Do I have to be like Ceasar’s wife and be above suspicion,” said a bank CEO on the subject of mis-selling. Instinctively, I felt that the point was missed. If you ask a banker about prevention of fraud or cash being stolen, the response would include charts, drawings, tables and process flows to impress you how robust the system is. However, on the question of right selling vs mis-selling, beyond the cliched “moral high-ground” and waxing eloquence, there is no attempt to implement a systemic solution.
Given the dominance of banks and other institutions distributing mutual funds in India, is there an institutional mechanism possible to guard against mis-selling? And, if so, what should it look like?
In mutual funds, intrinsic complexity and the absence of a physical product make it that much more imperative for institutions to be cognizant about potential mis-selling and implement a mechanism that would rest on the principles of right selling, the violation of which could result in mis-selling. For this, there would have to be some basic steps. One, each customer has to be profiled based on his risk appetite and investment objectives. Two, each product has to be profiled to reflect the customer category it is suited for. Three, there are potential conflicts in mapping the profiles of the products and customers. Four, it is the responsibility of the intermediary to recognize the potential conflicts and implement checks to ensure that these do not become real conflicts to the disadvantage of the investors. Five, it warrants an organizational mechanism to recognize these different roles and responsibilities and build in checks through a stringent compliance process. Six, it warrants a management oversight to ensure integrity for such systems to work efficiently and effectively.
Illustration: Shyamal Banerjee/Mint
To implement this framework, it is necessary to label roles and responsibilities. These include managers handling sales/relationship management, products, customer profiling, compliance, management, audit and board. Once that is done, it is important to identify and analyse potential areas of mis-selling and build preventive mechanisms.
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Taking the customer on board: This should include implementation of know your customer norms, obtaining sufficient and accurate information to assess the customer, look at his risk profile and investment objectives, categorize him, putting in place mechanisms for feedback on efficacy, and ensuring that information about customers is reviewed periodically.
Product evaluation: The institution should create a universe of products that are evaluated and are investment worthy. The products should be reviewed for its risk level and should be assigned to a pre-defined customer risk profile category. Also, there should be a written record of the suitability of the product to that particular customer category.
Transaction: The institution should provide documentation to every client covering two aspects: one, product recommendation indicating its appropriateness for that customer category and two, a statement of the fees (one-time and ongoing) earned by that institution from that product. Further, it should obtain the client’s acknowledgement. When the product is sold from a client’s portfolio or switched to another product, the institution should document the reasons—was it the client’s requirement, or was the product taken off the approved list or was there a need to realign his portfolio.
When a customer buys a product that is not in the universe of recommended products, then the client should acknowledge and confirm that the decision is the customer’s and that he does not seek advice from the institution. It would help the institution to receive no fees—other than reimbursement of transacting costs—for such investments.
Compliance process: The difference between right selling and mis-selling is the difference between compliance in spirit versus form. The process is challenging here due to many conflicts—between the institution’s objectives for business and profit against that of the client and the conflict between the investment worthiness of a product and attractiveness of the commission structure. The key, therefore, is in recognizing that these potential conflicts of interests exist and putting in place review processes.
A sales/relationship manager should neither determine the customer profile nor the product profile. This role should be monitored for correctness in matching products to customers. Further, there should be no freedom to undertake “execution only” transactions. Under the principles of “maker–checker”, compliance should ensure that any discretionary authority is one level removed from customer engagement.
Management process: The key areas that influence the behaviour and outcome of team members are the incentive structure and compensation oriented towards customer retention. There should be no emphasis on transaction revenue as it encourages portfolio churn and conflicts with customer interest. It is also important to create an environment that encourages transparency in relationships with customers as well as fund houses. Customer franchise is built over the long term—building a system that encourages doing the right things daily certainly helps.
K.N. Vaidyanathan is executive director, Securities and Exchange Board of India.
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