Consumer Protection: Recent developments on the regulatory front in Developing Countries – Part 3

As part of the Consumer Protection series, below is the concluding part of the three-part interview with Kate McKee of CGAP.

Q: Where has the ‘consumer protection function’ predominantly been placed? In developing countries, have we reached a stage where this function has indeed been carved out as a separate function and/or under a separate regulator? Or does this continue to be under the prudential regulators, as is the case currently in India?

For developing countries, the number one priority is to get some basic consumer protection measures in place. At this point, the most pragmatic option appears to be to put this mandate in the prudential supervisor. At the “getting started” stage, there are strong advantages to leveraging the expertise, resources, reputation, and clout of the Central Bank or other such entity(ies). The pluses are even greater when the entity(ies) has broad scope and coverage, that is, the authority to set rules for a range of financial institutions beyond banks, such as MFIs and other lenders and sometimes financial co-operatives, insurers, or even capital markets players. (As noted, the alternative of charging general consumer protection or competition authorities with protecting financial consumers where this is only one small part of their mandate, has generally not been very successful.)

The end state we want is for a consumer that uses a product (such as a small, unsecured loan) to receive equal protection whether they borrow from a bank or any other provider. Ideally, market conduct rules should be organized by service rather than by provider. This might argue for creation of specialised market conduct regulators with authority over the whole financial market (the “twin peaks” model) or over all providers of a given service (such as the South Africa National Credit Regulator), whenever feasible. Separating oversight of prudential and market conduct matters also helps address potential conflicts of interest between the two domains. As a practical matter, however, such bodies are very rare in developed countries and virtually non-existent in developing countries. Creating one takes considerable political will, time, and resources. In most countries, the Central Bank or other sector regulators are the most pragmatic option for starting a financial consumer protection regime and building it over time.

So the next question is how to organize this function within the supervisory body, including whether it should be relatively more integrated with prudential oversight or independent from it. In fact, typically prudential supervisors are already monitoring some aspects of market conduct or enforcing some rules or guidance that protect consumers. When regulation creates additional market conduct rules or principles more incrementally, at some point the decision may be taken to make this a specialized function with a dedicated small team that might eventually grow into a unit with more resources and independence. A country that enacts laws creating a more comprehensive financial consumer protection framework might opt to create a specialised team, division or department at that point. Over time, more enforcement powers and tools might also be required. No matter the set-up, it is essential to create appropriate coordination and communication with the prudential function (and with the general consumer protection body, when such an authority exists); in cases like India where there are multiple sector regulators, coordination mechanisms are also highly advisable to ensure consistency and harmonization of rules and enforcement over time.

The problem of patchy coverage is vexing and particularly problematic from an equity and inclusion perspective, since poorer and more vulnerable consumers are the least likely to use those providers such as banks that operate under more market conduct oversight. In India and many other countries, if they use formal services at all, their service providers are more likely to be financial cooperatives, MFIs, or money lenders and other consumer lenders. This is a huge policy challenge in almost any market: how do you achieve enough coverage that low income consumers, for the products they use, really have some measure of protection that is comparable to that of better-off consumers. Creating a more level playing field is important for inclusion. This constitutes one of the strongest rationales for creating specialised market conduct supervisors.

Q: In the fragmented system, certain products that fall under the mandate of more than one regulator, actually slip through, as there is confusion on which regulator is responsible for its consumer protection.

The jurisdiction and coordination challenges can indeed be huge. As noted, while coordination is helpful it cannot always solve gaps in consumer protection coverage or effectiveness. One relatively common case is where the Central Bank of a country has oversight over banks and deposit-taking MFIs but not financial cooperatives. Even if the Central Bank and the entity that supervises cooperatives have the exact same rules for disclosure or grievance redressal, it is rather unlikely that the latter would have the resources and expertise to enforce them as well as the former. This is a dilemma that needs to be worked on over time.

Q: In terms of India, what has the general trend been, in terms of how much freedom do providers have to present new products, and what do you think India should be doing?

