Why Trust Morphed Into Wealth Management

This is a chapter in a book I helped boutique investment banker Cohen Bros. & Company create. The Cohen family has a notable heritage in banking and financial services, and with this work they wanted to formalize some of their thinking and observations on banking gleaned over the years.

David R. Evanson

Present Value: Essays on Community Banking, Winter, 2005

Gently, the grandfather clock ticks. Coffee tables, sitting upon slightly frayed oriental rugs, hold picture books. Dark-colored walls with wainscoting bear rich oil paintings of the English countryside, or great merchant ships, or early trading under the Buttonwood tree in Lower Manhattan. Telephones ring in muted fashion. “Mr. Morgandale will see you now . . .”

Welcome to the trust department.

While this was the image that many bank trust departments sought to cultivate, over the past 10 years a veritable wanderlust of change has been fomenting beneath the surface. Since the beginning of the new millennium, these changes have bubbled to the top, and the concept of bank trust services has changed forever.

In summary, trust services have morphed into wealth-management services. Rather than simply holding assets, bank trust departments are now actively managing assets. This change is causing some fundamental shifts in how banks approach wealthy individuals.

But before we look at how bank trust departments are changing, it’s worth asking another question. Specifically, why did trust morph into wealth management? The short answer is that bank trust departments changed, not so much because they had to but — more to the point — because they could.

The ability to change surfaced from the confluence of three important trends. First, increasing liquidity in the U.S. economy created more wealth and more wealthy individuals who were candidates for trust services. Second, the changing regulations governing trust services made them more applicable and more desirable to families and individuals. Third, the easing of interstate banking laws, in combination with the emergence of technology, enabled trust services to migrate to states that offered families and individuals the most advantageous tax treatment.

Regarding the influx of new wealth, the capital markets have gotten larger, more transactional, and more liquid over the past 50 years. An important consequence of this was — and still is — a vibrant initial public offering market and the availability of debt to finance leveraged buyouts and acquisitions. This highly liquid environment has unlocked a tremendous amount of wealth that was created by American businesses. While assets in the form of going concerns were in some instances within the province of trust, more often they were not. This is hardly surprising, since many companies made money quietly in obscure businesses that required specialized expertise. Thus, many family and closely-held businesses were the generators of wealth, not the object of wealth managers.

The trend in IPOs is compelling. During the period from 1975 to 2000, nearly 7,000 companies went public, transferring about $424 billion of hard assets into liquid wealth. This is just a snapshot of prosperity at a moment in time. Presumably, these riches were redeployed and reinvested. While there can be no precise measure of where this wealth is today, by attaching some market metrics, it’s possible to get an idea of the value on an order or magnitude basis. Specifically, when applying the market return of 11 percent that was earned by the S&P 500 during those 25 years, the results show a compound annuity factor that takes the IPO proceeds well into the trillions.

Source: Professor Jay Ritter, University of Florida

The initial public offering market was complemented by the leveraged buyout market. In fact, the two were not unrelated. A white-hot market for new issues emboldened LBO firms, because it offered a mechanism to reduce or remove debt on the companies they acquired.

During the period from 1980 to 2002, the LBO market heated up in the United States. According to Securities Data Company, there were approximately 4,300 LBO transactions totaling $505 billion. This was just 5 percent of overall M&A volume, which also represented a way in which family assets were monetized.

It’s true that these figures represent a total market picture. The amount of liquid assets flowing into wealthy families is a subset of these figures. Still, they make it quite clear that initial public offerings, leveraged buyouts, and mergers and acquisitions were creating more assets within the reach — if not under the control of –trustees. And the proof is in the figures. While there are many fewer banks offering trust services now than there were 10 years ago, according to the Federal Deposit Insurance Corporation, total assets in trust accounts have risen from $10.6 trillion to $38.5 trillion during this time.

Once this wealth was monetized, there was a much clearer role for trustees to play. After all, they had always been champions and stewards of family affairs, and a windfall in the form of a partial or total sale of a family business was simply the next chapter.

The second major shift that enabled change in bank-based trust services was regulatory in nature. Specifically, the existence of the Prudent Man Rule kept bank trust departments, as well as nondepository trustees, from applying modern tools of portfolio theory to client assets.

The Prudent Man Rule owes its existence to an 1830 court case, Harvard College v. Amory. The Supreme Court of Massachusetts stated, “All that can be required of a trustee is that he conduct himself faithfully and exercise sound discretion and observe how men of prudence, discretion and intelligence manage their own affairs — not in regard to speculation but in regard to the permanent disposition of their funds considering the probable income as well as the probable safety of the capital to be invested. A standard of prudence in investment policy emphasizes how prudent men invest for income and safety of principal with a view to the permanent disposition of their funds.”

