Wednesday, August 27, 2014

Consumer protection in Indian finance: Going from ideas to action

by Renuka Sane and Ajay Shah.

Financial regulation in India, at present, is oriented towards product regulation. While protecting the interest of customers is part of the mandate of all existing financial agencies, the present regulatory strategy is weak. The evidence on mis-selling is building up. The main focus of policy discussions has been prevention (e.g. ban on entry loads) with little work on enforcement (where orders are issued that impose penalties upon firms that have misbehaved).

Many piecemeal changes of regulations are underway. The Reserve Bank of India (RBI), for example, has recently published a Draft Charter of Customer Rights, which include: the right to fair treatment, the right to transparency, fair and honest dealing, right to suitability, right to privacy, and the right to grievance redress and compensation. When compared with the draft Indian Financial Code and the FSLRC Handbook, many weaknesses in this draft are apparent. But writing in the Mint today, Monika Halan emphasises the importance of this document: She says that it represents a big shift for RBI, when compared with 80 years of indifference to the problems of consumers in finance. In this sense, this Charter may reflect the beginnings of improved knowledge at RBI in consumer protection. But it is unlikely, in and of itself, to induce the desired effects.

The situation in India today, is reminiscent of the UK in the 1980s, which went through a consumer protection crisis, even though conduct requirements were in place, on paper. We can gain perspective by looking back at that experience.

An example of a consumer protection crisis: The personal pensions mis-selling scandal in the UK


In a paper  Personal Pensions Misselling: The Causes and Lessons of Regulatory Failure, Julia Black and Richard Nobles provide fascinating insights into the pensions mis-selling episode that rocked the UK in the late 1980s and early 1990s.

In 1985, the Government allowed employees to opt out of employer provided defined benefit pension schemes, known as Occupational Pension Schemes (OPS) and choose to buy personal pensions (PP). Given the differences in benefits between the OPS and the PP, it was not clear whether the shift was optimal for all employees. In fact, according to the authors, the PP was only beneficial to a few. The government was aware of the risk that wrong decisions could be made, and sought to rely on investor protection measures to prevent this.

This was a time when banks and building societies, life insurance companies and Independent Financial Advisors (IFAs) were regulated by the Securities and Investments Board Ltd (SIB), Life Assurance and Unit Trust Regulatory Organisation (Lautro) and Financial Intermediaries, Managers and Brokers Regulatory Association (Fimbra) respectively. The three regulators required distributors to obtain sufficient information on the customers financial circumstances, advise on products that were suitable to customers, recommend products that met the goals of the customers, disclose information regarding commissions received, and to provide detailed product information. Rules required agents to either tie up with one service provider, or advise on all products. And yet, a large number of people ended up giving up their rights in the OPSs for inferior PPs.

In comparison with where we are in India, it is important to see that the rules in place at a time, in the UK, were much more detailed when compared with what we have in India today. Yet, the desired outcome -- consumer protection -- was not obtained.

The authors suggest that the observed outcome was a result of a complex interaction of political ideology, product complexity, regulatory novelty and industry dynamics. Regulators themselves had limited knowledge of the product, and little experience of what kinds of standards should be imposed, and how. In a world where the only parameter of payments and promotions to the sales staff was commissions, compliance never became part of the business strategy. Regulators believed that general principles had been outlined, but firms argued that no guidance was ever given on what suitability meant.

The authors draw four lessons:

  • Regulators need to have specialist knowledge of individual products and business areas, and the risks from each of the products from an investor protection point of view.
  • Regulations can often themselves contribute to risk. Regulators, therefore, need to think through the potential impacts of current and proposed regulatory policies, and the preferred response should they arise.
  • General principles, such as that of suitability, have to be supported by a shared understanding of what is it that they require.
  • Firms need to provide a central place to regulation in their management strategy. Compliance with regulations must not be a side show; it must permeate the strategy formulation of the firm
    at the board level.

The way forward for India


It is important to trace the full arc from law to regulations to enforcement and jurisprudence, to the incentives of financial firms, in order to understand how the desired legal effect will be achieved. Improvements in consumer protection will only come about when financial firms internalise these principles, and treat customer protection as a core element of business strategy. Financial firms will behave in better ways only when (a) there is credible communication about what is expected under the law, and (b) there is tough enforcement when these expectations are not met.


