Comment: ‘How the global regulatory backlash is affecting India’s advisory industry’

Like their counterparts in Europe, Asia, the US and elsewhere, financial advisers in India are having to cope with a growing burden of regulation, says the chairman of India’s Foundation of Independent Financial Advisors, Dhruv Mehta. Below, he explains how it is affecting practitioners in India.

During my recent meeting with FECIF – the Fédération Européenne des Conseils et Intermédiaires Financiers – I realised the common vision that both associations have for their members, investors, consumers and the industry, as well as our common challenges.

For financial intermediation is facing a regulatory backlash on a global scale – and it is a backlash which we believe is generally unwarranted.

Post the 2008 global financial meltdown, regulators across the world have been pushing forward a number of regulatory changes aimed at eliminating conflict of interest, providing greater transparency and enhanced disclosures.

Unfortunately, what has been lost sight off is that the problems that led to that meltdown were from different segments of the financial markets; namely, the housing/mortgage market, alternative investments market, and excessive leverage by the large investment banks and financial institutions – not the advisory sector or mutual fund industry.

Even in India, the mutual fund industry emerged relatively unscathed during the global economic crisis, and was able to weather the effects of the global meltdown, and fulfill all of its obligations to its customers.

Still, despite having no material evidence of any wrong doing by our industry or miss-selling by intermediaries, post 2008, the Indian regulator –  the Securities Exchange Board of India, or SEBI – also pushed for a number of significant regulatory changes, with a view to introduce micro-regulation of financial market intermediaries.

Mistaken belief that fee based advice is ‘the only way’

According to SEBI and some other global regulators, the client engaging with the adviser is in the best position to properly assess the value of that adviser’s services, and  should pay him accordingly. They also believe that financial intermediaries remunerated by commissions which are embedded in the cost of the products do not provide the right advice because of a conflict of interest.

Regulators have an apprehension that the presence of a commission-based fee structure has led financial institutions and intermediaries to focus on maximising commission incomes at the expense of the investor.

Globally, regulators have formed an opinion that there is a conflict of interest when an adviser receives commission from the product provider, rather than receiving a fee directly from the investor,  and  that this has to be eliminated, rather than managed.

Thus SEBI and a few other global regulators are considering a ban on commissions, and are working towards only allowing a fee-based service.

September, 2016 Consultation Paper

In September 2016, SEBI published a consultation paper which proposed migration to a fee-based system from a commission-based one, by banning distributors from giving advice to investors.

There was a clear objective to “un-bundle” mutual fund products, and migrate from an embedded, “commission-based” distribution scheme to a non-embedded, ‘”fee-based” intermediation.

The paper proposed a time period of three years for the intermediaries to compulsory migrate from being commission based advisers/distributors to becoming fee based.

Our organisation, FIFA, was at the forefront in engaging with all stakeholders and making representation on this subject.

Our representations highlighted the likely negative outcomes on a total ban on commission based distribution, which are:

  • The so-called “advice gap”  – retail investors will be orphaned
  • Around a 0.75% per annum increase in the total cost to investors
  • A dramatic fall in the number of intermediaries

Increase in cost to investors

Of the likely outcomes that we see following on from these changes, the increase in cost to investors is evident from FIFA’s study of expense ratios of 25 countries. The findings of this study have previously been presented to SEBI, and highlight the fact that the average expense ratios in countries with a fee model is 2.77%, whereas it is 2.02% where commission models still exist.

Thus, as noted above, an average estimated increase in cost to the investor of 0.75%.

Similar plans to herd and regulate advisers under a single regulatory regime in the UK, the Netherlands, and Australia have witnessed a contraction in the distribution channel, and a migration of remaining advisers/distributors towards  wealthier clients.

International Advisory Board

SEBI has an international advisory board, which has as its purpose guiding and advising SEBI and, in so doing, helps to bring to bear on its management global experiences and awareness of new developments and coming challenges.

During a meeting of this advisory board in January 2017, its members concluded that, for the time being, a commission-based as well as a fee-based approach to investment advice should co-exist in the Indian marketplace.

The transition from commission- to a fee-based approach, the advisory board believed, should be be gradual, and take place only after a thorough impact analysis has been conducted.

It urged SEBI to study the impact of migration to fee-based advisory models under RDR (the Retail Distribution Review) in the UK, FoFA (Future of Financial Advice) in Australia, and in markets in which robo-advisory models exist.

The compulsory migration of commission-based advisers/distributors to become fee-based advisers in India was then put on hold.

New proposals

However, in July 2017, SEBI came out with fresh proposals to separate the advice and sales/execution function, with fee-based advisers entitled to give advice, and commission based distributors only able to sell and execute but not to give advice.

These current and proposed regulations ignore the fundamental realities of the marketplace, and the way the advice profession has been structured globally and in India.

The investment advisory profession is predominantly a comprehensive service of advice, sales and execution. Execution would include purchase of the appropriate products. It also requires an ongoing service and hand holding.

Currently in India, and still across many countries, most intermediaries are remunerated through embedded commissions, which are paid out of the cost that the investor incurs on his investment, rather than in separately-paid fees.

In India, individual intermediaries are known as Independent Financial Advisors (IFA) and they are independent of any one product provider.

It is essential to understand the dual role that such IFAs have been performing – it is a role which includes an investment process of advice, sales, and service.

For his services, the IFA is compensated by the product provider from the cost that is charged to the investor.

In India, since the introduction of the RIA regulations, only 730 entities have registered, clearly indicating the lack of adoption of the fee-only model.

Today there are some 86,000 entities registered with the Association of Mutual Funds in India, which provide advisory services. A majority of them  – more than 80000  – are categorised as IFAs.

Reports indicate that nearly 80% of IFAs sell other financial products in addition to mutual funds  – for example, life insurance, general insurance and small savings plans. Most IFAs typically sell the mutual funds of five or ten asset management companies.

Included in this category of financial intermediaries are the national and regional distributors, which typically have a more organised and formal setup compared to the ordinary IFAs, with many of them having their own branch network, sales force, and online channels. In addition, many of them aggregate some of the sub-brokers’ business.

It would seem that the small number of registrations of Registered Investment Advisors is leading to measures by the regulator to force people to shift. Our concern is that the shift will be negative for the industry at large.

Conclusion 

As we see it, it is necessary that regulators the world over must evaluate the cost they are imposing on investors on account of their perception and fear of mis-selling because of conflicts of interest.

What needs to be acknowledged, first and foremost, is that the financial intermediary enables the investor to achieve his financial goals.

The focus has to shift onto achieving investor outcomes,  and away from the mode of intermediary compensation.

To truly empower investors,  they must be given the choice to invest on their own or through a financial intermediary. If they opt for the latter, they then need to be given the option of how they remunerate the adviser  – whether by way of fees or embedded commission.

Similarly, advisers must be given the freedom to offer the investor a fee-based or an embedded, cost-based service.

The regulator should not be making these choices or eliminating any of these options. Reducing the available choices to the consumer is never in the consumer’s interest in the long run.

The free market system will allow the most efficient model to grow and prosper.

The Foundation of Independent Financial Advisors (FIFA) represents independent financial advisers and mutual fund distributors across India. This column originally appeared on the website of FECIF (the Fédération Européenne des Conseils et Intermédiaires Financiers). 

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