The current landscape of financial consumer protection in India is one that shares responsibility among multiple sectoral financial regulators, supplemented by some general consumer protection and institutions such as Ombuds (although only in certain sectors). The result is rather a patchwork. The work underway now to explore creation of a more comprehensive framework offers an important avenue for filling in gaps, expanding effective coverage, and ensuring more consistent protection of financial consumers. In the meantime, regulation needs to continue to evolve to permit continued innovation and advances in financial inclusion. Improving the effective implementation of existing rules and mechanisms in key areas such as disclosure, business conduct, and grievance redressal will benefit from consumer research and an ongoing process of consultation with industry, design and testing of more effective measures, and monitoring the market for new risks.

Your question as to whether the regulatory framework has given providers enough freedom to innovate is a difficult one. Obviously the financial regulation and supervision system in India is both very large and quite complex, with many actors. The market is developing at a rapid pace. It is not surprising that there are some rub spots, where rules might have been put in place that were too cautious or conservative and slowed the pace of responsible innovation. In such a large, diverse, and fast-paced market, it would not surprise me if there were not some areas where consumers are at risk and no one is paying enough attention. Getting the balance right is not easy. But Indian regulators have also demonstrated an ability and willingness to respond to these challenges, revisit their assessment of risks, and permit the rules to evolve over time. I am pretty confident that this will be the case as efforts are made to create a more robust but flexible and inclusion-friendly framework to protect financial consumers in India.


Consumer Protection: Recent developments on the regulatory front in Developing Countries – Part 2

Below is the second part of the three part interview with Kate McKee of CGAP. The interview is part of our Consumer Protection series.

Q: Are there any specific examples in the developing world where there seems to be a nudge towards a less prescriptive principles-based approach? For instance, recently IRDA, even in a rule based system, had put out very rudimentary rules for suitability, so the insurance agent should not provide insurance without taking into account the specific requirements of the customer and analyse requirements before suggesting an insurance product. So even though not purely principles-based, it does make a shift towards that. Are there any other examples like this in other countries?

That’s a good example. I think there are some consumer protection objectives – such as transparency on price and product features – that are better pursued through articulation of specific rules and others – such as appropriateness of product features – that are better candidates for the more flexible principle-based approach. Articulating principles such as the IRDA concept of “suitability” might be a particularly good way to go in newer markets or segments where the regulator wants to encourage innovation. The concept may initially be hard to define very precisely, and the regulator also has the opportunity to engage in a genuine dialogue with industry around what is permissible. Then if market players are found to be obviously abusing this flexibility, the authority then has the option of putting more bounds around acceptable product features and practices. Many consumer protection regimes will exhibit a combination of these two tendencies. I doubt there are many pure systems of either the principle- or rules-based variety.

Let’s look at two IRDA-type cases from South Africa, where financial and economic inclusion are also urgent national priorities. One comes from insurance and the other from credit. To protect consumers against mis-selling and ensure appropriateness of policies sold to the buyer’s circumstances, the rules generally required that qualified intermediaries advise the sale of policies. Market analysis showed that the extensive requirements on insurers to recruit, train and oversee these individuals were a significant (and unintentional) barrier for micro-insurance innovation. The distribution model that resulted was simply too expensive for the types of policies that were useful to lower-income consumers. A careful and extended consultative process led to redesign of the rules, permitting more flexible distribution for certain kinds of simple products that pose fewer risks for consumers. For example, an insurer could now team up with a retail chain; the customer would buy the “starter kit” off the retailer’s shelf and activate the policy through a call centre staffed by someone trained to answer questions and ensure a good understanding of the product.

The emerging concept of “responsible lending” offers another example of a principle-based approach. South Africa’s National Credit Act specifies that lenders have an affirmative responsibility to assess the borrower’s repayment ability with adequate care. Otherwise, they risk the rule being declared unenforceable. Although the law is quite prescriptive in some areas, in this area it is not terribly detailed and rests on this principle of lender responsibility. As the practice has evolved, lenders are generally considered compliant if they at least check the borrower’s credit bureau records and can show that they have (and follow) a defensible policy and procedures for assessing repayment capacity. But the regulation has no specific rules on exactly how lenders must do this mandatory affordability assessment, leaving flexibility for different underwriting models and innovation in practices. We see the principles vs. rules choice playing out in other markets as well. In Latin America, for example, some countries have responded to concerns about over-indebtedness by articulating this “responsible lending” concept and then monitoring the market to see if it is working, while others have chosen the more rules-based approach of regulating the debt-income ratio.

