The Committee on Investor Awareness and Protection headed by D Swarup recently released a paper titled ?Minimum Common Standards for Financial Advisors and Financial Education?. The paper discusses measures which encourage participation in Indian financial markets through changing the framework for individual investors to increase returns.
The recommendations of the committee are an important step in moving towards a well-functioning financial system in India.
India?s financial system today is far from perfect. The success of a financial market is determined solely by the earnings that investors in the market make over time. An efficient market can be described in terms of several characteristics, but all of these are determining the single measure of success?efficiency of the market. Our first step in moving towards financial sector reforms in India is to stop thinking about various aspects of the financial system as goals in themselves; we must learn to measure them in terms of a single outcome?their impact on increasing returns to investors in the long run.
When we consider any recommendation aimed at financial reforms, we must learn to ask the single question?does the measure consistently increase returns for investors? If it does, we can be sure of greater parti-cipation in financial markets, increased financial awareness and deeper penetration of finance in the country, which we earlier considered as distinct character-istics of success of the finan-cial sector.
Once we have moulded our view to this new perspective, we must focus on how to achieve this single target of a more efficient market. What are the possible measures that answer the above question in the affirmative? This brings us to the second step in financial sector reforms?the role of laws and regulations. Our financial laws were not designed to achieve the objective of increasing the overall wealth of an investor in the Indian financial markets. Our current system of regulation is to have different segments of the financial sector come under different regulators. This ?silo model? means that no single body looks after the overall health of an investor, and no single body looks after the overall health of a company. Further, inter-regulatory conflict reduces returns for the investor, as was seen recently in the fiasco between IRDA and PFRDA, where the insurance regulator did not wish to lose regulatory turf by allowing LIC to promote NPS. The outcome of this was to reduce penetration of the NPS, which allowed pension savings to be made at low costs and in small amounts.
To resolve issues like these, an increasing number of countries are moving away from the silo model, which creates artificial segmentation of the financial sector, to a ?twin peak model?, where regulation is divided into two parts in terms of objectives. One arm looks after the health of investors, and the other looks after companies. The recent financial crisis shows how increased communication and coordination between separated regulators could prevent massive shocks to the economy.
The Swarup committee report focuses on the first part of this regulation model. It recommends a separate body to monitor all financial advisors, across all segments of the industry. This body will also focus on overall financial literacy for investors. The structure of this organisation is different from that of regulators seen in financial sector so far?it focuses on overall financial health of the system, and dismisses the artificial segmentation of finance we are accustomed to.
The report emphasises a minimum standard of financial knowledge for advisors, through a common exam. An important recommendation which redefines the role of advisors is the complete removal of commissions for insurance agents by 2011. This follows Sebi?s measure to remove entry loads on mutual fund investments last month. Sebi?s rationale was to unbundle costs and make them more transparent, by separating the cost of the broker from the cost of the product.
The insurance industry has been riddled with high non-transparent costs to investors. The commission to an agent from an insurance policy can go up to 80% of the first year premium. Further, as different products have different commission rates, there is frequent mis-selling. In the new scenario, the incentive of the financial advisor would be to increase the overall long-term wealth of the investor, rather than churning and extracting commissions. This move increases transparency and returns, and through lowered costs, it allows a greater section of the population to be insured. The quality of financial advice will dramatically improve, and more investors will choose to learn about financial products and invest without intermediaries.
Through these recommendations, the Swarup committee report paves our path from an inefficient and ill-functioning financial market which discourages participants due to high costs, low transparency, poor quality of services and the lack of proper redressal mechanisms to an efficient financial system, which ensures consistent high returns for investors.
?The writer, who has worked on financial securities, is a graduate scholar at LSE