By Vishnu Prasad, IFMR Finance Foundation

This post is a continuation of our blog series on the FSLRC report.

The FSLRC report identifies three problems that occur when regulators pursue the objectives of financial inclusion and market development like subsidizing credit for agriculture or increasing the flow of credit into certain states, for example:

1. When a bank is forced by regulation to provide more loans to open a branch in a non-profitable location, this imposes a hidden cost or tax on other branches, depositors and shareholders.
2. There could be dilution of accountability of the regulator due to conflicting objectives. For example, the number of households that participate in a certain financial product maybe increased quickly by reducing the burden of consumer protection. Similarly, the function of redistribution to exporters, by requiring banks to give loans to exporters, is in direct conflict with the function of protecting consumers who deposit money with banks.
3. The report takes the view that imposing costs on certain consumers for providing gains to others is a form of taxation. Such a selective taxation of certain consumers is inherently inefficient.

Due to the problems cited above, there is a need to clearly define the scope of objectives, powers and accountability of regulators. The report’s recommendations throw much clarity on three aspects-what the objectives of the regulators should be, how these objectives should be implemented and what the principles guiding policy-making should be. These are discussed below.

The FSLRC identifies three regulatory objectives of financial inclusion and market development:

1. Modernisation of market infrastructure or market process, especially those that relate to adoption of new technology.
2. Deepening consumer participation by undertaking measures that provide for the differentiation of financial products/services to specified categories of consumers, or that enlarge consumer participation in financial markets generally.
3. Aligning market infrastructure or market process with international best practices.

The report recommends the following institutional architecture for implementing the objectives identified above:

1. The Central Government should direct specific regulators on matters of financial inclusion. For example, regulators may be asked to ensure effective and affordable access to any specific financial service for a class of consumers. The Central Government is expected to reimburse the cost incurred by financial service providers in granting such in the form of cash or cash benefits and tax benefits.
2. Regulators should pursue a developmental strategy that seeks to achieve the objectives outlined. However, the goal of market development should be subordinate to the goals of consumer protection and micro-prudential regulation and should be pursued only when there is evidence of market failures that hinder it. The report recommends that the rule making process should involve features like cost-benefit analysis and notice-and-comment periods. There should also be ex-post evaluation of these initiatives, assessing their costs and benefits.
3. In initiatives that involve multiple regulators, the FSDC (Financial Stability and Development Council) will play the dual role of a think-tank (measuring the progress of initiatives, analysing past initiatives, recommending new ideas etc.) and be the agency that coordinates between regulators.

The report recommends that the regulators and the central government keep the following balancing principles in mind while formulating policies:

1. Minimize any potential adverse impact on the ability of the financial system to achieve an efficient allocation of resources.
2. Minimize any potential adverse impact on the ability of a consumer to take responsibility for transactional decisions.
3. Minimize detriment to objectives of consumer protection, micro prudential regulation, and systemic risk regulation.
4. Ensure that any obligation imposed on a financial service provider is commensurate and consistent with the benefits expected to result from the imposition of obligations under such measures.

Overall, the framework proposed by FSLRC focuses on regulatory functions that address market failures obstructing the efficient functioning of the financial system. The Commission is of the view that financial inclusion and market development are functions that aren’t strictly regulatory in nature. Financial regulators performing these functions could lead to distortions in the market (hidden costs, inefficient taxation and dilution of accountability). Such functions should therefore be pursued in case of market failures that hamper equitable distribution of financial services and market development.

By Deepti George, IFMR Finance Foundation

This post is a continuation of our blog series on FSLRC report.

Keeping in mind the existing state of consumer protection measures in place for India, FSLRC has proposed a consumer protection framework for financial services, with the stated objectives being – to protect and further the interests of consumers of financial products and services; and to promote public awareness in financial matters. It is pertinent to mention here that the Commission has included, in its definition of retail consumer, not just individuals but also enterprises that avail a financial product or service whose value does not exceed a limit as prescribed by the regulator¹, or who has less than a specified level of net asset value or turnover, also as prescribed by the regulator . The previous post mentioned the rights and protections that the draft Code sets out. Among these rights are the right against unfair contract terms and the right to redress of complaints.

