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Reg 9: A Differentiation Opportunity

Comply with Reg 9 by establishing and validating your firm is following an investment policy process.

Are you looking for ways to differentiate your firm? If so, consider regulations. There are several benefits to proactively responding to regulations such as Reg 9 - the Code of Federal Regulation 12, Part 9 (Fiduciary Activities of National Banks). One benefit is cost savings. This year, regulators are holding financial institutions of all types – not just banks or trust firms - to a higher level of fiduciary responsibility. As a result, it is much more likely your firm could be audited. By effectively preparing for an audit, you could be saving your firm both time and money.

Another benefit is that regulations can be a source of competitive advantage. For example, Reg 9 requires higher service levels, better reporting, more personal services and more investment services. As a result, firms that comply with Reg 9 are often viewed by clients as being safer environments for their money. In today’s competitive environment, that can be a distinct advantage.

Until recently, national banks (and state-chartered banks that comply with similar FDIC regulations) were most affected by Reg 9. However, Reg 9 is becoming increasingly important not only to national banks, but to all of the players in the investment industry who are not regulated. In the discretionary asset management business, for instance, Reg 9 is becoming the gold standard. In addition, it is of particular importance to non-bank financial services institutions, including — but not exclusive to — those offering trust services, a major market for firms seeking the business of high net worth (HNW) baby boomers.

What is Reg 9? Reg 9 is essentially full compliance with the Prudent Investor Act, a legal doctrine that provides guidance to investment managers regarding the standards for managing an investment portfolio in a legally satisfactory manner. It is focused on each investment, each position in its own right, and applies to each asset for which an investment manager is responsible. The Prudent Investor Act looks at a person's portfolio investments as a single entity, not as individual elements in a portfolio.

Reg 9 is, in essence, a primer on best practices that creates standardized processes for managing and reporting client information. For those looking to adopt a set of best practices, Reg 9 is as thorough a set of rules as can be found. So thorough that some of the larger full-service brokers — Merrill Lynch and Goldman-Sachs among them — have established their own regulatory best practices.

"The idea of investment policy statements, total-return investing and looking at the whole portfolio instead of individual investments, is very much second nature to banks," says John Rubin, former Executive Vice President/Senior Portfolio Manager of the Investment Management and Trust Department of 101 year-old The Mechanics Bank, one of California's most profitable community banks.

John Rubin retired at the end of the 2006 after a 26-year career with The Mechanics Bank. He virtually built the IMT department from scratch into a very profitable segment of the bank's business. While The Mechanics Bank is a state-chartered bank and not regulated by federal law, California state laws in terms of reporting and compliance are similar to Reg 9.

"There is probably some advantage for banks being able to say, 'hey, we're examined every year, and we're guided by Regulation 9," Rubin says. "That means a more secure environment and hopefully a better-controlled environment for clients.”

"From an examination point of view, Reg 9 is demanding but, on the other hand, it does provide a very high standard of service, and as long as we can say that, it's something that's appealing to clients."

Competition For Trust Business

How do broker-dealers compete with banks? Most have started by setting up their own trust services. They have tried to get into the game by offering better service and the prospect of better performance. That has increased the competition between providers.

"Historically, the trust business has been dominated by regional banks," says Juergen Dittgen, NorthStar Systems International Senior Vice President/Product & Field Services. "That has changed. There is now increased competition."

Creating a clearly defined investment policy statement process that includes a clean investor profile and validation that investors' profiles have been properly implemented within their portfolio will help broker-dealers narrow the compliance and confidence gap between them and banks.

"What is important is that we have a client market segment here — national banks and particularly their trust services — that knows how to do this business and has a framework that has evolved over the last 100 years," says Dittgen. "They understand what to do and how to make money in this business.”

"At the end of the day, what's important is that everyone competing in this market will have built a framework of sound reporting practices. The end result is that Reg 9 will require better practice management for everyone."

