Independent Research and Policy Advocacy

Consumer Protection: Recent developments on the regulatory front in Developing Countries – Part 1

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As part of our series on consumer protection, we seek to present views of leading experts in the field. Here, in this three-part series, Deepti George of IFMR Finance Foundation interviews Kate McKee of CGAP. Kate McKee leads CGAP’s research, writing, and policy advisory work on consumer protection and market conduct regulation. She shares with Deepti valuable insights and perspectives on recent regulatory developments within consumer protection for financial services in developing countries.

Q: While Indian regulation has predominantly been guided by caveat emptor (“buyer beware”), Australia has put in place provider liability and suitability regimes for almost all financial services. Given the stark contrast between the two regimes, what have been the broad regulatory trends in the developing world?

Financial consumer protection regulation and supervision is on the rise in developing countries (although admittedly from a very low base). Within that overall trend, in most countries regulators are beginning with the kinds of measures that would enable consumers to protect themselves: disclosure rules plus some kind of complaints mechanism. Most financial authorities see these as the building blocks on which to build consumer protection. And in developing countries and emerging markets, they seem to be relying on rules-based approaches more than principle-based ones.

I suspect that policy makers across the world may have looked at the results of the global financial crisis and concluded that principles-based regimes didn’t really measure up in preventing harm to consumers, financial markets, or the global economy. The consumer protection regime of the UK, for example, was probably the most developed regime at the principles-based end of the spectrum. It is very appealing philosophically. Yet it is hard not to conclude that many providers took advantage of that flexibility; supervisors seemed to face an uphill battle in responding quickly, decisively, and consistently enough to ensure acceptable market practices (In fairness, however, some regimes such as the US that were more rules-based did not perform very well either.)

The main concern that policy makers in developing countries seem to have about principle-based regimes is the discretion or “wiggle room” they give to market actors, some of whom will use this discretion to be deceptive or pursue practices that are perhaps quite profitable but unfair. Many also perceive — and I think they may be correct — that it takes more capacity to administer a principles-based than a rules-based regime. Some are also concerned that reliance on principles creates more provider uncertainty and burden, especially for those that plan to comply and operate responsibly.

Another factor that might tip the balance towards rules is the very pace of financial inclusion and innovation. In many markets many new consumers are entering formal financial markets in which providers, products, and channels are proliferating. Regulators are probably thinking: “How can we help these less experienced first-time consumers ‘self-protect’ and how can we reinforce whatever education efforts we are making, so that they understand what they’re buying, make good choices, and know what the risks are?” Just as Australia has chosen to do, regulators in these earlier-stage markets see the value in setting some boundaries around what kind of innovation is acceptable. I imagine they hope that clear rules will send a message to providers that they are expected to innovate in ways that add value for consumers. A final argument is that over time a rules-based regime could also help achieve a more level playing field and better competition; as long as they meet minimum standards, different types of providers can be allowed flexibility to offer new services and use new channels.

The challenge for regulators, of course, is to set rules that are clear enough but also permit some flexibility for innovation. This tension is present in many countries. What looks flexible to a regulator may appear as an insurmountable obstacle to a provider wishing to do business in a new way.

Q: Given that the capacity to regulate is less, would that be a factor that would drive regulators to continue under a rules-based regime, besides the many factors you have mentioned?

Yes, regulatory capacity is a really important consideration. Malawi offers an example of this challenge. The Reserve Bank oversees a rather broad range of provider types. The past few years have seen enactment of an ambitious set of new consumer protection laws and provisions. Implementing this new regime is going to be a big job, one which falls to a new market conduct team comprised of a small number of former prudential supervisors and others. The team is likely to find it easier to implement a regime based on rules than one that requires determination of what is fair and appropriate for the diverse providers and products that it oversees. Whereas prudential supervisors can be trained in desk review, sampling techniques, and quantitative analysis, assessing market conduct demands more judgment and the ability to see market practices from the consumer perspective. A few key rules can provide a touchstone to guide supervision and the use of scarce staff resources.

In fact, CGAP is trying to support the work of policy makers, regulators and supervisors in financial authorities that face major capacity constraints. The experience so far suggests the need for a very careful prioritisation and being very selective in determining which issues to tackle first. Consumer research and diagnostic work can help determine which problems in the market have the worst consequences and affect the most – or the most vulnerable – people. Basic rules can describe acceptable practices and product standards. Then it is a matter of improving enforcement and the scope of coverage over time. We need to acknowledge that 100% compliance is probably not a realistic goal even in a country like Australia with much greater resources to devote to the task.

Q: When the decision is to be taken on which are the important things that we need to regulate, and which are the less important, where does ‘fostering innovation’ stand in this regard?

This is a broader policy question, of course, but let me approach it in the context of consumer protection. Perhaps five years ago, before the global crisis hit, many policy makers and practitioners would have expressed the view that consumer protection measures would tend to run counter to both innovation and inclusion; the common wisdom was that such rules tended to increase compliance costs for providers, which would lead in turn to either less service to poorer consumers, more expensive service, or both. Post-crisis, however, a more nuanced view has emerged. Heavy-handed or poorly-targeted market conduct rules do indeed risk suppressing access to finance. On the other hand, not all access is healthy. Unchecked innovation of certain types such as predatory home loans sold with little regard to affordability can be unsafe for consumers and destabilizing, while other types of innovation promote responsible market development.

