Addressing mis-selling in Indian finance: Lessons from South Africa

by Sanhita Sapatnekar.

The setting

When a person seeks treatment from a doctor, he may worry about medical expenses or test results. What he probably does not worry about is a third party paying the doctor to actively damage his health, by providing unsuitable advice or administering an inappropriate medical product. In consumer finance, however, this happens all the time. Customers approach those perceived as finance experts for advice on financial products, or to buy these products. These experts often provide unsuitable advice or inappropriate financial products to the customers, because a third party is paying them to do so.

This problem is present across a large swathe of Indian household finance. As an example, a careful examination of one episode of one class of mis-selling problems has showen an estimated loss to investors of Rs. 1.5 trillion, or USD 28 billion from 2004-05 to 2011-12.

Three parties are involved in this problem:

1. The product supplier, whose goal is to sell his products;
   
2. The `middle-man', or the intermediary, who facilitates the product sale in
   return for a commission; and
   
3. The customer, who may potentially buy the product.
   

While `financial intermediary' in general covers all financial firms, in the present context, it refers to the persons who engage in the front-end seen by customers, and not the financial firms such as mutual funds who produce the product upstream.

Just as the doctor plays both the role of providing medical advice to the patient, and occasionally that of distributing the medicine provided by the product supplier, intermediaries perform two roles in the Indian financial distribution system: they perform advisory services for customers and provide distribution services to product providers (such as mutual funds and insurance firms).

How is retail finance different from health?

The first key difference is that, unlike in the health setting, intermediaries in India sell financial products to customers but earn commissions from the product suppliers. Intermediaries are likely to focus on the potential commission they can earn when selling a particular product, rather than catering to the best interest of customers. In the health sector, this situation is less prevalent as the intermediary (i.e. the doctor) earns his income from the consumer (i.e. the patient), and not the service provider (i.e. the company providing the medicine); the doctor's financial incentives are driven by patient satisfaction. Several retail finance mis-selling episodes can be traced back to this arrangement. While advice may not be explicit, given the nature of the products, it is embedded in the distribution. The advisory role is particularly important considering that India has an estimated 65% of the population that is financially illiterate.

Second, unlike in the health sector where the type of doctor (and the type of service they are qualified to provide) is clearly defined, the retail finance distribution system in India lacks these definitions. This allows for gaps and overlaps in the type of intermediary, and therefore the service they provide (e.g. whether an intermediary is a qualified financial advisor, or just a salesperson, needs to be clearly defined before the consumer can make an informed choice on whether to take the intermediary's advice). While a patient would ordinarily not seek advice on a heart condition from a gynaecologist, a retail finance consumer may find himself taking advice from an intermediary not qualified to provide that advice, as regulations governing the type of intermediary, and therefore the type of services they are qualified to provide, are weak.

Third, a retail intermediary can play both the role of the salesperson and the advisor, because the retail finance advisory market is underdeveloped. Usually, a patient actively seeks medical advice from a doctor when he is in need of it. Medical products are therefore pull products. Under the present arrangements, the same patient may never seeks advice in the retail finance sector. This has made retail finance in India a zone of push products. This has given two groups of problems: The lack of demand for advice has hampered the development of the advice industry and the pervasive supply of advice by conflicted intermediaries is leading to bad decisions by households.

Fourth, grievance and redress mechanisms in the retail finance sector are underdevloped and inconsistently applied. Currently, each regulator is responsible for providing redress relating to products under their jurisdiction. As a result, there is no standardised service for redress, especially for consumers of complex products that fall under more than one jurisdiction. In the health sector, the ethical incentive to ensure a patient's health is maintained has resulted in enforced regulations aimed at curbing malpractice; if the doctor were to intentionally administer the wrong medicine, it is likely he would face consequences for his actions, as institutions that allow for redress are already established and developed. This factor leads to mis-selling as, unlike in the health sector, intermediaries know they are more likely to get away with selling an unsuitable product to a consumer, or giving inappropriate advice.

Mis-selling in South Africa

In the study of how mis-selling is being treated in other jurisdictions, we often turn to the UK or Australia. An interesting case study on this subject is South Africa, a country whose financial system is more comparable to India.

The South African financial distribution system has suffered from large scale mis-selling. The country's financial literacy rate is estimated to be 34% (comparable to India's 35%), and the financial distribution regulatory framework has not been effective in protecting consumers. The 2002 Financial Advisory and Intermediary Services (FAIS) Act made progress in raising intermediary professionalism, improving disclosure to clients and mitigating certain conflicts of interest. However, poor customer outcomes and mis-selling of financial products persisted. As a result, the South African Financial Services Board (FSB) initiated its own Retail Distribution Review, the findings and proposed recommendations of which were published in November 2014.

