On Advice

Finra's financial woes no recipe for viability

SRO recorded substantial losses in 2012

Jul 14, 2013 @ 8:31 am

By Bruce Kelly

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Along with regulating broker-dealers, Finra's mission includes protecting investors.

But if the Financial Industry Regulatory Authority Inc. can't turn its fortunes around, that essential objective for financial advisers could be in jeopardy.

Finra at the end of last month released its annual report, and its financial results for 2012 show a self-regulatory organization that is struggling.

The number of broker-dealer members continues to slide, while the number of employees continues to increase. Over the past five years, the self-regulatory organization's staff has grown 13%, while broker-dealer membership has declined 14%.

Compensation and benefits have jumped 41% over the past five years, reaching $628.9 million in 2012, up from $446.1 million in 2007.


And Finra's operating losses are staggering — approaching $90 million for the second year in a row. Pension and retirement benefit costs also have skyrocketed; they are up 89% over the past five years.

Although industry observers said that Finra's operating losses aren't immediately threatening, such results are far from desirable.

“The financial position of the primary self-regulator for the securities industry has to be a concern of all market participants and investors,” said Steven Caruso, a partner at Maddox Hargett & Caruso PC and a former president of the Public Investors Arbitration Bar Association. “You need a well-financed regulator to perform its function and protect investors.”

Finra is a private organization and the successor to NASD, which was created under the Securities Exchange Act of 1934 as an SRO under the Securities and Exchange Commission.

Led by chief executive Richard G. Ketchum, Finra recently has worked to broaden its reach. It made a strong lobbying effort to become the primary regulator for registered investment advisers. So far, that effort has turned up empty.

Perhaps most alarming is that Finra is seeing its equity erode beneath its feet. Total equity in the organization, which stood at $2.1 billion five years ago, is $1.2 billion, a drop of 41%.

Finra said that there is no need for the securities industry or the investing public to worry about the decline in the number of broker-dealers it regulates or the increased compensation to its growing staff. It posted net income last year of $10.5 million after reporting a loss in 2011 of $84 million.

Indeed, the SRO is “clearly self-sustaining, as evidenced by break-even cash flows over the past two years,” Finra spokeswoman Nancy Condon said. “Operating income or loss is not the appropriate measure of financial organizations like Finra that are not-for-profit in nature.”

The rise in compensation is a result of its merger with NYSE Regulation in 2007, a subsequent agreement with the New York Stock Exchange to perform market regulation for the exchange and the effort to internalize its technology functions beginning in 2011, according to Ms. Condon.

And Finra, like the securities industry it regulates, was hard-hit by the financial crisis.

Financial information from 2007 is “based on pre-financial crisis figures that changed the economy and the industry drastically,” Ms. Condon said.

“Finra was not exempt from the financial crisis that negatively im-pacted [its] investment portfolio,” she said.

Pension costs have increased primarily as a result of the declining discount rate that has an impact on the accounting treatment of pension expenses, Ms. Condon said.

The decline in broker-dealers has no direct correlation with Finra's revenue, she said.

“Nearly 80% of the regulatory fees are paid by less than 10% of the total member firms,” Ms. Condon said.

Despite such assertions, Finra's 2012 results have forced it to admit in its most recent annual report that it is keeping a close eye on operations.

“We will continue to monitor the changing economic conditions and evaluate their potential impact on our organization,” the report said.

A scan of Finra's previous five annual reports revealed no other such pointed statement of concern.

Broker-dealers face increasingly complex regulations, including a new suitability rule that requires them to take extra steps when implementing investment strategies for clients with the explicit recommendation of holding a security.

The number of Finra employees likely will continue to increase to ensure that firms put those rules into place. Costs will rise for Finra and the broker-dealers that it regulates.

Meanwhile, broker-dealers will continue to shut down. Small and midsize firms face rising costs to keep pace with regulation and compliance expenses, with many seriously considering a merger or sale as a way out of the business.

And if the market were to tank, Finra's total equity again would take a huge hit, threatening its ability to perform its role in the market.

That simply isn't a recipe for growth and viability. Finra's financial condition is a cause for concern for investors and advisers alike.


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