The right against unfair contract terms

The Draft Code deems an unfair term of a non-negotiated contract² to be void. A term is unfair if it causes a significant imbalance in the rights and obligations of the parties, to the detriment of the consumer, and is not reasonably necessary to protect the legitimate interests of the provider³. Further, the Draft Code enlists a set of factors that would be considered in determining whether a term is unfair or not – such as the nature of the service, the extent of transparency of the term, the extent to which the term allows comparison with other financial products or services, and the dependency of the term with the remaining contract and with other contracts under question. If a term was found to be unfair, the contract will continue to be enforced with the remaining terms as long as it can do so without the unfair term.

This is very much in line with the laws laid out in Australia, in as late as 2010, through the Competition and Consumer Act 2010. While Australia already had laws in place to protect consumers against unfairness in contractual dealings (ex: prohibition of unconscionable or misleading and deceptive conduct), this Act introduced a new ‘unfair contract terms’ regime to standard form consumer contracts⁴ under which courts can decide if a term in the contract is found to be unfair⁵, in which case the contract is void. However, the contract will continue to bind parties if it is capable of operating without the unfair term. Examples of unfair terms are set out in an indicative list in the law⁶.

The right to redress of complaints

The Commission addresses this right in two steps – the first, is by placing a requirement on providers to have in place an effective mechanism to redress complaints internally, to inform consumers about their right to redress, and the process to be followed for it; and the second, is by having a statutory body external to the provider, that will be a unified grievance redressal system to redress complaints. This body termed the Financial Redress Agency (FRA), will replace sector-specific Ombudsmans currently in existence such as those for banking and insurance. Whether or not the FRA will replace the Consumer Courts (instituted by the Consumer Protection Act, 1986), will be decided later based on how well the FRA succeeds in its task.

FSLRC has also created a niche for consumer advocates to contribute to the regulator’s functions, through the creation of an Advisory Council on Consumer Protection. This body, with adequate representation from experts in the fields of personal finance and consumer rights, is expected to advice, comment on, and review the effectiveness of regulator’s policies. The regulator in turn is held accountable to respond to such proposals made by the Council, thereby bringing in an element of transparency to the regulatory decision-making process.
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1. This is not uncommon. In Australia, for instance, retail consumer includes small businesses, which are defined by s761G of Corporations Act 2001, as a business employing fewer than 100 people (if the business manufactures goods or includes manufacture of goods), or 20 people (otherwise)
2. A non-negotiated contract is one in which the provider has a substantially greater bargaining power relative to the customer in determining the terms of the contract; and it is a standard form contract
3. This however does not include a term that is reasonably needed to protect the legitimate interests of the provider, is a basic term such as the price of a product, or is a term required under any law or regulations
4. All contracts will be presumed to be standard form contracts unless otherwise established. It is typically one that has been prepared by one party to the contract (the supplier) and is not subject to negotiation between the parties
5. A contract term is considered unfair if:
   • - It would cause a significant imbalance in the parties’ rights and obligations arising under the contract, and
   • - It is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, and
   • - It would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.
6. s25, CCA 2010. Some are given below: A term permitting one party (but not another party)
   • - to avoid or limit contractual performance or to terminate the contract
   • - to renew or not to renew the terms of the contract
   • - to unilaterally determine whether to determine whether the contract has been breached
   • - a term limiting one party’s vicarious liability for its agents

As part of our blog series on the FSLRC report, we will be conducting a series of interviews with key experts to get their perspective on the report and its implications. Below we are posting an email interview that we did with Justice (Retd.) B. N. Srikrishna, Chairman of the Financial Sector Legislative Reforms Commission (FSLRC). Justice Srikrishna is a former Judge of the Supreme Court of India (2002-2006), Chief Justice of the Kerala High Court and Judge of the Bombay High Court. Previously he has been Chairman, Sixth Pay Commission of the Government of India and Chairman, Committee for Separate Telangana before taking over as Chairman, FSLRC.

Q.The future of financial market regulation in India will be determined by two needs – the need for greater financial innovation and the need to protect consumers from the hazards of excessive financialisation of markets. How has the Commission thought of this while recommending an overall regulatory architecture for India? How will the recommended structure foster greater innovation while protecting the rights of the consumer?

