The Case for Regulating the Bonuses of Advisors
ECONOMICS |

The Case for Regulating the Bonuses of Advisors

IN A NEW MODEL DEVELOPED BY MARCO OTTAVIANI AND COLLEAGUES, BONUS PAYMENTS ARE SHOWN TO DISTORT THE MARKET, WHILE INCREASING ADVISORS' LIABILITY MAY BE INEFFECTIVE

New research supports the case for regulating incentives provided to financial intermediaries and advisors, which could otherwise have detrimental effects on consumers. “We find that bonus contracts distort advice by generating an artificial link between otherwise independent transactions,” said co-author Marco Ottaviani, Full Professor at Bocconi University Department of Economics.
 
In their “When Liability Is Not Enough: Regulating Bonus Payments in Markets with Advice,” Jun Honda (Shinshu University), Roman Inderst (Goethe University Frankfurt) and Marco Ottaviani developed a model of advice in which firms steer advisors through the payment of bonuses.
 
Bonuses and commissions that increase more than proportionally with sales enhance the incentives for advisors to recommend investments that are not in the best interests of their clients. Clients’ choices that should be independent, the authors find, end up being linked when advisors are incentivized with bonuses. Intuitively, to clinch bonus commissions advisors are pushed to recommend products that are popular with other clients.
 
While consumer protection for retail financial products has been strengthened over the last decade in the aftermath of the 2008 financial crisis, bonus-driven remuneration practices remain widespread for mortgage brokers and other advisors and have escaped close scrutiny.
 
  

In theory, regulators could limit the distortion by stepping up advisors’ liability, holding them more accountable for any negative outcomes that can result from their advice or recommendations. In practice, though, financial product providers could also restructure the incentives to compensate for the increase in liability. Thus, regulators should pay more attention to how financial intermediaries and advisors are paid, and how this can impact the advice they give. Monitoring and managing individual compensation schemes may be necessary to ensure that advisors' recommendations are in their clients' best interests.
 
“Our results also apply to healthcare and other markets for credence goods, i.e. goods that are difficult or impossible to evaluate even after consumption has occurred,” Professor Ottaviani concluded.
 
Jun Honda, Roman Inderst, Marco Ottaviani, “When Liability Is Not Enough: Regulating Bonus Payments in Markets with Advice.” Management Science, published online ahead of print. DOI: https://doi.org/10.1287/mnsc.2023.4750.

 

by Ezio Renda
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