This post aims to establish the conceptual justification for why suitability should form the central principle underlying consumer protection in India. The following posts in the three part series will dive deeper into the implementation aspects of ‘suitability’.
Consumer financial needs are varied and have multi-dimensional aspects. Households planning for long-term goals such as retirement require inflation adjusted returns on investment over substantial time-periods. Parents planning for the education of children need to manage inflation risk. Households whose asset profile is concentrated in the local village economy need access to investments that will provide them exposure to the national economy. Farmers planning for their next crop require credit bundled with weather insurance that will pay out in case of extreme weather outcomes. Each and every household has a combination of such crucial needs that need fulfilment and it is the function of the nation’s financial system to provide accessible and economical solutions. In addition to the challenge of solving myriad household-level challenges, the Indian financial system, also needs to address certain critical national level socio-economic trends relating to formalisation of finance, retirement planning, healthcare financing and increasing urbanisation. How the financial system is able to respond to these challenges will have a significant impact on India’s future.
The nature of the challenges facing households today requires a fundamental shift in the way financial services are currently delivered. Consumers lead very complex lives and are faced with making complex financial decisions as part of their daily lives. If finance is to enhance the lives of consumers, it would need to embrace innovation and offer products and services that would keep all the associated complexity with the provider while keeping it simple for the consumer.
A product like the fixed rate 30 year home loan may appear simple and easy to comprehend, but it transfers a lot of the risks to the consumer while making the life of the provider simple. For instance, the fixed rate is a nominally fixed rate and transfers inflation risk to the borrower while her income and value of the home are both inflation linked. When a customer borrows and buys a house, he takes a leveraged long term position on real estate. If the customer’s cash flows are even somewhat volatile, adding leverage to it greatly exacerbates the experienced volatility and might impact consumption in a bad scenario. The apparent simplicity of a financial product is a poor measure of the impact it can have on the well-being of the household. Irrespective of whether the product appears simple or complex, the focus must be on the interaction of that product with the overall existing portfolio of the household. The housing loan and the house need to be viewed in the context of the global portfolio of the customer. If this is a customer who has reasonable financial wealth and negligible real estate exposure, this may be valuable diversification. For another customer, who already has high exposure to real estate, this exact same product would appear to be a bad solution. Therefore, even an apparently simple fixed rate home loan product hides a lot of important detail that has material consequences for the consumer.
It is impossible to expect that the consumer will have the expertise to assess these interaction effects of products with her existing portfolio. The financial service provider, however, has the knowledge and expertise to assess product-portfolio interactions and make suitable recommendations for consumers. It is imperative, therefore, that the onus for assessing the suitability of any financial product must rest on the financial service provider. There needs to be a decisive shift from disclosure-driven consumer protection regime where the onus is on the consumer to make the right choice, to one based on “suitability” – where the onus is on the financial service provider to ensure that the appropriate advice or product have been provided to consumers and informed consent has been obtained.
If we accept the fact that complexity in financial products and services will only increase over time, and therefore imbalances in information, expertise and power between the buyer and seller will further increase, then the most appropriate approach in protecting the welfare of the consumer is to put the onus of consumer protection on the seller. The seller must be held accountable for the service provided to the buyer, by ascertaining that the products sold or the advice given is suitable for the buyer considering her needs (as determined by the buyer using its expert judgment). This will ensure that consumer protection is built into the heart of a financial service provider’s business and their internal incentive structures will align themselves with the best interests of consumers.
6 Responses
Interesting read, yet again. A few points that you may want to run through your mind:
1. Goal linked savings : Consumers in poorer and middle-income segments look at goal linked savings. e g education, marriage of daughter (let’s accept this as a reality that exists) – and the easing of cash flows due to income volatility. My guess is that households who have these goals in place (due to their income levels), bat in a different league.
2. Two levels of choice on savings / investments : In addition to deciphering which financial route is suitable, the consumer has to pick WHICH FINANCIAL INTERMEDIARY/BANK is suitable. Regardless of regulation, there’ll be all types, some of whom may be less scrupulous. I don’t think that the answer is a large rule set, but an enabling mechanism. To explain :
a. The savings / investment product needs to be pre-assessed by the regulator (you’ve mentioned this) on two counts :
i) Volatility (how much of savings / return can be eroded on a down side). This can be assessed through historical data or a “banker’s” style risk assessment. (I suspect this may have reduced this 2008 housing disaster a little!); and
ii) flexibility (and liquidity) – homes with likely volatile incomes characterise the target segment this article seeks to address. Especially on long tenure products such as the housing loan.
b. Track record of financial product seller : A history of the seller’s record must be made available. e g a savings recommendation at point of sale goes into the records and monitored through its life (its not complicated, given bank systems these days). This will pin down sloppy recos, as they’ll come back to bite, and create a stake for the seller’s executives in ensuring customer benefit through the product life, not just the sales / commission / bonus period.
