Independent Research and Policy Advocacy

The Suitability Approach to Client Protection: Comments on the Mor Committee Report

Save Post

The Mor Committee Report offers a radical take on client protection, built around the concept of a legal right to suitability. After describing the recommendations briefly, I would like to tell IFMR’s readership why I’m excited about the approach (two big cheers), provide some thoughts on how to make it work (and how the Smart Campaign could assist), and raise a couple of questions.

Suitability is about ensuring that clients are sold financial services that are appropriate for their circumstances. A suitable product is one the client can be expected to manage with a low probability of serious hardship and a reasonable prospect that it will provide value. The concept has been present for some time in financial consumer protection regulation, most notably in the UK and Australia. The Mor Report proposes a unique approach to implementing suitability, which places responsibility on the service provider to install processes to ensure that clients are sold suitable products, e.g., client targeting and underwriting procedures that adequately assess repayment capacity. Regulation would hold the board of directors responsible for approving and overseeing the implementation of these processes, subject to external review. Hand in hand with this, the report recommends an energetic grievance redress system (which I will not address here), including both internal and external mechanisms to cope with individual problems.

The first big cheer goes to the decision to focus on suitability as the heart of client protection. This directs attention exactly where the greatest potential for harm occurs. Overindebtedness, is perhaps the greatest failure of suitability, resulting from selling loans that exceed a client’s debt threshold. This is why the Smart Campaign places Appropriate Product Design and Delivery and Prevention of Overindebtedness as Client Protection Principles #1 and #2, even ahead of Transparency. Among all the standard client protection problems, only overselling of credit has repeatedly caused sector-wide crisis and collapse, and thus if there is to be a focal point, this is the right one. (The report discusses the relative merits of suitability vs. disclosure as the core of consumer protection policy, which raises both practical and philosophical issues – an engaging topic for another day’s post.)

The second big cheer goes to the decision to place responsibility on providers in an intelligent way that appears to have good prospects for success. Regulators, no matter how empowered, have an uphill battle to identify and contain financial abuse. It is in the interests of the regulator to enlist providers on the side of good client protection practices to the greatest extent possible. This idea is, in fact, one of the tenets of the Smart Campaign, which seeks to embed good practices inside microfinance institutions. The Mor Report recommendations would require processes inside every financial institution that, if well executed, would provide suitability. The potential benefits of this are, first, that it enlists the staff of all provider institutions into the client protection effort (multiplying the reach of regulators), second, it distributes action on client protection into the capillaries of the financial system, as close as possible to client-provider interactions, and third, it allows providers to innovate products and processes rather than focusing on compliance with regulator-determined ones.

Enlisting providers is, nevertheless, tricky. After all, consumer protection problems arise from the existence of incentives for providers to use poor practices, and those incentives can be strong. Self-policing alone is bound to be insufficient. The Smart Campaign regularly sees institutions give themselves greatly inflated grades on client protection in self-assessments. Thus, skeptics would rightly question whether a mandate for responsible processes would have teeth in the face of counter-incentives. The Mor Report’s solution stands or falls on the superstructure that oversees the fulfillment of the responsibility placed on providers.

The first bit of the superstructure would be a requirement for the board of each institution to approve and annually review these processes, which in turn makes them a matter for scrutiny by external auditors. Thus the apparatus of governance and audit that every financial institution must have would be pulled into the task of protecting clients through a special customer audit.

But the concerned skeptic would still have questions. For instance, how would boards and auditors determine whether the processes are adequate and are adequately implemented? The report refers to case law based on legal liability to set precedents over time. This seems a slow and tortured process, not sufficient to result in the rapid spread of good practices. The experience of the Smart Campaign is relevant here. A body of good practice standards can be developed, such as the detailed standards of performance that the Smart Campaign uses in its assessments and certifications of microfinance institutions. And these standards must be well understood by providers, boards of directors and external auditors, which suggests the need for a massive effort to educate sector participants. Moreover, these standards are necessarily partly subjective, making the tasks quite different from the audit of financial statements. In 2013 the Smart Campaign introduced a program of third-party client protection certification, after a long process of preparation. The experience demonstrates the complexity of this challenge and underscores the need for accreditation of certifiers so that standards can be applied in a way that is rigorous yet fair.

And that raises another question about the Report’s recommendations: what is the role of Self-Regulatory Organizations (SROs) in this superstructure? A process of creating SROs in microfinance has been laid out by the RBI but not yet fully implemented. Yet the Mor Report makes no mention of SROs. Self-Regulatory Organizations could be significantly helpful as the custodians of standards and accreditation, and they can play an important role in oversight, bridging between the regulator and the provider.

Ultimately, incentives and accountability must be upheld by an entity representing the public interest, whose incentives align fully with client interests: the regulator must have oversight and responsibility for supervising this system. It is not fully spelled out how the Mor Report envisions this, though reference is made to overall market monitoring and use of techniques such as mystery shopping.

My final question harks back to the Client Protection Principles. While I agree that suitability is a suitable core principle, it does not encompass the whole of client protection, even if grievance redress is added. Four of the seven Client Protection Principles with which the microfinance industry works are partly but not adequately covered by suitability plus redress: transparency, responsible pricing, fair and respectful treatment of clients and privacy of client data. In my view, a sound client protection system would incorporate these important principles more explicitly.

