The topic of the third panel discussion at the sixth edition of Mint Mutual Fund Conclave was: Building Investor Centricity: Regulatory Direction. The panellists were: Amit Tandon, founder and managing director, Institutional Investor Advisory Services; Ananth Narayan, professor, SPJIMR; Arundhati Bhattacharya, former chairperson, State Bank of India; Cyril Shroff, managing partner, Cyril Amarchand Mangaldas; and Nilesh Shah, managing director, Kotak Mahindra Asset Management Co. Ltd. The discussion was moderated by Monika Halan, consulting editor, Mint. Here are the edited excerpts from the panel discussion:
Monika Halan: A lot of what mutual funds do is dependent on the regulatory and policy environment. In India, what we have seen is that we are almost at the third level of regulatory reform in the mutual fund space, whereas some of the other industries are at level one. We have seen extremely good regulatory action, which makes the product more transparent and easier to understand without the conflict of interest that other products have in terms of embedded loads. But there is still a runway ahead for regulatory work, and that is the subject matter of this panel.
The first part is light touch versus heavy touch regulation. What has happened in the debt market has somewhat reduced the validity of the ‘Mutual funds sahi hai’ campaign. We know that the regulator is fairly heavy touch, but do you think they could have done something differently ahead of this?
Arundhati Bhattacharya: One of the successes of regulators is to be able to envision the pitfalls, and take steps ahead of time. For instance, when Dr. YV Reddy was the governor of RBI, the mortgage market had just opened up. The private sector was already into it, but large public sector banks like SBI had gotten into it in full force and we were seeing huge growth in the retail mortgage market. One of the things he did at the time was specifying higher risk weight for the home loans. We, as players, were quite upset, because we felt that it was a very safe portfolio, which it was. We went and had a lot of conversations with him, and his stance was clear. He said, “I am seeing this growing too rapidly; so I’m trying to slow you all down because as this is a new area, we don’t know what pitfalls there might be ahead of you, and it’s better to be safe than sorry.
As market players, we didn’t really appreciate that, but now when I look at it in hindsight, I think as a regulator, he was doing the right thing. Putting a brake allows for a pause so that we can take a good look at why the brake has been put and what we can do to mitigate any possible risks. But I still think what we need to aspire to is more of a light-touch regulation. Heavy-touch regulation creates a drag for growth and doesn’t allow for innovations. Especially in a developing market like ours, where you still need innovations and animal spirits, we need a lighter touch. But this is not something that the regulator can do on its own. You need two hands to clap. If the industry self-regulates well enough, the regulator will have less opportunity and requirement to come in with a heavy hand. If the industry sticks to the word of the law, but not the spirit of the law, the regulator tends to come in with a heavier hand, and you can’t really blame them.
So, if we want light-touch regulation, I feel the industry has to be equally responsible. If there are some people who are not playing by the book, they need to be called out. Very often, this is not done because you are one community and you don’t want to point fingers. But the fact of the matter is that a few people breaking regulations will tempt more people to follow suit, and soon the regulator will have to come in with more and more heavy-handed regulation. It is the responsibility of both to figure out where to draw the line, but if we really want to have less regulation, then self regulation is the only way.
Halan: From what I understand, even if the regulator wants to be light-touch, the behaviour of some people in the industry forces it to be heavy touch. For instance, C.B. Bhave had to specify the font and speed of the “mutual fund investments are subject to market risks" disclaimer in the advertisement, because the industry just wasn’t following the spirit of the regulation. So, what do you think the industry can itself do for that light-touch regulation?
Nilesh Shah: We have to self-regulate ourselves. And yes, we might have heard the disclaimer about mutual funds being subject to market risks being read a little faster, but let us appreciate what we have already done. In terms of transparency, Indian mutual funds are better than the best in the world. In terms of market practices like valuation, we are better than the best in all of India. The sector which madam (Arundhati Bhattacharya) represented, allowed state development loan (SDL) to be valued 25 basis points over G-sec even though they were placed in the market at 75 basis points. Today, at least in our portfolios, in an illiquid market, we are giving daily NAVs and daily redemption. So we have done something right. Each industry has done some things right, some things wrong. Please punish us for what we have done wrong, but do appreciate what we have done right. Also understand the limitations within which we operate. If there are best practices to be copied from the insurance and banking industries, I will be happy to copy it. But if we are doing good things, then please appreciate it. Ultimately, the ₹25 lakh crore which is lying with the mutual fund industry shows that we are doing something good.
