Since the birth of investment programs at financial institutions in 1982, there has been an explosion in the number of brokerage firms, insurance companies, marketing companies, financial planners, and others offering these services.
It is now estimated that over 300 firms provide banks, thrifts, and credit unions with retail investment and insurance/annuities products and services. And more firms are entering the marketplace.
The prospects for continued strong growth, particularly for mutual funds and fixed and variable annuity sales to financial institution customers, are too great to ignore.
While many financial institutions dedicate substantial time and resources to the selection process involved in choosing a program provider, some do not. And those that do so may not know how properly to conduct a thorough due-diligence evaluation of a provider.
Knowledge Comes First
A comprehensive evaluation of a provider requires a comprehensive knowledge of the provider's business.
Most bankers don't possess this level of expertise. Given the importance bankers place on the selection of a securities program provider, the due diligence conducted should be thorough, expert and precise.
However, the number of financial institutions that change their relationships or appear to be unhappy with the provider leads to the conclusion that many selections have been based on false assumptions, incorrect evaluations, or even irrelevant data.
Before a financial institution embarks on a due-diligence review of a third-party broker dealer or annuity provider, the first task should be to set priorities. A sound understanding of internal capabilities, goals and requirements will set the stage for what the third party will need to provide.
Understand the Numbers
Regardless of any other considerations, one area should always be the most important agenda item for any third-party due diligence: financial strength.
While most bankers understand the importance of a financial analysis of a third-party marketing firm, too few know which numbers to analyze or what the numbers really mean. And the fact that most third-party firms are privately held or are a part of a much larger organization makes a comprehensive review difficult.
The third party may provide numbers, but their meaning and relevance to financial strength must be understood.
A case in point is the focus report. All registered securities firms must file this report with the Securities and Exchange Commission. For privately held firms, it is frequently the only document sent to financial institutions for review.
The focus report provides the SEC with information regarding a broker-dealer's required capital. While this sounds like the right information to conduct a good financial analysis, it may not be.
Most third-party firms are known as "fully disclosed" broker-dealers, meaning that they hold no securities or cash, and their required capital is only $10,000.
The focus report was never intended to convey a firm's ability to withstand customer lawsuits, adverse markets, or loss to key customers. A fully disclosed broker-dealer can look a banker in the eye and say they have 300% of required capital and yet have only $30,000 of operating cash.
Cash Is What Counts
The real measures of financial strength for a broker-dealer are cash and net income. Cash is the only true measure of the brokerdealer's ability to pay its bills, survive prolonged business downturns and meet unexpected needs. And net income for the third party or its parent is the only accurate reflection of the viability of the business.
Third-party marketing firms that don't make money on their bank programs must be questioned as to the strategic objectives of their business.
If they have proprietary mutual funds, is this their primary business? Is their goal to build a network and sell it to another broker-dealer or product manufacturer? Any provider that doesn't share audited numbers with you should be regarded with skepticism.
Depth of Personnel
Along with financial strength, resources to support their programs are critical.
Many third-party operations are very small. It's important to see organization charts and meet department heads. If the same person is head of marketing, sales, and training, and is also the CEO, that says something about the strength of the organization.
The third party's product duediligence procedure should be thoroughly reviewed. Most third parties rely solely on outside research. There's nothing inherently wrong with outside expertise, but the third party should be reviewing what it receives and there should be written procedures and files maintained on every product.
If the third party reviews products internally, again, ask to see files or sit in on a due-diligence meeting.
Always keep your customers in mind. You are asking them to trust the third party with their money. Make sure you're comfortable with the third party's review process.
You might also ask the third party if it receives any special compensation from a product supplier that could influence its recommendations. And obviously, if the third party offers proprietary products, it's important to know how they are reviewed for suitability and how compensation is handled.
Along with financial strength, resources, and product due diligence, the following is a list of other critical areas that should be addressed in the review.
* Is the third-party management stable and does it have securities industry experience, particularly in down markets?
* Does the third party carry errors-and-omissions insurance? What is covered and what are the deductibles?
* Does the third party clear its own trades or use an unrelated clearing broker? How are communications with the clearing broker handled? Do you have any say if the third-party changes clearing brokers?
* How many financial institutions have terminated relationships with the third party? Why have they left? Can you get a list of former relationships?
* Does the third-party firm cater chiefly to larger institutions? Does a large percentage of the third party's business come from a small number of relationships?
* In the event that you terminate your relationship with the third party firm, who owns the customer? How would a transfer to another broker-dealer be handled?
The Bottom Line
When all is said and done, the third party you select will be perceived by your customers as having received your endorsement. The people selling securities and annuities, the way they sell, and the products themselves all reflect upon you.
Before you select a third-party firm, ask yourself these questions: Would you seek out the advice and help of the third party for your own personal investments? Do you have the confidence in the people, systems and products to trust them with your own investment dollars?
When you can answer these questions without hesitation you know that you have found your investment program provider.