RELC - Textbook

Chapter 4: Social & Political Environments You will learn Items of social and political environments relevant to financial planning, financial advice and the economic environment. The previous section on economics implied that governments play a dominant role in a nation’s overall economic strength or weakness. In reality, in various parts of the world, regional governmental and quasi-governmental entities also have an impact. Trade blocs are free trade zones designed to encourage trade activities across nations. Theformation of trade blocs involves a number of agreements on tariff, trade and tax. The activities of trade blocshave huge importance in the economic and political scenarios of the contemporary world. The popular trading blocs are the European Union, the ASEAN Free Trade Area (AFTA), the Latin American Free Trade Association (LAFTA), the Latin American Integration Association, the North American Free Trade Agreement (NAFTA), and others. Each of these, to a greater or lesser degree, has an impact on local, regional and global economies. The European Union: The European Union is a unique economic and political union between 27 EU countries that together cover much of the continent.Since 1957, the European Union has benefited its citizens by working for peace and prosperity. It helps protect our basic political, social and economic rights. The goals of the European Union are:  promote peace, its values and the well-being of its citizens  offer freedom, security and justice without internal borders  sustainable development based on balanced economic growth and price stability, a highly competitive market economy with full employment and social progress, and environmental protection  combat social exclusion and discrimination  promote scientific and technological progress  enhance economic, social and territorial cohesion and solidarity among EU countries  respect its rich cultural and linguistic diversity  establish an economic and monetary union whose currency is the euro. NAFTA: The North American Free Trade Agreement (NAFTA) came into effect on January 1, 1994. It was initiated bythe government of President George Bush, but it was concluded by the Clinton CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 47

Administration. It isfundamentally a trade and investment agreement created with a view to reduce barriers in the flow of goods,services and people among United States, Canada and Mexico. ASEAN Free Trade Area (AAFTA): The Association of Southeast Asian Nations, or ASEAN, was established on 8 August 1967 in Bangkok, Thailand, with the signing of the ASEAN Declaration (Bangkok Declaration) by the Founding Fathers of ASEAN, namely Indonesia, Malaysia, Philippines, Singapore and Thailand. The aims and purposes of ASEAN are:  To accelerate the economic growth, social progress and cultural development in the region through joint endeavours in the spirit of equality and partnership in order to strengthen the foundation for a prosperous and peaceful community of Southeast Asian Nations;  To promote regional peace and stability through abiding respect for justice and the rule of law in the relationship among countries of the region and adherence to the principles of the United Nations Charter;  To promote active collaboration and mutual assistance on matters of common interest in the economic, social, cultural, technical, scientific and administrative fields;  To provide assistance to each other in the form of training and research facilities in the educational, professional, technical and administrative spheres;  To collaborate more effectively for the greater utilisation of their agriculture and industries, the expansion of their trade, including the study of the problems of international commodity trade, the improvement of their transportation and communications facilities and the raising of the living standards of their peoples;  To promote Southeast Asian studies; and  To maintain close and beneficial cooperation with existing international and regional organisations with similar aims and purposes, and explore all avenues for even closer cooperation among themselves. In this section we will explore government and politics in the context of its impact on: Local (internal) economic environment  Legal and monetary issues  Political party gridlock and alliances Regional economic environment  Looking outward from inside a territory  Participating as a regional member Global economic environment  Trade  Financial markets and banking  Treaties and alliances Given the size and scope of the course, this section provides only a general overview. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 48

Local Economic Environment National governments set the stage for each territory’s economic environment. To be sure, there is argument over whether this is the government’s role, but makes no mistake, the government does have a great economic impact. Sometimes a government’s impact comes from what it does directly to affect the economy. Other times, its impact comes from what it does not do. A government has two primary tools to impact its economy: the legislature and the central bank (and treasury). We have already looked at some ways in which the legislature and central bank can affect the economy, so we will not go into further detail here. When a government passes a law, there is often an economic impact. Sometimes the impact is indirect or unintentional, such as when the legislature enacts a law to improve worker safety, to provide certain legal protections for its citizens, or to protect the environment. Increased worker safety almost always increases business expenses. Businesses will try to pass these expenses on to consumers with the result that prices increase. This is not to suggest that improving worker safety is a negative decision. Rather, it is an acknowledgement that there is an economic cost. The same is true with many other areas. Consider the following. Few people would argue that increased worker safety is a bad thing . . . that it’s OK for workers to get hurt on the job. Throughout the world, years ago (and even today in some places), worker safety was not much of a concern. In fact, about the only thing that would happen when a worker sustained a serious injury on the job was that the worker lost his or her job, because the worker could no longer perform the duties. As time went on, people deemed this to be unacceptable, and various government agencies developed policies and programs to address these concerns. Interestingly, while few if any business owners or politicians complain about on-the-job safety today, that certainly was not the case when the government was originally trying to make the changes. Many business owners were concerned that the increased costs would put them out of business and cause an economic recession. There were (and are) increased costs, but they have been absorbed into the overall pricing model. Most people willingly pay more to protect worker safety. The same is not necessarily true when it comes to protecting the environment. Humans affect their environment, and sometimes that impact is small. Other times the impact is substantial. Periodically, we can read about one city or another where pollution seems to have reached dangerous levels. There is both an environmental and human cost to this. Over the years there have been problems with nuclear reactors that caused radiation to spread in a region. Mining companies have received fines for allowing poisons used to extract minerals to seep into streams and watersheds. There is an environmental and human cost to progress. We recognize this as a necessary part of economic growth and development. However, what can we do to protect the environment? This is not a new question. Many nations have wrestled with these questions for years, and there do not seem to be any simple answers (certainly, simple answers have been offered, but they almost always ignore one or more key aspects). Businesses may not adequately police themselves, so governments step in to CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 49

pass laws protecting one environmental aspect or another. When the government does this, as beneficial and necessary as it may be, there is an economic cost. The decision of what to do often comes down to whether the benefits gained are deemed to be worth the cost (and this is not always as simple as it might seem). For our purposes, we just need to acknowledge the cost of government intervention. There are also times when the government passes legislation that directly impacts the economy. Tax increases (or decreases), changes to pension and other benefits, balanced budget amendments and deficit spending all are among the laws with a direct impact on the economy. Let’s acknowledge that some governments are well-run, while others are less so. Sometimes a government can face a crisis that in some way forces it to act. Such crises may be natural (e.g., tsunami, earthquake, etc.), social- cultural, political or other. Regardless of the cause, when the government acts, there is likely to be an economic impact. Internal political actions can impact a nation’s economy. The political environment in some territories can lead more to gridlock (i.e., doing nothing) than positive support of the economy. Causes for gridlock are many, but most come down to forceful support of an ideological position. This is not a course on politics, but politics definitely impacts the economy. A financial advisor needs to keep this in mind when guiding a client, and not necessarily count on a continuation of the current political and economic environment as a condition of whether a plan of action will be successful. A good practice for financial advisors is to plan for the worst and hope for the best. What will happen if the government stays in a gridlock condition? What needs to be done if the territory enters internal or external war? Is there a possibility of extended territory-wide strikes that may impact the client’s livelihood? Does the current plan work in a significantly different tax or legislative environment? It’s a practical impossibility to anticipate all possibilities, but a good financial advisor will invest time to consider likely situations and potential solutions. Regional Economic Environment No territory today exists in total isolation. What happens in the region around a given territory can have an impact on the economy. Territories in close proximity to one another are in a position either to positively or negatively affect each other’s economies. This can be especially important if there are regional military conflicts. The reality is, governments change, nations plunge into civil or external war, trade agreements change. All these things should be considered when evaluating the economic environment. There can be implications for investments, standard of living, even personal and property safety. A financial advisor will recognize this and look carefully at a client’s insurance and risk management portfolio. The financial advisor may decide to diversify an investment portfolio more broadly to mitigate risk of loss by being too concentrated in a given geographical area. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 50

Many geopolitical regions have free trade agreements. Some of these have little economic impact, while with others the impact is great. Perhaps the most well-known agreement, and the one with the most global impact, is the European Union or EU (European Union, 2017). The EU is a partnership between European territories that began with an economic focus and has grown into a political union. By eliminating border controls between member nations, people more easily can work, travel, live and purchase goods and services across the EU. As an idea, it’s brilliant. In practice, despite some difficulties, the EU seems to work pretty well. Economically, it remains to be seen the degree to which the EU is successful in raising the standard of well-being throughout the region. Recent economic difficulties among some of the member nations highlight a potential problem. What does the regional group (EU) do when one or more of its members experiences great financial distress? This has happened over the last several years as the economies of several EU nations have been distressed (e.g., the social unrest following implementation of austerity measures in Greece). The upside of an economic union is increased trade and better regional economy. The downside occurs when one or more members become economically distressed, possibly leading the entire region to suffer. This has been, to some degree, happening throughout the EU. In some ways, the union has been a resounding success. In others, there has been a real struggle to maintain progress. The recent decision by the UK to leave the EU points to actual and potential difficulties. Most other free trade agreements are less political and more economic in nature. The Asia-Pacific Economic Cooperation (APEC) is a good example here. APEC’s focus is on ensuring that goods, services, investment and people move easily across borders. APEC’s 21 members facilitate this through faster customs procedures at borders, more favorable business climates behind the border, and aligning regulations and standards across the region[21]. The Andean Community, in South America, is another regional economic and somewhat political cooperative organization[22]. Remember, though, the EU started on a primarily economic basis, and has since become much more of a political entity. The same may happen with other treaty nations. For our purposes, it’s important to consider the benefits of such treaties as well as potential problems. From a financial advice perspective, it’s also beneficial to keep in mind that treaties may be temporary and any potential financial benefits should be viewed, at least somewhat, through that filter. Global Economic Environment On any given day, in any given territory, one can read financial market information specific to that territory. Interestingly, even 50 years ago, it was hard to find financial information relating to territories other than one’s own.)Furthermore, part of the financial market reporting in most territories will include reference to how one foreign territory or another is affecting the local economy. A recent web search for “world economy” returned 1.84 billion results in 24 seconds. In various ways, you can recognize the truth of the phrase, “When one territory sneezes, another catches cold.” We live in a global economic environment. Exports and imports are essential elements of global trade. When a territory imports something, it gets something (e.g., cars, televisions, computers), and for that something, sends money to the exporting CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 51

