 6. Faced with rising wage costs, firms pass on these cost increases in higher prices It quickly became accepted that policymakers could exploit the trade-off between employment and inflation. During the 1960s and 1970s, governments around the world would select a target inflation rate and contract the economy to obtain that rate. Figure 3 shows this trade-off. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 43

Figure 3: Employment and Inflation Trade-off (Economics Online, 2017) Consider an economy with an official target inflation rate of 2%. If the inflation rate in this economy stood at 6% with unemployment at 3% on the Phillips Curve then the inflation rate would be above the target rate and the government, through its fiscal policy, would intervene to reduce the inflation rate. The government would typically reduce money supply to reduce inflation to 2%; however, unemployment would increase to 5% at point A. The government would be prepared to accept more unemployment to achieve its inflation target. History has not been particularly kind to any of the unmodified economic schools of thought. Reality has revealed flaws in each of the theories. Variations have emerged over the years. One such variation is supply-side theory. Supply-side theory is a macroeconomic theory that suggests that the way to improve a nation’s economy is to free the markets from regulation, eliminate price controls and lower taxes. Supply-side theory supports the idea that improving production costs and labor productivity, along with no government regulation, will prevent recessions. The two main themes here are lower taxes and deregulation. Modern economics continues to struggle with the causes of recession. A recession occurs when there is a fall in economic growth for two consecutive quarters. Some say recessions are an unavoidable part of the business cycle. Others, such as new classical economists, support the idea that recessions (resulting from a fall in aggregate demand) evolve from unpredictable supply shocks (i.e., events outside of anyone’s control). Supply shocks include things such as earthquakes and other natural disasters, as well as political events. The other major cause of recessions is the government. However, there are many other factors that may cause a fall in aggregate demand. These factors can include: • Higher interest rates which reduce borrowing and investment • Falling real wages • Falling consumer confidence • Credit crunch, which causes a decline in bank lending and therefore resulting in lower investment • A period of deflation (falling prices). Falling prices often encourage people to delay spending. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 44

Deflation also increases the real value of debt causing debtors to be worse off. • An appreciation in the exchange, which makes exports expensive and reduces demand for exports A recession is associated with a decline in prices. When for example, people lose their jobs and cannot afford to pay as much for goods and services, businesses must lower prices (e.g., by conducting sales offering large discounts) to keep profits up as much as possible. The supply and demand curves in Figure 3 illustrate this since a leftward shift in the demand curve will result in a lower equilibrium price and demand levels. However, not all demand curves are affected equally in a recession. Basic essential commodities, such as bread sales, decline far less. How much businesses reduce their prices during a recession depends on the severity of the shift in the demand curve for its products. Milton Friedman is one economist who stands alone between classical (new or old) and Keynesian (new or old) economics. Friedman basically disagreed with both positions. Friedman’s major contribution is in support of monetarism. Monetarism teaches that the supply and demand of money should be controlled. Friedman posited that excess money supply expansion is inflationary, and that, rather than increase money supply, central banks should focus on keeping prices stable by controlling the money supply’s rate of growth. A steady rate of money-supply growth can help support a steady rate of economic growth with low inflation (Encyclopedia Britannica, 2012). New Keynesian economists have updated Keynes’s economic theories. Remember the idea of price and wage flexibility? New classical economists believe in that flexibility, while new Keynesian economists generally do not. New Keynesians believe in wage and price “stickiness,” and that they do not drop as quickly as new classical economists believe. Why sticky prices? There are many suggestions, some of which are as simple as the cost and time needed to change the prices (think about changing the prices in a printed catalog). Additionally, businesses have an incentive to maintain prices rather than lower them. New Keynesian economics, like the original version, supports government intervention to improve a faltering economy. The preceding summary identifies some of the key individuals and schools of thought in the world of economics. As we have seen, when it comes to economic theory, you should be able to find one that supports your beliefs. However, finding one economic theory that is irrefutably correct and applicable for all situations in the global economy is difficult, to the point of impossible. New schools of thought continue to emerge, and many provide valuable insights. Those who want to develop their own economic theory will have no lack of resources from which to draw. Chapter Review Review Questions 1. How do monetary and fiscal policy differ? What are the primary tools or approaches used to carry out each policy? 2. How would you describe the two major types of economic systems that exist among territories? CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 45

3. Assume your territory’s economic environment has become weaker than normal. What factors might be causing this weakness, and what indicators should you research to gain usable information? 4. What are the primary stages of the business cycles? Associated Websites  Monetary and Fiscal Policy definitions: http://www.investopedia.com/ask/answers/100314/whats-difference-between-monetary- policy-and-fiscal-policy.asp  Basic description: https://www.federalreserveeducation.org/about-the-fed/structure-and- functions/monetary-policy/  Federal Reserve: https://www.federalreserve.gov/pf/pdf/pf_2.pdf  IMF: https://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm  https://www.imf.org/external/np/pp/eng/2015/082815a.pdf  Fiscal policy/IMF: https://www.imf.org/external/pubs/ft/fandd/basics/fiscpol.htm  http://economicsonline.co.uk/Managing_the_economy/Fiscal_policy.html  World Bank (Europe and Asia): http://siteresources.worldbank.org/INTECA/Resources/257896- 1182288383968/FiscalPolicy&EconomicGrowthinECA_FullReport.pdf Websites for Global Economic Statistics Here is a sampling of places on the web to access global economic data.  World Bank: http://datacatalog.worldbank.org/  Organization for Economic Co-operation and Development (OECD): www.oecd.org/  European Central Bank: www.ecb.int  Markit Economics: www.markiteconomics.com  United Nations Statistics Division: http://unstats.un.org  University of Toronto Data Centre: http://datacentre.chass.utoronto.ca/  Latin Focus: http://latin-focus.com/  Asian Development Bank: www.adb.org  Asia-Pacific Economic Cooperation: http://statistics.apec.org/  African Development Bank Group: www.afdb.org  International Monetary Fund: www.imf.org  U.S. Economic Indicators: www.esa.doc.gov CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 46