1-Dec-03
One of the main reasons that private clients leave a Private Banking organization is lack of understanding of their needs and expectations(*). It goes without saying therefore that these should be identified and formalised as early as possible. The impact of the recent market downturn on portfolio performance has revealed lots of misunderstanding and dissatisfaction from clients who were unprepared for potential loss and strong volatility. This has led to the closing of numerous accounts, and sometimes, costly lawsuits. In both cases, banks that had not systematically documented the entire Investment Profiling process and client decisions were not in a position to prove that they had invested or advised their clients with all due diligence. As a consequence, Investment Profiling has progressively emerged as a compliance issue. Many senior executives in Private Banking have recently put this subject on top of their agenda.
From a compliance perspective, a financial institution must not only implement a disciplined Investment Profiling process, but also document, store and archive all the details of this process and the decisions made by the client. The Investment Profiling process should not be restricted to discretionary accounts - it should also be systematically extended to all the non-discretionary accounts for which the bank is also expected to exercise due diligence.
Several Private Banks have already decided to use IT to implement a more systematic Investment Profiling process. The traditional paper-based approach is now considered as inadequate and not cost efficient.
Investment Profiling consists primarily in understanding a client's risk tolerance in relation to his or her current financial situation and future financial needs, and proposing the most appropriate risk profile and related investment strategy. The client risk profile reflects both the level of risk capacity and return expectations agreed with the client.
Investment Profiling is one of the most critical steps in a relationship with a client. As a pre-requisite to any investment decision, this process should be formalised and systematically performed, not only at client opening but also periodically on a repeat basis to take into consideration changing needs and risk perception.
Investment Profiling is a privileged moment in the relationship with a client. Relationship Managers have a unique opportunity to sensitise their clients to the potential risks and rewards of a portfolio and to make sure that a common understanding is reached. Using software, or based on a report, these sometime confusing concepts can be demystified and mastered.
In a typical Investment Profiling process, clients are first requested to answer a questionnaire aimed at analysing their risk aversion, quantify the assets that can be invested, and define financial goals. The answers to the questionnaire determine the risk capacity of the client and indicate a risk profile. Next, if necessary, clients are requested to specify their main investment constraints (holding, allocation or trading constraints).
Using a software solution the information collected is processed to suggest a risk profile and combines this with the client constraints to propose a relevant investment strategy. The investment strategy can be clearly presented by the Relationship Manager to the client. The Investment Profiling software may also simulate the expected return and risk measures of different alternative investment strategies, so that the client can appreciate and ascertain the trade-off between risk and expected return in practical terms. With this information the client decides which investment strategy will be implemented, and the output of the process is stored in a database for documentation purposes. Note that the client might decide to implement an investment strategy that is not in line with the risk profile determined initially - this is not a problem as long as it is properly documented.
Investment Profiling does not limit itself to understanding the client and agreeing on a trade-off between risk and expected return. It can also involve the automatic generation of a structured investment proposal to invest or rebalance an investment portfolio. The investment proposal will describe the portfolio before rebalancing, the list of proposed orders, and the portfolio after rebalancing, and the proposal will also be stored for documentation purpose.
Finally, Relationship Managers can print an Investment Profiling report that can be handed or sent to the client. The report presents all the steps of the Investment Profiling Process. It includes the answers to the questionnaire, the initial risk profile and investment strategy proposed, the risk profile and investment strategy finally selected by the client and the structured investment proposal.
Investment Profiling is a dynamic process. A client portfolio must constantly be monitored against the agreed investment profile and action must be taken if significant differences are revealed. Relationship managers must also be able to track any change in client needs and risk aversion and anticipate the impact on the Risk Profile and the Investment strategy. Any significant changes must therefore lead to a full reassessment of the Investment Profile. The latest generation of software allows Relationship Managers to entirely delegate the heavy work of monitoring clients and portfolios to an ‘alert engine’. For instance, a Relationship Manager may create an alert that is triggered if any of his portfolios is over-weighted by more than 5% in US stocks compared to the target asset allocation.
By implementing a streamlined and disciplined approach to Investment Profiling, financial institutions will understand, reflect and document their clients’ needs and risk tolerance more systematically. They will be able to define commonly agreed investment guidelines and the underlying expectations, reduce misunderstanding and dissatisfaction, eliminate disputes and, in some cases, save on costly and damaging law suits.
(*) Source: PWC Private Banking Survey 2003