territory. The exporting territory loses the thing it exported, but receives money, or sometimes good and services, in return. When one territory imports from another territory more than it exports, the first territory is said to have a trade deficit. More money is flowing out of a territory than is flowing in. Is this good or bad? Generally, an extended or growing trade deficit is not a healthy economic sign. Short-term trade deficits are not necessarily bad. People get to enjoy goods and services, often at lower prices, than they could otherwise obtain within their own territory. Over time, however, trade deficits can cause job loss (when few people purchase domestically-produced goods, related jobs can go away), national debt increases, and a large amount of a territory’s currency goes to foreign hands. As a result, trading partners generally try to maintain some level of balance between imports and exports. This leads to the question of why one nation should trade with another. Economists generally group reasons why territories gain from international trade under three categories (Sowell 2011, 502-509): 1. Absolute advantage 2. Comparative advantage 3. Economies of scale Absolute Advantage Theory of Absolute Advantage was propounded by Adam Smith. Absolute advantage is achieved when one producer is able to produce a competitive product using fewer resources, or the same resources in less time. A nation or company is said to have an absolute advantage if it requires fewer resources—generally raw materials, manpower, or time—to produce a given item. For example, assume France and the United States both produce airplanes. In one month, France can produce 14 planes while the U.S can churn out 45 of comparable quality. This means it takes France 2.14 days to manufacture each plane versus the U.S. rate of 0.67 days. In the above example, the U.S. has the absolute advantage because its ability to produce high-quality products at a quicker rate than its competition indicates a more efficient production model or more available and more talented labor. Similarly, Brazil, Colombia and Ethiopia are among the highest global producers of Arabica coffee (Doom, 2011). Reasons for their prowess are many, and include their geographic location, soil quality and climate, agricultural focus, etc. This allows these territories to produce high-quality Arabica coffee beans at a reasonable cost. As a result, many nations import coffee from these nations. If you happen to live in a territory that does not produce coffee, and you want coffee, you must get it from elsewhere. That producing territory (e.g., Brazil) is said to have an absolute economic advantage, because it can commercially produce coffee in a more economically viable way than other territories. Many territories have an absolute advantage in one area or another, due to lower costs, better climate or geography, better skills, and similar factors. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 52

Important: While absolute advantage can be used to compare similar production, it does not take into account the opportunity cost of choosing one product over another, possibly more beneficial one. Comparative Advantage Theory of Comparative Advantage was propounded by David Ricardo. Comparative advantage is all about reducing the opportunity cost of a given production strategy. The opportunity cost of producing a particular item is equal to the potential benefit that could have been gained by choosing an alternative. It is also what a business or country misses out on when choosing one option over another. Assume that, utilizing the same amount of time and resources, China can produce either 30 computers or 45 cellphones. The opportunity cost of manufacturing one computer is 45/30, or 1.5 cellphones. Conversely, the opportunity cost of producing one cellphone is 30/45, or 0.67 of a computer. Sometimes one territory has a clear advantage when it comes to producing goods. That territory may be able to produce most goods more efficiently than any other territory. Why would that territory want to trade with other territories? Opportunity cost. It may be true that one territory can produce something more efficiently than another territory. However, while it is producing that item, it may not be producing another item, and few territories are able to produce everything more efficiently than all other territories. A territory may decide to focus on producing mobile phones, because it does so far better than another territory. At the same time, it would need to import computers, because while it can produce them internally, shifting production away from cell phones would be detrimental to the economy. It is therefore more economically feasible to import computers than to produce them domestically. There is need for caution in limiting production of some goods in favor of others. At least on a short- term basis, this creates a dependent relationship to get the non-domestically produced good. However, every nation’s resources are scarce to some degree, and it makes sense to focus on those areas of greatest strength and ability. At least theoretically, this points to a solid rationale for global trade among nations, because almost every nation can produce some type of goods more efficiently than other nations. Economies of Scale Economies of scale are cost advantages reaped by companies when production becomes efficient. Companies can achieve economies of scale by increasing production and lowering costs. This happens because costs are spread over a larger number of goods. Costs can be both fixed and variable. The size of the business generally matters when it comes to economies of scale. The larger the business, the more the cost savings. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 53

Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors. Sometimes it’s more advantageous to let another company or territory makes all the necessary investments to produce a product, and then buy it from them. For example, car manufacturing requires a significant investment of time, training, resources, workers and money. Some territories have already made these investments, and are able to produce good cars efficiently. A territory that does not yet have the capability to produce cars may, after evaluation, decide that development costs are greater than the benefits it could receive. In this case, the territory would decide to purchase its cars from elsewhere. The territories from which the cars are imported are benefitting from investments made to support their car industry and the resulting economies of scale. As a side note, even without economies of scale, a territory may decide to begin car production just to protect itself in the event it cannot purchase vehicles from external sources. The decision to do this is related to national security (and perhaps other needs), rather than being primarily financial in nature. Exchange Rates Exchange rate refers to the rate at which a country’s currencies are exchanged for currencies ofother country. In other words it is the price of one currency in terms of another currency. For E.g. Ifthe value of 1 US dollar in Indian rupees is 45 then the exchange rate is 1 US $ = 45. Thus foreignexchange rate indicates the external value of a country’s currency. It also shows the purchasingpower of a country’s currency in terms of currency of another country. Any time goods or services are purchased in a territory other than one’s own, the purchase may be affected by exchange rates. The relative value, or purchasing power, of one territory’s currency can be different—sometimes substantially—than the purchasing power of another territory’s currency. At the time of this writing, one Euro equals seven and one-half Chinese Yuan while one Brazilian Real equals just over two Chinese Yuan. What makes the difference? Currency exchange rates are determined either by market conditions or by governments. Rates controlled by markets are said to be floating, while rates controlled by governments are said to be fixed (Robinson, 2011, p. loc 1153). Even territories with floating rates usually exercise at least some control over their currency’s value. Fixed rates are relatively easy to understand. A territory’s government decides the value of its currency will be X, and it is. How is this decided? Generally, one territory decides to peg or link its currency value to another territory’s currency (or basket of currencies). The rationale for this usually is to stabilize the currency’s value, and may be an attempt to control inflation. In the case of the Euro, exchange rates between member nations and the Euro are fixed to facilitate treaty agreements. Most territories use market or floating exchange rates. A floating rate is “set” by the foreign-exchange market. As such, it changes regularly, as market forces come to bear. When the market determines that a territory’s economy, and therefore its currency, is strong, its value rises. The reverse can also be true. As a practical matter, this forces someone who wants to make a purchase in another territory to CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 54

check the relative currency values. It may be that there is enough of a difference between the currency values (high or low) that a desired purchase may be delayed, or perhaps accelerated. Currencies can also be traded. As discussed in FPSB’s Investment Planning and Asset Management course, there is an active market to buy and sell currencies. Investors normally do this for one or two reasons. Safety may be a concern, and the investor may try to hedge an investment in one currency by investing in another. Another reason is more basic—to make money. Arbitrage is the purchase of an asset in one market (i.e., territory) and the sale in another, with the goal of taking advantage of price differences. So if a person owns Swedish Kronas, and their value relative to U.S. dollars is high, the owner may be able to make some money as a result of that price difference. It may be as simple as using the Kronas to buy an American product, or just using one of the currency exchange markets (e.g., Forex), to buy and sell the two currencies directly. This is another example of supply and demand at work. When you make investments in another territory, currency risk can be a concern. For example, if you live in territory A and invest in territory B, and the investment increases by 10%, but territory B’s currency also appreciates against your territory’s currency by 10%, you have effectively realized no gain. There are various ways to hedge against this exposure (see FPSB’s Investment course for more information), but the risks are real and must be recognized. The preceding identifies the economic impact of several inter-territorial interactions. Now, we will turn our attention to some of the intra-territorial activities that can have an equal—or greater—impact on a territory’s economic environment. We will focus on three areas: 1. Social welfare policy 2. Taxation policy 3. Retirement policy Example 1 How may internal politics impact a territory’s economy? Solution: 1. When a government passes a law, there is often an economic impact. Sometimes the impact is indirect or unintentional, such as when the legislature enacts a law to improve worker safety, to provide certain legal protections for its citizens, or to protect the environment. Increased worker safety almost always increases business expenses. Businesses will try to pass these expenses on to consumers with the result that prices increase. This is not to suggest that improving worker safety is a bad thing. Rather, it is an acknowledgement that we must recognize an economic cost. The same is true with many other areas. 2. The decision of what to do often comes down to whether the benefits gained are deemed to be worth the cost (and this is not always as simple as it might seem). For our purposes, we just need to acknowledge the cost of government intervention. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 55

3. The political environment in some territories can lead more to gridlock (i.e., doing nothing) than positive support of the economy. Causes for gridlock are many, but most come down to forceful support of an ideological position. Social Welfare Policy Social welfare can be broadly defined as organized public or private social services for the assistance of disadvantaged groups. It is also concerned with the quality of life that may include areas such as drug abuse, environmental quality, level of crime, and as already mentioned, availability of essential social services. Research areas in social welfare policy include:  systems of care for children/families/elderly  community, organization and policy development  race, class and gender  health and healthcare disparities  violence and victimization  mental health and prevention/intervention For some, the idea of social welfare is unwelcome, while others see it as an essential part of a stable, thriving economy. There is no question, though, that there is a financial impact. Environmental oversight and provision of social services can come with a relatively high cost. Many of those who see social welfare as being unnecessary do so mostly based on its cost to business as well as diverting funds that could go to other purposes. Regardless of your point of view, there is one undeniable impact of such programs. They cost money and generally increase taxes. You may or may not feel that the benefits are worth the increased expense, but there definitely is a cost. The level of social welfare can have an impact on the financial well-being of clients. People lose jobs due to layoffs or ill health. Family members require extended levels of care with the result that the family caregiver cannot continue working at the same level. Crime can impact individuals (and businesses) in many ways, both financial and physical. The same is true of almost all areas within the scope of social welfare. As a financial advisor, you should know the range of benefits that may be available, along with having a good directory of organizations that provide services. Further, when clients find themselves in a situation where they need to take advantage of social welfare services, it can be a good opportunity to step in and provide support. Let’s look at an example. Example: Diego and Maria are professionals with reasonably good incomes. They have been married for 20 years and have three children. The children, with one exception, are healthy, growing and maturing as well as their parents could hope. Unfortunately, their oldest child (Tomas) seems to be struggling much more of late than in his early years. Diego and Maria have been called to the school several times to address Tomas’s behavioral issues. After many late nights talking and wondering what to do, the parents decide to make an appointment to take Tomas to see a mental and behavioral CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 56