3. Consumer friendly prospectus / product info: A recent media clip estalished that Paypal’s terms and conditions document is longer than Shakespeare’s Hamlet!!! An easy reference FAQ (ok’d by the regulator post consumer-forum discussions) should be mandatory and expressed in simple terms. For example, the concept of “global portfolio” or “diversified” won’t ring a bell with many homes. Telling them to procure say, land, outside the village so that ALL crops don’t fail at the same time may be an easier way to explain it (I’ve taken an unlikely example, but you get the gist!).
The above points are applicable to ALL consumers. However, those who have surplus (above goal level) money, may not appear to be the baseline for consumer protection, as they’re likely to have access to “expert advice”. However, if you consider many may be the first “generation” family with surplus, they need such protection as much as the lower income groups. (not saying the others don’t need it). My feeling is that many of these recos you are making will hold across the board.
Hope this gets some aspects ticking for your study!!
Prasanna
Thank you for sharing your observations. A few comments below:
1. While the weaker sections are more vulnerable and hence may require more protection, financial consumer protection is important for all consumers considering the inherent problem of information asymmetry between providers and consumers. Also finance is complex in the sense that the outcome of a purchase becomes clear
only in the long term. Assessing the interaction effects of a particular product (simple or complex) with the overall portfolio requires expertise that even sophisticated consumers may not have. The Suitability regime lays the onus of assessing suitability of any financial product with the provider, who has the knowledge and expertise to assess these interactions and make suitable recommendations for consumers.
2. The regulator may require financial service providers to have a board approved Suitability policy that the company must follow. A clear policy (which lays out processes for consumer data collection, analysis, communication of recommendations, and follow-up) will be powerful in dis-incentivising providers from acting in ways that promote their own self-interest at the cost of consumers. The only way to make this happen however is to hold providers legally liable for the Suitability process. This means that a financial service provider will be required to maintain a record of the recommendations they provide to customers and will be held responsible for it. Like you rightly mentioned, this will ensure that the process is continuous, that the provider will be required to check for suitability at all points of interaction with the customer. We will be writing more about these aspects of suitability in the next post in the series.
3. While there are many limitations to a regime of consumer protection based on disclosures alone, effective disclosures do play an important part in the suitability regime. An easy reference FAQ approved by the regulator may be good way to simplify the necessary information for customers. One of the aspects that came up
in the IFMR Financial Systems Design Conference 2012 ( https://dvararesearch.com//2012/09/08/ifmr-financial-systems-design-conference-2012/ ) was that approaches in India have focused on product disclosures being comprehensive rather than being comprehensible to the end customer. Nutrition information on food boxes was quoted as an example of disclosure approaches in the positive direction, where there is standardised comprehensive disclosure driven by regulation, which feed into industry analysts who then work on converting it into comprehensible information for customers.
Well said. A very key point. In fact, the article highlights a never before dimension which usually has not figured in any policy making so far. The existing protection regime in India calls for action against the seller only when the damage is already done to the consumer. That’s “Reaction”. Why not be “pro-active” and hit out right at the source of the transaction rather than after it gets executed. Given that in this country access to justice is still a highly privileged “commodity” and more so when the subsequent lengthy judicial process kills the very purpose of consumer protection………….this would indeed be a very right direction to introspect the source rather than the subsequent flow of the perceived benefits from the seller.
And Regulation should be at the center of this “at-source” consumer protection. More so when it is a complex and risk prone investment like that of real estate.
Regulation in property business in this country assumes significant importance given that there is a complex combination of two sellers whose services should ideally compliment each other but unfortunately not happening currently. While real estate remains without any regulator altogether, housing finance continues to be ambiguously or in fact loosely regulated.