Cyril Shroff: We as a society are in a state of transition. I’m not talking only about the mutual fund industry, but on a more general level. We are moving from a relationship-based culture to a rules-based society, and during this transition, we can’t make the jump too fast to make it a principle-based system or to leave things fully on the spirit, in the hope that the marketplace will imbibe the spirit and do the right thing. We are still halfway into that mega-process that is going on in Indian society, and we have seen that where there is ambiguity, the traditional mindset takes over. The Indian entrepreneur and the Indian marketplace have basically grown up with the mindset of finding the loophole, because the spirit of regulation and the regulatory philosophy has always been to prevent something rather than a more balanced framework. But it is in the process of transition.
At this point, I don’t think there is much choice in terms of taking a big leap to move to a principle-based system. I think it will be a gradual transition because whenever there has been a gap, we have seen a big crisis. Currently, what’s going on in the NBFC sector is a classic system. The elephant in the room are the issues facing the NBFC industry, and by contagion, the mutual fund sector and you can pin down some of this to gaps in regulation. If I was sitting in a regulator’s chair, I would be more biased in favour of heavy touch right now. There has to be a new normal and a compliance culture created before I start toning things down.
For self regulation to take root and be successful, I think, we need to pass through a phase of more detailed, clearly defined regulatory system.
Halan: So you are saying the rule of the game earlier was no rule of the game. The playbook has changed and therefore it will be some time before we can come to a new regime where rule of law becomes the norm. Anant, as an academic, I’m sure you have sat in policy conversations where their version of the market is beyond belief. They really do think that economic agents make decisions and if you do enough disclosures and make people financially literate, regulators are only needed in principle and that it is very Neanderthal to have such heavy-touch regulation. But when you come to the market, you realize how spirit can be violated. It’s partly badly worded regulations which allow people to take leeway. This is all in the context of the regulator having done extremely well compared to other regulators; how would you perceive the market?
Ananth Narayan: I’m an academic now because I’m trying to wash away the sins of being a banker for 24 years. Of those 24 years, 20 years I was a derivatives trader, which is the lowest level of cretin possible in terms of ethics. I’ll give you my own parallel. We had a fantastic time between 2002 and 2009. This was the glorious period of derivatives trading for Indian banks. Across the globe, we did a lot of business, and it was breathtaking, and very similar to the growth we have seen in mutual fund AUMs—25-30%.
It’s not as if regulations were light touch at the time. There were onerous regulations. RBI inspections used to be a pain in the neck. But they were always a few steps behind the market. The truth is, the people in the frontline are smart, the greed is of a good variety, and they are getting paid well. The regulator is trying to play catch-up.
The regulations were there, but they were looking at the wrong areas and causing a lot of pain to us. We knew there were things building up and we didn’t pay attention to it at the time. One, everyone else was doing it, so we had to do it. Two, there was a lot of competition and we had to catch up others. There was some impetus behind what we were doing; so even though we knew something was wrong, it became institutionalized as ‘aisa hi hota hai’ and then we went ahead with it.
The reverse happened after 2009. Then we were seen as the dregs of society. Regulators and the mob were baying for our blood. It didn’t matter if you were reasonably clean and there were people worse than you. Anything you did, you got chopped.
As a banker who lost a lot of hair during that period, my advice is, don’t ever let that period come to your industry or business. As experts, you know what the grey areas are in your industry. If there is mis-selling, if there are gaps, a lack of liquidity, please highlight the problem areas and get them sorted out.
