The markets regulator SEBI is in the process of overseeing the formation of an SRO-Self Regulatory Organisation-for mutual fund distributors. There are reported to be three organisations in the fray for being selected as the SRO for fund distributors. The SRO will handle a wide range of regulatory functions that one normally expects a regulator to handle. For example, it will qualify distributors and certify that they are fit for the business. It will form the rules and regulations under which distributors will work and monitor whether they are working according to these. Finally, it will hear complaints from investors against distributors and punish and/or disqualify those found to be violating rules or committing any other transgressions.
It all sounds very good. It reduces SEBI's workload to just regulating the regulator, instead of regulating tens of thousands of distributors. Do you see a problem in this vision, if I may use such a fancy word? The problem is obvious. In dozens of conversations I have had with actual mutual fund investors, I'm yet to find even one who thinks that this is a good idea. The fundamental problem is this--and this is something that no one admits officially: the relationship between financial intermediaries--using that term in the broadest sense--and their customers is fundamentally adversarial. Practically every customer expects financial intermediaries to act in their own interest and not the customers. And what's more, he holds this expectation not out of some innate perversity, but out of bitter experience, either his own or of someone known to him.
There is a very basic reason for this relationship to be adversarial, one that is built into the nature of the business. Fundamentally, the returns to the investor and the profits of the intermediary must come out of the same pool of money. Across all the activities that are called 'misselling', this is the common theme--the intermediary chooses to act in a manner that will mean that a relatively larger share of the customer's money comes to him. This inevitably means that a relatively smaller amount of that money works for the customer. Depending on the product class, this behaviour could mean different things. In insurance, it could mean selling a ULIP or an endowment plan instead of a term insurance and in mutual funds and stockbroking it could mean needless churning of portfolios.
The implication is straightforward. Instead of believing happy talk about everyone working together as one happy family for everyone's good, SEBI should recognise that self-regulation will not work. In financial intermediation, the nature of the products and the poor state of knowledge of the customer means that the balance of power is tilted towards the provider. This has been amply proven in every retail financial product in India. Allowing greater self-regulation is a fundamentally anti-customer stance.
There's a further problem with self-regulation. If one looks at the internal politics of all kinds of professional organisations and even industry associations, one inevitably sees larger and financially more powerful members capturing the functioning to the detriment of smaller and newer members. In financial intermediation, the implications are worse because experience has shown that larger intermediaries are more prone to misselling than smaller ones simply because the smaller ones expect the customer to have permanent personal contact with them.
The idea of self-regulation is based on the assumption that businesses can be trusted to take decisions that are in the larger interest of customers even if such actions reduce their profits. Unfortunately, practical proof of this idea is lacking, at least as far as retail financial services go. On the contrary, experience suggests self-regulation would end up giving them an even greater advantage over their customers.
All in all, there's a good chance that a self regulatory organisation will actually end up as a self-serving organisation for a subset of powerful members, as professional organisations, which act as SROs and gatekeepers in other fields, have become.
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