Both the builder and financier work in complete isolation with the entire associated risks from both sides passed on to the ignorant consumer without any fault on his part. For example, its compulsory for the consumer to first book the property before applying for a home loan. What if the home financier rejects his loan for reasons unknown ? In that case the consumer has to either arrange the entire funds on his own (which is very unlikely for a middle class buyer) or else he is compelled to seek refund from the builder – which again does not guarantee 100% refund. So in the midst of the isolation between the builder and home financier, the consumer gets punished. What if the builder is not able to complete the construction in due time given reasons perceived to be beyond control. Even in that case, the financier will keep charging interest on the consumer. What if the builder charges penalty on the buyer due to delay in disbursements (or no disbursement) from the financier for market linked reasons again beyond control of anyone, particularly the consumer. Lot of things which require consolidation and umbrella regulation is not there in real estate. And the consumer is most vulnerable to such ambiguity and scattered business practices. Just to quote specific regulatory aspect : RBI is having specific Fair practices code for Banks and NBFCs but not for housing finance companies.
Another instance can be highlighted from the eco-system of DSAs in India. While Banking regulations do stipulate certain outsourcing guidelines, but that still leaves sufficient room for the consumer get misguided by the DSAs right from the sourcing stage of business on behalf of a Bank. There is no Fair practices code for the DSAs.
So, as truly said in this article, the business environment in India has underwent a sea change and therefore regulations need to remain matched with the same keeping consumer protection at the center stage proactively right “at-source” rather than reactive.
Unless that happens, the ideology that “Consumer is king” just remains good on paper
Dear Saurabh, Thank you for your comments. The current framework for consumer protection in India
revolves around information disclosure requirements and redressal mechanisms for consumer complaints. Information disclosures alone will not be sufficient
to ensure good outcomes for the customer. Infact, studies have also shown that
such regimes have led to information overload for the customers and led them to
make sub optimal decisions resulting in bad financial outcomes. And as you
rightly pointed out, while an a strong ex-post redressal mechanism is
important, this only deals with the problem after the damage is done. A regime
with suitability as the central principle will ensure that financial services providers
through ex-ante liability and ex-post enforcement act in the best interest of
the consumer at all times. The power of this approach is that it will be
necessary for financial service providers to repeat this process in an on-going
basis in every interaction with the customer. We will be diving deeper into the
implementation aspects of suitability in the coming posts on this series.
I thought I’d commented, but obviously didn’t save it!
Just a few points to consider :
1. Savings plans are best sold in terms of how consumers view it. e g building a house, cushioning cashflows, daughter’s wedding (let’s accept this as a reality for many). etc
2. Those with surplus over and above this aren’t the weak sections.
3. It may be relevant to have an FAQ section that reflects key concerns of the savings holder, viz., : i) Safety; ii) liquidity and iii) what happens if I miss an instalment. The standard document is too complex for even the educated to comprehend. This FAQ can be vetted by the regulator. Items such as “diversified risk” or “global portfolio” won’t mean much to most.
4. Its important to document the performance of the product seller. After all the regulations, why should the savings holder trust one financial services co/agent over another? Building a track record of performance ie recommended savings plan/investment vs actual situation over 4 to 5 years will create a basis to weed out the chaff over a period of time. Incentives for the person enabling the “sale” will always be skewed towards sales rather than outcomes. Introducing a quality element (as suggested here, there could be others) may balance this out.
How to document a risk profile of an investment recommendation?
i) Volatility of the product historically – so if the advice is that return would be in the range of 12 to 15 percent, the track record will support this.
ii) rating of the product provider
iii) worst case scenario picture (if applicable, as say a mutual fund with an equity/real estate blend).
Without point 4. the end objective of consumer protection will be undermined and, when something goes south for the individual which will happen, it doesn’t undermine faith in the entire system or process.
Hi Darshana,
Some excellent points made up there and a very well underlined conclusion. Could not agree more about the growing imbalance with the growing complexities. In addition, here are few points I was pondering over from a slightly different viewpoint –
* True that the onus of a service provided must be shared by the seller,and a lot of accountability has to reside with the service provider, but at what fractions. I feel putting the onus completely on the seller would be as bad as putting it completely on the consumer.
* There is a lot of mistrust in the market,and especially rural markets, between the service providers and the consumers. More so if there is a third party involved. As such we have a lot of work to do before we can change the roles of a seller and a consumer to a consultant and a valued member of the framework.
* Do you think that technology in terms of better risk prediction from either end would help in the scenario with growing complexity in the financial sector?
* As a well known fact, suitability can be somewhat subjective as it is, by definition, unique for an individual product in an individual scenario.How do we then deal with the problem of altering of scrutiny if the overall suitability,based on the volatility of the products the agent or the advisor is recommending?
A very interesting and thought provoking read overall. And bravo to Saurabh for for bringing up the point of a pro-active consumer interests addressing system in addition to a post deal care period. Thank you for the read.