Overall, regulations can help you save money and increase your firm’s competitive advantage. Reg 9, in particular, can help your firm position itself as a secure environment for clients’ investments. If you are not familiar with Reg 9, we encourage you to read more about it below.

To comply with Reg 9, firms should have a clear investment policy process and be able to validate that clients’ investment policies have been correctly implemented in their portfolios. Investment Policy Statement tools can help automate this process and ensure your firm effectively complies with Reg 9. Proactively using these tools and complying with Reg 9 can help differentiate your firm and give your clients confidence that their investments are secure.

About Reg 9

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national banks. The OCC regulates and supervises more than 1,900 national banks and 51 federal branches of foreign banks in the U.S., accounting for about $5.8 trillion, or more than 67 percent, of the total assets of all U.S. commercial banks (as of June 30, 2005).

Money managers should pay particular attention to the General Procedures — Bank Activities, and Appendices D and E in the OCC's Comptroller's Handbook.

Reg 9's objective, as outlined in the General Procedures — Bank Activities, is to "develop a preliminary assessment of the quantity of risk and the quality of risk management relating to investment management services. The assessment should address the types and level of risk from functionally regulated activities conducted by the bank or an RIA subsidiary or affiliate. It should be used to establish the scope of examination activities for investment management services, including the examination of individual asset classes managed in fiduciary investment portfolios, if appropriate."

The General Procedures — Bank Activities covers:

• Transaction Risk: To determine the quantity of transaction risk from the bank's delivery and administration of investment management services.
• Compliance Risk: To determine the quantity of compliance risk from the bank's delivery and administration of investment management services.
• Strategic Risk: To identify and estimate strategic risk inherent in the bank's delivery and administration of investment management services.
• Reputation Risk: To identify and estimate reputation risk from the bank's delivery and administration of investment management services.
• Quality of Risk Management — Risk Activities: To determine the adequacy and effectiveness of policies for investment management services.
• Processes: To determine the adequacy and effectiveness of supervision by the board, senior management, and business line management.
• Personnel: To determine the adequacy of investment management services management and supporting personnel; the bank's personnel policies, practices, and programs; and third-party service provider selection and monitoring processes.
• Control Systems: To determine the adequacy and effectiveness of investment management control and monitoring systems.

Appendix D (Investment Management and 12 CFR 9): National banks serving in a fiduciary capacity must comply with 12 CFR 9, Fiduciary Activities of National Banks. The following discussion covers selected sections of the regulation that relate to investment management.

This appendix outlines what's needed to be compliant in a variety of areas, including Administration, Policies and Procedures, Review of Fiduciary Accounts, Fiduciary Funds Awaiting Investment or Distribution, Investment of Fiduciary Funds, Self-Dealing and Conflicts of Interest, and Collective Investment Funds.

Appendix E (Investment Policy Statements) covers Investment Policy Benefits, Continuity of strategy, Investor Confidence, Structure and Content, Portfolio Background and Purpose. It also includes a Statement of Objectives and Constraints, Investment Policy/Strategic Asset Allocation Guidelines, Investment Guidelines, Selection of Investment Managers/Advisers, and Control and Monitoring Processes.

Reg 9 says an investment policy is weak if it:

• Lacks specificity.
• Fails to establish appropriate and realistic goals and objectives.

A fiduciary investment management organization is weak if it fails to:

• Effectively monitor client circumstances, economic trends, and capital markets, updating investment policies as conditions warrant.
• Ensure that portfolio managers consistently apply investment policy guidelines, preventing them from making ad hoc changes based on short-term views.
• Effectively monitor compliance with the bank's investment management policies and applicable law.

Reg 9 further states, "An investment policy statement may be the most important document a fiduciary manager prepares for an account. Rather than a static or historical document, it is a dynamic instrument for the fiduciary and client to use. The document should ensure frequent communication with a client, prudent investment guidelines, and thorough monitoring and documentation."

SOURCE: The Office of the Comptroller of the Currency, Comptroller's Handbook, General Procedures - Bank Activities; Appendices D and E. - http://www.occ.treas.gov/