health professional. Their decision, while good for Tomas, will not turn out to be so positive for their financial well-being. The first surprise is that their health insurance does not cover the mental health expenses. Some providers are covered, but not the best, and not the one with whom they and Tomas have an appointment. This is the first expense of what will become a regular outflow of money. In the follow-up meeting after the initial appointment, the mental health professional recommends psychiatric therapy, counseling and medication to help Tomas. Thankfully, their insurance covers the medication, but neither the therapy nor the counseling will be covered. Further, they are amazed at the amount of time required simply to find helping professionals to whom they can take Tomas. In fact, Maria, who has taken the lead in finding help, has had to invest so much of her time, she can no longer support her professional work. After a serious discussion, she and Diego decide that they will live on his income so that Maria can concentrate on finding good help for Tomas, which they finally do arrange. Following a period of medical and psychological intervention, most of which they fund themselves, the professionals with whom they are working recommend that Tomas should move into a residential home. The home looks wonderful, but its expenses will consume one-half of Diego’s monthly income (and Maria has given up her income to care for Tomas). As has been the case already, their insurance plan will not cover the expenses. They both agree with the decision for Tomas, especially as he has become increasingly violent and destructive. However, they have no idea how to pay for his care and maintain a home for themselves and the other two children. The whole situation is wearing them both out, and Maria has become so worn down and sick she can barely function. They have borrowed money to pay the medical bills, but the payments are more than they can sustain, and they are running out of lenders who will provide the funds. Expenses are mounting to such a degree that they are in danger of losing all they have accumulated— including their home. They need help—mental, emotional, social and financial. This scenario may sound far-fetched, but it is not for many families. It highlights one way in which individuals can go from reasonable well-being and success to a point where they are running out of options to keep their home and family together. What does someone like this do when they have explored all available private options and seem to have nowhere to turn? In some societies and cultures, the answer is they lose everything and become street people. However, in places where a social welfare safety net exists, they can find help, and hope. Diego and Maria are unaware of some resources available to them, but as they continue to explore, they begin to learn about more options. These include special benefits to provide income, food and clothing, assistance with Tomas’s care, and more. In fact, the social welfare benefits provide a bridge between where they are and the road back to well-being. As a result, it will take time, but they will be able to go on, support their family, continue Tomas’s care, and regain financial stability. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 57

Diego and Maria show us the type of people and situations for whom social welfare programs are developed. If their financial advisor knew about available programs, she could provide assistance and be a strong resource to guide them forward. Taxation Policy We have already identified that government-provided services often increase taxes. Tax rates can have a significant impact on an individual’s available income and assets. Some territories have no income tax while others have taxes in excess of 50% (sometimes higher). If a person earns $100, there’s a big difference in potentially available money between a zero percent tax rate and one that takes half the income. As a result, a territory’s tax policy provides incentive for the financial advisor to include tax planning as a service. (It’s understood that it is not possible, or possibly illegal in some territories, for a financial advisor to address tax planning. This is why it’s a good idea to have a relationship with a tax professional to whom the financial advisor can make a referral.) Whether or not the financial advisor can address tax-related needs, it is good to be aware of some relevant information. A recent Organization for Economic Cooperation and Development (OECD) taxation report showed that the tax burden on the average worker is 35.9% in OECD territories (OECD Taxation, Executive Summary). Some territories taxed incomes less than previously, but many increased taxes. Personal income taxes are responsible for most of the tax burden, but taxes may also include social security contributions and other items that serve to increase the total personal tax burden. The so-called “tax wedge” consists of income tax and social security contributions from employers and employees. This represents the difference between take-home pay and what it costs to employ the worker. The tax wedge can be defined as the ratio between the amount of taxes paid by an average single worker without children and the total labor cost for the employer for that individual. It measures the extent to which income taxes discourage employment. According to the Economist, employment taxes exceed the take-home pay of the average single production worker in several European territories. As mentioned previously, some territories address this issue by having no payroll tax. Others vary the degree to which income and social security taxes are levied. Taxes on additional income streams within a family also vary by territory. In some situations, increased second-income taxes can go a long way toward negating the benefits of second earner income streams. It’s outside the scope of this course, but income earned in other (i.e., nonhome) territories is likely to be taxed differently. In most situations, these taxes can be greater than those on income earned domestically. In addition to income-related taxes, most territories levy taxes on purchases. There are four states in the U.S. that have no personal income tax, but in its place, levies a state sales tax that is quite high (six percent or greater). The result, at least for some, is that personal income is as negatively impacted by the state sales tax as it would have been by state income taxes. Territories also tax corporate profits, but we will not discuss corporate taxation in this course. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 58

Retirement Policy Retirement benefits are closely related to tax policy in many territories. Some territories don’t provide any benefits while others offer full pensions, including health care benefits. It’s likely that most territories fall somewhere between the two extremes. For our purposes, let’s assume some level of retirement benefits, but not total coverage. Those with total coverage have much less (or no) need to plan in this area (although it’s good to remember that government policies and programs can change). Implementation of each of the preceding areas largely depends on how the government approaches governing. As a result, it’s appropriate for us to consider government sentiment. Government-provided pension systems vary widely across the globe. In a “Pensions at a Glance” report from the Organization for Economic Cooperation and Development (OECD), in the aftermath of the global economic crisis, pension systems continue to be strained. This should come as no surprise, as economic recovery remains tepid in most OECD territories. Globally, this has meant that pension contributions have remained low, while there is increasing pressure for public pension reform. Territories generally have been increasing normal retirement ages and, in certain cases, decreasing government-supplied benefits. There have been continued incentives for people to work longer. Globally, the average retirement age has increased from 64.0 to 65.5 years (OECD p. 13). Net replacement rates from mandatory schemes for a full-career average-wage worker average 63%, but that average has a wide range from around 27% to 105% (OECD p. 14). First-tier pensions exist in all OECD territories, but with quite a bit of variation in structure and value. If you think in terms of a financial safety net for the elderly, payments range from around 6% to 40%. Most territories pay at least a partial benefit after 20 years of contributions, and delay full minimum benefits until the individual has worked at least 26 years. Most of the plans reduce benefits somewhat when individuals work for fewer years, but they may also simply require a slightly longer working period rather than reduce payments. Women who interrupt careers to stay home and raise children are not always penalized, but in many cases they experience a decrease of pension payments. Globally, reforms are underway (or under consideration) to refine pension systems, cutting costs and increasing efficiency. This may result in a benefit decrease for clients. What does all of this mean for the financial advisor? First, the financial advisor should have a sense of government sentiment in this area and know the basics of the system in their territory. What are typical retirement benefits and at what age can a person expect to receive them? Is this changing? What are the penalties for stepping out of the workforce (either to raise children, or for some other reason)? Is there a standard private (i.e., contributory) pension or other retirement plan, and how can individuals improve their retirement income by contributing? One of the primary considerations is the gross replacement rate. That is, what amount or percentage of a worker’s income can be expected to be replaced during retirement? This is the baseline for understanding government sentiment in this area. It is also the foundation of an individual’s retirement income. Along with this information, the financial advisor should know what factors may CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 59

decrease or increase payments during retirement. As an example, several systems reduce future benefit payments if the individual begins receiving payments prior to the full or normal retirement age. Conversely, it may be possible that benefits will increase if the individual delays retirement beyond the regular retirement age. Another question to answer is whether income replacement rates vary by gender. Do women generally receive lower benefits than men? Is this related more to increased longevity potential for women or a pro-male bias? Is the income replacement rate percentage greater for low-income workers than for those who have reached higher income levels? Each of these factors can vary by territory, and it’s important for the financial advisor to recognize the potential impact in the territory, as well as any other territory from which a client may receive benefits. The availability of private pension arrangements is another important consideration. In some territories, the government does not support private pensions. For those territories that do allow or encourage private pension plans, what are the benefits, restrictions and other requirements, and how are potential clients affected? Each of these considerations can have an impact on clients’ retirement well-being. It’s also important to remember that government policies can change and benefits may be reduced or eliminated. This is potentially truer in territories experiencing economic distress. A government’s desire or requirement to move into a more austere economic environment has the potential to impact existing retirement planning. While it’s true that a financial advisor cannot foresee the future, and probably should not plan as though retirement benefits were diminished or dismissed, developing contingency plans might be beneficial. Example 2 How can government-sponsored retirement policies and programs impact financial advisors and their clients? About what things should the financial advisor be aware? Solution: 1. Those with total coverage have much less (or no) need to plan in this area. 2. The financial advisor should have a sense of government sentiment in this area, and know the basics of the system in the territory. What are typical retirement benefits and at what age can a person expect to receive them? Is this changing? What are the penalties for stepping out of the workforce (either to raise children, or for some other reason)? Is there a standard private (i.e., contributory) pension or other retirement plan, and how can individuals improve their retirement income by contributing? CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 60

Chapter Review Review Questions 1. What are the two primary tools a government has to impact its economy? 2. Social welfare programs can be expensive. In what ways do you believe the value provided may or may not justify the expense? 3. What is the tax wedge and what is its primary potential negative? Associated Websites  OECD (Personal): http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/taxing- wages-2016_tax_wages-2016-en#page2  World Bank Group (Corporate) https://openknowledge.worldbank.org/bitstream/handle/10986/21794/952190WP0Box380C0 0Paying0Taxes02015.pdf?sequence=1&isAllowed=y  http://www.economist.com/node/347867  http://www.apec.org/About-Us/About-APEC.aspx  http://mea.gov.in/Portal/ForeignRelation/Andean_Community_February.2013.pdf) CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 61

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Chapter 5: Compliance & Implications You will learn the impact of legal, regulatory and ethical compliance issues on the practice of financial advisory. The term “compliance function” is used as a generic reference torefer to the range of roles and responsibilities for carrying out specific complianceactivities and responsibilities. Compliance is intrinsic to theoperations of market intermediaries because they must have systems or processes in place to help ensure that they are complying with all applicable laws, codes of conduct andstandards of good practice in order to protect investors and to reduce their risk of legal orregulatory sanctions, financial loss, or reputational damage. For many financial advisors, the term does not evoke positive feelings. It often involves filling out and filing forms, submitting client-facing materials to a department that seems to always take too long for approval, and modifying documents as rules and regulations change. Financial advisors often complain that the burden of compliance takes them away from their core activities—providing financial advice to their clients. However, compliance is a necessary activity in the provision of financial advice and services. Compliance activities arise from regulations mission to protect the public and are aimed at ensuring policies, procedures and controls are in place throughout the financial system to support its integrity at all levels. Financial intermediaries such as financial advisors play an important role in this effort and compliance should be approached as a professional obligation and a valuable component in restoring and maintaining the public’s trust in the financial services marketplace. The International Organization of Securities Commissions (IOSCO) produced a paper covering compliance requirements for financial intermediaries, firms that serve as liaisons (or the “middleman”) between financial product manufacturers and product purchases. While the report focuses on corporate intermediaries, it has indirect implications for all intermediaries in the investment community. For our purposes, we will highlight compliance portions of the IOSCO report. According to the IOSCO report, market intermediaries should conduct themselves in a way that protects the interests of their clients and helps to preserve the integrity of the markets, and comply with all regulatory frameworks in which they operate. Compliance with securities laws, regulations and rules (referred in the paper as securities regulatory requirements) is part of the essential foundation of fair and orderly markets as well as investor protection. It is equally important, however, that firms develop a business culture that values and promotes not only compliance with the “letter of the law,” but also high ethical and investor protection standards. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 63

