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.