The Commission was of the view that all financial laws and regulators are intended to protect the interest of consumers and that should be the primary focal point of our thinking. Hence, a dedicated forum for relief to consumers and detailed provisions for protection of unwary customers against mis-selling, overselling, underselling, wrong advice, defrauding by smaller print etc has been recommended. There is a marked shift from the traditional thinking of buyer beware, as consumers in our country, even if otherwise educated, are not financially savvy. The overall regulatory architecture is designed around this philosophy. Both regulators have to make regulations to carry forward and implement this philosophy at the ground level. Apart from this, each regulator must be clear and upfront with why it is regulating, what it intends to achieve, get inputs from the regulated entities and the public at large, and put out a statement of costs and benefits analysis in the public domain. The attitude of all is well and status quo, and resistance to all innovation by overkill of excessive caution has also been attempted to be met.

Q.What changes do you expect the recommendations bring to the mission of deepening financial inclusion in the country? What measures have been suggested to ensure that there is a more equitable development of financial markets and enhanced participation of marginalized groups in the country?

The burden of financial inclusion cannot always be thrown on the regulated entities. If financial inclusion means development of the regulated entities to expand the scope of their activities so as to benefit larger numbers, that is legitimate scope of the regulator and can be done by the regulators. If financial inclusion is intended to achieve a social purpose that is not the legitimate scope of the regulator, then it becomes a part of the government’s policy and the government is obligated to compensate the regulated entities which have to carry the additional cost of such financial inclusion. If the government requires the regulators to regulate to this end, then it has to bear the additional cost. That way, there is financial inclusion, but that cost is not solely thrown upon the regulated entities. That comes out clearly in the recommendations made.

Q.FSLRC’s approach to consumer protection represents a paradigm shift from the approach traditionally followed in India (caveat emptor). What is the rationale behind this shift in approach and placing consumer protection at the heart of regulation?

The rationale is that the consumer in India is still unaware of his own rights, either because he is ignorant, illiterate and uneducated. Even if literate and educated, he is trammelled by the traditional caveat emptor approach. To some extent, there is consumer awareness in the general sectors and the consumer fora are alleviating the situation. But, financial products are much more complex as compared to other consumer goods and therefore it was felt that a consumer forum dedicated to deal with problems and grievances of consumers of financial product was necessary at the trial and appellate stage. That certainly marks a new step forward.

Q.What transitional issues do you foresee if the recommendations of the Commission are accepted? What safeguards need to be kept in place to ensure that the smooth functioning of the market is not disrupted during this period?

Transitional issues are many. First, the status quo mindset has to change. Second, the notion that there is no need to fix the system as it is not broken, has to be abandoned because what is envisaged by the Commission is not routine repair work, but creation of an ethos necessary to be the frontrunners in the world economy at some time in the not too far future. Third, the existing regulators will oppose the recommendations as they are bound to see them as affecting their turfs. Fourth, setting up of the UFA (Unified Financial Agency) with requisite qualified personnel will pose a formidable challenge. Finally, recruiting suitable persons with requisite knowledge to man the consumer fora and the FSAT (Financial Sector Appellate Tribunal) will also be a difficult task. All these are no doubt challenges, but can be overcome with determination and persistence. Else, we as a country must give up ambition to be the leaders in world economy some day and continue with our all is well attitude. As a high functionary in the finance ministry told me in Australia, “It is better to make changes in peacetime and not when war has broken out”.

Q.The Indian Financial Code written by the Commission itself represents a shift in the way drafting of laws have been done in the country- it is written in simple English and is immensely readable. What factors motivated the Commission to break away from the traditional over-use of legalese and how difficult was it to ensure that a high quality of drafting?

We adopted our existing legislative language from the British and continue to use it even now, although they have abandoned it. Reading their latest Financial Acts there we were struck by the fact that it is written in simple English. While they have advanced in this regard, we continue to use unnecessarily complicated language and make life difficult for everybody. We modelled the language on the present British law.

Q.The Commission has proposed a Unified Financial Code for India – What ramifications does it have for the other financial sector laws in India-will they become null and void or will they need to be suitably amended? Can you throw more light on the law-making process that will ensue if the recommendations are accepted?