Two key concepts that stand out are protecting the interests of clients and preserving integrity of the markets. These are similar concepts to what we saw in the first chapter on legislation and regulation. Notice the emphasis at the end of the last paragraph on having a culture that values and promotes high ethical and investor protection standards. It seems clear that the desire is for financial service firms and employees to embrace protecting clients’ interests as a regular part of their business dealings. The role of the compliance function is, on an ongoing basis, to identify, assess, advise on, monitor and report on a market intermediary’s compliance with securities regulatory requirements and the appropriateness of its supervisory procedures (IOSCO, p.7). Notice that monitoring is not the only compliance function. Additionally, compliance should engage in the identification and prevention of violations of the regulatory requirements. This becomes much more proactive than simply requiring reports. That said, accurate reporting is a standard part of compliance. It is the role of senior management to establish and maintain a compliance function,and compliance policies and procedures designed to achieve compliance with securitiesregulatory requirements. Within the context of compliance, there are two specific areas for us to cover: disclosure documents and potential conflicts of interest. Both items are key compliance components in the investment field. Example 1: In the IOSCO compliance paper, what are two key concepts that focus on the value of compliance? Solution: Two key concepts that stand out are:  protecting the interests of clients, and  preserving the integrity of the markets. Disclosure Documents What information is a financial advisor required to disclose? As has been true with most topics in this course, the answer depends on rules and regulations in the territory or organization. Each regulator has its own requirements, and what is required in one territory may not be required in another. That said, there are similarities because of the overall interest in increasing and maintaining transparency. Disclosure is closely related to conflicts of interest, which must be disclosed and will be covered next. As a general rule, a financial advisor working with retail clients must disclose certain information. While the requirements vary by territory, the underlying principle is to provide essential information the client needs to make an informed decision. Information disclosed cannot be misleading, deceptive or confusing. Remember, the principle is to clarify rather than obscure. Typically, there are rules requiring information to be disclosed prior to entering a relationship with the client (or at least, within a reasonable period afterwards), and rules requiring disclosure during the relationship, such as when the financial advisor provides advice to the client. These rules are designed to ensure clients have the information they need to make their decisions: whether to use the financial advisor and whether to accept the financial advisor’s advice. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 64

Going back to our original question about what must be disclosed, the following can be used as a guideline (remembering that regulations in each territory may have different requirements) for the types of information that should be disclosed to clients.  Name, organization, address and other contact information, including, in some territories, who is responsible for the financial advisor’s actions  Services provided and by whom, along with relevant qualifications and credentials  Methods of analysis, including investment strategies and risk of loss  Disciplinary actions along with current licenses  Fees and other expenses  Financial advisor compensation (not so much the amount as the source) and third-party payments (i.e., additional compensation arrangements)  Agency relationships and affiliations, including required brokerage agreements  Other relevant business arrangements  Code of ethics  Supervision  Conflicts of interest (covered below)  Additional information that may be relevant to the relationship Each territory may require a particular form or format, and likely will have other specific procedures for the financial advisor to follow. There are also likely to be varying requirements based on the financial advisor’s position in the firm and scope of activities. Someone who only sells investment products probably will have disclosure requirements that differ from an individual who provides investment or financial planning advice. The disclosure requirement for financial advisor compensation typically does not require the financial advisor to have to disclose total personal income to the client (a financial advisor has the right to privacy with regard to this). What is required is that the client has a right to know what their relationship with a financial advisor— including transactions and everything else—will cost them (e.g., commissions, fees, etc.), and how they will have to make payment. Costs can also relate to the fees charged by the product provider, which should be disclosed to the client. Providing for adequate client disclosure is a requirement of being in the business of giving financial advice. For those who wish to comply with regulations, maintain transparency and operate from high ethical standards, there is not an alternative to full and accurate disclosure. Additionally, most territories levy fines and other penalties for not complying with disclosure requirements. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 65

Potential Conflicts of Interest According to an article in Forbes, self-dealing and conflicts of interest were a significant factor in the 2007-2008 global economic collapse. The same article identifies some guidelines for financial advisors to follow. First, conflicts of interest are generally to be avoided. This relates to loyalty. Investors want financial advisors to look out for their clients’ interest. The conflict of interest concern relates primarily to improper economic incentives that have a real cost to the investor. Second, investors should tolerate conflicts of interest only when they are either unavoidable or when the potential rewards outweigh the potential risks. As to the first, some conflicts of interest are unavoidable. The financial advisor can often make necessary changes, or the investor can decide to work with another financial advisor without those conflicts. As to the second, it’s possible that the reward will outweigh the risk, but not likely. If conflicts of interest are likely to harm clients, it makes sense to understand the sources of potential conflicts. While there may be many sources, one of the primary ones is when the financial advisor is an employee of a financial product provider and obligated to recommend the firm’s products as part of any recommendations or advice. In this case, the financial advisor must disclose these limitations on his or her recommendations to clients. At that point, the client may decide that he or she can accept the conflict or choose to work with another financial advisor. It may also be possible that the financial advisor has a relationship with another product provider, or a conflicting business relationship, that is more beneficial to the financial advisor than the client. Product providers sometimes offer incentives to use their products that may bias the financial advisor to recommend those products rather than some that might be a better option for the client. Broadly speaking, anything that benefits the financial advisor more than the client can be classified as a potential conflict of interest. Some of these are subtle, and reflect a poor firm culture. This might include misaligned financial incentives, herd behavior (everybody else is doing it), or just personal weaknesses (e.g., vanity, self-delusion or poor judgment). Placing the client’s interest above the interest of the financial advisor will go a long way to mitigate conflicts of interest. Full and accurate disclosure will also help. Disclosure by itself will normally not be enough. This is especially true when information is provided in a way that obscures the existence, relevance or importance of the disclosures being made. Rather than simply disclosing conflicts, financial advisors should make every effort to avoid potential conflicts whenever possible, at all times placing the interest of the client ahead of the financial advisor. Some conflicts of interest will remain, regardless of a financial advisor’s best efforts to avoid them. This is where full and appropriate disclosure can help. If the financial advisor makes full disclosure and gives the client the opportunity to make an educated decision about working together, conflicts may be mitigated. While disclosure by itself may not be the answer, it certainly plays a key part as a beneficial component to looking out for the interest of the client. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 66

In summary, three basic approaches should guide financial advisors acting in the best interests of their clients. Financial advisors should: 1. Be able to identify conflicts, even when they might be indirect and not obvious, especially to the client. 2. Understand how to manage their business so they can avoid conflicts wherever possible. 3. Ensure that where conflicts arise and are unavoidable, they are fully disclosed in a way that the client can understand and make an informed decision. While compliance is predominantly focused on responding to legal and regulatory requirements, professional ethics provides the framework for how financial advisors should carry out their compliance activities. The principles in FPSB’s Code of Ethics and Professional Responsibility that guide financial advisors in the areas of conflicts of interest and disclosure are Principle 2 – Integrity and Principle 4 – Fairness: Principle 2 – Integrity: Provide professional services with integrity. Integrity requires honesty and candor in all professional matters. Financial professionals are placed in positions of trust by clients, and the ultimate source of that trust is the financial professional’s personal integrity. Allowance can be made for legitimate differences of opinion, but integrity cannot co-exist with deceit or subordination of one’s principles. Integrity requires the financial professional to observe both the letter and the spirit of the Code of Ethics. Principle 4 – Fairness: Be fair and reasonable in all professional relationships. Disclose and manage conflicts of interest. Fairness requires providing clients what they are due, owed or should expect from a professional relationship, and includes honesty and disclosure of material conflicts of interest. It involves managing one’s own feelings, prejudices and desires to achieve a proper balance of interests. Fairness is treating others in the same manner that you would want to be treated. As is true of the legal system, regulators have a responsibility to protect the public. As a result, the laws and regulations with which financial advisors must comply have the same general focus as the ethical standards under which financial advisors choose to abide. While violating an ethical standard may cause a financial advisor to be censured by his or her professional body, violating a law or regulation may lead a financial advisor losing the ability to practice, to criminal prosecution or severe penalties. A financial advisor should choose not merely to comply with the letter of the law in a territory, but to seek to practice at levels that benefit clients, other professionals, the profession itself and the larger public. Once the financial advisor had completed providing advice, advisors need a “checking process” to ensure that the advice delivered to the client is complete. This checking process is referred to as conducting due diligence. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 67

Example 2 1. How can a financial advisor mitigate potential conflicts of interest? 2. Does following disclosure requirements eliminate the negative impact of conflicts of interest? Solution 1:  Make full and appropriate disclosure.  Focus on the client’s interest rather than on that of the financial advisor. Solution 2: Disclosure by itself will normally not be enough. This is especially true when information is provided in a way that obscures the existence, relevance or importance of the disclosures being made. Rather than simply disclosing conflicts, financial advisors should make every effort to avoid potential conflicts whenever possible, at all times placing the interest of the client ahead of the financial advisor. Due Diligence Due diligence is defined as a: “measure of prudence, responsibility and diligence that is expected from, and ordinarily exercised by, a reasonable and prudent person under the circumstances.” (Business Dictionary, n.d.) For financial advisors, due diligence is the process of systematically verifying the accuracy of information provided by the client, ensuring that the requirements of relevant legislation have been complied with, full disclosure had been made to the client, and that a full record of conversations and justification of decisions made by the financial advisor are recorded in the client file. In many territories clients are becoming more litigious, particularly as they become better educated and more informed about finance and investing and their legal rights. The outcomes of court actions against financial advisors in different territories highlight the importance of conducting due diligence. For example, following the conclusion of one recent court action, the unsuccessful defendant financial advisor made the following statement about what he needed to do going forward: “Meticulously keep notes. Ensure that all discussions and comments to clients and prospective clients are documented. Ensure that everything is signed off and there is a paper trail for everything.” Source: Richard Swansson (plaintiff) vs Russell Harrison (advisor) &Ors (others) In another example of a case against a financial advisor where his defense was severely compromised due to his poor record keeping and his lack of knowledge of his obligations under the insurance law applying in that territory, the trial judge made the following observation: “The one thing that became clear in the case … a lot of advisors haven’t known what their obligations are *but because of cases like this+ they are becoming aware of what they need to do.” (Commonwealth Financial Planning Ltd v Couper NSWCA 444, 2013) CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 68

