Since banks are the biggest distributors for all financial products, they need to operate within a strong consumer protection framework. This is lacking
The Reserve Bank of India (RBI) is, finally, working on a consumer protection framework that will empower it to ensure that banks treat their customers fairly. This is in line with global best practices that RBI deputy governor Dr KC Chakrabarty has been espousing for a long time. The crux of the new thinking is that “self-regulation, often, does not work and a strong, intrusive and hands-on regulator/supervisor provides the confidence that markets will operate on sound principles and be free from unfair and unethical practices.”
In India, growing consumer complaints, media sting operations on banking practices, as well as RBI’s own observations based on inspection of banks, have repeatedly highlighted how they are willing to wink at the rules leading to the laundering of unaccounted money. At the same time, they happily sell toxic, third-party products to their own customers in violation of their fiduciary obligation to sell and recommend products appropriate to the customer’s needs and financial profile and after ensuring that she understands the risks involved.
Over the past year, RBI has repeatedly exhorted banks to treat customers fairly (TCF) through various public statements, meetings and circulars. But this is clearly not enough. While moral suasion may have worked in a closed economy, the freedom to fix charges and the formation of an informal pricing cartel through the Indian Bank’s Association (IBA) seems to have weakened RBI’s ability to compel good behaviour.
A voluntary code of adherence to customer services and the inadequate provisions of the Banking Ombudsman’s Act have also had little impact on critical issues such as pricing, mis-selling and grievance redress. A clear framework for customer services, empowering RBI to act against unfair practices, is the need of the hour, along with increased competition through new banks, so that banks, on their own, feel the pressure to treat their customers fairly.
RBI has already warned banks about the many practices that it considers unethical or unfair to customers. These include:
• Levying charges that are based on competition (or cartel) rather than costs for services. Levying charges when no service is provided (failure to maintain minimum balance, intersol charges, pre-payment penalty on loans, and cancellation of demand drafts) or where it is a security imperative (like text messages for transactions).
• Mis-selling of third-party products (like insurance), collective investment products (like art funds) and mutual funds, through monetary incentives to bank employees. Bundling insurance with loans, term deposits and other deals to earn fees.
• Misuse of floating rate policies to increase spread when interest rates rise, but failing to pass on interest rate cuts with the same alacrity. Offering better rates to new customers and treating existing customer unfairly. Taking advantage of the festive buying to mislead customers with false claims of zero interest through deals with manufacturers.
• Helping customers to avoid the tax reporting requirements by providing multiple customer identity numbers, splitting fixed deposits and accepting cash.
While these specifics may be covered by RBI’s customer protection framework, the conceptual raison d’être for this is the realisation, worldwide, that weak consumer protection poses a significant risk to the wider economy and the financial sector cannot be trusted to self-regulate, even in its self-interest.
For RBI to align its own customer protection framework with the demands from consumers, it would do well to consider some key suggestions from bodies such as Consumers International (CI) which is a worldwide federation of consumer groups and represents 220 members across 115 countries. Moneylife Foundation, our sister entity, has recently become a supporter member of CI. Some of the suggestions are still to be accepted by central banks across the world, although some countries have made big strides in their implementation.
CI points out that half the world’s population is still unbanked. This is a real concern in India, which probably has the largest number of unbanked persons worldwide. Unfortunately, financial inclusion has only meant various gimmicks, including the push for unique-identity-based bank accounts for delivery of subsidies, without any clear thought about how to ensure genuine usage that is cost-effective.
Banks want to charge customers for ATM transactions beyond the fifth every month, because interchange costs and taxes amount to nearly Rs20 per transaction. Banks need to push customers into making fewer transactions for higher denominations, but there is no attempt to ensure this through awareness campaigns; instead, they are toying with restrictive costs. At the same time, there is a push for biometric-enabled ATMs in the name of financial inclusion, which is sure to involve only low denomination transactions. Unfortunately, there is no pressure on banks to work with consumers, or consumer groups, to come up with innovative solutions to these issues.
