Regulating the financial sector is a tightrope walk in any jurisdiction, but more so in a country like India. On one hand, loose regulations can result in fraud or mis-selling as firms use regulatory arbitrage and a soft regulatory regime to maximize their profits at the cost of investor. On the other hand, a very tight regulatory regime has the potential to stifle innovation, and consequently the deepening of financial markets in the economy.
One of the big challenges in the Indian context has been the weaning of the household from real assets such as gold and real estate, both of which are used as insurance and investment vehicles, towards formal sector finance. In the pre-liberalisation era, with an absence of a large middle class and a state run economy, the two state monopolies, the Life Insurance Corporation of India (LIC) and the Unit Trust of India (UTI), were perhaps sufficient to provide the Indian household a safe vehicle to channelize savings into investments.
Relatively low rates of return, as long as they were safe, were acceptable to the household in the nascent stage of the Indian financial market. The role of regulation was limited since the government was the vendor. As a consequence, there was little focus on evaluating sales incentives, product structures and disclosures. However, over the decades as the market grew both in terms of demand for and supply of financial products, there was a need for changing the rules of the game.
Two other factors led to the need to bring about a change in the way the financial system was managed. The opening up of the market to private players meant that there was need for a set of rules by which the private and state firms could do their business. Also, market linked products needed a different mindset than a public monopoly mindset where the government decided every economic variable in the system – not just interest rates but even the price at which an Initial Public Offering (IPO) could come to the market.
The need for a change in rules is obvious when one considers the evolution of the financial system from hundis to a modern stock exchange. While verbal and personal relationships were adequate to run an efficient system of hundis, these obviously did not work for stock exchanges.
Modernization of the stock markets has often followed large scams. The modernization of the Indian mutual fund industry came in the wake of the UTI crisis and the imploding of the US 64 pool. Several lessons have since been learnt in terms of what attributes a modern financial product should have and what regulation should and should not do. Modern financial products should be such that costs and benefits are clearly visible to the buyer. Costs should sit in one place under a common head and that cost head must have a regulatory cap.
Within that cap, the firms should be free to manage costs and profits. The buyer should be able to clearly understand the contract. Market linked products should declare a benchmark that must reflect the investment mandate of the product. Market linked products must be portable to allow investors to move from less efficient fund managers to more efficient ones. Incentive structures should be such that the problem of asymmetric information is solved. Once these ground rules are in place, the regulator should be able to catch the errant driver jumping the red signal. Consumer protection in finance has taken centre stage post the 2008 global financial crisis – which was essentially a mis-selling episode at a massive scale. Unsuitable loans were sold to consumers and the assets on the books of the mortgage companies and banks were further resold to institutions. When consumers defaulted, the entire system collapsed.
In India too, we have witnessed mis-selling across various financial products. Household finance is now a rapidly growing academic discipline. The overwhelming evidence from household finance points towards agents maximizing their own income at the cost of selling unsuitable financial products to households. It is well documented that non-transparent product structures encourage mis-selling by agents and advisors. Corroborating this work are the learnings from a new field of economics – Behavioral Economics – which prove that an average human being is not predisposed to taking rational decisions in finance, with emotions, anchoring and loss aversion driving investor behaviour.
There is increasing evidence to show that a move to a seller-beware market is the road ahead in financial regulation. The proposed Indian Financial Code (IFC) that is in various stages of implementation, too envisages a seller beware market. In the current stage of the Indian market, seller beware would perhaps have very high regulatory costs that might slow down the pace of the deepening and widening of the financialization of the Indian economy. One way to reduce the regulatory cost is to reduce the potential of mis-selling by ensuring clean product structures, clear benchmarks and by aligning incentives of the manufacturer, seller and buyer to the outcomes that households derive from the purchase of the financial product.
An additional problem in the Indian market is the multiplicity of financial sector regulators with overlapping products and regulatory cracks. Overlapping products between regulators causes firms to gravitate towards markets with relatively weaker regulatory oversight and poorer standards on consumer protection.
Technically, a Hundi is an unconditional order in writing made by a person directing another to pay a certain sum of money to a person named in the order. For more details, see: http://web.archive.org/web/20131126010531/http://rbi.org.in/scripts/ms_hundies.aspx
The IFC envisages a two regulator structure – with the Reserve Bank of India (RBI) and the Financial Authority (FA). A pre-requisite for a unified financial sector regulator would be the removal of arbitrage in product structures, costs and incentives across products in the system. Not only will this remove the skew in the market, but would also prepare the ground for better consumer protection through the proposed Financial Redress Agency (FRA).
The report of this Committee needs to be seen in the larger context of a deep change in the Indian financial sector regulation to get it ready for the job of taking India from a $2 trillion economy to a $20 trillion one in the coming decades.
Given this background, the mandate of the Committee, as laid out in the terms of reference, was to study the prevailing incentive structure among various financial investment products taking into account the historical evolution of such a structure in India and globally and also the differential nature of the product itself with a view to:
M1 Address the issue of providing level playing field in the commission / incentive structure of financial products;
M2 Suggest policy measures such that differential regulatory norms do not favour any particular financial product and prevent mis-selling;
M3 Address issues with respect to hidden costs and identical financial products under different regulatory jurisdiction; and
M4 Rationalize the incentive structure across financial products.