The RDR approaches the current landscape in South Africa from three perspectives:

1. First, it looks at services provided by intermediaries. The RDR proposes clearly defining the types of services provided as advice (which is a service to the customer); intermediary services (which are services connecting product suppliers and customers); and other services provided by advisers and intermediaries (which are services to product suppliers). Further, the RDR defines types of advice an intermediary can provide. The RDR then sets proposed standards for each type of advice, including intermediary disclosure requirements and steps for mitigating and managing certain conflicts of interest.
   
   
2. Second, the RDR looks at the relationships between intermediaries and product suppliers. In line with defining the types of advice offered, the RDR proposes definitions for the types of advisers, based on whether they are tied to one or more product supplier, or if they are independent. The RDR also sets proposes qualifying criteria for an adviser to be fully independent based on the products offered; the product supplier in connection with these products; and level of influence from product suppliers. Standards for product suppliers' responsibilities are proposed for each type of adviser as well as for non-advice sales.
   
   
3. Third, the RDR looks at the remuneration earned for the services concerned. Among the proposals relating to remuneration, the most notable is the one banning commissions for all investment products, which comes only after the recommendations for reconstructing the retail distribution system. The recommendation states that: Product suppliers will be prohibited from paying any form of remuneration to intermediaries in respect of investment products, and from including any costs associated with intermediary remuneration in product charging structures, whether in the form of ongoing charges or early termination charges. Intermediaries will correspondingly be prohibited from earning any form of remuneration in respect of investment products other than advice fees agreed with the customer, in accordance with the applicable requirements for such fees.
   

Lessons for India

South Africa's financial distribution system is complex and lacks clear structure. As a result, creating legislation to address mis-selling without first restructuring the distribution system (including defining services provided and relationships between intermediaries and product suppliers) has failed as a solution, as demonstrated by the FAIS Act.

In countries such as the UK and Australia, where these definitions are already in place and redress mechanisms are well established, the focus of regulatory reform falls mostly on resolving conflicts of interest in relation to intermediary remuneration. The South African proposals also address intermediary remuneration, but only after first addressing the services provided by intermediaries and the relationship between intermediaries and product suppliers. In India (as in South Africa), the problem is twofold:

1. A sound distribution framework needs developing before implementing changes to commission structures can be fully effective. This entails conducting a thorough review of the current retail distribution system in India, developing a clear understanding of retail distribution dynamics, and then establishing rules and regulations on the types of services provided by intermediaries; their relationship with product suppliers; disclosure norms; and qualifying requirements.
   
2. Effective grievance and redress mechanisms that are consistently applied nationwide across the retail finance sector (regardless of which regulator's jurisdiction a financial product comes under) need to be developed.
   

In the short run, consumer protection thinking will need to be grafted on top of the present legal framework in India, which was not designed with consumer protection in mind. Financial agencies are in the process of adopting the FSLRC Handbook where Chapters 2 and 3 are about consumer protection. This article should feed into this work process.

The fuller solution, however, requires the Indian Financial Code (IFC). The IFC approaches retail finance with consumer protection as an objective, making it the regulator's responsibility to create regulations for these consumer protection provisions. The IFC defines "advice" as a "recommendation, opinion, statement or any other form of personal communication directed at a consumer that is intended, or could reasonably be regarded as being intended, to influence the consumer in making a transactional decision". Further, it defines a "retail advisor" as a "financial service provider or financial representative that gives advice to a retail consumer".

The draft law then gives the regulator powers to discharge its functions with the objective of protecting and furthering consumer interests, and promoting public awareness of financial products and financial services. The IFC then places the responsibility of making regulations for these provisions to the regulator. Under the IFC, the regulators could thoroughly review and reconstruct the retail distribution framework within these bounds.

The Ministry of Finance has established a task force aimed at creating the Financial Redress Agency (FRA) of India, as envisaged in the IFC. The FRA will be a nationwide independent agency providing redress for financial consumers across all sectors, with the ability to handle large volumes of relatively low value complaints. While this addresses the grievance redress aspect of the problem, other provisions in the IFC facilitate the second aspect, and allow for the retail distribution system to be reconstructed.

Acknowledgements

I thank Renuka Sane for valuable discussions.