Example 3: What is the ongoing role of the compliance function? Solution:  The ongoing role of compliance is to identify, assess, advise on, monitor and report on a market intermediary’s compliance with securities regulatory requirements and the appropriateness of its supervisory procedures.  Additionally, compliance should engage in the identification and prevention of violations of the regulatory requirements. Chapter Review Review Questions 1. What is a financial intermediary and how does being one relate to compliance? 2. In general, what information should the financial advisor disclose and why is it important to do so? 3. How does the financial advisor’s relationship with the employer potentially cause a conflict of interest? Associated Websites  http://www.sec.gov/News/Speech/Detail/Speech/1365171491600  http://www.forbes.com/sites/edwardsiedle/2011/12/08/siedles-rules-for-handling-financial- advisor-conflicts-of-interest/#4e84059d39c5  http://www.iosco.org/library/pubdocs/pdf/IOSCOPD214.pdf CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 69

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Chapter 6: Anti-Money Laundering You will learn about money laundering, its purpose, practices, global laws and regulations to counter money laundering and how financial advisors can comply to these laws . Glossary of Key Global Organizations The World Bank: Established in 1944, the World Bank Group is headquartered in Washington, D.C. The World Bank Group is one of the world’s largest sources of funding and knowledge for developing countries with membership across 189 nations. Its aim is to reduce poverty, increase shared prosperity, and promote sustainable development. The Bank Group works with country governments, the private sector, civil society organizations, regional development banks, think tanks, and other international institutions on issues ranging from climate change, conflict, and food security to education, agriculture, finance, and trade. United Nations Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances: The United Nations Office on Drugs and Crime (UNODC) is a global leader in the fight against illicit drugs and international crime. Established in 1997 through a merger between the United Nations International Drug Control Program and the Centre for International Crime Prevention, UNODC operates in all regions of the world through an extensive network of field offices. UNODC assists members in their struggle against illicit drugs, crime and terrorism. UNODC was established to assist the UN in better addressing a coordinated, comprehensive response to the interrelated issues of illicit trafficking in and abuse of drugs, crime prevention and criminal justice, international terrorism, and political corruption.The office aims long-term to better equip governments to handle drug-, crime-, terrorism-, and corruption-related issues, to maximise knowledge on these issues among governmental institutions and agencies, and also to maximise awareness of said matters in public opinion, globally, nationally and at community level. In UNODC’s Millennium Declaration, member countries and territories resolved to intensify efforts to fight transnational crime in all its dimensions, to redouble the efforts to implement the commitment to counter the world drug problem and to take concerted action against international terrorism. UNODC five areas of activity are:  Countering TERRORISM  Tackling CORRUPTION and its catastrophic impact on societies CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 71

 Strengthening Member States’ capacities to confront threats from TRANSNATIONAL ORGANIZED CRIME  Strengthening crime prevention and building effective CRIMINAL JUSTICE SYSTEMS  Supporting Member States in implementing a balanced, comprehensive and evidence-based approach to the WORLD DRUG PROBLEM that addresses both supply and demand United Nations Convention Against Transnational Organized Crime: The United Nations Convention against Transnational Organized Crime (UNTOC) is a 2000 United Nations-sponsored multilateral treaty against transnational organized crime. The convention was adopted by a resolution of the United Nations General Assembly on 15 November 2000. It is also called the Palermo Convention and its three supplementary protocols (the Palermo Protocols) are: 1. Protocol to prevent, suppress and punish trafficking in persons, especially women and children 2. Protocol against the smuggling of migrants by land, sea and air 3. Protocol against the illicit manufacturing and trafficking in firearms. Vienna Convention: The Vienna Convention on the Law of Treaties (VCLT) is a treaty concerning the international law on treaties between states. It was adopted and opened for signature on 23 May 1969. The convention entered into force on 27 January 1980. The VCLT has been ratified by 116 states as of January 2018. Some countries that have not ratified the Convention, such as the United States, recognize parts of it as a restatement of customary law and binding upon them as such. Known as the \"treaty on treaties,\" it establishes comprehensive rules, procedures, and guidelines for how treaties are defined, drafted, amended, interpreted, and generally operated. Financial Action Task Force (FATF): The Financial Action Task Force (FATF) is an inter-governmental body established in 1989 by the ministers of its member jurisdictions. The objectives of the FATF are to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system. The FATF is therefore a “policymaking body” that works to generate the necessary political will to bring about national legislative and regulatory reforms in these areas. FATF has developed a series of Recommendations (the “40 Recommendations”) that are recognized as the international standard for combating money laundering and the financing of terrorism and proliferation of weapons of mass destruction. They form the basis for a coordinated response to these threats to the integrity of the financial system and help ensure a level playing field. The FATF monitors the progress of its members in implementing necessary measures, reviews money laundering and terrorist financing techniques and countermeasures, and promotes the adoption and implementation of appropriate measures globally. In collaboration with other international stakeholders, the FATF works to identify national-level vulnerabilities with the aim of protecting the international financial system from misuse. The Organization of American States (OAS): Founded on 30 April 1948, OAS was created to promote regional solidarity and cooperation among its member states, comprised of all 35 independent nations of the Americas. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 72

Inter-American Drug Abuse Control Commission (CICAD): Established in 1986 from The Organization of American States (OAS), the CICAD’s purpose is to promote and facilitate multilateral cooperation to control the production, abuse and traffic in illicit drugs and related crimes.[33] Basel Committee (BCBS): The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The committee frames guidelines and standards in different areas—some of the better-known among them are the international standards on capital adequacy, the Core Principles for Effective Banking Supervision, and the Concordat on cross-border banking supervision.[34] Background Money is the economic backbone of all territories—the medium by which governments, businesses and individuals engage in commerce. Except for a relatively few cultures, no money means no commercial interaction. For most, monetary interaction is a legal activity—a necessary component of modern life. However, for some, money can be the currency financing illegal activities. Those who knowingly engage in such activities often engage in a practice known as money laundering. Money laundering is the practice of making money gained through illegal activities appear to be legal. Most territories have anti-money laundering laws and regulations. Financial advisors should become familiar, and comply, with universal guidelines and relevant regulations in their territory. Upon completion of this chapter, financial advisors should understand money laundering, its implications, how to identify and avoid it, and how to comply with relevant regulations in a territory. Most territories actively pursue policies to limit money laundering, along with the financing of terrorist organizations. There are some exceptions but most territories have policies against these activities. Unfortunately, those who practice money laundering have gotten increasingly sophisticated, which makes recognizing and prosecuting perpetrators difficult. Money launderers can use different types of financial institutions, multiple financial transactions, various intermediaries (such as financial advisors), shell corporations, and many other types of service providers, operating in multiple territories, using various processes and techniques, to launder money. While reliant on a complex system, at its core, money laundering is fairly straightforward. Illegal activities produce income, which is then disguised to conceal its origins. From there, the laundered money can be used in mainstream economies for all types of purposes, including the funding of terrorist activities. The result is criminals profit and society is harmed. Money Laundering and the Financing of Terrorism According to the World Bank, most territories subscribe to the definition adopted by the United Nations Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances, and the United Nations Convention against Transnational Organized Crime. According to these documents, the definition includes: CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 73

The conversion or transfer of property, knowing that such property is derived from any offense or offenses or from an act of participation in such offense or offenses, for the purpose of concealing or disguising the illicit origin of the property or of assisting any person who is involved in the commission of such an offense or offenses to evade the legal consequences of his actions. The concealment or disguise of the true nature, source, location, disposition, movement, rights with respect to, or ownership of property, knowing that such property is derived from an offense or offenses or from an act of participation in such an offense or offenses. The acquisition, possession, or use of property, knowing at the time of receipt that such property was derived from an offense or offenses or from an act of participation in such offense...or offenses. The Vienna Convention limits causal offenses to drug trafficking, which means other activities do not technically qualify as causal to money laundering. However, the larger international community has determined that causal factors go beyond drug-related activities. In fact, the Palermo Convention requires all participant territories to apply money laundering offenses to the widest range of predicate offenses (Palermo Convention, Article 2). The Financial Action Task Force (FATF) is the recognized international standard setter for anti-money laundering efforts. It defines money laundering as the processing of criminal proceeds to disguise their illegal origin to legitimize the ill-gotten gains of crime. Defining terrorism is one of the more difficult tasks for some territories. The meaning of what constitutes terrorism is not universally defined and accepted due, in part, to political, religious and other national implications. This has resulted in some uncertainty over prosecution of activities used to fund terrorism specifically, and money laundering crimes more generally. Interestingly, most of the regulations also do not clearly define terrorism—likely for the same reasons. That said, there is general acceptance that terrorist activities include acts intended to cause death or serious bodily injury to any person not taking an active part in recognized armed conflict. Further, such activities are designed to intimidate people and/or compel a government to act in a certain manner. When funds are used for this type of purpose, they fit into the overall criteria of money laundering. Money laundering efforts globally involve extremely large amounts of money—as reported by the FATF, approximately 2.7% of the world’s GDP is being laundered. Given the nature of the activities, it’s difficult to know with certainty the actual amount of money involved, but financial advisors can be assured the amount of money laundered globally each year is exceptionally large. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 74

Figure 4: The Three Stages of Money Laundering According to the FATF and others, in the initial—or placement—stage of money laundering, the launderer introduces illegal profits into the financial system. This might be done by breaking up large amounts of cash into less conspicuous smaller sums that are then deposited directly into a bank account, or by purchasing a series of monetary instruments (checks, money orders, etc.) that are then collected and deposited into accounts at another location. After the funds have entered the financial system, the second—or layering—stage takes place. In this phase, the launderer engages in a series of conversions or movements of the funds to distance them from their source. The funds might be channeled through the purchase and sales of investment instruments, or the launderer might simply wire the funds through a series of accounts at various banks across the globe. This use of widely scattered accounts for laundering is especially prevalent in jurisdictions that do not cooperate in anti-money laundering investigations. In some instances, the launderer might disguise the transfers as payments for goods or services, thus giving them a legitimate appearance. Having successfully processed criminal profits through the first two phases, the launderer then moves them to the third stage—integration—in which the funds re-enter the legitimate economy. The launderer might choose to invest the funds into real estate, luxury assets or business ventures. As for where all of this occurs, as money laundering is a consequence of almost all profit-generating crime, it can occur practically anywhere in the world. Generally, money launderers tend to seek out territories or sectors in which there is a low risk of detection due to weak or ineffective anti-money laundering programs. Because the objective of money laundering is to get the illegal funds back to the individual who generated them, launderers usually prefer to move funds through stable financial systems (that have weak anti-money laundering programs). CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 75