With the best of processes in foreign banks, the valuations I used to see were not correct. I have done corporate bond deals, and I have lost money in it. I can tell you that if you let it be, eventually, things will go wrong and people will come for you. So if you see things going wrong, please highlight it. If there is a monkey on your back, pass it on to your boss or the next person in charge. My broad answer, therefore, is that there are always regulations, and they are usually heavy-touch, but they don’t necessarily look at the right areas. There are people who can point them to the right areas. Unfortunately, it is very difficult for the frontline to point out the problems.
Monika Halan: Amit, you have seen the dark side of the moon with firms taking action when you tried to protect the interest of the small shareholders. If we look at mutual fund investors as small shareholders, what are the lessons that a regulator could learn from your experience?
Amit Tandon: We focus on governance of companies and therefore we try and nudge investors to focus on that area as well. It’s not for us to decide if a company that makes bicycles should make airplane parts as well or not. We may have a view on it, but we are not very vocal on it. Our focus is much more on the fact that if you have a shareholder who owns 45% of the company, and another who owns 1% of the company, both of them should have an equal share of the cash flows that go out, not just by way of dividends, but also if anyone is misusing their dominant part to take advantage at the expense of others.
In this narrow context, if you look at some of the regulatory changes that have happened, the mutual funds have progressed quite rapidly. The regulator has nudged them by getting them to start voting on shareholder resolutions. Before the company acted or took a lot of decisions, they were coming to shareholders and asking them to vote on it. What was typically happening, and I saw this as an investor myself, when you got the annual report, there would be a sheet attached, and you would throw it away and look at the report. But it was what was in the document that we were all throwing away that would tell you how the company would be years down the line, as well as some things they planned to do over the next year or so.
Sebi started by saying that companies should have a voting policy. A year later they said that they should start voting. Two years later they asked them to disclose how they had started voting, and 4-5 years down the line, in 2013-14, they asked them to give their rationale. All this is encompassed in something called ‘stewardship’, although Sebi hasn’t used the term. While you have governance for companies, what happens for investors is that you are handling the money of the small investor on the street. But is the money being managed well? Are they engaging with the company, recording their vote, and if there is an issue that matters to them a lot, how are you reporting on it?
Sebi is stopping short of calling it ‘stewardship’. They have gone the whole hog and said that everything needs to be done. This was followed by PFRDA asking pension funds to adopt a stewardship code, and 18 months ago, the insurance companies also started it. In terms of this aspect, we are seeing a big change. In practical terms, it all starts with ticking the box—be it the firms and people who take it seriously, and the questions that they then start asking that matter—from capital allocation to board composition.
Different funds have different degrees of rigour in terms of adopting regulatory changes, and we should see significantly more progress in this area, going forward.
Halan: The second part of this conversation is about the intermediary—the self-regulatory organisation that is being thought about for distribution. There is ambiguity about who is an adviser and who is an agent in the mutual fund industry. We are not even talking about insurance, where these questions are not even being thought about. For this industry, there are registered investment advisers, there are IFAs who are the halfway house between advisers and distributors, and then there are the pure agents. What is it that can happen ahead, which will break the market up into a pure agent versus adviser market? We also need to remember that in a market-linked product, advice is embedded in the sales process.
Shroff: I agree that there needs to be regulation to fill the gaps and lay down the professional standard. Whether the self-regulatory organization (SRO) structure is adequate is still a question mark. While the direction is correct, I think there are several gaps in it. For instance, what is its formal status? Who is going to enforce it? Does it have the proper force of law? The fact that this service needs to be segregated from the rolled up regulation pertaining to the SRO under Association of Mutual Funds in India (Amfi), is the need of the hour. There needs to be a standard approach to all forms of advice, and sharing of best practices across market segments.
Halan: In the retail financial sector, you will have to move to a ‘seller beware’ model. We have a ‘buyer beware’, which is coming out of neo-classical economics because you have economists who are perfectly logical, they have degrees in finance and can make predictions. That version of the market gave us the ‘buyer beware’ model. But if we extrapolate the academic thread from behavioural economics, we can only reach a ‘seller beware’ market.