CI also points to the need for a national consumer protection body that covers multiple regulators. Such an independent body was also recommended by the Financial Sector Legislative Reforms Commission (FSLRC), but has met with quiet and determined resistance from India’s multiple independent financial regulators. Interestingly, Indian financial regulators, including RBI, have signed a memorandum of understanding (MOU) to monitor large conglomerates, but there is no such understanding or cooperation for consumer protection, although it is clear that sale of third-party products by banks has cheated financial consumer the most.
Some of the other issues flagged by CI for the protection of financial consumers:
1. Information Design and Disclosure: Consumers should receive clear, sufficient, reliable, comparable and timely information about financial service products. The pricing should be clear and allow consumers to appreciate costs before buying a product and information must be provided in standard formats. Failure to do so should make contracts void. Financial products must be tested for quality and comprehension by companies and audited by regulators. This is a clear shift away from disclosure-based regimes.
2. Contracts, Charges and Practices: Regulators should introduce a requirement of comprehensibility and prohibit products that are not comprehensible to ordinary consumers without expert knowledge. Conflict of interest in the provision of advice and sale of financial services needs to be addressed. Financial advice to consumers should be separated from sales-based remuneration. And contracts with consumers should be void-able, if they fail to get informed consent of the consumer, charge unfair or unreasonable fees, or are contracts designed to ensure a waiver of basic consumer protection and sale of inappropriate products, based on the consumer’s profile.
3. Redress and Dispute Resolution Systems: Ensure that consumers have access to adequate redress mechanisms that are ‘expeditious, fair, inexpensive and accessible’.
While India surely needs to look at the global debate on this issue, it needs to formulate a policy that works best for India, taking into account our own socio-economic milieu. A strong national consumer protection body, as recommended by the FSLRC in India or Consumers International overseas, may not be immediately feasible in India. Instead, since banks remain the big and trusted source for selling a host of financial products, including wealth management and advisory services, a strong consumer protection framework under RBI is an immediate imperative.
Sucheta Dalal is the managing editor of Moneylife. She was awarded the Padma Shri in 2006 for her outstanding contribution to journalism. She can be reached at [email protected]
Stories of price manipulation
Lime Chemicals (Rs5)
Lime Chemicals Ltd manufactures calcium carbonate, a raw material for several industries. It failed to disclose its shareholding pattern as per the listing agreement of the BSE in June 2011. Interestingly, the company was declared ‘sick’ by an order from the Board for Industrial and Financial Reconstruction, way back in 2010, and Bank of Baroda had been appointed to revive the company. But nothing has happened so far; the company continues to incur losses. Over the past nine reported quarters, beginning September 2011 and up to September 2013, its net sales increased from Rs2.72 crore in September 2011, peaked at Rs8.67 crore in March 2013, and declined marginally after that. However, during the same period, i.e., from September 2011 to September 2013, the company reported losses in eight out of nine quarters. The biggest joke is on the regulators, namely, the BSE and SEBI. Why? The share price of this sick company rocketed a humongous 492% between 29 April 2013 and 13 January 2014. Clearly, the regulators don’t give a damn about regulating.
The real problem with present day peer-to-peer or P2P lending is, several times, lenders are clueless about financial health of the borrower. This is because the information used by the P2P lenders comes from the borrowers and can be inaccurate or intentionally false
Peer-to-peer (P2P) lending is the practice of lending money to unrelated individuals directly without the need or expense of a traditional intermediary such as a bank. It is supposed to be one of the newest and most innovated business models of the social network era. Actually, it is nothing of the sort. P2P lending is very old. It is exists in many countries. But there is one major difference. The older variety is far safer for one reason: information.
The old names for P2P lending differ by country. In Vietnam they are called hui (associations). The Koreans call them keh (contracts). The Chinese refer to them as biaohui and they have been around for centuries. The Caribbean community in the US calls them su-su (among us or savings). Mexican Americans call them tandas (turns) and they are also widely used in Ghana.
They all operate on the same principal: a group of unrelated individuals get together and agree to pool their capital. Then one member of the group gets to borrow a sum agreed upon by the group. How the borrower is chosen varies from country to country. Some do it by lot. Others take turns. Some present business plans.
