Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Wednesday, March 23, 2016

Financial Crisis, Corruption and Conflicts of Interest: What Central Banks Need to Understand in Regulating and Supervising the Financial Sector!

Ramesh S Arunachalam 
If one looks closely at many of the past financial crisis situations (like the 2008 global financial crisis fuelled by the US sub-prime), it is clear that they can be linked to lax and laissez-faire regulatory and supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall financial industry concerned!

In other words, these regulatory and supervisory frameworks created had serious “conflict of interest situations” that led to such lax and laissez-faire regulatory and supervisory frameworks being developed in the first place! This was corruption at its best indeed and there can be no two doubts about that.

Despite all that has happened, even today, there is a puzzling lack of attention given to the role played by conflicts of interest in the corruption saga and especially with regard to the larger financial sector. Look at the United Nations Convention Against Corruption (UNCAC). Even the UNCAC only makes a fleeting mention about the role played by conflicts of interests, despite it being very important to understanding and unearthing corruption worldwide.

Nevertheless, it is my humble opinion that conflicts of interest are of significant importance to regulatory ethics and this is something that all central banks need to note with urgency because if not eliminated, these conflict of interest situations could spell disaster for the larger financial sector as they could (result in corruption and) ultimately, lead to financial crisis caused by laissez-faire regulation and supervision

First, let us look at what is meant[i] by “conflict of interest”?

A ‘conflict of interest’ is a conflict between the duty, roles and responsibilities and private interests of any official, which could improperly and unfairly influence the performance of his/her official roles and responsibilities.

By private interests I mean the following…

Private interests include financial, pecuniary and other interests[ii] which generate a direct personal benefit to the public official as also personal affiliations, associations, and family ties, that could (practically be considered as likely to) improperly and unfairly influence the official’s performance of his/her roles, duties and responsibilities.

Defined in this way, conflict of interest has the potential to undermine the proper functioning of institutions (public, private, not-for-profit), governments and the like by:

         Weakening adherence by officials to the ideals of impartiality, objectivity, fairness and legitimacy, in decision-making, and
         Distorting the rule of law, the development and application of policy, the functioning of organizations and markets, as well as the allocation of resources. 

And what indeed is the difference between conflict of interest and corruption?

Conflicts of interest situations exist where officials could abuse their position (s) for personal and private gain. On the other hand, corruption exists where officials have abused their position (s) for personal and private gain. Put differently, conflicts of interest situations DO NOT always lead to corruption. However, where there is corruption, you can be sure that conflicts of interest INDEED exist!

OK, Why do we need to attach so much importance to conflicts of interest with regard to regulation and supervision in the financial sector? This is because if it is not entirely eliminated and/or at least properly reduced, the conflicts of interest can lead to corruption in regulation and supervision and thereby even threaten the entire financial system.

At least, this is what past crises situations have taught us. In fact, if there is a single most recurring theme in financial crises and scandals globally, it is the failure to manage conflicts of interest. And here are some examples:

Let us look this with regard to the larger financial sector in the United States and India, which provide very useful learning with regard to conflicts of interest and their relationship to crisis situations. They hold very important lessons for Central Banks globally! 

As described by former SEC Chairman Arthur Levitt, “Bank involvement in the securities markets came under close scrutiny after the 1929 market crash. The Pecora hearings of 1933, which focused on the causes of the crash and the subsequent banking crisis, uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest; the underwriting of unsound securities in order to pay off bad bank loans; and "pool operations" to support the price of bank stocks.”

In fact, as Levitt has further argued, it is the significant revelations of ‘uncontrolled conflicts of interest’ (please note this carefully) that provided the basis and rationale for the passing of many subsequent regulations - the Securities Act (1933), the Securities Exchange Act (1934), and the Glass-Steagall Banking Act (1933). In fact, it appears that conflicts of interest were also the major reason for the enactment of the Investment Company Act (1940) and the Investment Advisor Act (1940).

