Bose committee on mis-selling

The policy discourse in personal finance in India has been shaped by two concerns. The first is that of the limited participation of households in finance. The second is the increasing evidence of mis-selling of financial products. At present financial products are regulated by multiple regulators who do not coordinate strategies. The sales channel sees different incentive structures emanating from different regulators for identical products. Product disclosures are often not transparent. Returns are not comparable, and costs get hidden. The standards of disclosures are different across regulators. This makes it difficult for customers to evaluate products. All of these contribute to mis-selling.

Mis-selling not only causes losses to customers, but also is likely to impact low participation. Consumer protection in finance has therefore become an important objective. The Ministry of Finance decided to set up a Committee, led by Sumit Bose, to go into these questions in detail. The Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products was released on 3 September 2015.

What the report says

The Report seems to have identified some core areas of concern, and made recommendations addressing each of them. These include:

Regulatory arbitrage

The key recommendation of the Committee is that regulation of financial products must be seen in terms of the product function and not form. These functions are Insurance, Investment and Annuity. The lead regulator, according to function, should fix the rules. In bundled products, the rules of each component should be set by the lead regulator. For example, in a bundled insurance product, the rules on the investment component should be set by the investment regulator, while the rules on insurance should be set by the insurance regulator. This will help remove distortions that result in investment oriented products from insurance being relatively expensive and opaque. The committee has suggested specific steps to create a level-playing field between all products, steps that are essential to curb mis-selling.

Improved disclosure

The Committee recommends that the way in which returns is computed should be standardised and should be a function of the amount invested. Returns in bundled products should be shown on the invested amount, and not on a third number such as sum-assured. Ongoing disclosure should show historical returns as an average annual number based on the IRR of the product. An average customer should be able to understand what the product costs, what the benefits are and for how long the product should be held. The norms of this disclosure for investment products should follow the rules set by the lead regulator. All disclosures should be machine readable. These measures are designed to help consumers compare products objectively and make appropriate choices.

Commissions and charges

Investment products and investment components of bundled products should have no upfront commissions. All investment products, and investment portions of bundled products, should move to an AUM based trail model. 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. Financial products should have flexible exit options. The cost of exit must be limited. The costs of surrender for each product should be reasonable. After deduction of costs, the remaining money should belong to the exiting investors. Lapsation profits, or profits from exit charges, if any, should not accrue or be booked by product providers. These measures will help align the interest of intermediaries with those of the consumers as the commissions will grow based on customer's tenure of investment, investment size and the returns earned.

Common distributor regulation

Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them. 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. These steps will enable tracking of distributor actions across products and improve enforcement actions.

What is missing?

The report makes some important recommendations that should have a significant impact on the disclosures of product features, as well as incentive alignment between distributors and customers. Both these are fundamental to any regime that desires consumer protection in finance. There are, however, a few areas where the report falls short of going the full distance.

First, while the report recognises that regulation of products, and not of function, has led to regulatory arbitrage, and recommends regulations by the "lead" regulator, it does not go as far as to recommend moving away from product regulation. The only way to carry the thought process of the report through is to break with the present financial regulatory architecture, of having RBI/IRDA/SEBI as presently constructed.

Second, the report makes only cursory mention of the design of penalties on financial firms if they are found guilty of dubious sales practices. Regulation in India has focused on prevention, and largely ignored enforcement. This philosophy seems to have been carried over to the report as well. Only when bad behaviour is costly, will financial firms re-design their policies towards "good behaviour". Penalties designed by regulators are usually far too small compared to the benefits gained by firms and distributors through mis-selling. In addition, regulators are mostly reactive and impose penalties only after consumers complain. Regulators must establish mystery shopping programmes to find out the behaviour of regulated entities. Penalties should not only disgorge all potential profit from mis-behaviour but include some penal component which removes the incentive to repeat the behaviour. This component should be based on probabilistic models of getting caught and not on vague standards of "strict penalties." To implement such systems, regulators need to write detailed penalties regulations which consider the nature of the violation, the illegitimate gain and the probability of getting caught.

Third, the report does not adequately address the issue of composite products such as traditional insurance plans, which combine investment and insurance components. The management of assets of the pooled products make the product structure opaque. The way forward would have been for the assets of the investment portion of the product and the mortality portion of the product to be separately managed and kept independent of each other. This requires far-reaching change in the management of the investment pool for non-linked products. The report, sadly, has not been bold enough on this important aspect of the present retail market.

Fourth, the report should have placed a greater emphasis on requiring regulators and industry agencies to collect or create information in a way that supports downstream information processing and dissemination activities. While the report does require machine readable disclosures, it should have also stressed regulators to make publicly available disaggregated data to provide analysis to consumers and encourage creation of tools (mobile based apps etc) by third parties from the fintech industry, thus helping consumers make better choices.

Finally, the report leaves it to the regulators to frame a time-bound road map to implement the recommendations. This almost gives regulators a free pass at ignoring all that is in the consumers interest, as has been the case thus far. The report should have provided a road map with time lines for regulators to act upon.

The way forward

The report has attempted to address some of the basic issues and importantly has suggested specific measures that the government and the regulators need to take to address the same. These would be useful preparatory steps for the regulators and the industry as they gear up for the Indian Financial Code, which once enacted will provide for:

1. A single financial agency to regulate securities markets, investments, insurance, pension, and all other financial services except banking and systemically important payments.
   
   
2. A comprehensive framework of consumer protection to be implemented by financial service providers and the regulators. This framework would include rights and protections for all consumers, as well as some enhanced protections for individuals and small businesses. This consumer protection framework would seek to ensure adequate initial and continuing disclosures, minimising conflicts of interest, provision of suitable financial services, and protection against unfair conduct.
   
   
3. A fully articulated rule of law framework for enforcing against violations and giving out punishments to financial firms.
   
   
4. A single Financial Redress Authority to redress complaints of retail financial consumers in a speedy, inexpensive and predictable manner.