Narayan: What is the concern we have about the intermediation part? The risks are clearly of misselling. Are people aware of the risks of the product? Often, they aren’t, particularly in a pass-through industry like mutual funds, where there is no guarantee of any kind. The second factor is, is there full disclosure happening? At the third level, there are systemic risks for the industry, which I cannot see IFAs or individual adviser taking on. These risks have to be dealt with on a systemic level, and that’s where the entire ecosystem has a role to play, starting with the regulator. We do need an SRO, but I still worry that the number of people is too many to handle. Beyond the SRO, there has to be a taking on of responsibility by the regulator and the frontline industry.
Shah: Even in a pure capitalist market like the US, ‘buyer beware’ doesn’t hold true. There are regulations to protect the investor. In a country like India, we carry the fiduciary responsibility to ensure that there is some protection available to the investor. But we should not take it to ridiculous levels and rewrite the lending rules that have been honoured over centuries. That would break down the cycle.
Bhattacharya: Technology is probably the answer. The Indian investor, in general, is opposed to paying anything for advice. It’s not only the investor, everyone in the market expects that advice should be free. If that is the model they are used to, it is very difficult to segregate distribution and advisory.
On the other hand, the MF industry has only 2 crore folios, so we have a long distance to go. So to expect that this will be traversed without people being able to ask questions and finding out what they are getting into is unrealistic.
For preventing misseling, technology can play a part. There are efficient ways of ascertaining what should be a person’s risk appetite and what they are putting their money into. Therefore, there is a way to match the two and spot potential red flags. This is something that is already being done in the insurance industry, where if a 70-year-old puts a huge amount of money in an Ulip, there is a system of a call-back to ask the investor if they understand the risks.
We should probably take the technology route, because we have a far greater number of people to cover and most of them are not aware of the risks. Advice is necessary, it is a requisite for getting the product accepted by many more people; so segregating the two very strictly at this point of time may be counterproductive.
Tandon: It’s also a question of what the intermediary is advising on and what the expectations are. Another thing we often ignore is that while the manufacturers and advisers have responsibilities, for the man on the street to blindly follow is unfair. They also should do a little bit of homework before jumping into any of these products. The focus should also be on financial literacy.
Halan: Everything happens in an ecosystem, and the way the market is set up in India, an investor is forced to choose a regulator. The regulations across different industries vary widely. Is there a way to approach the goal of categorising products by function and not form?
Narayan: I completely agree that it should be based on to the function you are fulfilling for the client rather than the product name you have chosen. I don’t think anyone here would disagree with the notion of having one regulator for one product. The only thing I would caution against is that if I was in the MF industry, I would not take too much comfort in the fact that insurance companies are worse off or that PFRDA is worse managed.
Tandon: You are preaching to the converted here. We all believe that the way it is structured right now is not correct. If you look at it, each does have a separate KYC process. You do get a consolidated account statement. One of the questions I asked was if they could include insurance policies in the statement and I was told they couldn’t, because Irdai didn’t permit it. Clearly, investors today are crying out for a solution, but there are turf issues.
Bhattacharya: One good news is that getting that consolidated statement is a reality now. Just last week, the account aggregator NBFC model was launched. It will do precisely this; you have to register with an aggregator and give your consent, and you can register all of your financial accounts. The aggregator will then draw all the details and create a consolidated account statement.
It seems like such a silly waste of time and effort to do KYC for different segments of the market. Now they say once the cKYC is done, that will be enough. Now we will have to wait and see.
Regarding having one regulator, there are plenty of countries where that is the case. But to expect India to evolve into the same state is not realistic. I think the best thing that can happen is that the financial stability and development council can become a forum to resolve issues.
Halan: Nandan Nilekani had spoken about this at the PFRDA in 2009. He listened to all the problems and said “You need a screen with everything on it," and it has taken us 10 years to do this.
Shah: When we try to put structure into one part of the market, other unstructured parts take terrible advantage. For instance, there are chit funds and unregulated deposit schemes offered by jewellers. People keep losing money, but it doesn’t hit the headlines. It should be ensured that the structuring is in line with the larger ecosystem.