By Anand Sahasranaman, IFMR Finance Foundation
This post is a continuation of our blog series on the recently released FSLRC Report.
Why does consumer protection assume so much more significance in financial services, more so than perhaps for other services? Financial services don’t have fixed characteristics. They can have almost infinite variations and in a sense, can be synthesised on the spot by the provider varying one or more features. They are also constantly interacting with the context of the user. Given the complexity in designing products to suit diverse consumer situations, there exists a gap in information and understanding between the providers and the consumers; a gap that has been widening over time and is only expected to widen further. The nature of financial services therefore points to consumer protection as the central objective that should drive financial sector regulation. India’s consumer protection regime has been built on the doctrine of caveat emptor or ‘buyer beware’, which holds that, since the buyer has been given all information relating to a product, the buyer is to be responsible for all risks associated with the product after its purchase. The FSLRC rightly recognises that there needs to be a shift in the approach to consumer protection and that a higher standard is required.
The ‘buyer beware’ doctrine has translated into several pages of legal and technical documentation which a customer signs on, and which the representative of the seller is usually unclear about. The real risk here is the chance that the product sold is unsuitable and therefore will result in bad customer outcomes. This is further exacerbated by industry-level sales-incentives such as commissions and soft-benefits given to agents to push product uptake. The ULIP controversy involved the commission driven mis-sale of equity-linked investment product to customers seeking an insurance cover. Entry loads in mutual funds is another example of mis-sale where agents get unsuspecting customers to churn their portfolios in order to cash in on the entry-loads each time the customer bought into a new mutual fund. Since agent incentives do not reward maintenance of customers, this has inevitably led to lapsed insurance policies, clearly making a massive portion of the customer base worse-off with the policy.
In this context, it is heartening that the FSLRC “marks a break with the tradition of caveat emptor, and moves towards a position where a significant burden of consumer protection is placed upon financial firms.” The draft code establishes basic rights for financial consumers:
- Financial service providers must act with professional diligence;
- Protection against unfair contract terms;
- Protection against unfair conduct;
- Protection of personal information;
- Requirement of fair disclosure;
- Redress of complaints by financial service providers.
Retail consumers have three additional protections:
- The right to receive suitable advice;
- Protection from conflicts of interest of advisors;
- Access to the redress agency for redress of grievances.
It is especially significant that the Commission has decided that retail consumers have the right to receive suitable advice in relation to the purchase of a financial product or service, and that the provider must collect all relevant information on the needs and situation of the consumer in making its recommendation. It could be argued that this decisively shifts the onus of consumer protection from the consumer to the financial services provider.
Since providers have greater expertise on financial products and can get the household-level information they need to make an informed judgment on the suitability of a product for a particular consumer, it is only appropriate that the onus of consumer protection be placed on the provider. Enshrining this right in the law will mean that financial service providers will be legally required to act in the best interest of consumers and that consumers will have legal recourse in case they have been sold unsuitable products or given unsuitable advice. While the penalties for errant financial service providers are not clear yet, enacting legal liability on providers to ensure suitability is possibly the single most powerful step to align the incentives of providers with those of consumers.
It is useful to take a moment to consider how a “Suitability” based consumer protection framework could actually work. “Suitability” should be seen as a process that covers all aspects of consumer interactions, right from the time of enrolment, data collection and analysis, through to the communication of product recommendation or advice, and follow-up with consumers on recommendations made. The financial services provider needs to ensure through the implementation of the “Suitability” process that the design and sale of services meets the needs of the consumer. The provider should be held legally liable on the implementation of this process of “suitability”, and not the intentions of the provider or consumer outcomes (which are difficult to objectively measure).
Such a provider-led regime might seem alien to many but it is the standard being followed in corporate banking and investment products in most countries. While insurance and credit providers are not being held to this standard, it is only a matter of time before this anomaly gets corrected.
The principles-based approach of law-making suggested by the FSLRC also indicates that while the right to suitable contract is enshrined in law, it is possible to meaningfully interpret “Suitability” only through the development of case law over time, reflecting the evolution of ground-level realities of consumer protection in the Indian context.
The application of ex-ante firm-level “Suitability” processes combined with the creation of a credible ex-post redressal mechanism such as the proposed Financial Redressal Agency (FRA) together can create a robust framework to meaningfully protect the interests of financial consumers.
Read our previous posts on Suitability: A Paradigm for Suitability