These P2P group lending clubs work for two reasons. First, they are small; all the members know each other. They all have a large incentive to get as much information about the borrower as possible and then keep tabs on them until the loan is paid off. So they have excellent information. Second, they are at some level—social institutions. So like a lot of micro lending programs, the group is collectively responsible. There are enormous social pressures to make sure the loans are repaid. Legal recourse is basically unnecessary. These two factors are not available to the modern online P2P platforms.
Nevertheless, these P2P businesses have mushroomed. The largest in the US are LendingClub and Prosper. Both have experienced triple digit growth. In 2013, LendingClub originated $2 billion worth of loans, while Prosper made $350 million. The process is quite simple. Borrowers make loan requests of between $2,000 and $35,000. Lenders, both ordinary retail investors and large institutional lenders can select which requests they want to fulfil. They can take fractional parts of loans or the whole loan.
The real problem with P2P lending is the extent to which lenders have information about the financial health of the borrowers. In the US, most borrowing depends on your credit score (called a FICO score). These scores range from a perfect score of 850 down to a miserable 300. Average credit is considered a score of 620 to 679. Scores below 580 mean higher interest rates and a score below 500 mean no credit at all. In addition to FICO scores, the P2P companies have their own proprietary systems for determining credit. Minimum scores for lending on LendingClub are 660 and Prosper is 640. Interest rates vary from 6% to 35%, both quite high in a lending environment where prime is presently at 3.25%. So for lenders it seems ideal way to get double-digit returns in relative safety. Generally FICO scores are a good indicator of credit.
But there is a catch. People sometimes lie. The information used by the P2P lenders comes from the borrowers and can be inaccurate or intentionally false. LendingClub states that it cannot verify income for 40% of its sample borrowers. For those borrowers who were asked to verify their incomes only 60% provided satisfactory responses. Of the rest, 10% withdrew their applications and 30% either failed to respond or provided information that failed to prove their stated income.
There are other risks that we should have learned from the crash six years ago. Double digit interest rates in a lightly regulated industry should be approached with extreme caution. A 15% interest rate should be a major red flag that you may loose your entire investment. P2P loan rates look good because of their short history during a time of unprecedented easy money. P2P lenders also use proprietary ‘black box’ programs to determine a borrower’s credit. A lender who advertises that they can approve a loan in minutes should be suspect. Lenders do not have any ‘skin in the game’. They just put borrowers and lenders together and then collect fees. Their incentives are quite distinct from investors just like subprime originators before 2008.
But just like 2008, Wall Street is now in on the action in a big way. The P2P portfolios are now being securitised. The deals are only in the tens or hundred million range, but if the search for yield continues, they will grow.
The business model has become popular all over the world. The UK has three major one, Zopa, Ratesetter and Funding Circle. These sites have expanded despite the fact that two Dutch sites and one UK site failed after they piled up large bad debts. Sites have also struggled in Spain, Italy and Friends Clear in France was forced to close. But the risks have not stopped the creation of sites in countries as different as Estonia, Korea, Japan and India.
The risks rise in countries as regulation falls. This is especially true of emerging markets. China is a perfect example. Many of the P2P lenders that started in the last few years as a $4.4 billion part of the massive $6 trillion shadow banking industry have closed. The largest firms are still active, but there is trouble ahead. There are about 1,000 P2P companies in China providing investors with an average return of 19.7%. Obviously too good to be true! Because 58 of those firms, went bankrupt in the final quarter of 2013. It is estimated that 80 to 90% of the firms will go under as the Chinese central bank tightens rates.
The reason for the problems in China is obvious, bad information. In game theory, borrower’s incentive is simple. Don’t pay the lender back. In the original P2P lending societies, lenders got around this problem by having a long term and direct relationship with the borrower. It is this type of relationship that also made lending by smaller local US banks so successful. But these close relationships and the local banks are a thing of the past. The knowledge they gained about their borrowers will be sorely missed as the credit cycle turns. The supposed disrupting influence of P2P may only be disrupting to the lenders’ pocketbooks.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)