A contrasting case is disclosure, where I would argue that rules make more sense than principles. In this space, some countries rely more on principles (e.g., information should be provided to consumers on a timely basis, fairly stated, in a plain-language and comprehensible fashion, etc.) while others mandate the “what,” “how,” and “when” of the information to be disclosed and prescribe definitions and formats such as a standardised Key Facts document for a class of products. The regulator’s goal is that the consumer understands exactly what she or he is getting and is able to compare offers among providers. Principles are probably not very helpful, since this leaves it up to each provider to interpret what is important information, how to make it comprehensible, and when to share it with the consumer. Even if the temptation to be selective and deceptive were not so great, the ability to comparison-shop is likely to be extremely limited with this proliferation of approaches by different providers (and the experience on the ground in jurisdictions that rely on broad principles for transparency supports this conclusion).

Overall, I wonder if it is more useful to explore the following questions: Which consumer protection issues are best addressed by principle- vs. rules-based approaches? What is the experience in moving from principles to rules, in response to developments in the market? And how should regulator capacity and insights from consumer research inform these choices?

Q: In such experiments, what has been the role of supporting institutions such as industry organisations, the regional regulatory institutions, and other oversight bodies, in taking this forward?

Industry bodies and support organisations can play a really useful role. In many markets the boundary between regulation and “self-regulation” (broadly defined) is a shifting one. (I do not mean only self-regulation in the very formal sense of Self-Regulatory Organisations with sanctions for non-compliance and so on, but also in a more affirmative sense of industry seeking to articulate and follow codes of conduct and standards of behaviour.) A healthy back-and-forth between industry and regulator is particularly constructive and needed in new areas like interpreting the concepts of “suitability” or “responsible lending” or even in making disclosure or recourse rules actually work better.

For example, in the area of complaints handling and dispute resolution, I think there is quite a lot of scope for the regulator to set broad goals and then see what kind of specific service standards industry proposes. What would industry come up with to translate a principle such as “fair treatment” into practical measures to ensure that consumers know about their rights in this area, have access to convenient mechanisms, and can expect that their complaints will be logged, tracked, and handled objectively and within a reasonable period of time? This is at least a good starting point for dialogue between the regulator and the regulated. The regulator might come back and say “well, the mechanisms you propose will not really work for BOP consumers,” in which case the industry association might propose a toll-free number and processes to orally inform low-literacy consumers about their rights and so on. When the regulator plans to require that providers report their complaints data in a standardised way, industry and supporting institutions might have good suggestions about how to do this in the least burdensome and most meaningful way. On some consumer protection issues, there is much latitude for this type of dialogue. Because industry associations are one step removed from individual providers, they may be able to take a somewhat bigger-picture and longer-term perspective than their members.

Q. You gave examples of rule-based regulators actually going out and experimenting with concepts in a principles-based space. In doing so, have these regulators actually put down a very clear view-point about the transition from one form to another, or has it been rather an ad hoc process? For instance, Australia’s Wallis enquiry for moving towards principles-based approach was not triggered by a crisis. But it was something that was more driven by political will to take a step back and look at current system and what should the vision be for the financial system. It was a very deliberate approach. What has been the sense in developing countries?

I wonder if “incremental” is a better way to describe the process, especially in developing countries where if there are any consumer protection or market conduct regulations, they are likely to be few and fragmented. In these cases, it may be hard to say whether the system is principle– or rule- based and how it is evolving. Many jurisdictions then start by trying to fill in the highest-priority gaps in their rather sparse consumer protection landscape. Other countries have opted for a big push strategy, by creating a more comprehensive framework for market conduct regulation over and above prudential oversight. One example is Malawi, mentioned earlier. Another is Armenia, which enacted a rather thorough framework through three new laws (to regulate loans and deposits as well as create a financial mediator). Brazil is now creating a larger market conduct unit with stronger powers within its Central Bank. The dominant trend in developing countries is to get additional consumer protection regulation in place, sometimes comprehensively and other times piece by piece. This has often involved a very deliberate approach and a long-term vision, but not necessarily around the merits of a rules- vs. principles-based regime per se. The links between protection and other important policy goals such as inclusion are often prominent in the debates.

