Comments on the Report of the Committee to recommend measures for curbing mis-selling and rationalizing distribution incentives in financial products : 30-Sep-15
The Ministry of Finance (Government of India) has recently released a report on recommending measures to curb mis-selling and rationalizing distribution incentives in financial products in India. At the outset, I would like to extend my admiration on the way the report has highlighted and brought into laser focus the critical issues that trouble the distribution of financial products to the retail Indian investor. The report is detailed and backed up with relevant data. I strongly recommend this report to be read even by retail investors who have a modicum of financial literacy. While the report is 72 pages long, the retail investor will do well to read the executive summary that is just 5 pages long. I will try to focus on the main recommendations of the report.
1.Policy choices for India (p55): In page 56, the report shies away from a total ban on commissions giving a variety of reasons:
Reason 1: While recognizing that commissions influence distributors to not act in interest of customers, the report then says that commissions play an important role in incentivizing distributors to seek new customers and thus, expanding the market for financial products. To me this sounds self-contradictory. If distributors through mis-selling acquire new customers, how then have we moved forward? Have we not betrayed the trust of a new entrant into the financial system and possibly lost him forever when he realizes he has been mis-sold a financial product? Is it not, instead, two steps backwards?
Reason 2: The report weighs upon the comments from the insurance industry that an insurance agent’s role in educating customers, doing risk evaluation and primary underwriting, long-term servicing and claims assistance are enough to justify giving them commissions. I disagree. Yes the agents have to be paid. Let the insurance companies clearly state that for the customer to sign up, the insurance agent will have to be paid INR xx for his services. In other words, there will be two cheques from the customer - the first to the agent for his services, and the second to the insurance company towards the product. This way the customer clearly understands how much he is paying for the services he is getting from the agent.
Reason 3: The report says that the Financial Intermediaries Association of India emphasizes that distributors play a critical role in channelizing savings into mutual fund products, and a no-commission world will make it difficult for the distributors to function. Why I beg to understand, should the report concern itself with the livelihood of 50,000 odd distributors to the detriment of potentially 60 crore retail Indian customers?
Reason 4: The report recognizes that the Indian market suffers from a lack of a market for advice and that a body of financial advisers capable of advising on the entire portfolio of products is not available. Instead of dwelling upon the reasons for this lack of a market for advice, the report uses it as an excuse. How would one expect a market for advice to flourish when commissions are allowed? By tolerating commissions are we not killing the market for advice? Can we not explore how a deep and professional market for financial advice can be stimulated? Have we asked ourselves how a market of advice could evolve if commissions are totally banned?
I would like to refer to a line coming towards the end of the report in page 68 second paragraph – 'It is only when customers trust the market place that the financialization of the economy will be deep and wide'. I cannot agree more. Trust is the bedrock upon which any deep and meaningful financial system can be built. It starts from the simplest financial instrument – the rupee note which states, “I promise to pay the bearer the sum of …” to the most complex of financial instruments. Without trust it is difficult, if not impossible to contemplate the creation of a thriving and deep financial system, which brings into its fold the public at large. Why should a commission system be tolerated when even the report says that it leads to behavior that is not aligned with the customer? Commissions simply increase the trust deficit in our financial system and continue to hurt us more than help us. Let us bite the bullet and ban commissions totally. Let us also in parallel think deeply of how we can create a genuine and deep market for financial advice. This is a difficult transition no doubt – but whatever progress we make will be solid and genuine.
2.Form over function (p62): In page 62 under generic recommendations point 1, the report recommends that product regulation must be in terms of product function (insurance, investment and annuity) rather than form is very insightful. It gets to the heart of the problems that exist with all bundled products. The detailed recommendations that follow from this principle would significantly improve transparency and informed decision-making by the retail customer.
3.Regulatory and Tax arbitrage (p62): Again in page 62 under generic recommendations point 2, the report has articulated very incisively on the fragmentation in the industry on account of regulatory arbitrage. Further, the non-uniform tax incentives that exists across products create opportunities for product manufacturers to design products that in form (insurance) can claim tax benefits but in function (investment) serve another purpose. There is also a serious question that needs to be asked when a regulator such as SEBI undertakes upon itself to incentivize mutual funds to deepen markets beyond the top 15 cities by relaxing norms on expenses and commissions for business generated beyond the top 15 cities. Are these not creating perverse incentives for mis-selling in those very cities in which we wish to increase financial inclusion?
4.Move to an Advisory model (p62): In point 8 of page 62, the report says that since financial products are relatively complex, they are advised products and over the long term, the Indian markets should be guided by an advisory model where customers are advised holistically and are allowed to purchase products over the counter without any intermediation. It goes on to say that under this regime, product provider-led commissions will not be permissible, and advisors will function under a regime of higher fiduciary standards. I cannot agree with this more. The only term I disagree with in the above statement is the use of the words- “over the long term”. If we genuinely want to move to an advisory model, then lets jump in and not take half-hearted stabs. If we genuinely want a market for fee only advice to thrive, commissions have to go. Fee-only advisors will be held to high fiduciary standards and they will scour the market for the best products for their customers. This model aligns incentives and allows market forces to come into play, allowing the best products to thrive while booting out sub-standard products recommended with dubious motives.