Doing More Harm: Confused regulation of financial products
Debashis Basu | 27 February 2014

A friend of mine used to joke that in the deep south of Bengal, the Sundarbans, there are three brands you would come across: the Communist Party of India (Marxist), Pepsi and Coke. Coke and Pepsi, of course, do not have offices there. The strength of any consumer product company is, as we know, its distributors. What about financial products like mutual funds and insurance? You will find agents of the Life Insurance Corporation in many small towns. Other insurers are expanding, but they have a minimal presence beyond 50 locations. Mutual funds are almost absent beyond the major cities.

The Securities and Exchange Board of India, or Sebi, wants to change this forcibly. To make mutual funds go beyond the top 15 locations, it has decided to rob investors and pay the funds. But even before this destructive move comes into effect – from January 1 – comes the startling news in a business paper on Saturday that one of the largest distributors of financial products, HSBC Bank, will shut down its distribution business. If the paper is to be believed, HSBC has suddenly become ashamed of rampant mis-selling and the backlash thereof.

If a Rs 1 lozenge is available 50 kilometres from Kohima, but something that has given 20 per cent compounded annual tax-free return over the last 10 years (a top-performing mutual fund) is almost unknown in fast-growing towns across India, something is fundamentally wrong with the product, the manufacturer, the distributor — or the regulator, since everybody has to dance to its capricious ways.

Actually, everybody has contributed to a situation in which savers don’t want to have much to do with financial products other than essential banking and fixed-income products. This can be best understood by comparing mutual funds and insurance with healthcare. Drug companies are researching and manufacturing drugs – some dubious – for our health; mutual funds and insurers are selling financial products for our wealth. But there is nothing equivalent to doctors in retail finance. A small group of financial planners/advisors liken themselves to doctors, but this is nonsense. As for chemists and dispensers, there are distributors of financial products.

Now imagine a situation in which drug manufacturers deal directly with patients through chemists. Imagine, also, that drug companies do not have to go through 8-10 years of tests to be reasonably sure of the efficacy of their drugs. Finally, imagine that there is a regulator overseeing drug companies but not chemists. This is exactly what happened in 2004-07, when insurers and mutual funds pushed hard market-linked products by incentivising distributors who were unregulated. The products turned out to be like spurious drugs when the market crashed. Though it was the manufacturers that were regulated, they escaped. The distributor felt the heat. Regulations for insurers and funds became tighter, and distributors of mutual funds are now sought to be regulated. But by now, people distrust both.

Sebi now wants to split the role of chemists — between those who would only sell what customers have decided for themselves to buy and those who would only advise customers but not sell. In effect, chemists would have to choose whether they want to run a medicine shop or want to become doctors.

The real money is in selling (medicine shops). Financial patients don’t want to pay for advice (doctor’s fees). Advice is seen to be freely available — in newspapers, magazines, on the internet and so on. Some customers want tips. Many are capricious and mean. They remember only the advice that did not work and ignore the many that did. Some want passbacks. The business of advising is a thankless, low-paying business, unlike that of doctors.

But, as usual, Sebi has no grip on any of these issues. Very soon, chemists may be formally recognised through a process of registration with Sebi as advisors. The registration will mean higher costs for them. It will not bring about increased revenues. Sebi’s move makes no sense because the larger business, insurance, will not be within the purview of this registration.

What are financial distributors supposed to do? Unlike those distributing Coke or Pepsi, there is no clarity about the role of financial distributors. Some commentators have offered gratuitous advice to the advisors: be valuable to clients. Act like a doctor. Just as we do not shop around for the cheapest doctor and do not try to second-guess his advice (although these days we look up the internet), we would all listen to a good financial advisor.

This seems intuitively correct, but falls apart under the slightest scrutiny. The first is simply competence. A doctor has to go through a tough process of education spread over many years. The education is a formal one; the curriculum, however flawed, developed over many decades. Financial education is in its infancy. The four pillars of modern financial theory – the efficient market hypothesis, the random walk theory, the modern portfolio theory, and the capital asset pricing model – have turned out to be useless again and again. The day I was writing this piece, Vanguard, a giant US fund that promotes index funds, came up with a new piece of research: lump-sum investment does better than dollar-cost averaging! If this is the case, the aggressive pushing of systematic investment plans seems like a suspect piece of advice.

The solution to this mess is simple. But it would need consensus and deep conviction among policy makers and all regulators, a topic I shall cover some other time. Pending that, Sebi can borrow something from the physician’s book, but the right way: do no harm. But with Sebi continuing to make guinea pigs out of investors and distributors with its endless experimentation, that is too much to expect.