The Commission has recommended some amendments to existing laws, some wholesale repeals and some new legislations. These changes will have to be carefully brought about accordingly. The remit of the Commission was to suggest a Financial Architecture that can withstand the pace of development that is envisioned. It is envisaged that by 2050s our economy will grow into 35 trillion USD economy. The big issue is, can our creaking financial apparatus keep pace with it? In the view of most of the experts who interacted with the Commission, the answer was in the negative, hence, the bold and – perhaps to unaccustomed thinking – brash attempt to design a new financial architecture taking the wisdom from several experts in this country and abroad.

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:

1. Financial service providers must act with professional diligence;
2. Protection against unfair contract terms;
3. Protection against unfair conduct;
4. Protection of personal information;
5. Requirement of fair disclosure;
6. Redress of complaints by financial service providers.

Retail consumers have three additional protections:

1. The right to receive suitable advice;
2. Protection from conflicts of interest of advisors;
3. 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

By Anand Sahasranaman, IFMR Finance Foundation

Financial Sector Legislative Reforms Commission (FSLRC) was set up by the Indian Government in 2011 with a mandate to help rewrite and harmonize financial sector legislation, rules and regulations. On March 22nd 2013 it released its final report and the draft law.

The Financial Sector Legislative Reforms Commission (FSLRC) has submitted its final report to the Ministry of Finance with its recommendations on the legal and institutional framework for the future of India’s financial system.

It is widely recognised that there is a need for a framework of financial laws and regulation in order to address market failures and protect consumers. Market failures can be due to many reasons, some of the important ones being:

1. Information asymmetry: Because of the expertise that is required for the development of most financial products and strategies, the seller of a financial product is always at an “informational” advantage over the buyer (who generally lacks expertise). This information asymmetry has the potential to adversely incentivise the seller to mis-sell the product, which could lead to poor financial outcomes for the buyer.
2. Nature of financial decisions and outcomes: Many important financial decisions such as investing in a mortgage or saving for retirement are undertaken very infrequently in the course of a lifetime. The outcome of many financial investments and strategies becomes obvious only in the long term, and not immediately upon product purchase.
3. High Search Costs and Price Dispersion: Despite the fact that financial service providers provide almost identical products, there can be substantial price differences between them. These price variations across sellers of similar financial products can be attributable to high search costs that consumers have to incur to meaningfully compare products and as a result, lead them to pay higher prices than they should.
4. Behavioural Characteristics of Consumers: Consumers are beset with a number of cognitive limitations and biases which influence their decision making and make them act in ways contrary to the traditional model of hyper-rationality.

The fact that the Commission started off by taking a first principles view of the financial sector and the need for regulation, has meant that the their approach has been guided by the objective of developing appropriate legal and institutional frameworks to address different types of market failure. Considering the fact that financial sector laws in India have developed piece-meal over time, this is a welcome move. As a result, the sectoral focus that characterises India’s financial sector today is absent in the FSLRC’s approach, which has enabled it to harmonise laws on issues such as consumer protection and micro-prudential regulation.

The other important aspect of FSLRC’s approach, one that is closely tied to the non-sectoral approach, is the creation of princples based law. The incremental changes of financial sector laws in India so far has meant that there are no clear over-arching principles underlying the law and therefore, a lack of coherence. On taking the principles based approach, the report states the following:

“The advantage of this arrangement is that specific details of technology and market process are not embedded in the law. Over the years, changes in technology and institutions would lead to modifications in regulations. Timeless principles would be re-interpreted in the future by courts and the tribunal, which would create case law. The Commission believes that the draft Code will, with no more than minor modifications, represent the essence of financial law for many decades to come. In this respect, the work of the Commission has taken Indian financial law closer to its roots in the common law tradition.”

It is vitally important that the Commission has recognised the importance of the need to allow space for the financial markets to evolve and respond to changes. Considering the need to both broaden and deepen access to finance in India, it is critical that financial service providers have the incentives to innovate – in technology, product design and development, as well as channels of delivery. It is only in an environment that creates the space for financial service providers to constantly innovate can we meaningfully hope to address the challenge of financial inclusion. The need for innovation becomes all the more apparent when we consider some of the national socio-economic trends that India confronts, and that the financial system must respond to: retirement planning, healthcare financing, urbanisation and public infrastructure financing.

Overall, the Commission identifies nine components of focus for financial law: consumer protection, micro-prudential regulation, resolution, capital controls, systemic risk, development and redistribution, monetary policy, public debt management and contracts trading & market abuse.

In subsequent posts, we discuss some of these components in greater detail.