The previous post covered the process of “Suitability” in financial services. Here, we cover aspects of the legal and regulatory structure that will aid in establishing an effective Suitability regime in India.
The primary objective of finance is to improve the financial well-being of consumers. For this to happen in India, there needs to be a shift towards a higher-trust-equilibrium between the consumers, financial service providers and the regulators. However, this is not possible to achieve under the following two scenarios:
- A disclosure-based approach to financial intermediation, which has inadvertently ended up as a way for providers to absolve themselves of their responsibilities to their consumers.
- A purely rule-based regime in which product approval is left in the hands of the regulator, absolves the provider of the responsibility of creating products that are truly welfare-enhancing for the consumer.
The “Suitability” regime seeks to reach this higher trust equilibrium by placing a direct responsibility, through legal liability, on the financial services provider for its advice or recommendation. To give teeth to this responsibility, it becomes a prerequisite to insert into law the Right to Suitability. The Approach paper recently put out by the Financial Sector Legislative Reforms Commission seeks to enshrine this right in the law. Every citizen must have the right to be provided suitable advice or recommended suitable products. By incorporating this, consumers would be empowered to move a court of law in case this right is denied. Its introduction into primary law would be followed by changes to subordinated legislation which the regulators have the mandate to execute and supervise. This will shape the behavior of financial services providers, who will evolve the suitability process and practices that are consistent with subordinated legislation. The suitability regime places a very strong burden on everyday behaviour of the provider.The interpretation of suitability will emerge from the building up of case laws and judicial precedents, ensuring that our understanding of suitability comes from the reality and evolution of the market over time.
The Suitability regime would require the regulator to take a more non-interventionist approach towards product approvals for providers; providers should be free to develop products based on the needs of the market. This will ensure that both providers as well as regulators will have more leeway and will enable the creation of incentives that push the providers to innovate on socially useful product development. This does not however, in any way, indicate that the Suitability Regime would be a ‘light-touch’ one solely characterized by completely unrestrained market participants let loose on unsuspecting consumers. While the regulator steps back from product approvals, it would have greater supervisory responsibilities. This ex-ante regulatory oversight, coupled with a strong, unified ex-post redressal mechanism that also gives ‘real-time’ feedback to all regulators to aid in their monitoring, would provide severe disincentives for providers to offer bad advice or recommend inappropriate products to consumers. The redressal mechanism must include penalties that are not just compensatory in nature (to cover the losses incurred by the aggrieved), but also heavily punitive for non-compliance, which would act as a severe deterrent for the future. This could be in the form of direct liability on the heads of financial institutions, product recalls, and the like.
Coordination among regulators would assume tremendous importance in this regime. The Financial Stability and Development Council (FSDC) plays a big role in facilitating this. The agenda for development of the financial sector must be decided solely by the FSDC and the Finance Ministry. Keeping the regulators responsible only for their respective domains will help remove any conflicting objectives the regulators might have faced otherwise.
How can suitability be enforced in a country like India where vast majority of the population have only limited or no access to basic financial services? If a consumer has access to only one product provider, should the provider sell the consumer a product that it has concluded to be unsuitable for her? Is Unsuitable access better or worse than no access? This situation, of a single product in low-access environments, can be overcome by getting the provider to develop natural suitability guidelines – which indicate a class of consumers for whom the product is automatically suitable; and serving the product to only those consumers. Besides, the provider can come up with natural “unsuitability” guidelines which, at the very least, stand by the principle of ‘do no harm’. This framework will automatically push for a bias in favour of distributors who can offer a single yet perfectly suitable product, and going forward, offer multiple products. It is likely that the Suitability equilibrium will shift the market from single product providers to multiple product providers.
The regulatory costs of implementing the Suitability paradigm need to be considered in greater detail. Further work will need to be carried out to arrive at a conclusion of whether the costs would be lesser or greater both in the short term and in the long term.
Also, greater thought will need to be given to develop a framework for supervising the Suitability regime. We can however learn from experiences from other countries which have already covered considerable ground in this aspect. The box below looks briefly at how Australia has been enforcing Suitability.
Enforcing Suitability – Lessons from Australia
Australia has a single market conduct regulator, the Australian Securities and Investments Commission (ASIC), whose mandate is to ensure that Australia’s financial markets are fair and transparent, and are supported by confident and informed investors and consumers. ASIC administers the Financial Services Reform Act 2001 (FSR Act), which requires persons who provide financial product advice to retail consumers to comply with certain conduct and disclosure obligations. More details can be found here.
ASIC places legal obligations on financial services firms to meet specific conduct, disclosure, skills as well as professional indemnity insurance requirements, amongst others, to implement the Suitability requirement. Potential breaches of the law are brought to ASIC’s notice through reports of misconduct from the public, through referrals from other regulators, statutory reports from auditors and the licensees themselves, and through ASIC’s own monitoring and surveillance work (through regular surveillance visits and shadow shopping studies, the results of which are shared in the public domain). ASIC is empowered to take a variety of actions such as:
- Punitive actions such as court order, prison terms, criminal and civil financial penalties;
- Administrative actions (without going to court) such as ban on providing financial services, revocation, suspension or variation of conditions of licenses, public warning notices;
- Preservative actions such as injunctions; and
- Negotiated resolutions such as through enforceable undertakings, and others
ASIC can decide on which remedy to take depending on various factors such as the severity of the suspected misconduct, the extent of losses, the compliance history of the individual or firm in question, and so on. The table lists major deterrence outcomes by type of action taken
(Source: ASIC Annual Reports):