In some countries, the decision to strengthen financial consumer protection grew out of recognition that the general consumer protection law and authority (or sometimes the competition law and authority) was really inadequate for financial consumers. Many have concluded that general consumer protection bodies have more life-threatening matters to deal with such as tainted baby formula or unsafe buses, and that they rarely have the requisite expertise, clout, and investigative and enforcement tools to be effective in this specialized area. In these cases, the evolution is perhaps from “let us hope that a general consumer protection framework will protect financial consumers from harm”, to “let us give this mandate to our financial regulators.”

Q: Regulatory approaches to consumer protection need to draw the line between too much regulation (that lead to the death of certain types of institutions or products) and too much flexibility (leading to consumer interests being compromised). Are there any specific examples that come to mind in this regard?

At first I should say that I think these examples are rather rare, but it is also hard to observe because if something doesn’t happen in the market, you don’t see it so who knows what innovation could have achieved without rules. My sense is that it is rare to have too many and too prescriptive rules in developing countries. That is really not the dominant scenario.

Q: but in that case, India is an exception.

In certain respects it may be, although stepping back and looking at the entire financial consumer protection framework, there are many gaps and there is quite a bit of diversity in approach. One dominant feature of this landscape is the sheer number of entities with some role in financial consumer protection, due to the multiple sector regulators and Ombuds, as well as the authority that states have or assert in certain areas. That said, access to well-designed financial services has been shown to be protective for the poor in and of itself, and the regulatory balance of protection and innovation measures has not always been optimal.

One area that has clearly been problematic is regulation of prices or margins, although it should be noted that even before the AP crisis, India had relatively low prices for products such as micro-loans in comparison with other countries. Many other jurisdictions also struggle with this politically-sensitive issue. Clearly we need to be able to make a stronger case for the combination of “smart disclosure” and consumer education to bring prices down. At the moment this is difficult, since hard evidence that disclosure can work, including for more vulnerable consumers, is scarce and current models of financial education struggle to prove their effectiveness and scalability.

In the case of the new micro-credit regulations, one wonders whether there might be scope for greater flexibility over time, including relaxation of certain rules in the face of evidence that by restricting prices and business practices so much they are actually harming the poor by reducing their access to a service they value. The evolution of the BC regulation and the experiments such as the IRDA one you mentioned might be signs of a pragmatic rebalancing of measures aimed at protection and innovation.


Consumer Protection: Recent developments on the regulatory front in Developing Countries – Part 1

As part of our series on consumer protection, we seek to present views of leading experts in the field. Here, in this three-part series, Deepti George of IFMR Finance Foundation interviews Kate McKee of CGAP. Kate McKee leads CGAP’s research, writing, and policy advisory work on consumer protection and market conduct regulation. She shares with Deepti valuable insights and perspectives on recent regulatory developments within consumer protection for financial services in developing countries.

Q: While Indian regulation has predominantly been guided by caveat emptor (“buyer beware”), Australia has put in place provider liability and suitability regimes for almost all financial services. Given the stark contrast between the two regimes, what have been the broad regulatory trends in the developing world?

Financial consumer protection regulation and supervision is on the rise in developing countries (although admittedly from a very low base). Within that overall trend, in most countries regulators are beginning with the kinds of measures that would enable consumers to protect themselves: disclosure rules plus some kind of complaints mechanism. Most financial authorities see these as the building blocks on which to build consumer protection. And in developing countries and emerging markets, they seem to be relying on rules-based approaches more than principle-based ones.

I suspect that policy makers across the world may have looked at the results of the global financial crisis and concluded that principles-based regimes didn’t really measure up in preventing harm to consumers, financial markets, or the global economy. The consumer protection regime of the UK, for example, was probably the most developed regime at the principles-based end of the spectrum. It is very appealing philosophically. Yet it is hard not to conclude that many providers took advantage of that flexibility; supervisors seemed to face an uphill battle in responding quickly, decisively, and consistently enough to ensure acceptable market practices (In fairness, however, some regimes such as the US that were more rules-based did not perform very well either.)