Work process of the committee
The Committee held twelve meetings between December 2014 and July 2015 and Dr. Manju Puri attended the meetings through skype. In its very first meeting, the Committee decided to limit its focus to examine financial products where the degree of responsibility with which such products are sold to the retail consumer was a matter of concern. These products were generally those (i) which did not offer assured returns and/ or (ii) had high and more importantly, non transparent cost structures. These are, what are called, push products.
This narrowed down the focus to insurance, mutual fund and pension products. As a corollary, products like bank deposits, public provident fund, post office small savings got excluded from the review. The reason for excluding them was not only that they were essentially pull products but also that returns on these products were relatively predictable. More importantly these products did not have opaque, high or misaligned cost structures.
The Committee studied the current scenario of the retail financial sector in detail. It drew on international experience, as well as the Financial Sector Legislative Reforms Commissions (FSLRC) recommendations on consumer protection, financial regulatory architecture, financial inclusion and market development. It also reviewed the approach taken by the Financial Stability and Development Council (FSDC) to implement FSLRC’s principles relating to regulatory governance, transparency and improved operational efficiency that do not require legislative action.
The Committee followed a consultative approach by hearing the concerns of the stakeholders in the retail financial sector, including regulators, product providers, distributors, and actuaries. The complete list is provided in Annexure F. These guided the formulation of the recommendations.
Financial sector reform is an ongoing process. It must be remembered that due to historical reasons, certain products in the industry may have lagged behind the reforms that other parts of the market have embraced. Given this, certain product categories have a larger focus in the eyes of the Committee so that they are brought to par with the rest of the market. The endeavour of the Committee is to ensure that there are no dark patches in the industry or product category that leads to mis-selling and investor anguish resulting in loss of trust in the financial sector.
The Committee believes that consumer interests will be served by more transparent disclosures that enable consumers to understand products, compare them, and consequently choose those that serve their interests.
It is commonly recognized that tax breaks and assured returns work as pull strategies. This can be seen from the pull towards taxable bank deposits. What is perhaps not commonly recognized is that presence of assured returns and/or tax breaks can in fact, make the product more susceptible to irresponsible sales where the products also have opaque or mis aligned cost structures as well as opaque benefits, as can be seen in some traditional insurance products.
The recommendations of the Committee are in two parts (described in detail in Section 6). The first part, outlines the broad principles that should be applicable to any retail financial product. These are sub-divided into recommendations on product structure, costs and commissions and disclosures, followed by generic recommendations. Part two deals with recommendations for specific products.
The Committee suggests that the regulators frame a time-bound road map to implement the recommendations. The spirit behind the recommendations is the idea that customers must be treated fairly. Firms must understand the spirit behind the recommendations in order to implement these in a holistic manner.
The summary of recommendations is as follows:
1. Regulation of financial products must be seen in terms of the product function and not form. These functions (for the purpose of this committee) are: Insurance, Investment and Annuity.
2. The lead regulator, according to function, should fix the rules of the game. In bundled products, the lead regulator for the function of the sub-part must fix rules of the game.
3. Investment products and investment components of bundled products should have no upfront commissions.
4. All investment products, and investment portions of bundled products, should move to an Assets Under Management (AUM) based trail model.
5. Upfront commissions on pure insurance products and pure risk portions of bundled products should be allowed, and should be decided by the lead regulator since pure risk is a difficult product to sell.
6. Financial products should have flexible exit options. The cost of exit must be limited. The current rules as decided by Securities and Exchange Board of India (SEBI) for mutual funds and Insurance Regulatory and Development Authority of India (IRDAI) for Unit Linked Insurance Plans (ULIP)s are robust. The same principles should govern surrender and lapse costs in traditional plans, and form the basis for future products as they are innovated by the industry.
7. The costs of surrender for each product should be reasonable. After deduction of costs, the remaining money should belong to the exiting investors.
8. Lapsation profits, or profits from exit charges, if any, should not accrue or be booked by product providers.
9. At the point of sale, returns should be clearly disclosed and should be a function of the amount invested. Returns in bundled products should be shown on the invested amount.
10. At the point of sale a one page disclosure form that both the customer and the seller sign off on should be included. The disclosures should be in a manner that an average customer can understand what the product costs, what the benefits are and for how long should the customer hold the product.
11. On-going disclosure should show historical returns as an average annual number based on the Internal Rate of Return (IRR) of the product. The norms of this disclosure for investment products should follow the rules set by the lead regulator.
12. Machine readable disclosures enable creation of web-based tools and mobile apps that help consumers make smarter choices in the marketplace and as such all disclosures should be machine readable. Machine readable does not mean soft copy. Machine readable is when data can be processed by a computer for further analysis and interpretation. Comma Separated Values (CSV) is a basic example of machine readable.
13. For similar products, there should be a similar structure with regard to service tax, stamp duty and rural and social sector norms.
14. Similar products should have a similar free look-in period.
15. Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them.
16. Regulators should create a single registry of all distributors. Anybody facing the customer should be registered. The registry should identify each individual distributor with a unique number. The registry should have the past history of regulator actions and awards for each individual distributor. Strict penalties should be defined for distributors who are not registered.
Courtesy : Ministry of Finance