To restore small investor faith in financial savings, policymakers have trained their guns on Ponzi schemes. But retail investors often lose money in regulated financial products as well, due to mis-selling, over-blown product claims and inherently flawed products peddled by financial firms. This is why the report of the Sumit Bose committee on mis-selling and streamlining of incentives for market-linked products, submitted last week, deserves careful consideration. With an unerring focus on consumer interests, the report has gone into the nitty-gritties of products such as mutual funds and insurance to make very specific recommendations on how their incentive and product structures can be reworked. This was the missing piece in the draft Indian Financial Code as well as recent consumer protection guidelines from the RBI and IRDA, which merely laid down ‘best practices’ for market players.
This report identifies three main problem areas in investor protection and goes on to recommend fixes for them. One, that front-loaded commissions are at the root of the problem of mis-selling. It finds that first-year commissions, as high as 35 per cent on traditional insurance plans and 7-8 per cent on new fund offers, have led to agents hard-selling them over low-cost NPS or exchange traded funds. Therefore, it suggests that upfront commissions be banned, with all financial products moving to a full trail model, where distributor fees are pegged to returns. This is indeed the best way to seamlessly align the interests of distributors with those of investors and financial firms. Two, incomplete disclosures and confusing jargon play a key role in misleading investors. The report frowns upon practices such as insurers using the term ‘bonus’ to describe plain-vanilla returns and new fund offers being marketed as ‘at par’. It recommends moving all market-linked products to a uniform cap on costs and allowing investors an easy exit if they are disappointed with performance. Three, noting the yawning regulatory arbitrage between assets, the committee recommends either that all financial market regulators be merged (as suggested by the Indian Financial Code) or, somewhat over-optimistically, that they willingly cede turf to each other.
Overall, while the report offers unambiguous solutions to plug the regulatory gaps in market-linked products, implementing them will cause quite a shake up in financial markets. The blanket ban on upfront commissions, as the ban on mutual fund entry loads has shown, cannot be achieved without sizeable upheavals in the agent force. Cracking down on the sky-high commissions on traditional insurance plans is bound to dent the profitability of insurers and force them to completely rework their business model. Similarly, transitioning all financial products to uniform cost and incentive structures will require hundreds of products to be withdrawn and reworked, with grandfathering clauses for older investors. But if policymakers want investors to shed their mistrust of market-linked products, they may have to bite the bullet on at least some of these prescriptions.