A consensus seems to be emerging among policy makers that basic but effective consumer protection is actually quite critical for successful innovation –- and inclusion — over the longer term. Except in the case where the product is very simple and the risks low and well-understood, first-time consumers need trust and confidence in order to be willing to try out formal providers and products if they have some basis for believing they will not be mistreated (and word can spread very quickly when such consumers have a bad experience). Client-focused research is beginning to show that lower-than-expected uptake of products, even products that are designed to offer clients good value-for-money, can be traced in part to lack of trust. By choosing the right things to regulate and doing so competently, financial authorities can help build confidence. To my mind, a good starting point in many markets is making sure that effective disclosure and grievance mechanisms are in place and that they actually work for customers with lower levels of income, education, and experience with formal finance. These measures should be relatively uncontroversial. And they should result in better-informed and more confident consumers and a healthier market.

Most Central Banks and financial sector authorities now have either an explicit or a strong implicit mandate to promote financial inclusion. This is a significant development and quite different from where the policy world was five years ago. As a result, most regulators are very sensitive to the risk that heavy-handed rules could harm innovation. Let’s explore three areas where the trade-offs between protection and innovation policy goals need to be analyzed carefully:

1) Practices and conduct: This is where issues such as sales practices, collections, or qualifications of staff are addressed by either principles (e.g., prohibition of “aggressive” sales, “abusive” or “coercive” collections or requirement for “well-trained” staff) or rules (e.g., prohibition of home-based sales, specified procedures for auctioning of seized collateral, specific training standards). Other examples include provisions concerning customer data handling or accuracy of data reported to credit bureaux. The devil is in the details, of course. There is always the risk that regulatory measures taken to address unacceptable conduct that has been observed in the market can unintentionally make it impossible for legitimate providers to innovate or even operate. The cumbersome debt collections procedures put in place in Andhra Pradesh probably fall in that category. More narrowly-tailored rules might have been sufficient to rein in bad practices while not undermining the viability of collecting delinquent loans altogether. The evolution of rules around business correspondents (BCs) offers another example from India. Initial caution about who could be a BC probably stemmed in large part from consumer protection concerns, particularly since the authorities’ ability to oversee the BCs’ practices was — by definition — limited. When the rules proved to have created unreasonable barriers to innovation – and to customer value from more convenient payment options – the rules were revised to be more inclusion-friendly.

2) Product features: From our analysis, it is actually not all that common for specific products or product features to be prohibited outright. Many regulators would prefer to avoid direct product regulation if lighter-touch measures such as transparency rules can be tried first. However, setting boundaries around acceptable product features can be justified in some cases. For example, certain categories of the loans at the heart of the US sub-prime crisis had features that made them “predatory” and punitive. Excessive pre-payment penalties or dormancy fees can be both unfair and pose switching barriers for consumers, leading a number of authorities to regulate them. In some jurisdictions contract law defines categories of “unconscionable” or “unreasonable” contract provisions that a court might find to be inherently unfair. Even very prescriptive disclosure rules or grievance procedures might prove insufficient. Yet care is needed, since product regulation can pose obvious barriers for innovation and inclusion.

3) Price regulation: Caps on interest rates, fees and commissions, insurance premiums, or margins are really a special case of product regulation. They are often justified on consumer protection grounds. But they tend to be a blunt instrument that can create unintended negative consequences and make legitimate products or business models unviable. One can understand the frustration of regulators, policy makers and politicians when increased competition in financial markets seems to result in little or no price reduction. Before turning to price caps, however, other tools such as well-designed disclosure and targeted consumer education should be tried. And when price caps are set unrealistically low, we observe in various countries how they tend to either drive legitimate providers to deception (e.g., a proliferation of fees in response to an interest rate cap) or make it difficult for providers serving higher-cost segments such as remote rural customers to operate.

So, particular care is needed in balancing protection and innovation in these areas.

There are two alternatives to product regulation that are employed in some regimes. The first is one that has been tried in India with somewhat mixed results: “basic” or “plain vanilla” products. Some governments have either mandated or encouraged the offer of these simple, transparent and safe products. I suspect part of their motivation might be that they can then justify leaving space for innovation, since more vulnerable consumers have an acceptable alternative to potentially complex, harmful, or poor value-for-money products that might result from that innovation. The challenge, of course, is to create adequate incentives for providers to enhance their bottom line and brands with these products, since otherwise they simply will not market them. But this might be a better option than the outright requirements and prohibitions of product regulation.

We observe the second alternative in countries including Peru, Mexico, and Malaysia, where providers need to get approval or at least notify the regulator about new product features and new products they intend to offer. This offers a way for the regulator to keep a hand on the faucet, so to speak, to shape innovations in the market without having to prescribe practices and product features. This alternative offers some middle ground between mandating safe products and leaving it to consumers to protect themselves in the face of providers with significant advantages in information and power.

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