Money laundering activity may also be concentrated geographically according to the stage the laundered funds have reached. At the placement stage, for example, the funds are usually processed relatively close to the underlying activity; often, but not in every case, in the territory where the funds originate. With the layering phase, the launderer might choose an offshore financial center, a large regional business center or a world banking center—any location that provides an adequate financial or business infrastructure. At this stage, the laundered funds may also only transit bank accounts at various locations where this can be done without leaving traces of their source or ultimate destination. Finally, at the integration phase, launderers might choose to invest laundered funds in still other locations if they were generated in unstable economies or locations offering limited investment opportunities. All of this points to an overall problem impacting business and economic development. To operate properly, the banking and financial services industry relies on the trust of the general population. In turn, this requires a perception that it operates with high legal, professional and ethical standards. In other words, the financial services industry depends on a perception of integrity, without which the system begins to deteriorate. When money is laundered through a banking or other financial institution, that business is in danger of becoming part of the criminal enterprise—or at least being perceived in that way, which can undermine the company’s reputation and even potentially undermine a territory’s economic environment. Global Rules and Regulations Although anti-money laundering (AML) oversight is the responsibility of each territory, as previously discussed, international standards have been developed. Territories tend to adopt AML laws that are consistent with their own environment, and incorporate eight standard legal system requirements established by the World Bank to cooperate with the global community. The eight standard principles are (Site Resources, World Bank, V-2): 1. Criminalization of money laundering in accordance with the Vienna and Palermo Conventions 2. Criminalization of terrorism and terrorist financing 3. Laws for seizure, confiscation and forfeiture of illegal proceeds 4. The types of entities and persons to be covered by AML laws 5. Integrity standards for financial institutions 6. Consistent laws for implementation of FATF recommendations 7. Cooperation among competent authorities 8. Investigations FATF has developed and circulated “Recommendations on International Standards on Combating Money Laundering and the Financing of Terrorism and Proliferation”[42]. Much of what follows is derived from FATF’s 40 Recommendations. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 76

If money laundering is to be considered a criminal offense, it is important to identify the categories of underlying activities. They are as follows (Forty Recommendations, V-7):  Participation in an organized criminal group and racketeering  Terrorism, including terrorism financing  Trafficking in human beings and migrant smuggling  Sexual exploitations, including sexual exploitations of children  Illicit trafficking in narcotic drugs and psychotropic substances  Illicit arms trafficking  Illicit trafficking in stolen and other goods  Corruptions and bribery  Fraud  Counterfeiting currency  Counterfeiting and piracy of products  Environmental crime  Murder, grievous bodily injury  Kidnapping, illegal restraint and hostage taking  Robbery or theft  Smuggling  Extortion  Forgery  Piracy  Insider trading and market manipulation Note that each of the categories above are quite broad, with the idea being to provide broad powers to governments to criminalize the proceeds from the type of conduct listed. It’s worth noting that the listed categories are considered only to identify the minimum categories. AML regulations consider the individual’s state of mind—the intent or purpose in committing the money laundering offense. Actual knowledge of the illicit origin of property[43] may or may not be required. Some territories may operate under a concept that the financial advisor who facilitated the money laundering activity should have known or at least suspected the fund’s origin. Example 1 How would you describe the three common money laundering steps? Solution: 1. In the initial—or placement—stage of money laundering, the launderer introduces illegal profits into the financial system. 2. The second—or layering—stage takes place. In this phase, the launderer engages in a series of conversions or movements of the funds to distance them from their source. 3. The third stage—integration—is when the funds re-enter the legitimate economy. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 77

Financing of Terrorism The Organization of American States (OAS), through its Inter-American Drug Abuse Control Commission (CICAD), developed “Model Regulations on Money Laundering Offenses Related to Drug Trafficking and Other Criminal Offenses.” This document, in addition to drug-related activities, addresses financing of terrorism (FT), and identifies three different states of mind related to these activities. It states that the accused:  Had knowledge that the property constitutes proceeds of a criminal activity as defined in the convention  Should have known that the property was obtained with the proceeds of criminal activity  Was intentionally ignorant of the nature of the proceeds The third category points to the individual who suspects that the property came from criminal activity, even though he or she may not have “known.” Although it is quite difficult to prove an individual’s state of mind, laws permit the inference of the required state of mind from objective factual circumstances. You can see that the focus is not just on the actual money laundering, but on the underlying activities relating to the money laundering. Financial Institutions and ML/FT Risk When it comes to money laundering, financial institutions have come under special scrutiny, for obvious reasons. Knowing this, it becomes important to understand how the regulations define a financial institution. FATF recommendations define financial institutions as any person or entity who conducts as a business one or more of the following activities, or operations on behalf of a customer:  Acceptance of deposits and other repayable funds from the public (including private banking).  Lending (including consumer credit, mortgage credit, factory, with or without recourse, and finance of commercial transactions—including forfeiting).  Financial leasing (but excluding leasing for consumer products).  The transfer of money or value (including formal and informal sectors, such as alternative remittance activity).  Issuing and managing means of payment (e.g., credit and debit cards, checks, traveler’s checks, money orders and banker’s drafts, electronic money).  Financial guarantees and commitments.  Trading in:  Money market instruments (checks, bills, CDs, derivatives, etc.)  Foreign exchange  Exchange, interest rate and index instruments  Transferable securities  Commodity futures trading CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 78

 Participation in securities issues and the provision of financial services related to such issues.  Individual and collective portfolio management.  Safekeeping and administration of cash or liquid securities on behalf of other persons.  Otherwise investing, administering or managing funds or money on behalf of other persons.  Underwriting and placement of life insurance and other investment-related insurance (this applies to both insurance undertakings and intermediaries, such as agent and brokers).  Money and currency changing. Looking at the list, it’s clear that, to one degree or another, many financial advisors work in environments where they could be in violation of these recommendations. There are, of course, additional individuals and institutions who fit into related categories, but we will limit the focus of this course to financial institutions (and those who work in them). Detecting Money Laundering Money cannot be laundered, or terrorism financed, without the involvement of financial institutions, certain business entities and certain persons (Reference Guide to AML, World Bank, p V-23). As a result, the international community developed provisions that include requirements for:  Licensing and authorization to engage in business.  Evaluation (fit and proper determination) of directors and senior managers, with regard to integrity, expertise and experience.  Prohibitions against participation by directors and managers with criminal records or adverse regulatory findings.  Prohibitions against ownership or control by those with criminal records. Additionally, regulations address customer due diligence (CDD), which can directly impact financial advisors working with the public. The regulations get rather detailed, and we will not delve into them too deeply. However, it will be worth looking at an overview to get an idea of areas of potential risk and concern. According to FATF, there are four broad measures to be taken and that come under areas for supervision. The four are: Identifying the customer and verifying that customer’s identity using reliable, independent source documents, data or information.  Identifying the beneficial owner, and taking reasonable measures to verify the identity of the beneficial owner such that the financial institution is satisfied that it knows who the beneficial owner is. For legal persons and arrangements this should include financial institutions taking reasonable measures to understand the ownership and control structure of the customer.  Obtaining information on the purpose and intended nature of the business relationship.  Conducting ongoing due diligence on the business relationship and scrutiny of transactions undertaken throughout the course of that relationship to ensure that the transactions being conducted are consistent with the institution’s knowledge of the customer, their business, and risk profile, including, where necessary, the source of funds. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 79

Financial institutions and those tasked with conducting CDD are to take these measures when:  They establish a business relationship.  They carry out occasional transactions:  Above the applicable designated threshold (e.g., $10,000) or  That are wire transfers in the circumstances covered by the FATF interpretive notes  There is a suspicion of money laundering or terrorist financing.  The financial institution has doubts about the veracity or adequacy of previously obtained customer identification data. The Basel Committee (Bank for International Settlements, 2017) distilled these guidelines down to a simple rule: Know your Customer. Coming from the supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States, this rule seems to carry some weight. Each institution, in cooperation with relevant territories, has developed its own implementation procedures related to know your Customer and its supervision. That said, the procedures come under the requirements and regulations the committee established for effective banking supervision. This is another area where the guidelines are many and somewhat lengthy, so we will not identify them in their entirety. Instead, we can identify some points for general guidance to financial advisors.  Supervisors must have the authority to review and reject any significant change in ownership and set minimum capital requirements for banks.  Inter-organizational lending and other transactions must be handled on an arm’s-length basis.  Banks must have and adhere to a comprehensive risk management process.  Institutions must have strict “know your customer” rules that promote high ethical and professional standards in the financial sector.  Supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors.  Supervisors must practice global consolidated supervision.  Local operations of foreign banks must be conducted with the same high standards required of domestic institutions. Supervision, then, extends beyond local institutions and embraces the global business operations of organizations. One implication of this is that financial advisors must also think and operate to protect and oversee any cross-border relationships they may have. It might be worth stating who the global community considers to be a customer. There are three points of criteria (Basel Due Diligence for Banks, provision 66):  A person or entity who maintains an account with a financial institution or on whose behalf an account is maintained (i.e., beneficial owners). CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 80

 Beneficiaries of transactions conducted by professional intermediaries (e.g., agents, accountants, lawyers).  A person or entity connected with a financial transaction who can pose a significant risk to the bank. For the financial advisor, this means being diligent in following regulations and watching for any warning signs, statements or requests that raise concerns. Complying with Relevant Anti-Money Laundering Regulations The World Bank has identified that a crucial aspect of customer identification is establishing whether the customer is acting on his, her or its own behalf, or whether there is a beneficial owner of the account that may not be identified in the documents maintained by the financial institution (World Bank, p VI-4). When there is a question about beneficial ownership, the financial advisor needs to conduct appropriate due diligence. This can be especially difficult in situations when tiered ownership is involved with corporations or other legal entities. Tiered ownership involves one corporation owning or controlling one or more other corporate entities. The question a financial advisor must ask in these situations is who, exactly, the real parent owner is. It is important for financial advisors to have clear customer acceptance and identification procedures for clients. If the financial advisor operates independently, he or she must do this on their own. When working for a financial institution, the financial advisor must diligently maintain full compliance with all governing regulations. Not all potential clients will require high levels of investigation and security. However, for those who might be in that category, financial advisors and their institutions should develop specific guidance to address customers with high risk profiles. For potential customers who might have a higher risk profile, the institution or independent financial advisor should identify standard risk indicators like personal background, territory of origin, high profile positions, linked accounts, and the nature of business activities. Standard Customer Due Diligence (CDD) Procedures When a financial advisor establishes a relationship with a new client, the financial advisor should include AML notes and CDD documentation as suitable for the type of client and the financial advisor’s assessment of ML/FT risks. The AML portion of the client file will record the financial advisor’s reasonable activities to verify the identity of the client and the nature of transactions made on the client’s behalf through the financial advisor or the financial institution where the financial advisor works. While each country or territory will have its own regulations, globally recognized standard CDD guidelines include: Name and legal form of customer’s organization  Client address  Names of directors  Principal owners or beneficiaries CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 81

