Selling it right

Indian Express, 11th April 2013

Consumer protection should be at the heart of the financial regulatory framework

Does India need a new law for consumer protection in finance? One lesson from the global financial crisis is that unsuitable housing loans sold to poor, uneducated consumers could pull down the world's financial system. Very few people would have believed that sub-prime loans, which constituted a very small part of housing loans and that too only in one country, could trigger a crisis that led to banks failing, money markets crashing, governments falling, countries going bankrupt, millions becoming unemployed and the GDP of many nations going down. This is not to argue that the sale of unsuitable housing loans was the only regulatory failure that led to the global crisis, but an important lesson is that a regulatory system that does not prevent the sale of unsuitable financial products to consumers could be putting the financial system and the entire economy at risk. Not only is consumer protection an important end in itself, if it lies at the heart of financial regulation, bad practices that result in the failure of firms and markets can be checked.

Today in India, there is very little reference to consumer protection in primary legislation in the financial sector. Not surprisingly, none of the financial laws on which regulation is based, and which were written long before there was clear thinking about the need for consumer protection, provides consumers with basic rights or protections. Nor do they give regulators a specific set of relevant powers to pursue the objective of consumer protection. It is not treated as a core pillar of financial regulation. Many countries are rewriting laws to bring this perspective into financial sector regulation.

Some regulators have issued regulations based on the general rule-making powers given to them in their respective laws. For example, SEBI issued Disclosure and Investor Protection Guidelines in 2000. Various guidelines have been issued by the RBI and IRDA to protect consumers in banking and insurance. However, consumer protection regulation remains weak and varies across different sectors and services.

The approach adopted by the Financial Sector Legislative Reforms Commission (FSLRC) is that consumer protection needs to be treated as a core part of the legal and regulatory framework. So the first step towards ensuring consumer protection is to have good primary legislation that provides for it and makes it a priority for regulators, empowering them adequately. The primary law should require all regulators to formulate regulations that ensure consumers are protected from unfair practices. If, in a contract, there is a term that permits one party (often the financial firm) but not the other party (often the customer) to avoid or limit the performance of the contract, or to vary the terms of the contract or the services provided, the contract is unfair. If the conduct of the financial service provider, who often has greater market power, is misleading or abusive or coercive, such conduct is unfair.

Similarly, consumers should have a right to financial privacy, data ownership and data security. The laws were written before it was easy for an employee to sell a CD containing the digital records of his firm's customers for a small price. So the laws, unsurprisingly, were not geared to handle this eventuality. Today, we can argue that consumers should have the legal right to own their financial data. Consumers dealing with financial institutions must have the right to expect that their financial activities will have a reasonable amount of privacy. They must have the assurance that the data is secure.

Additional rights and protection need to be given to retail customers, who may be individuals or businesses, carrying out small value transactions. They are often at an even bigger disadvantage. Retail consumers should not be sold unsuitable products. The suitability of a financial service or product depends on the profile and needs of the specific consumer. The lack of knowledge often makes it difficult for the consumer to decide what will work best for her. The law should make it a right for the consumer to be given sufficient time, relevant information and, if possible, sound advice to help her decide on the suitability of the financial product she is buying.

For example, if a consumer is considering buying life insurance, in most cases, simple information disclosure is inadequate. There should be an assessment of the consumer's need. Proper advice would be necessary to ensure that the consumer purchases the right kind of insurance, with the optimal level of coverage. For certain services, the regulator may mandate advice. Providers of such services would then not be allowed to approach the potential consumer without some kind of a basic process of needs assessment and advice. For example, regulations could mandate that before a financial institution makes a recommendation to a consumer regarding a specific financial service, it gathers sufficient information from the customer to ensure that the service is likely to meet her needs and capacity.

Under the draft Indian Financial Code (IFC), advice would typically be accompanied by increased responsibility for the financial service provider, making it accountable for consumer outcomes, leading up to compensation for consumers if they have been poorly advised. Most services should come with a high level of responsibility for the providers, especially if the providers approach the consumer.

Consumers should also be given reasonable time to take the decision. For example, consumers going in for certain financial services with long-term implications could be allowed a cooling-off period, during which they may cancel the contract or decide not to enter it.

Consumer protection regulation is ineffective if consumers do not have an effective ex-post grievance redressal mechanism. At present, this is highly inadequate and varies across sectors. The draft IFC proposes to set up a fast and efficient non-sectoral, widely accessible consumer redressal mechanism.

It seems fairly obvious that consumers should have protection against unfair conduct and terms. But we need to put that in the law, because unless it says so, regulators cannot write regulations that ensure such protection or penalise firms that violate these principles. The draft IFC proposes to enshrine these principles in law.