The main concern that policy makers in developing countries seem to have about principle-based regimes is the discretion or “wiggle room” they give to market actors, some of whom will use this discretion to be deceptive or pursue practices that are perhaps quite profitable but unfair. Many also perceive — and I think they may be correct — that it takes more capacity to administer a principles-based than a rules-based regime. Some are also concerned that reliance on principles creates more provider uncertainty and burden, especially for those that plan to comply and operate responsibly.

Another factor that might tip the balance towards rules is the very pace of financial inclusion and innovation. In many markets many new consumers are entering formal financial markets in which providers, products, and channels are proliferating. Regulators are probably thinking: “How can we help these less experienced first-time consumers ‘self-protect’ and how can we reinforce whatever education efforts we are making, so that they understand what they’re buying, make good choices, and know what the risks are?” Just as Australia has chosen to do, regulators in these earlier-stage markets see the value in setting some boundaries around what kind of innovation is acceptable. I imagine they hope that clear rules will send a message to providers that they are expected to innovate in ways that add value for consumers. A final argument is that over time a rules-based regime could also help achieve a more level playing field and better competition; as long as they meet minimum standards, different types of providers can be allowed flexibility to offer new services and use new channels.

The challenge for regulators, of course, is to set rules that are clear enough but also permit some flexibility for innovation. This tension is present in many countries. What looks flexible to a regulator may appear as an insurmountable obstacle to a provider wishing to do business in a new way.

Q: Given that the capacity to regulate is less, would that be a factor that would drive regulators to continue under a rules-based regime, besides the many factors you have mentioned?

Yes, regulatory capacity is a really important consideration. Malawi offers an example of this challenge. The Reserve Bank oversees a rather broad range of provider types. The past few years have seen enactment of an ambitious set of new consumer protection laws and provisions. Implementing this new regime is going to be a big job, one which falls to a new market conduct team comprised of a small number of former prudential supervisors and others. The team is likely to find it easier to implement a regime based on rules than one that requires determination of what is fair and appropriate for the diverse providers and products that it oversees. Whereas prudential supervisors can be trained in desk review, sampling techniques, and quantitative analysis, assessing market conduct demands more judgment and the ability to see market practices from the consumer perspective. A few key rules can provide a touchstone to guide supervision and the use of scarce staff resources.

In fact, CGAP is trying to support the work of policy makers, regulators and supervisors in financial authorities that face major capacity constraints. The experience so far suggests the need for a very careful prioritisation and being very selective in determining which issues to tackle first. Consumer research and diagnostic work can help determine which problems in the market have the worst consequences and affect the most – or the most vulnerable – people. Basic rules can describe acceptable practices and product standards. Then it is a matter of improving enforcement and the scope of coverage over time. We need to acknowledge that 100% compliance is probably not a realistic goal even in a country like Australia with much greater resources to devote to the task.

Q: When the decision is to be taken on which are the important things that we need to regulate, and which are the less important, where does ‘fostering innovation’ stand in this regard?

This is a broader policy question, of course, but let me approach it in the context of consumer protection. Perhaps five years ago, before the global crisis hit, many policy makers and practitioners would have expressed the view that consumer protection measures would tend to run counter to both innovation and inclusion; the common wisdom was that such rules tended to increase compliance costs for providers, which would lead in turn to either less service to poorer consumers, more expensive service, or both. Post-crisis, however, a more nuanced view has emerged. Heavy-handed or poorly-targeted market conduct rules do indeed risk suppressing access to finance. On the other hand, not all access is healthy. Unchecked innovation of certain types such as predatory home loans sold with little regard to affordability can be unsafe for consumers and destabilizing, while other types of innovation promote responsible market development.

A consensus seems to be emerging among policy makers that basic but effective consumer protection is actually quite critical for successful innovation –- and inclusion — over the longer term. Except in the case where the product is very simple and the risks low and well-understood, first-time consumers need trust and confidence in order to be willing to try out formal providers and products if they have some basis for believing they will not be mistreated (and word can spread very quickly when such consumers have a bad experience). Client-focused research is beginning to show that lower-than-expected uptake of products, even products that are designed to offer clients good value-for-money, can be traced in part to lack of trust. By choosing the right things to regulate and doing so competently, financial authorities can help build confidence. To my mind, a good starting point in many markets is making sure that effective disclosure and grievance mechanisms are in place and that they actually work for customers with lower levels of income, education, and experience with formal finance. These measures should be relatively uncontroversial. And they should result in better-informed and more confident consumers and a healthier market.