 Provisions regulating the power to bind the organization  Agent(s) acting on behalf of the organization  Account number (if applicable)  In addition, when addressing insurance-related interactions, the file should include:  Client’s financial assessment  Need analysis (to justify application)  Payment method details  Benefit description  Copy of documentation used to verify customer identify  Post-sale records  Information regarding any claim settlements Enhanced Customer Due Diligence (CDD) Procedures For clients who are assessed as having higher ML/FT risk, the financial advisor should follow enhanced CDD policies, procedures and controls. Customers and clients who fall into this category should be vetted using standard CDD procedures and be further investigated on topics such as personal background, country of origin, source of wealth, relationships with others in high profile positions (particularly governmental positions), linked accounts, and the purpose and nature of business activities. When an agent represents a beneficiary (e.g., through trusts, corporations, etc.), it becomes important to take reasonable measures to verify the identity of the background individual or organization. To do this, financial entities should get the following information (The Forty Recommendations, Rec. 5):  Name and legal form of customer’s organization  Address  Names of directors  Principal owners or beneficiaries  Provisions regulating the power to bind the organization  Agent(s) acting on behalf of the organization  Account number (if applicable) Beneficial Ownership Beneficial owner refers to the natural person(s) who ultimately owns or controls a customer and/or the natural person on whose behalf a transaction is being conducted. It also includes those persons who exercise ultimate effective control over a legal person or arrangement. Reference to “ultimately owns or controls” and “ultimate effective control” refer to situations in which ownership/control is exercised through a chain of ownership or by means of control other than direct control. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 82

Cross-Border Financial Services and Transactions When dealing with cross-border situations, a financial advisor will need to take additional precautions. Most of these involve learning about the respondent bank and its policies and procedures. It will also be helpful to have the respondent bank accurately identify the customer. Non-face-to-face customers present one area that can be especially difficult to monitor. With the increase of internet and/or phone-based transactions, it may be difficult to accurately identify the customer to the degree that it mitigates potential risk concerns. While there is not a simple solution to this potential problem, senior management should be involved in helping to make the decision about whether to enter a business arrangement. The Forty Recommendations specifically apply to the banking sector. However, they are applicable also to insurance and securities. IOSCO (International Organization of Securities Commissions) has not specified due diligence requirements, but the IAIS (International Association of Insurance Supervisors) has. At their core, the IAIS recommendations mirror the Forty Recommendations, with additional guidance for life insurance-related concerns. Each financial services institution will likely have its own AML requirements with which the financial advisor must comply. If the financial advisor is not attached to a financial institution (i.e., independent), he or she will need to determine, and comply with, the relevant laws and regulations within the home territory and any additional territories within which they do business. Caveats to a Risk-Based Approach to AML Compliance The purpose of AML regulations in any country or territory is to mitigate the risks of money laundering and the financing of terrorism. The purpose of client due diligence is to aid the financial advisor or financial institution in making judgments on risk and concern, not merely to include an added layer of compliance. Not all clients (or even most) will be exposed or involved in money laundering, and it is important to ensure that AML policies and procedures do not by their nature exclude those who are socially disadvantaged. Policies should not restrict the general public’s access to financial services. When complying with internal AML policies and procedures and external regulations and supervision, all parties must be careful to not to violate individual rights, including those that relate to privacy. In today’s environment, money laundering is a fact of life, especially in the financial services sector. Every financial advisor has an individual responsibility to take all reasonable measures to work within the anti-money laundering arena. It may be that the problem will not be solved, but following prudent procedures will help. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 83

Example 2 What basic information should a financial advisor get and maintain from a client to support anti-money laundering? Solution:  Name of client and any beneficiaries  Address  Date and nature of any transactions  Type and amount of currency involved (especially when working in a cross-border situation)  Type and identifying account number  Additional information that will be helpful in identifying the client  In addition, when addressing insurance-related interactions, the file should include:  Client’s financial assessment  Need analysis (to justify application)  Payment method details  Benefit description  Copy of documentation used to verify customer identify  Post-sale records  Information regarding any claim settlements Chapter Review Case Studies Case Study I Life Insurance purchase Mrs. T (teacher) from Territory A entered a life insurance policy with a small initial premium being paid. The transaction was arranged by Mr. B, who was the agent of Insurance Company C and a cousin of Mrs. T. Two days later, Company C made a payment of an additional premium, in excess of $540,000, on behalf of Mrs. T. After one month, Mrs. T cancelled her policy and transferred the refund of contributions to three different accounts: Mr. MD (managing director of Company C)—$240,000; Ms. N (niece of Mr. MD)—$150,000; and Mr. U—$150,000. All of them subsequently transferred the money onward to other accounts in different banks. CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 84

Questions 1. Is there anything about this situation that causes money laundering concerns? If so, what are your concerns? 2. What might the agent have done differently at the beginning (if anything)? 3. What customer identification information should have been gathered? 4. Do you think the agent has any liability? Case Study II Intermediaries. A person made a financial investment of $250,000 by contacting a broker and delivering a total amount of $250,000 in three cash installments. The broker did not report the delivery of that amount and deposited the three installments in the bank. These actions raised no suspicion at the bank, since the broker was known to the bank as being connected to a local financial firm branch. The broker delivered, afterward, to the company responsible for making the financial investment, three checks from a bank account under his name, totaling $250,000, thus avoiding raising suspicions with the company. Questions 1. What money laundering red flags are there in this case study? 2. Should the bank have handled the transactions differently? 3. Is the broker culpable of illegal activities? 4. Is the bank or the financial firm liable for contributing to money laundering? Case Study III Suspicion of helping money laundering activity. Mr. A, through an offshore company, operated an investment scheme purporting to offer high returns from the skilled investment of funds in government-backed securities. He attracted about $140 million, mainly from small investors. Some of the investors’ funds were paid away through bank accounts maintained by another offshore company, headed by Mr. B and Mr. C. Mr. B helped Mr. C to reallocate, inappropriately, investor funds. Although he had suspicions regarding the funds’ origins, Mr. B decided not to investigate further. The investment scheme later closed and investors were unable to recover any of their funds. Questions 1. Were there any illegal activities in this situation, and if so, what were they? 2. Which of the three individuals—Mr. A, B, C—are guilty of wrongdoing? 3. Should Mr. B have acted differently? Why? CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 85

Case Study I: Afterward Following an investigation, it appeared that the money being laundered was linked to fuel smuggling. The accounts were blocked and the case forwarded for prosecution. Case Study II: Afterward The person making the initial deposit was later arrested for drug trafficking. Case Study III: Afterward Mr. A and Mr. C were convicted of fraud and sent to prison. The court found that Mr. B should have known (as a reasonable person) that the funds were being misappropriated, and should have alerted authorities. He was required to repay funds to investors. Review Questions 1. What is a usable description of money laundering? 2. What are the activity categories that comprise money laundering? 3. According to FATF, what are the four broad measures that come under areas for supervision? 4. What can a financial advisor do to clearly identify beneficial customers when working with an agent for those customers? Associated Websites  http://siteresources.worldbank.org/EXTAML/Resources/396511- 1146581427871/Reference_Guide_AMLCFT_2ndSupplement.pdf  http://www.bis.org/publ/bcbs30.pdf  http://www.cicad.oas.org/lavado_activos/eng/Model_regula_eng12_02/REGLAMENTO%20LAV ADO%20-%20ENG.pdf  http://www.fatf- gafi.org/media/fatf/documents/recommendations/pdfs/FATF_Recommendations.pdf  http://www.unodc.org/images/money-laundering/money_laundering_scheme_big.jpg  http://www.fatf-gafi.org/faq/moneylaundering/  http://www.incb.org/incb/en/precursors/1988-convention.html  http://www.unodc.org/unodc/en/organized-crime/index.html CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 86

To do additional research in this area, you can view the following sites:  https://www.imf.org/external/np/leg/amlcft/eng/aml4.htm  http://www.sec.gov/news/speech/anti-money-laundering-an-often-overlooked- cornerstone.html  http://bankersacademy.com/resources/free-tutorials (list of AML and tutorials in many territories)  https://www.fdic.gov/regulations/examinations/bsa/index.html  https://www.imf.org/external/np/leg/amlcft/eng/aml1.htm  http://siteresources.worldbank.org/EXTAML/Resources/396511- 1146581427871/Reference_Guide_AMLCFT_2ndSupplement.pdf  http://www.fatf- gafi.org/media/fatf/documents/recommendations/pdfs/FATF_Recommendations.pdf CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 87

CFP Level 1 - Module 3 – Regulatory Environment & Compliances - Global Page 88

REGULATORY ENVIRONMENT & COMPLIANCES (INDIA SPECIFIC) CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 89

CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 90

Chapter 1: Regulatory System & Environment You will learn the various aspects of compliances, laws, regulatory, economic and political environment in relation to financial services in India. India is a parliamentary democracy. Financial economic policy is implemented by the regulating agencies who are assigned functions by the Parliament with laid down objectives, powers and accountability mechanisms. Thus, financial sector regulators in India are the executive branches of the State and are accountable to the legislature. The individual regulators, though having a fair bit of independence in performing their role, therefore fall in the ambit of various Government Departments or Ministries, which are held accountable to the electorate through the legislature. The Ministry of Finance (MoF) in India is the channel to ensure the parliamentary oversight of regulators. Thus, the regulators in India are statutory bodies governed by Board of Members, who are appointed by the MoF. In order to cover the costs of regulation, the regulators charge fees from industry participants or the entities which are regulated by them, and therefore function fairly in financial independence from the Government. The financial regulation space in India is divided along the sectors with respective sector regulators overseeing the products and the industry players who issue such products. The credit and deposits are mainly in the domain of RBI; the issue of capital, related products and securities, except government securities, are regulated by SEBI; the insurance products are exclusively monitored by IRDA; and the National Pension System (NPS) in under the purview of PFRDA. Reserve Bank of India (RBI) India’s financial sector is dominated by banks which manage more than half of the total assets of the financial system. Among the entities regulated by RBI are commercial banks, urban cooperative banks (UCBs), non-banking finance companies (NBFCs) and some financial institutions such as National Bank for Agriculture and Rural Development (NABARD) and National Housing Bank (NHB). NABARD, in turn, regulates other entities created for the specified purpose, viz. Regional Rural Banks (RRBs) and Co- operative banks. Similarly, NHB supervises the activities of housing finance companies (HFCs). The Department of Company Affairs (DCA) under Government of India regulates deposit taking activities of corporate registered under the Companies Act, other than NBFCs. The Registrar of Cooperatives of different states in the case of single state cooperatives and the Central Government in the case of multi-state cooperatives are joint regulators, with RBI regulating their banking functions. CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 91