The effect of the Prudent Man Rule, which was subsequently upheld in a myriad of cases, was to put assets held in trust outside of the purview of modern portfolio theory. Under the Prudent Man regime, each asset held in trust had to be evaluated on its own merit and pass muster for prudence. Therefore, a wide range of investments, which might make sense in terms of an entire portfolio, made no sense on their own and thus fell outside the offerings of most trust departments.

The first hint of change came in 1994 with the creation of a model act by the National Conference of Commissioners on Uniform State Laws. The Uniform Prudent Investors Act had five key objectives that appear here verbatim:
• The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. In the trust setting, the term “portfolio” embraces all of the trustzzs assets.
• The tradeoff in all investing between risk and return is identified as the fiduciaryzzs central consideration.
• All categoric restrictions on types of investments have been abrogated; the trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investing.
• The long familiar requirement that fiduciaries diversify their investments has been integrated into the definition of prudent investing.
• The much criticized former rule of trust law forbidding the trustee to delegate investment and management functions has been reversed. Delegation is now permitted, subject to safeguards.

Taken together, the five objectives introduced important changes. First, assets were no longer considered in isolation but within the context of a portfolio. In addition, the removal of restrictions on specific asset categories opened up possibilities with alternative investments, which include private equity, hedge funds, funds of funds, and real estate. Equally important, the ability to delegate investment management opened up trust to a wider talent pool, while at the same time preserving one of the time-honored functions of trustees and perhaps the one they do best: oversight.

These changes set the stage for a wide range of assets to be held in trust, and they enabled trust departments and trust companies to offer a complete menu of tailored financial services.

Also on the regulatory front, more states adopted the State Trust Company and Modernization Act, which was developed by the Conference of State Bank Supervisors. Many states that have not adopted the law wholesale have adopted comparable interstate trust-office legislation.

Prior to this legislation, an air of mistrust and misunderstanding prevailed between trust companies and bank supervisors. For instance, most states required trust companies, private or bank-affiliated, to be capitalized at levels similar to a bank. In addition, state regulations — borne of federal regulations serving to protect the interests of federally insured deposits — were haphazardly applied to trust companies.

Finally, while the legal underpinnings of trust services were evolving in ways that would make them applicable to a wider pool of individuals, changing interstate banking laws were also exerting their influence. The opening of state boundaries unlocked a tremendous new frontier for trustees. Specifically, trust companies could now develop trusts in states that offered the most advantageous tax treatment.

At the same time, the emergence of technology removed the importance of place to trust services. The musty old-money offices described at the beginning of this chapter are, in many ways, obsolete. The ability to look at assets from anywhere and make investment decisions from anywhere has opened up competition, but it has also opened up opportunities in offering trust services. Moreover, with technology, individuals can now look at their assets in totality. As a result, trustees and their clients can now think more strategically about assets held in trust.

Taken together, these three trends -– monetization of wealth, change in trust regulation, and repeal of interstate banking –- have made trust services more relevant to a larger number of individuals and families. But even before these changes had taken hold, the market for trust services had begun to bifurcate: Hyperwealthy families and individuals were gravitating toward nondepository and boutique trust services.

In some respects this is unfortunate, because at one point banks owned the trust market. However, the bifurcation of the market has left the lower end of the trust market to banks. This is not to say that banks can’t and won’t do business in the upper echelons of the market. It’s simply that they will not have unfettered access to this market like they once did.

Because of these changes at the top end of the market, there exists an opportunity at the lower end for wealth-management services, for which trust is a key but not central element. This is an appropriate market for banks, because their cost structure requires markets where they can run their expenses over a larger base of customers.

Bank trust services will change in two fundamental ways. First, bank trust services will be increasingly offered as part of a total wealth-management solution. Rather than a solution in and of itself, trust will be offered alongside other wealth-management products and services. Within this context, bank trust services remain a profit center but also take on a role as a customer-retention tool.

Second, as minimums for wealth management decrease, so too will minimums for trust services. Regulations governing assets classes and management delegation are still in their early stages. As they are increasingly embraced, bank trust departments will avail themselves of outsourced asset-management solutions, whose minimum asset requirements are decreasing due to technological and competitive factors.

To see some of these concepts in action, consider the case study of FirstMerit Financial Corporation (Nasdaq: FMER), a northeastern Ohio banking company with $10.5 billion in assets.