Closer to the 1990s, when I lived in the United States for several years, I personally saw numerous examples of conflicts of interest leading to a crisis:
  • The insider trading scandals (such as, the Ivan Boesky and Dennis Levine scandals in the 1980s), the closure of Drexel Burnham Lambert (the investment bank) and the associated (criminal) conviction of its famous employee (Michael Milken) are still fresh in my memory.
  • And then there were more financial scandals in the early 2000s – for example, the internet bubble in 2000/2001 exposed problems with dubious high flying research analysts (with very significant conflicts of interest) whose reports were in fact influenced by their own institutions’ investment banking interests. This, in fact, led to specific provisions in the Sarbanes-Oxley Act that dealt with conflicts of interest among research analysts.
  • And just about a decade ago, in 2003, SEC found that the use of brokerage commissions to facilitate the sales of fund shares [was] widespread among funds that relied on broker-dealers to sell fund shares. This led to the adoption of new rules to prohibit funds from this practice[iii].
And then, we had the mother of all financial crises in the recent times—the global financial crisis of 2008, which was again based on significant conflicts of interest in many areas such as the production and sale of mortgage-backed securities, rating of these instruments and so on.

As noted in the 2007 report of the Financial Crisis Inquiry Commission (“FCIC”), conflicts of interest that existed among rating agencies in evaluating collateralized debt obligation (“CDO”) deals was investigated by the SEC which subsequently issued a report in June 2008 that stated that conflicts of interest at Moody’s was indeed a very, very major issue. And I quote from this report:

“We introduce some of the most arcane subjects in our report: securitization, structured finance, and derivatives—words that entered the national vocabulary as the financial markets unravelled through 2007 and 2008. Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market depended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed 20 years earlier, were the first dominoes to fall in the financial sector.” (Page 28)

Just as an aside, I would like to state there are huge problems with securitisation in the Indian micro-finance sector as well and hope India’s central bank, the RBI, takes note of the same.

Getting back to the FCIC report, it cited several other conflicts underlying the crisis such as: a) underwriters assisting CDO managers in selecting collateral; and b) hedge fund managers selecting collateral from their funds to place in CDOs that they offered to other investors. The FCIC report notes in the above connection that:

“The SEC investigated the rating agencies’ ratings of mortgage-backed securities and CDOs in 2007, reporting its findings to Moody’s in July 2008. The SEC criticized Moody’s for, among other things, failing to verify the accuracy of mortgage information, leaving that work to due diligence firms and other parties; failing to retain documentation about how most deals were rated; allowing ratings quality to be compromised by the complexity of CDO deals; not hiring sufficient staff to rate CDOs; pushing ratings out the door with insufficient review; failing to adequately disclose its rating process for mortgage-backed securities and CDOs; and allowing conflicts of interest to affect rating decisions.” (Page 212)

Yet another conflict cited in the report was about Citigroup offering “liquidity puts” that gave it significant fees in the short term but placed significant financial risk on it in the long term. And I quote the following on Citigroup from the report –

“There is a potential conflict of interest in pricing the liquidity put cheep [sic] so that more CDO equities can be sold and more structuring fee to be generated.” The result would be losses so severe that they would help bring the huge financial conglomerate to the brink of failure, as we will see.” (Page 139)

Another high profile example of conflict of interest in the recent years is the settlement that the SEC reached with Goldman Sachs, in which that firm paid $550 million to settle charges filed by the Commission, and acknowledged that disclosures made in marketing a subprime mortgage product contained incomplete information as they did not disclose the role of a hedge fund client who was taking the opposite side of the trade in the selection of the CDO. And I quote

“2. Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was "selected by" ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure. (http://www.sec.gov/litigation/litreleases/2010/consent-pr2010-123.pdf , Page 2, point 3)”

After the 2008 financial crisis, there are a couple of examples of problems that arose from poorly controlled conflicts of interest. One is the famous case of Barclays Bank, which acknowledged misconduct related to ‘possible collusion’ to artificially set LIBOR (the London Interbank Offered Rate). As all of us know, LIBOR is a very significant benchmark that is used to set short-term interest rates on different financial instruments including derivates.

