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Financial Industry Regulations Make or Break Us!

Mukesh Dedhia, CFP, IndiaBy Mukesh Dedhia, CFP

Regulation is needed for any market to function properly. If it weren’t for regulation, markets could be manipulated by big, influential players. But, just as good governance is not ensured by holding proper elections, existence of regulations does not ensure healthy competition or protection of market participants. Hence, effective enforcement of regulation is a must.

SEBI’s Regulation of Investment Advisors

SEBI, the Indian Capital Market regulator, protects the interests of investors in securities and promotes the development of the securities market through appropriate regulation.

In October of last year, SEBI published a concept paper on regulation of investment advisors. This article discusses the pros and cons of the concept paper, because it could lead to a massive change in the way investment advisory business functions.

The concept paper mentioned that financial products are intangible and conceptually, more difficult to understand, as well as the fact that financial literacy levels in India are low. SEBI realizes that distributors occupy a key role to help India reach the target of financial inclusion. As compared to 120 crore of population, India has about 30 lakh insurance advisors and only about 45 thousand mutual fund distributors. Is this situation great? Obviously not. So, India should not only have an executor but also a hand-holder. Indian investors today need an agent combined with an advisor. Demarcating both of them is not practically feasible in the current Indian environment, though.

Implementing Regulation is a Big Deal

The thought of announcing a regulation that separates advisors and agents in India is too premature because Indian markets are still at a nascent stage. The UK Regulator, FSA, has delayed implementation of the same model by one year. Also, in the US, their regulator is yet to come out with any such regulation. A similar regulation has been announced in Australia, but it seems even their regulator has hesitated to bring in such rules. Now, financial planners are moving away from retail investors and concentrating only on high net worth individuals or HNIs who can pay fees. Thus, retail investors are left to make financial decisions on their own.

Compulsory Exams Aren’t Enough

Rather, in India, reforms are required not only for investor awareness but also for distributor education. Having compulsory exams such as those of the AMFI and IRDA were good steps. But now, we need to go to the next level. Advisors should carry, at least, one of the following certifications:

  • Certified Personal Financial Advisor
  • National Institute of Financial Markets
  • CERTIFIED FINANCIAL PLANNER

As continuous education is mandatory, advisors should conduct investor awareness programs where regulators, manufacturers and intermediaries join hands.

A Conflict of Interest?

In the concept paper, SEBI talks about the existence of a conflict of interest, as a dual role is played by distributors. Distributors act as agents of investors and also of manufacturers. This issue has been partially dealt with by banning entry loads. But, there is apprehension, as upfront costs are still paid by Asset Management Companies, so this upfront payment can be banned and only trailing commissions can be allowed. Effectively, completely banning upfront commissions will not lead to frequent churning of the investor portfolio.

Situations where the distributor is paid by both parties should not be an issue because fewer than one percent of distributors are in a position to charge fees from a client if they are receiving commissions from the manufacturer. Also, we must assume that planners who charge are able to do so because they are providing some additional value to their clients. So, why bother reforming such a model?

SEBI fears that distributors are likely to be partial to manufacturers, because they are the best paymasters. But, the August 22nd circular on due diligence took care of the prudent checks required while advising clients. SEBI should state standard minimum and maximum commissions that can be paid to advisors. This range should be balanced and it should also create incentive for newcomers (AMC level and advisor level) to enter the industry.

In India, Client Engagement is Necessary

To do this hand-holding while making sure clients don’t feel the pinch, distributor incentivized commissions are required. Distributors/advisors can negotiate with the client a certain fixed fee or a percentage of assets under management (AUM) and give a discount for average commissions they would be receiving from the Antitrust Modernization Commissions. This method would give total transparency and remove the conflict of interest.

To achieve financial inclusion, I would like to suggest introducing the concept of financial planning at the base level. To reach all Indian investors I would like to first categorize them into two categories: 1) tax payers and 2) non-tax payers. As a tax payer is serviced by a chartered accountant or a tax practitioner, these professionals could potentially offer financial planning to these clients. So, I feel these professionals should undergo training for financial planning.

On the other hand, non-tax payers are the ones who need financial planners the most. Non-tax payers avail financial services of IFAs for insurance and mutual funds and banks for banking solutions. It would be wise to do their basic level financial planning such as risk profiling at these very levels. This would make the investor acquainted with the financial planning ideology.

In summary, I think the Indian regulator needs to raise the level of education and qualifications for investors and distributors. Execution of investment should not to be separated from advising. No upfront commissions should be paid. Regular trail commissions should be continued by regulating the range of commissions. Fee-based financial planning should be encouraged where discounts of commissions received can be passed to clients, assuming transactions are also executed by the advisor. All in all, regulations should not only look good on paper, but should be such that their practical implementation leads to a constructive and healthy industry.

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