In its judgment passed on 3 January, the Supreme Court concluded that there was no apparent inadequacy in the investigation by SEBI on the Hindenburg report, which had accused the Adani Group of stock manipulation and other financial misconduct last year. While the main issue under consideration was regulations for identifying “beneficial owners”, the judgment also emphasised investor protection in financial markets, based on the recommendations of the Sapre committee, a six-member expert panel appointed on the Adani-Hindenburg case by the court.
This comes around the same time as the government’s proposed measures to institute checks on mis-selling in insurance markets.
As households turn to financial markets, the regulatory response will have to work towards aligning the interests of the sellers and buyers to ensure consumer protection.
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Disclosures, financial literacy, and grievance redress
More and more Indians are investing in financial assets. Assets under management (AUM) of the mutual fund industry reached Rs 50 lakh crore in December 2023, the highest ever. There were 7.4 crore Systematic Investment Plan (SIP) accounts in November 2023. And, as of last September, there were 80 million unique investors directly investing in the stock market, according to the National Stock Exchange. The insurance industry has also registered 10.3 per cent compound annual growth over the last decade.
But as the market grows, so do concerns about retail consumer or investor protection. If households don’t feel safe, they will not invest, and the actual market will be smaller than its potential.
Regulators have often argued that if service providers made disclosures, then investors would have all the information to make informed choices. However, the Sapre committee, in its May 2023 report, rightly points out that there is a “surfeit of disclosures”, making it difficult for anyone to understand exactly what is being said. How does one decide what are the most important factors that a potential investor should know? The more complicated the product, the more combinations of features that will need to be disclosed, making it more difficult for consumers to understand what is really at stake.
This brings us to the committee’s recommendation on financial literacy. It noted that financial literacy should be introduced in school curricula to ensure that general numeracy and familiarity with financial products is inculcated at a young age. However, how best to design such curricula remains a challenge. Ultimately, it is not just what consumers know in theory that is important, but how well this knowledge serves them when they face an investment decision. Experience suggests that the gap between theory and practice is difficult to bridge.
The third recommendation made by the committee is on setting up a Financial Redress Agency (FRA). Regardless of how good the disclosures are, and how financially literate the customer is, things will go wrong. At that point, having a grievance redress agency that is able to address customer complaints will go a long way in improving the experience of investors. The redress agency also becomes a way to capture trends in the market, and to take this information back into policymaking. The current redress processes are organised across each regulatory domain, making access difficult and redress inconsistent. The Supreme Court judgment, based on the committee recommendations, also acknowledged the importance of the FRA.
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Aligning seller and buyer interests is key
The Sapre committee’s recommendations are all important ways to improve investor protection, but more needs to be done to make these tools deliver. In most markets, competition between suppliers ensures that there is some correlation between price and quality. If consumers perceive that a particular good or service is of poor quality, word spreads quickly and there is impact on the business. Conversely, if a product is of high quality, then customers are more willing to pay a higher price for it. The incentives of the seller and the buyer are aligned.
This alignment gets broken in financial markets for two reasons. First, it is difficult to tell whether a particular product is of inferior quality. The products are complex, and it is hard to infer whether there is consistency between what it says it does and its actual features. Second, the actual quality of the product unfolds over time. By the time a consumer finds out, it may be too late. For example, when one buys an insurance product, it might be hard to understand all the features by just looking at the brochure. The fine print is often discovered many years into the investment, after continuous premium payments. Mandatory disclosures become checkbox compliance, and the most financially literate person finds it difficult to disentangle the product before buying or the complaints mechanism subsequently.
The seller will behave in the interest of the buyer only if it is also in their interest to do so. Regulation can help by ensuring that the seller is incentivised to do the right thing, and penalised for not doing so.
At the point of sale, the story is about how sales staff is remunerated—flat fees and trail commissions seem to work better than large upfront commissions. A high upfront commission leaves no incentive to the seller to stay with the customer through the long tenure of products such as mutual funds or insurance. Most of her remuneration is at the point of the sale—there is little to incentivise the seller to think long term. A change in the structure of the payment for the same amount will go a long way in shaping incentives. Other regulatory interventions such as disclosures and grievance redress will have more bang for the buck when the incentive story is aligned.
Renuka Sane is research director at TrustBridge, which works on improving the rule of law for better economic outcomes for India. She tweets @resanering. Views are personal.
(Edited by Asavari Singh)