India is not alone in blindly staggering around for a solution to the problem of getting the last mile correct in retail financial products. I’m back after a week in Seoul (pronounced to rhyme with Yowl), South Korea, as a spousal add-on to a global financial planning congress. Spouses, luckily, were invited to the gala dinners and other evening events and I used the time effectively to wrangle information out of different parts of the world. Some of the information was alcohol-soaked, but is still worth consuming. The brief upshot is this: retail financial products have always been sold with commissions and charges embedded in them. This has led to an information asymmetry with the person facing the consumer having more information and knowledge than the buyer. This has led to sales of products carrying higher loads to be sold more rather than those that are actually good for the buyer. Paradoxically (and in a beautiful ode to behavioural economists), consumers are wonderfully irrational: as long as charges are embedded into the products, they are fine with paying even very high costs. But take costs out of the product and charge the consumer separately, the hand signing the fee cheque freezes. The consumer of financial products, globally, finds it very difficult to pay for advice. But if embedded, is happy in ignorance—as long as the final amount in whole numbers looks larger than what is put in. Consumers are oblivious of the effects of inflation, taxes and costs; they compare one whole number (what I put in) to another whole number (what I get out).
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Academics, policymakers and regulators were made to realize the seriousness of the principal-agent problem during and after the sub-prime crisis, where unregulated brokers sold mortgages without disclosing the full cost and impact of the product to borrowers—who, possibly, were not very keen to question what looked like free money. The question of “whose agent is he?”—the producer’s or the consumer’s—has not been effectively answered. Regulatory action in parts of the world and parts of the markets has been to work with product structures to remove the incentive for mis-selling. Going no-load (removing embedded sales charges) seems to be the regulatory response to institutional mis-selling of financial products. India is already off the block in funds and even the life insurance product is in effect a no-load product, as all costs finally need to collapse into an annual charge on the corpus. The UK is next in line with the 2012 deadline to go no-load on all investment bearing financial products (including insurance). Australia is on the no-load path as well. While the product structure rules are being worked upon, I suspect not enough thought is being given to construct a system that will replace the current global standard on which the distribution system works—of how the distributor will be compensated. It is a good time to reconstruct this space as the world goes through collective navel gazing to try and fix what broke in 2008.
We’ve got some parts of the picture in place. Product manufacture rules are such that product structure makes it more and more difficult to cheat. Most parts of the world have adviser regulations in place (India, for some reason, is resisting this regulation, but it will happen in the next two years). Consumers realize the need for quality advice but can’t get themselves to pay for it. The distributor is a key link between the consumer and producer, but getting him to be on the side of the consumer rather than the producer is a problem that has not been cracked yet. How the distributor will get compensated (and he must—he provides a key service without which the financial system will freeze up) is not yet clear to anybody in the world.
One possible reason for the lack of a solution coming out of academic halls is the relative neglect that consumer finance has faced historically. Writes Peter Tufano of the Harvard Business School in a comprehensive National Bureau of Economic Research paper titled Consumer Finance (http://bit.ly/9cLASp): While every one of the top 20 US MBA programmes offers at least one course on corporate finance, as of 2008 only two MBA programmes offer explicit courses on consumer or household finance. It’s a paper worth reading and Tufano ends with leaning on integration between various fields (economics, finance, psychology, biology neural networks) to get answers. He writes: “Consumers need to make a bewildering array of financial decisions. Offering sensible defaults can dramatically change behaviour.”
One way to move on this may be to define the goal of effective distribution. Writes UK financial service professional Michelle Cracknell: “I would like to be a part of a new model in financial services that has innovative distribution; allowing customers to access financial products in a way that suits them rather than squeeze them into boxes that suits the provider.”
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and can be reached at email@example.com