Authors :

Tags :

Share via :

3 Responses

  1. Thanks for a very interesting post, Ms. Rhyne. It presents some very important aspects to be kept in mind for the implementation of Suitability. I would like to bring your attention to the assertion that overindebtedness is perhaps the greatest failure that can be rectified by Suitability measures. While Suitability would categorically take care of overindebtedness, it can be argued that it is in the interests of credit providers to prevent overindebtedness even without a Suitability requirement, as every provider has a natural incentive to minimise NPAs and maximise portfolio returns. Suitability is envisaged to cover the whole host of concerns around the mis-sale of (all) financial products that consequently compromise client welfare.

    Additionally, you express the fear that a reliance on the build-up of case laws to create sufficient deterrent could take a long time and will not be enough to achieve a rapid spread of good practices. This is perhaps desirable in a way because it is only though this build up of laws can we reach a meaningful, contextual understanding of Suitability. However, even just a handful of cases where customers seek redress and receive appropriate punitive damages (for breach of Suitability) could sufficiently trigger adoption of the Suitability process in its true spirit by financial services

    There does not always have to be an event of failure for Suitability to get adopted. The process would of course be checked as part of internal audits as well as be subject to periodic external scrutiny. The key, as you pointed out, is to have in place the effective redress mechanism to implement Suitability – the Internal mechanisms and the district-level FRA offices, as envisaged by the FSLRC fix this gap.

  2. Deepti —
    Thanks for your comment. I’m happy that we can have this online discussion to highlight these important issues. I think we see some things the same and some differently, and of course your views are informed by a deeper understanding of the Indian context, so I’m happy to hear more.
    My comments on your comments:
    1. Yes, one would think that self-interest is sufficient to prevent providers from over-indebting clients, but self-interest has repeatedly failed in catastrophic ways, and additional protections are needed.
    2. By my focus on overindebtedness, I’m not implying the it’s the only thing suitability deals with, just the most important. It is a much broader concept and a very interesting starting point for consumer protection policy.
    3. On case law as a mechanism to incentivize practice, I remain skeptical about the speed with which this can happen. The Mor Report has very ambitious timetables that are out of sync with the leisurly timetable implied by a reliance on building up a body of case law. What happens in the meantime? Moreover, the speed of financial innovation compared to the speed of court processes would seem to leave a big ongoing gap.
    4. The repoort places a great deal of weight on redress mechanisms. While these are important for correcting individual problems, they are not sufficient mechanisms for correction of bad policies and practices at the institution and industry level unless the redress bodies have additional powers beyond those normally associated with grievance redressal.

  3. My comments on the post .
    There are some concerns over the terms ‘ suitability’ ‘customer protection’ Grievances redressal’ ‘All 18 years” “Every person” particularly under the focus of ‘ Financial inclusion’ and financial deepening used in Mor’s committee.
    First, Who is the customer being taken into consideration for the said report ? Is the customer who is already included ? or is the prospective customer hither to excluded financially and likely targeted for financial inclusion? My hypothesis is that given whatever values of CPP including SMART , financial structure , sector specific grievances redressed system, extent of suitability factor in both demand and side , so far financial inclusion has been successful in terms of 49% of farmers households in India.(FI committee report of Dr C.Rangarajan 2008) which clearly suggests saturation point for the given inputs and the benchmark to focus on 51% of excluded cohort for further inclusion. In such case could we focus more on inclusion of these excluded community with fair treatment of a prospective customer towards financial deepening in the demand side. ? If these excluded cohort is fairy treated for future inclusion , then the coverage of ‘suitability factors’ need to be hovering around their socio economic profile as well their physical area profile for successful responsive financial deepening and sustainable working of financial inclusion even in the last mile. Now it is clear for the concern “for whose suitability? Once the clarity is made on benchmark and the client profile in the demand side forming the premise for future inclusion, then only ‘suitability’ factor could be prudently worked out for designing pro excluded products and services , CP, FRA, etc. Where as in Mor’s report focus on coverage of “All 18 years”, “ every resident” is not clear
    Second, regarding legal rights to suitability reinforcing CPP , following concern need to be addressed . Although the Aadhaar system, as a digital medium for inclusion, eliminates middlemen in the process of cash transfer of social benefits ( wages, pension, subsidy etc) a new breed of assistants if not middlemen is bound to emerge for the prospective customers from the excluded cohort at the bottom pyramid people after nascent inclusion. The demographic profile of these group by and large includes illiterate gender , elderly, , widows, destitute & deserted women , single mother , differently abled gender, blind, etc requiring such assistance for the transaction using the machine like ATM, MOBILE etc in interior villages . This system already is happening in rural areas, involves risk as the beneficiary has to necessarily reveal to their assistants their personal data including PIN /password for operating the machine in the transaction process leave alone other charges , cheating etc in the process. . In case the electronic system is claimed unsuitable or lacking ‘suitability’ by these the above cohort contextually in certain backward areas, can they have the right to claim reject digital mode and claim alternative suitability for access or inclusion?
    Third,, in the context of joining more number of actors in the supply chain ( banks, network service providers, mobile Co. BC, SHG etc., the customer protection with fair treatment or customers’ right to suitability ( as suggested in Mor’s report ) will be at stake Who is the principle stakeholder to ensure treating customer fairly? The nascent included need multiple products ( credit plus)integrated together appropriately and the means of access suitable to them
    Last concern is on how to challenge the sustainability of inclusion in the context of prevailing phenomenon of drop outs, occurrence of dormancy of a/cs , inoperative a/c, group mortality etc causing economic and social cost of financial inclusion and as a corollary, how to protect these customer from subsequent exclusion after inclusion through various means like FRA/consumer regulators ( FSLRC) and SMART . This vital inclusion concern is excluded in Mors’ report
    Dr Rengarajan

Leave a Reply

Your email address will not be published. Required fields are marked *

Related Posts :