Late last week, the Financial Sector Legislative Reforms Commission, or FSLRC, released its two-volume report. In the aftermath of the global financial crisis, financial regulation, especially consumer financial protection, has undergone significant changes. The United States set up the Consumer Financial Protection Bureau in July 2011. Across the Atlantic, the Financial Services Authority is being split into the Prudential Regulation Authority and the Financial Conduct Authority.
The key component of all these reforms is consumer financial protection, on which the FSLRC devotes a chapter. How good is the FSLRC's approach on this? Listen to its breathtakingly immodest self-assessment: "The work of the commission in the field of consumer protection marks a watershed compared with traditional approaches in Indian financial law." How exactly? "It 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."
Well, it just so happens that on October 1, 2012, I myself had argued in this column that the doctrine of caveat emptor should not be applied to financial services ("It's time for 'seller beware' "). It strikes me as a bit disingenuous to see the FSLRC laying claim to that "watershed" idea six months after my piece was published. Beyond that, a watershed contribution would have been to lay down a detailed path for implementing a new regime. Not only is this missing, but the FSLRC does not even spell out why caveat emptor does not work. I suspect it does not know the reasons.
All that the report does is to offer some homilies: financial service providers must act with professional diligence; there must be protection against unfair contract terms, unfair conduct and conflicts of interest; and consumers have the right to receive suitable advice and access to an agency for redress of grievances.
The existing law does not preclude any of this. The preamble of the Sebi Act includes the words "to protect the interests of investors in securities", while the very first point in the Insurance Regulatory and Development Authority's (Irda's) mission statement is "to protect the interest of and secure fair treatment to policyholders." The recent advisor regulations are another step in this direction. So, what is new in what the FSLRC has proposed?
Well, here is what could have been new: a detailed analysis of how consumer financial protection is not working. All regulators have a clear mandate to protect consumers and have supposedly set up systems to redress consumer grievances, but these are woefully inadequate. Instead, there is plenty of evidence now that regulators have, more often than not, failed to act in the interests of consumers. The mea culpa interview of Irda's former chairman J Hari Narayan to every business paper before retirement is an example. Given this background, isn't it preposterous for the FSLRC to claim to have found a new path to consumer protection that does not go beyond sermons?
My conclusion is that the FSLRC is clueless as to why caveat emptor actually does not work. A dead giveaway is its principle that consumer protection should "promote, and not hamper, innovation". The FSLRC talks glowingly of preserving financial innovation without explaining as to what really defines "innovation" and in whose interest? I can only quote the legendary US central banker Paul Volcker on financial innovation: "The most important financial innovation that I have seen the past 20 years is the automatic teller machine. That really helps people and prevents visits to the bank and is a real convenience … which is in fact more of a mechanical innovation than a financial one."
Here are just three of the many reasons why caveat emptor does not work, and none of these finds mention in the FSLRC report.
There are plenty of studies to prove that choice leads to paralysis and poor outcomes - exactly the opposite of what more choices are supposed to foster. Choices in financial services create worse outcomes because customers are rarely involved in making their choices. This is best reflected in their impatient "tell me where to sign" attitude, when asked to read a legal document. Studies show that if there is a default choice, a majority of customers would choose it.
Rational consumers rarely exist. They cannot calculate the impact of inflation, cannot understand risks, have irrational fears and cannot deal with volatility, among other frailties.
- The reason caveat emptor does not work is that consumers move from the physical world to the financial world without realising the fundamental differences between the two, and make gross mistakes.
Consumers are blindsided. You could say the same about FSLRC members.
The writer is the editor of www.moneylife.in