Most Central Banks and financial sector authorities now have either an explicit or a strong implicit mandate to promote financial inclusion. This is a significant development and quite different from where the policy world was five years ago. As a result, most regulators are very sensitive to the risk that heavy-handed rules could harm innovation. Let’s explore three areas where the trade-offs between protection and innovation policy goals need to be analyzed carefully:

1) Practices and conduct: This is where issues such as sales practices, collections, or qualifications of staff are addressed by either principles (e.g., prohibition of “aggressive” sales, “abusive” or “coercive” collections or requirement for “well-trained” staff) or rules (e.g., prohibition of home-based sales, specified procedures for auctioning of seized collateral, specific training standards). Other examples include provisions concerning customer data handling or accuracy of data reported to credit bureaux. The devil is in the details, of course. There is always the risk that regulatory measures taken to address unacceptable conduct that has been observed in the market can unintentionally make it impossible for legitimate providers to innovate or even operate. The cumbersome debt collections procedures put in place in Andhra Pradesh probably fall in that category. More narrowly-tailored rules might have been sufficient to rein in bad practices while not undermining the viability of collecting delinquent loans altogether. The evolution of rules around business correspondents (BCs) offers another example from India. Initial caution about who could be a BC probably stemmed in large part from consumer protection concerns, particularly since the authorities’ ability to oversee the BCs’ practices was — by definition — limited. When the rules proved to have created unreasonable barriers to innovation – and to customer value from more convenient payment options – the rules were revised to be more inclusion-friendly.

2) Product features: From our analysis, it is actually not all that common for specific products or product features to be prohibited outright. Many regulators would prefer to avoid direct product regulation if lighter-touch measures such as transparency rules can be tried first. However, setting boundaries around acceptable product features can be justified in some cases. For example, certain categories of the loans at the heart of the US sub-prime crisis had features that made them “predatory” and punitive. Excessive pre-payment penalties or dormancy fees can be both unfair and pose switching barriers for consumers, leading a number of authorities to regulate them. In some jurisdictions contract law defines categories of “unconscionable” or “unreasonable” contract provisions that a court might find to be inherently unfair. Even very prescriptive disclosure rules or grievance procedures might prove insufficient. Yet care is needed, since product regulation can pose obvious barriers for innovation and inclusion.

3) Price regulation: Caps on interest rates, fees and commissions, insurance premiums, or margins are really a special case of product regulation. They are often justified on consumer protection grounds. But they tend to be a blunt instrument that can create unintended negative consequences and make legitimate products or business models unviable. One can understand the frustration of regulators, policy makers and politicians when increased competition in financial markets seems to result in little or no price reduction. Before turning to price caps, however, other tools such as well-designed disclosure and targeted consumer education should be tried. And when price caps are set unrealistically low, we observe in various countries how they tend to either drive legitimate providers to deception (e.g., a proliferation of fees in response to an interest rate cap) or make it difficult for providers serving higher-cost segments such as remote rural customers to operate.

So, particular care is needed in balancing protection and innovation in these areas.

There are two alternatives to product regulation that are employed in some regimes. The first is one that has been tried in India with somewhat mixed results: “basic” or “plain vanilla” products. Some governments have either mandated or encouraged the offer of these simple, transparent and safe products. I suspect part of their motivation might be that they can then justify leaving space for innovation, since more vulnerable consumers have an acceptable alternative to potentially complex, harmful, or poor value-for-money products that might result from that innovation. The challenge, of course, is to create adequate incentives for providers to enhance their bottom line and brands with these products, since otherwise they simply will not market them. But this might be a better option than the outright requirements and prohibitions of product regulation.

We observe the second alternative in countries including Peru, Mexico, and Malaysia, where providers need to get approval or at least notify the regulator about new product features and new products they intend to offer. This offers a way for the regulator to keep a hand on the faucet, so to speak, to shape innovations in the market without having to prescribe practices and product features. This alternative offers some middle ground between mandating safe products and leaving it to consumers to protect themselves in the face of providers with significant advantages in information and power.