This content is from: Wealth Management

Where Crooked Advisors Thrive

And where they’re scarce.

For many financial advisors, character truly is destiny.

According to a recent academic report, the most cohesive counties in the U.S. do the best job of excluding advisors who have engaged in financial misconduct. And advisors that commit misconduct in these places tend to relocate to areas with less “social capital” where it’s easier for them to avoid scrutiny.

The study – “Social Capital and Financial Misconduct: Evidence from Individual Financial Advisers” – shows that law-breaking advisors decamp in predictable ways and are susceptible to “a geographic contagion effect of misconduct,” according to authors John (Jianqiu) Bai, Chenguang Shang, Chi Wan, and Yijia (Eddie) Zhao.

“The industry has been plagued by the common occurrence of financial adviser misconduct,” the professors write, noting that “the regulation that is currently in place does not seem to be adequate in deterring such fraudulent behavior.”

The study’s authors define social capital as “the norms and networks that facilitate collective actions and foster cooperation and trust within a community.” The networks are real world links between groups and individuals, according to the Paris-based Organisation for Economic Co-operation and Development. An example might involve neighbors banding together to tackle an issue in their community. 

The states ranking highest in social capital are Utah, Wyoming, Colorado, North Dakota, South Dakota, Nebraska, Iowa, Minnesota, Wisconsin, Maine, New Hampshire, and Vermont, according to the Joint Economic Committee’s Social Capital Project.

Among the 11 lowest-ranking states, 10 fall within “a contiguous bloc of states running from Nevada, across the southwest and south over to Georgia and Florida,” according to the project. Louisiana ranks lowest, followed by Nevada, Arizona, and New Mexico. Among the lowest ranking states, New York is the only one outside this geographic area.

The professors point to previous research suggesting that high social capital areas promote economic growth. However, for their research, they wanted to study the predictive powers of social capital on individual advisors and the likelihood that they would engage in misconduct. The researchers’ findings provide “support for both the deterrence and displacement effects of social capital on financial adviser misconduct.”

High social capital areas are able to “screen out” bad actors, suggesting that “social capital can also serve as an ex post disciplinary and enforcement device for misbehaving advisers, rendering these individuals unsuitable for communities where trust and conformity are valued.”

The professors also highlight an osmotic dynamic in which counties close to areas with significant advisor misbehavior experience more misconduct. However, “this geographic spillover effect is significantly dampened by social capital, which highlights the deterrent effect of social norms” on opportunistic behavior.

That said, regardless of where they live, older people remain especially vulnerable. Among Americans age 50 and above, those most in need of quality financial advice are the least likely to pursue it, making them more susceptible to predatory pitches. 

And misconduct remains widespread, according to a study titled “The Market for Financial Adviser Misconduct” that examined advisor behavior from 2005 to 2015. The study found that seven percent of advisors had been disciplined for a fraud dispute or misconduct, and roughly a third of those that had engaged in misconduct were repeat offenders. It also revealed that prior offenders were five times more likely than the average advisor to engage in new misconduct.

The authors of the social capital study conclude that activities and policies that facilitate trust within communities could “play a crucial role in affecting household participation in financial markets with significant implications for long-term economic growth and prosperity.”