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Tuesday, April 30, 2013

Mis-selling: from impressions to evidence

by Renuka Sane.

Retail finance in India is once again in the news for reasons of fraud, this time in the form of the Saradha Group in West Bengal. There is a general sense that such schemes proliferate because of the failure of financial inclusion, and that better supervision by current regulators will bring us back on track. The problems of mis-selling however, are not confined to the unregulated chit-fund industry. For many years now, problems of consumer protection have been gathering prominence. While there is concern about the collision between hard-driving financial firms and the average unsophisticated investor, it has been over-ridden with the argument that the problems are minor, sporadic and over-stated by a sensationalist media.

Evidence on mis-selling


There may not be consensus in policy circles on the pervasiveness of mis-selling, but the incipient academic literature on the problems of consumer protection in household financial choice in India reflects otherwise. The following papers are of note:

  • Anagol and Kim (2010) study a 22 month period in which closed-end mutual funds were allowed to charge an arguably shrouded amortized fee whereas open-end funds were forced to charge standard entry loads. They find that inflows into the more expensive funds were much higher, and that investors paid approximately 500 million dollars in extra fees in this period.
  • Sane and Thomas (2013) discuss the failure of consumer protection in the micro-finance crisis in Andhra Pradesh in 2010.
  • Anagol, Cole and Sarkar (2013) conduct audit studies of insurance agents. They find that insurance agents overwhelmingly recommend products which provide high commissions to the agent and are unsuitable for the customers. This is exacerbated for customers who appear to be less financially literate.
  • Halan, Sane and Thomas (2013) study the lapsation in insurance policies after the introduction of unit-linked insurance plans (ULIPs) and find that investors lost more than a trillion rupees from mis-selling over the 2005-2012 period. This shows us that while chit funds are a problem in India, (regulated) ULIPs have imposed bigger losses upon households than (unregulated) chit funds.
These papers offer hard evidence about the problems of consumer protection across products and income-groups and establish that the magnitudes of money involved are substantial. It is not easy to now argue that the problems are sporadic and small and of second-order importance.

Weak regulation


These problems have not taken place in an environment of unregulated finance. The regulation in India is product oriented, focuses on form and not function, and places great emphasis on prudential regulation. While protection of customer interests is a key part of the mandate of all regulators, there is no framework on how to bring this about. Each regulator has its own procedures for licensing and registration of intermediaries, expected code of conduct, caps on commissions, grievance redress procedures. The focus is on inputs, and checking the correct boxes, and not on outcomes. This often leads to instances of regulatory arbitrage, or leaves open the possibility that several entities slip through the cracks and get regulated by no one regulator. The system does not clearly identify the rights of the customer, or place responsibility of outcomes on the distributor. There is no basic definition of whether a product is suitable for a specific customer and no standard to which distributors can be held responsible for what they sell. Once investors get duped into signing consent forms, redress seems unlikely. The evidence that the current redress systems are effective in providing relief to customers is also very weak.

Early regulatory responses


The response from Indian regulators has been in the form of policy changes that should prevent mis-selling that has been seen in the past decade. The key milestones are:
Each of these initiatives is an incremental response by a regulatory agency that became uncomfortable with the status quo. However, they do not add up to a comprehensive and internally consistent strategy for consumer protection, and they are not adequately rooted in law. One regulator has banned commissions for a product, while similar products are permitted to charge commissions under a different regulator. Various distributors such as banks come under far less scrutiny on distribution because they fall under a different banking regulator. SEBI regulations on investment advisors do not apply to agents who provide advice solely on one financial product. This implies that the existing network of agents, including banks, can continue to function in the current framework which does not require agents to act in a fiduciary capacity towards their clients.

Considering the low financial literacy and low access to finance in India, perhaps it is also not advisable to require each agent to have a fiduciary responsibility. There is a strong case to be made for simple products that may be sold without the imposition of high suitability standards. However, no such provision exists in the current regulations. The micro-finance regulations focus predominantly on prudential regulation, even when the problems in the sector arose on issues of customer protection. There is also no understanding of whether the measures imposed have brought about the desired change. A framework for evaluation of the costs and benefits of various regulatory interventions is completely missing from the current regulatory discourse in India, and the response so far has continued to ignore its importance.

The Indian Financial Code will yield transformative change


The Indian Financial Code (IFC) is an important landmark in financial regulation in that it identifies customer protection as a central goal of regulation. The draft law enshrines the customer with rights to prevent mis-selling at the time of sale, and provides for a redress system after an event has occurred. In the IFC, the consumer has a right to get fair disclosure and suitable advice from financial service providers. This recognises that the market for financial products is an uneven playing ground with customers not being in a position to evaluate financial products, especially over long horizons. The code also requires the regulator to undertake measures to promote financial awareness.

The IFC has appreciated the possibility that excessive regulation may have its costs which ultimately get borne by the customer. It has put in place several checks to ensure that regulation is not stifling the market, including that of continuous evaluation of outcomes brought about by policy. Section 54, of Chapter 13 specifies that the financial agency is required to measures the costs and benefits of regulations by using the best available data and the best scientific method when such data is available. There are important connections between the incipient literature on household finance in India, and the requirements for analysis that are embedded in the IFC.

1 comment:

  1. I think this blog post raises some very important issues that need careful debate. I agree with the author that there is a great deal of misselling in progress and that the recently published report of the FSLRC offers, for the first time, a framework that could start to move us in the required direction, particularly by identifying the right of the consumer to suitable advice. However, I feel that there are multiple issues that have been raised in the post which need to be carefully separated out. I want to focus in particular on the issue of simplicity that is raised by the author.

    The author expresses a concern that the regulators are weak, customers are unable to get any redress, and there is low level of literacy amongst the providers, the distributors, and the customers. She then goes on to suggest that given all these problems perhaps there is a need for “simple” products that are exempt from suitability standards. I would like to argue that there are no simple products only suitable ones and unsuitable ones and that there are no “universally suitable” products. An apparently simple product like a fixed interest rate loan with a fixed repayment schedule adds an enormous amount of leverage to an individual’s balance sheet and has the risk of rendering her net cash-flow into one that has the riskiness of a stock-option portfolio. This interactive nature of financial products is what makes them fundamentally different than physical products with fixed characteristics. Simplicity is also a not a well-defined idea and in the hands of highly risk-averse regulators will not only kill much needed innovation but will become another tool for exclusion.

    The way I see it there is no way around a strong regulator implementing well designed regulations with a high degree of fidelity. There are a number of design problems which keep regulators very busy without really achieving much and there has to be a continuous attempt to address them so that regulators do have the time to focus on important issues such as customer protection – the effort of the FSLRC represents one such attempt. Giving up on the requirement of strong regulators essentially amounts to accepting an unregulated financial system even if the regulations are well designed. The imposition of simplicity as a design principle as a response to weak regulators I feel in addition risks doing away with the core the benefits financial services can offer to their clients.

    My experience on the ground is that households need significant innovation / complexity of product design which allows them to “cancel out” the real-sector volatility in their lives. Disallowing such products to develop in my view is equivalent to banning a much needed new cancer medicine because of concerns that the FDA cannot frame and implement guidelines that prevent misuse of the medicine or contamination in its production. Suitability as a principle supports a high level of innovation in product design but requires the provider to ascertain suitability carefully through a well laid out pre-sale process and enjoins upon the regulator the responsibility to ensure that this actually happens using a number of tools. To my mind this approach has the power to deliver the true value of finance to households and enterprises while offering a high degree of protection against misselling.

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