Second is the 2010 Andhra Pradesh (AP) micro-finance crisis which is again a classic example of the conflict of interest problem! In the 2010 AP crisis, the lax regulation and laissez-faire supervision of the NBFC MFIs (done at the behest of the micro-finance industry at large and NBFCs in particular and RBI’s own misplaced trust in NBFC MFIs as Dr Y V Reddy, former Governor has admitted) led to the eventual crisis on the ground.

To summarise, what needs to be emphasized here is the fact that the ‘broad industry of financial services’ which needs to be regulated surely cannot decide on its own regulation. In fact, many of the past crisis situations given earlier, can be linked to lax and laissez-faire regulatory/supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!

And central banks must guard against this and specifically, they must attempt to protect independent committees (an instrument often used by central banks) that are looking into regulation/supervision of the larger financial sector from the influence of the companies (institutions) operating in the same financial markets. This is a strong prerequisite to ensure effectiveness of the regulatory architecture being developed.

Otherwise, the threat arises that, instead of being guided by public and larger client interests, such so-called independent committees (at central banks) will promote the interests of those companies and institutions whose activities are supposed to be regulated and supervised in the first place, which, in the long-term may lead to the collapse of the entire financial system (as it happened in 2008). And central banks (globally) can ignore this important fact at their own peril!

Thank You and have a nice day!

[i] These definitions have been compiled from several sources including OECD and other material found on the web, which are far too numerous to quote. These are gratefully and sincerely acknowledged.
[ii] The negotiation of future employment by an official (for himself/family/friends) prior to his leaving his present office is one example here and there is many more examples that I could provide. This is like negotiating a job with a vendor. For example, an official may say, “I will make rules governing X and Y situations very lenient provided you make my nephew the CEO in another project of yours.”
[iii] Please see http://www.sec.gov/rules/final/ic-26591.pdf - Prohibition on the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Release 26591 (Sept. 2, 2004), 69 Fed. Register 54728, 54728 (Sept. 9, 2004).

Monday, March 21, 2016

Digital Financial Inclusion and Violation of Client Rights in India: Time to Have An Independent Client Protection Agency?

Ramesh S Arunachalam

If you look at the structure of what’s happening in digital financial inclusion, you are seeing a large number of stakeholders get involved and these are not necessarily financial institutions. TELCOS, merchants, intermediaries, agents and a whole range of other NEW stakeholders are getting involved in the delivery of (digital) financial inclusion services. That is fine but what is very important and also needs to be noted is that none of them have serious regulatory/supervisory oversight and because of that client rights are being violated!

Let me give a few examples of what happened to a friend to illustrate what I am saying. This friend recently started using a digital wallet (through his mobile) to top up air time and also buy small things. On several occasions, his complaint was that due to poor network connectivity and/or some other (technical) reason, the money had been debited from his digital wallet account but the purchase did not go through. Now he claimed that this is also happened in the case of his recently acquired credit card and he offers these two instances.

First, when he tried to top up his mobile, a transaction for Rs. 500/- (about US $ 7.5) through the digital wallet, the money got debited from his digital wallet account but then the TELCO did not top up air time. He called their customer care department (with great difficulty as there was a long list of options to go through and choose from to reach a customer service staff) and the staff were extremely rude. When he told the staff about the problem, they said they would check and revert and soon enough, he got a message from the TELCO saying that due to technical reasons the top up did not happen. It is important to note that he did not get any message initially but got this only after he spoke to the customer service staff.  

He again called their customer care and told them that his money had been debited already for which the customer service staff said it will take at least 5 working days for the money to reflect back in his digital wallet. The key point to note here is that apart from not getting the airtime top up, which my friend required at that point in time, he was also poorer by Rs 500 (about US $ 7.5) for a few days. Technically that was his money and it should not have been parked with someone else – either the Digital Wallet owner and/or TELCO to whom it did not belong. In this case, the digital wallet was owned by the TELCO and so, the money was essentially with the TELCO.

The flip side is that if several such transactions occurred in a day, imagine the money that the digital wallet company and/or TELCO would be holding (unfairly). This is one serious issue with (digital) financial inclusion and needs to be noted by the regulators. And when this happens, while the amounts may be small for the individual clients, the aggregated amounts can be large on a PAN India basis for the digital wallet company and/or TELCO.