The diagram above shows the story that must now unfold. The Indian Financial Code (IFC) writes down the foundations of consumer protection in the law at the level of timeless principles. At each financial agency, this would lead to drafting of regulations, through the formal regulation-making process of the IFC. Once this stage is set, some firms would inevitably violate the regulations. This would lead to enforcement actions and the issuance of reasoned orders. Some of these orders would be appealed and result in rulings in FSAT.

There has been too much emphasis on prevention in Indian work on consumer protection. As an example, entry loads of mutual funds were banned. The right strategy in public administration has to have a combination of prevention and enforcement [linklink]. As an example, consider suitability requirements. These will be dismissed as pious phrases by the industry until regulators show teeth in enforcing against violators. This will require considerable technical skills in supervision. The prosecution will need to demonstrate that suitability analysis was done in ways which violate the law and the regulations, beyond all reasonable doubt.

Consumer protection would come about when individuals inside financial agencies, and those inside financial firms, have a shared understanding of all four steps: of the law, the regulations, of the kinds of enforcement actions that get taken, and the stance of the judiciary on the standards of proof that are required and on contemporary interpretation of timeless principles from the IFC.

All four elements have to fall into place for the desired legal effect -- consumer protection -- to be achieved.

What is to be done?


Until the IFC is enacted, we have sectoral regulators. As has been argued in the FSLRC report, sectoral regulators are particularly vulnerable to abuses of consumer protection, as each one tends to advocate the interests of their own industry. Even under the IFC, there is a pocket of sectoral regulation in the form of payments and banking being regulated at RBI, which will generate enhanced problems in public administration. Whether with two agencies in the future (RBI and UFA) or multiple agencies today (RBI, SEBI, IRDA, PFRDA, FMC), there is a need for a consistent perspective on consumer protection all across the Indian financial system. Otherwise, it is all too easy to set off a race to the bottom where parts of the industry co-opt their regulator and try to gain market share by hurting consumers.

As emphasised above, the key requirement is a shared body of knowledge and perspective. In this journey, there is value in a Consumer Protection Handbook


This Consumer Protection Handbook would utilise the timeless principles of the IFC, and help shape the drafting of regulations and the work of enforcement. It would only be an interpretative document and have no legal status. It would help individuals in financial agencies and financial firms understand the full picture of consumer protection in finance, that is now unfolding. It would improve coherence across the Indian financial system, and accelerate the construction of State capacity. An understanding of consumer protection in finance is now found in 10 people in India; this needs to turn into a shared understanding between 10,000 individuals spanning financial agencies and financial firms.

For this viewpoint, four elements of work are now required.
  1. Enacting the Indian Financial Code. Consumer protection is at the heart of the draft Indian Financial Code (IFC). The IFC has given us the foundations for consumer protection, with a draft law which is at the global state of the art. The IFC also improves the financial regulatory architecture, thus reducing though not eliminating the problem of sectoral regulators in India that get captured by the interests of their industry.

  2. A Consumer Protection Handbook. At present, the key document which elucidates consumer protection in the IFC is the FSLRC Handbook which was released in late 2013. While this is useful, it is not adequate. Much more needs to be done in the field of consumer protection, in creating a document, which we may term the Consumer Protection Handbook, which translates the principles-based IFC into a shared contemporary practical understanding. This work needs to take place through a collaborative process between all financial agencies, so as to ensure a consistent approach across the Indian financial system. Regulators and the industry need to achieve a shared understanding of what the principles of consumer protection in the IFC imply, and how these can get translated into clear regulations on the ground. What are the risks of the various products from a customer protection point of view? What do the customer rights, specially those of suitability, imply for the different products and circumstances? What kind of compliance reports should be designed so that firms and regulators can communicate with each other? What kind of enforcement actions will be taken against errant firms?

  3. A new wave of regulations. The regulations that we ultimately desire under the IFC can be issued under present laws, hence the process of re-engineering financial agencies to come up to IFC quality consumer protection, embedded in regulations, can start once the Consumer Protection Handbook is in place. The immediate area of focus should be the achievement of a strong team with skills in consumer protection at one or two regulators, who produce a few high quality regulations.

  4. Enforcement.  Considerable knowledge is required in enforcement for consumer protection: the enforcement team needs to understand the law, the  Consumer Protection Handbook, the regulations, the actions by a financial firm, and demonstrate before a quasi-judicial authority that there was guilt beyond all reasonable doubt.
This is ultimately about building State capacity in the legislative and executive arms of regulators, to draft a new wave of regulations on consumer protection that are grounded in the IFC, and then to enforce them.

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