The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. RBI is banker to the Government in that it performs merchant banking function for the Central and the State Governments. It is banker to all scheduled banks in India by maintaining banking accounts. RBI is the monetary authority. It frames, implements and monitors the monetary policy with the objective of maintaining price stability while keeping in mind the objective of growth. It prescribes broad parameters of banking operations with the objectives to maintain public confidence in the system and protect depositors' interest. RBI is the issuer of currency and monitors it along with other exchange mediums and payment systems. It is responsible for facilitating external trade through orderly development and maintenance of foreign exchange market in India[1]. The Indian economy of the 1980s was characterized by fiscal expansion and the monetization of budget deficit which tilted macroeconomic scales to high risk zone. The headwinds of huge oil import bills due to Gulf War worsened the situation to a full blown balance of payments crisis in 1991. RBI played a crucial role in the course correction that followed in the form of liberalization and decontrol of industry, structural economic reforms including fiscal correction, development of securities market and its integration with money markets and foreign exchange markets, and the overall strengthening of the payment and settlement systems. RBI is in many respects the conscience keeper of the Indian Economy. It ensures price stability, supply of money and keeps in check various macro-economic parameters. Through supervision of banking and allied sector RBI ensures that the financial consumers and general public has confidence in dealing with thousands of economic outlets in the form of bank branches for their needs of savings and credit. RBI monitors the health of the real economy, capital flows, trends in demand and consumption, savings and investments, capital formation and gross value added within sectors. It conducts open market operations in money markets to maintain adequate levels of money supply; buys and sells foreign exchange to maintain the exchange rate. It is the repository of gold stock and foreign exchange reserves. RBI oversees payment and settlement systems that are not just safe and secure, but are also efficient, fast and affordable, while recognizing the need for continued emphasis on innovation, cyber security, financial inclusion, customer protection and competition. Securities and Exchange Board of India (SEBI) The securities market provides avenue for the productive use of capital, a channel that enables entities who need the capital, meet those who provide that capital for a consideration to be earned for the period of time they cede that capital. The National Institute of Securities Markets states in the basics of Securities Markets, “…..the savers and investors are not constrained by their individual abilities, but by the economy’s abilities to save and invest, which inevitably enhances savings and investment in the economy”[2]. CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 92

The history of securities markets in India dates back to the nineteenth century with the informal cotton trading, the main activity in the city of Bombay. The financing for this trading came to be formally provided initially by Bank of Bombay (1840) and later by many banking entities sprung up for the purpose. Gradually, some people started trading in shares of these cotton companies as well. The American Civil War (1861-65) led to the rise in demand for Indian cotton, and along with this the demand for raising money for share trading. Cotton prices crashed as the civil war ended in 1965, and with this crashed all the associated financial cycle: the closure of cotton companies, crashing of shares, credit losses for banks. The onus of the crisis was mainly felt on the brokers. Despite the damage from the civil war crash, share business had caught the imagination of a large number of players. They realized that equity markets are a good avenue to raise capital and then trade in their shares. Brokers formed an association, the Native Share and Stockbrokers Association on July 9 1875 to conduct their share business. They hired a hall in Dalal Street. Later the Association was formalized in 1887 with an Articles of Association. The Articles specified the purpose was to facilitate negotiation of sell and purchase of joint stock securities promoted throughout the Presidency of Bombay. In 1895, the old BSE building was purchased[3]. The Capital Issues (Control) Act, 1947 provided a structural approach. The “issue of capital” meant issuing or creation of any securities whether for cash or otherwise, and included the capitalization of profits or reserves for the purpose of converting partly paid-up shares into fully paid-up shares or increasing the par value of shares already issued. The definition of securities was wide enough to include shares, stocks, bonds, debentures, mortgage deeds, pledge or hypothecation and any other instruments creating or evidencing a charge or lien on the assets of a company, instruments acknowledging loan to or indebtedness of the company and guaranteed by a third party, or entered into jointly with a third party. The controls over issues of capital were concentrated entirely with the Central Government which restricted the issue of capital, public offer and sale of securities, renewing or postponing the maturity of any security. The Central Government had the power to give consent for purchase and sale of securities and has the powers to grant exemptions and revoke the consent given. There were severe penalties for contravening provisions of the Act, with burden of proof lying with the prosecuted. The Securities Contracts (Regulation) Act 1956 defined contracts relating to the purchase or sale of securities. The Act included under securities: derivatives, options and government securities, units issued by collective investment schemes, securities receipts and rights and interest in securities. It provided for the recognized stock exchanges by the Central Government. It laid down conditions for listing and delisting of securities. Also, the Companies Act, 1956 served as the most important piece of legislation that empowers the Central Government to regulate the formation, financing, functioning and winding up of companies. It served to protect the interests of the investors by furnishing fair and accurate information in the prospectus; recognizing the rights of the shareholders to receive reasonable information for making an intelligent judgment with reference to the management; ensuring full and fair disclosure of the affairs of the companies; protecting the interest of the creditors through liquidation and takeover of mismanaged companies; preventing misconduct and malpractices on the part of company’s management and abuse of power vested in them, etc. CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 93

A landmark development in the Indian capital markets took place with the establishment of the Securities Exchange Board of India (SEBI) in 1988 to regulate the functions of securities market. With the passage of SEBI Act, 1992 along with the repeal of the Capital Issues (Control) Act, a journey began for the modernization of the securities market. Various reform measures undertaken since the early 1990s by SEBI and the Government have brought about a significant structural transformation in the Indian capital market. With the promulgation of various Acts such as the Depositories Act, 1996, the Securities Laws (Amendment) Act, 2004 laid the foundation for game changing mechanisms. With the establishment of the National Stock Exchange of India (NSE) in 1993 and the National Securities Depositories Limited (NSDL) in 1996 and the resultant trading in dematerialized securities, 98% settlement in demat form took place as early as in June, 2000. The improvement in stock market settlements (rolling settlements from T+5 in 2001 to T+2 in 2003), fully electronic trading in equity shares paved the way for Indian securities market to have an infrastructure on par with the best in the world. The speed of development in securities market had SEBI ramp up its activities to be up to the challenge with the main aim to protect the interest of investors, keep a check on malpractices, and promote orderly development in the stock markets and capital market. SEBI’s objectives are to regulate the activities in stock exchanges and ensure safe investments as well as to prevent fraudulent practices by striking a balance between business and its statutory regulations, thus the triumvirate of protective, developmental and regulatory functions. The protective functions check price rigging, prevents insider trading and prohibit fraudulent and unfair practices. The Developmental functions are geared towards an orderly enhancement of business in stock exchanges, promotion of training of intermediaries in the securities market, and increased use of technology to facilitate investments in primary and secondary markets. Among the regulatory functions are the regulation of the business in stock exchanges, stock broking, merchant bankers, registrars and share transfer agents, custodians, depositories, mutual funds and other investment vehicles including collective investment schemes, portfolio management schemes, alternative investment funds, foreign venture capital investors, foreign portfolio investors, infrastructure investment trusts, etc. SEBI regulates substantial acquisition of shares and takeover of companies, and buyback of securities. It has laid down the prohibition of fraudulent and unfair trade practices relating to securities market. SEBI has also detailed the regulation of self-regulatory organizations. In a drive to protect the interest of investors in the intermediation of broking and investment products, SEBI has issued several regulations such as certification of associated persons in the securities markets, intermediaries, investment advisers and research analysts. The market capitalization of listed companies in India, in the vicinity of Rs. 150 trillion, has risen to 80% of GDP from 35% in the 1990s. Over 5,000 companies are listed with 41 million registered investors with Demat accounts. The annual turnover in the cash segment exceeds Rs. 87 trillion whereas turnover in the derivatives segment exceeds Rs. 4,500 trillion. Additionally, there are more than 45 million unit-holding accounts in mutual funds. The assets managed in thousands of mutual fund schemes are to the extent of Rs. 25 trillion[4]. CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 94

The Forward Markets Commission (FMC) was set up as a statutory body under Forward Contracts (Regulation) Act, 1952 for commodity futures market in India. It functioned under the administrative control of the Ministry of Consumer Affairs till September 5, 2013. Thereafter the Commission functioned under the Ministry of Finance, Department of Economic Affairs[5]. On September 28, 2015 FMC was merged with SEBI. The functions of the erstwhile FMC were to keep forward markets under observation and to take necessary actions in exercise of the powers conferred under the Act. It collected and published information regarding supply, demand and prices of the applicable commodities; made recommendations generally with a view to improving the working of forward markets; undertook the inspection of the books of accounts and other documents of the registered associations, whenever necessary. India had a thriving commodity futures market in the 1950s and mid-1960s until the activity was banned in most of the commodities. The ban was gradually eased in 1980s in select commodities like Potato, Castor Seed and Jaggery. In 1999, the futures trading in various edible oilseeds was permitted. In 2000, the National Agricultural Policy recognized the positive role of forward and futures markets in price discovery and price risk management. The year 2003 saw lifting of the ban on futures trading in all commodities with the recognition of three electronic commodity exchanges: the Multi Commodity Exchange (MCX), the National Commodity and Derivative Exchange (NCDEX) and the National Multi Commodity Exchange (NMCE). During 2009 to 2012 three more exchanges were recognized, being Indian Commodity Exchange (ICEX), Ace Derivatives and Commodity Exchange (ACE) and Universal Commodity Exchange (UCE). Billion constituted the bulk of the traded commodities followed by energy, other metals and lastly agricultural commodities until 2016. During 2019, the commodity derivatives trading also commenced on the equity exchanges, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Crude oil is currently the highest traded commodity, though metals as a segment accounts for the biggest share of trading. There are over thirty commodity futures traded in all the exchanges put together, the largest being 19 in the agricultural segment followed by 6 in metals. The aggregate turnover at all the exchanges in the commodity derivatives segment came at Rs. 74 trillion during 2018-19. MCX accounts for nearly 92% of the total traded volume[6]. CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 95

CFP Level 1 - Module 3 – Regulatory Environment & Compliances – India Specific Page 96