As 2002 came to a close, senior management of FirstMerit Financial Corporation was convinced that the firm could do more business with its affluent clients if it had more resources. It also aimed to more effectively coordinate the different disciplines in the bank, which included trust, brokerage and insurances services.

First Merit’s initial change was to form a Wealth Management Services group with financial planning and investment-management expertise to round out the total wealth-management product offering. It would then reorganize the entire division in hub-and-spoke fashion. In the middle was a new group called Private Client Services. To run its Private Client Services, First Merit hired an executive who was previously in charge of the Cleveland-area private banking operations for Key Corp. Interestingly, Key Corp was FirstMerit’s biggest competitor in the region. In the cloistered financial-services industry of northeastern Ohio, it was big news when such a high-level executive moved to a new firm to compete with his old one.

There was plenty of work to be done to bring the plan to life. Prior to the formation of Private Client Services, private bankers were calling on prospects and leading with depository, lending and cash-management products. The old formula had met with some success in driving trust business: FirstMerit Private Banking had some $2.5 billion in assets.

But as the minimums were going up at the major brokerage firms and the world of trust services was shifting all around them, FirstMerit saw an opening in the market for clients with household incomes of $150,000 and investable assets of $250,000, a cohort that still has a set of needs which can be profitably addressed.

Some of this focus had to do with geography and the regional economy in which FirstMerit operates. While the northeastern corner of the state, home to Cleveland and Akron, has its share of industrial manufacturers like Goodyear, TRW and Eaton, 90 percent of the businesses in the region are small businesses, and the majority of these are owner-managed. As a result, when FirstMerit was building out its Wealth Management division, the company sought practitioners with expertise in business and well as personal financial planning.

Competition also drove FirstMerit to enhance its Wealth Management division. Larger banks were calling on affluent FirstMerit customers, and FirstMerit management felt that the company needed to put its arms around their relationships and close off competition.

Under the reorganized approach to wealth management, the Private Client Services relationship manager had the express task of bringing to bear all the internal resources a client might need to address his entire financial picture. These resources include specific groups with a focus on different disciplines. For instance, FirstMerit Trust, which has a lengthy tenure at FirstMerit, offered a large cap growth as well as fixed-income asset management product. FirstMerit’s captive insurance group, Abell & Associates, provided insurance and executive-compensation consulting services. The newly formed Wealth Management Services group provided financial-planning services as well as asset-management services. Finally, FirstMerit Investment Services provided securities brokerage and other transaction services, which Wealth Management Services clients could use for their personal trading.

Under the new regime, rather than leading with depository, lending or cash management services, Private Client Services relationship managers lead with absolutely nothing. That is, when these relationship managers meet with bank clients or prospects outside of the bank, their only focus is to understand the client’s complete financial picture. The net result of such a meeting or series of meetings is the development of a plan from the firm’s financial planners, which might include a variety of solutions, including or excluding trust services.

This holistic focus on customer needs is delivered in a decentralized fashion. Lending authority is at the local level with loan officers making decisions on loans up to $5 million. Trust is also offered from local offices. And marketing support, though centralized, is focused on local markets.

As FirstMerit began reengineering its wealth-management product offering, one area of particular importance was asset management. Though FirstMerit Trust officers believed in the principals of asset allocation and diversification, trust laws and tradition meant that FirstMerit Trust offered customers only large cap growth and fixed-income asset management through in-house managers.

In the reorganization of FirstMerit’s wealth-management offering, and on the heels of sweeping regulatory changes, FirstMerit began offering clients separately managed account (SMA) services. SMAs are programs offered by banks, brokerages, registered investment advisors, and even mutual fund companies that enable them to allocate their clients’ funds to best-of-breed investment firms. These firms, in turn, manage the assets in individual accounts. FirstMerit is using SMAs extensively with clients who have $1 million or more in investable assets.

In order to install themselves as a vital cog in a client’s entire financial picture, relationship managers at FirstMerit had to expand their breadth of expertise beyond lending and cash management to include financial planning, trust, insurance, estate planning and corporate finance.

Ultimately, the delivery of wealth-management services at FirstMerit has been reengineered for a very specific purpose: client retention. According to the relationship managers on the front line, the reorganized approach is paying off. That is, with the existing bank clients whom they get in front of, the close rate on at least one other Private Client Services offering is quite high.

The details of FirstMerit’s transformation are not an isolated incident. They are indicative of how community and regional banks are responding to regulatory and market change in ways that are transforming the notion of bank-based trust services forever.

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