February 18th, 2019

When clear rules that govern the financial sector are enforced well, it ensures that both providers and consumers emerge from the market place as winners

At the 2018 FIFA World Cup in Russia, the video assistant referee (VAR) stoked a bit of controversy since it was the first time that the technology was being used in what is arguably the world’s biggest sporting event. However, behind the VAR intrigues, there was a much deeper issue that was going on – a strong desire to have clear rules that are enforced fully, in an area where opposing teams have high stakes pegged on a particular outcome.

Even though participating in financial markets cannot be likened to lifting the world cup trophy, the outcomes that consumers of financial services enjoy depend a great deal on 1) rules that govern how providers of these services interact with those who consume them, and, 2) if and how those rules are complied with and enforced. By rules, I mean the laws, regulations, standards and even industry practices that govern how the two parties in any financial transaction interact. There is emerging thinking that good outcomes depends as much on regulation as it does on culture in the industry.

At the heart of any regulatory regime – whether in financial services, airline safety or drug manufacturing – is the management of conflicts of interest among various players. Let’s illustrate with a practical example.

Most countries aim to increase the volume of credit to ordinary people. This spawned the rapid growth of retail credit, premised on the idea of a lender understanding the circumstances of the customer, hence – so the theory goes – being able to provide the most appropriate credit, by for instance not lending too much beyond what the customer can afford. However, the lender’s primary interest (or incentive, in the jargon) is to sell as many credit products as possible. Immediately, the interest of the lender conflicts with that of the customer, who may suffer from not being aware of the true, total costs of the loan. Charges may be hidden, unclear or require a degree in law to understand!

This situation immediately puts the customer at a disadvantage. Some of the consequences could be life-long: mis-selling a long-term mortgage could subject a borrower to years of financial ruin. With the advent of financial technology (fintech), selling financial products remotely could mean a customer misses the chance to petition a provider to satisfactorily resolve a compliant on time.

Until the emergence of statutory frameworks for regulating financial services, the basic legal framework contended that this situation was alright. The borrower, as one of the contracting parties (the lender being the counterparty in the loan contract), was offered limited recourse in private law (i.e. the law of contracts) because he was assumed to have entered into that agreement willingly, consenting to its terms and conditions. The remedies open to a customer would only be available if he could prove the grounds that courts use to set aside contracts, e.g., misrepresentation (if the lender lied) or duress (if he was somehow forced into the agreement). This situation highly favoured banks and other lenders.

It soon became clear that relying on private and contract law was grossly insufficient for several reasons. First, regardless of how informed a customer is, the balance of power will always be in favour of the lender. Second, the interests of providers were such that they disclose as little information as possible or delay the point at which that information is revealed. Third, in recent decades, it became clear that the actions of one institution could have wider impact, affecting players in the entire market. The bad actions of one institution could adversely affect others (so called negative externality). This realization shifted the basis on which financial services are regulated from predominantly private law to public law, embodied in various statutory frameworks currently in place.

It is important to point out that regulation – conceived as a mechanism to remedy the conflict of interests and incentives – should not be seen as an evil that prevents the market (supply and demand) from providing services to those who can best afford them. Regulation sets the ground rules, and good regulation, just like the VAR in a football match, ensures that rules are complied with and fully enforced.

Two British economists, John Vickers and John Kay (the latter delivered FSD Kenya’s 3^rd Annual Lecture on Financial Inclusion) once wrote “competition where possible, regulation where necessary,” arguing that regulation, when properly designed, can enable a market to work efficiently and generate good outcomes for customers and providers alike.

This rationale for regulation has several practical implications. A few examples include:

• Soundness of institutions – regulation requires shareholders of a bank to invest enough capital, so that an insolvent institution doesn’t have to meet its obligations by relying on bail outs or reneging on its obligations to third parties
• Consumer protection – regulation can give an irrevocable right to a borrower to cancel a product, even after signing the agreement, if the product does not work per how it was sold. This ensures that the provider has every incentive to ensure that there is not only full disclosure but that product features are exactly as the customer expected. In short, trading on the principle that honesty is always the best policy
• Product governance – in the U.S., strong consumer protection was triggered when academics argued that financial products should be developed with suitability and safety standards just as microwaves, lawnmowers and infant car seats: both are goods that can cause harm if poorly designed. If a poorly designed microwave can be returned to the seller because of a manufacturing defect, or attract hefty fines if harm is caused by negligence on the part of the manufacturer, so can a mortgage whose design and selling was improper. These safeguards ensure that shareholder interest does not trump the customer interest
• Market integrity – for example, rules to prohibit money laundering ensure that the financial system is not used to channel funds for financing of terrorism or cleaning dirty money, activities that harm society when providers fail to operate with high standard of care, skill and diligence

These outcomes are important especially for poor people who are likely to suffer the most abuse. They can be easily misled by, for example, false advertising and an unrealistic promises for ultra-high returns as has been the case with pyramid schemes and other financial scams.

In the end, like the World Cup VAR, good regulation should not guarantee that a team will have its way, or advantage one individual over the other. Like teams that take time to practice, consumers must also be careful. What good regulatory practice simply means is that whoever wins, that victory will be a result of clear rules and fair play, enforced in a way that even those who fail to lift the trophy will feel that the system has worked for them too, and not just for those who had greater muscle.

The author can be reached on: gitau.mburu@fsdkenya.org; Twitter: @mjgitau

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