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Most of economics can be summarized in four words. ‘People respond to incentives.’ The rest is commentary," claimed economist Steven E. Landsburg in his best-selling book The Armchair Economist: Economics and Everyday Life. The problem in real life arises when incentives are not properly structured.

The 2008 financial crisis was in a sense a consequence of misaligned incentives. Individuals in the US were borrowing because housing prices were rising; lenders were lending without much due diligence, partly because they had the option of selling those loans to some other agency which would convert them into mortgage-backed securities and pass them on to investors looking for higher returns. Everything was going according to script, and everyone in the system had the incentive to do what they were doing, until it all came crashing down in 2008.

A story of misaligned incentives has also been playing out in the Indian retail financial product market for many years, and can affect intermediation and development of the financial market if it remains unchecked. Mint’s consulting editor Monika Halan and economist Renuka Sane, in a recently published working paper, showed how banks are mis-selling financial products to customers. Since the conversation between the banker and the customer—which often translates into an investment decision—happens in private, Halan and Sane used an audit methodology for the study. Auditors were actually sent to bank branches in Delhi, looking for tax-saving products. A total of 400 audits were conducted over two different time periods.

The results clearly establish that bankers are driven by their internal incentive structure and are not really concerned about what the customer needs. The study finds that while bankers in the private sector recommend products with high commission, as their variable pay is linked to sales, bankers in the public sector recommend fixed deposits because their promotions are partly dependent on deposit mobilization. The study also noted that bankers misrepresent returns and costs associated with financial products. For instance, and this should worry regulators, 99% of bankers did not show correct returns for insurance products. It is highly likely that a wrong financial product can lead to real or opportunity losses for the investor and end up denting the individual’s faith in the financial market.

However, it’s not that only banks mis-sell financial products. Halan and others have shown elsewhere that between 2005 and 2012, Indian investors lost up to $28 billion on account of mis-selling of unit-linked insurance plans. It has also been documented elsewhere that even in a relatively low-cost product like a mutual fund, investors are sold schemes promising higher commission. It’s not that regulators are not aware of the problem, or have not framed rules in this regard, but it is not easy for them to monitor all transactions. And at the end of the day, it’s the individual investor who signs on the dotted line, accepting all terms and conditions.

So, what can be done? One option is to increase investor awareness. But this is a long-term process and is unlikely to yield desired results in the short run. The other and more doable option is to simplify product structure in such a way that costs and expected returns are easier to understand. Progress has been made on this front in recent years, but it’s not uniform across product categories. Perhaps the most important thing to do at this stage is to align the incentive structure across product categories. There is no reason why one kind of product should offer a fat upfront commission to agents and distributors. Also, regulators need to strike a fine balance between regulation and market development, keeping in mind that companies will always be more organized and vocal compared to small individual investors.

One of the critical roles of the financial market is to mobilize household savings to fund productive sectors of the economy. Investment plays an important part in overall economic growth. But if households lose faith in the financial system and start shifting away from the financial market, it can affect the economy’s medium- to long-term growth prospects.

How can regulators stop mis-selling of financial products? Tell us at views@livemint.com

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