Second, the friend related a similar happening in the case of an airline booking thorough the mobile using his recently acquired credit card. Now that’s again using a digital financial inclusion service where my friend used his SMART credit card through his mobile and the money for the transaction was debited and went into the account of the airline (and/or merchant) but the ticket was not issued.

“The booking could not completed successfully was the message that flashed on my friend’s mobile and yet his money had been debited!”

Is this not unfair to my friend, the customer? Now there are serious issues here too. Also, for the money to come back to my friend’s credit card, it took more than 3 weeks.

Now, imagine that 500 rupees (about US $ 7.5) or, 10,000 rupees (about US$150) or 15,000 rupees (about US$225) are lying somewhere in between heaven and earth with somebody to whom they don’t belong because the service/product was not sold. Without doubt, this is legitimately clients’ money which is lying elsewhere and it takes more than 2/3 weeks to come back. Imagine the digital wallet company or airline or intermediary or merchant whose is making money out of this! How to regulate this is again a very serious issue for the regulators? And what happens to my friend and thousands of others like him whose accounts have been debited but who have not received the services that they desired? Have they not been unfairly treated? Who protects them now?

Three issues need to be answered given the above:

a)                 If educated and technology savvy customers (like my friend) themselves find it a huge problem to deal with such issues, what can low income and bottom of pyramid clients do, provided the same aspect happens when they use a (digital) financial inclusion product/service? Who, specifically, will provide them redressal and who, specifically will protect their very hard earned money (which in relative terms could make all the difference to their daily living)?

b)                How does a regulator/supervisor (presently, the RBI) sitting in Mumbai or for that matter a state capital reach out to customers and assure them that their money is safe under such circumstances? Specifically, how can the regulator even know that this is happening on the ground especially, when low income and bottom of pyramid clients are involved (as these clients have no real means to get back to the regulator who is presently, the RBI)? Intimidation aspects apart, there are logistic and livelihood issues which prevent low income and bottom of pyramid clients from getting back to regulators like the RBI.

c)                 What about the money (in an individual and aggregate sense) unfairly gained by the TELCO or the digital wallet company at the expense of a customer? What happens to that money? Let us not underestimate this amount as small change. Having been an enterprise architecture person for over 25 years and having been involved in development and implementation of core banking and ERP systems for a long, long time, “aggregation of small change” can indeed be very big. This is analogous to the “rounding off” phenomenon in core banking and ERP systems.

There are many more issues and examples that I can give you with regard to (digital) financial inclusion but the larger point is that when this can happen to highly literate customers, imagine the plight of low-income and bottom of pyramid clients. And most importantly, how can we expect bottom of pyramid and low-income clients to deal with these issues and who will ultimately protect them and their hard earned money?

That is why we need a specialized client protection agency focussing exclusively on (digital) financial inclusion as newer products/services using newer technologies are being delivered through newer stakeholders through newer processes. Innovation is fine but cannot come at the expense of client rights and these need to be protected! On a daily basis, client rights are INDEED being violated even as we rake up innovations through digital financial inclusion and that needs to be squarely addressed!

Treating the client fairly is a very critical component of any service and that is sadly missing in much of India’s digital financial inclusion space in real time! As noted above, I can provide innumerable examples but the key point is that the Reserve Bank of India doesn’t have wherewithal to look at all of this. And I don’t think clients (educated or low income or BoP) have the tenacity, ability and time to approach the Reserve Bank of India for redressal as some of these violations happen regularly.

And as I noted earlier in another post, I am very sorry to say this but given the past poor experiences of clients trying to contact people in the Reserve Bank of India for client protection issues, getting in touch with the banking ombudsman or other such stakeholders will indeed prove extremely difficult! Therefore, given the fast pace of innovations and given the burgeoning rate at which clients (including low income and bop clients) are being acquired in the digital financial inclusion space in India, it is about time that we set up an exclusive agency for client protection immediately!

Sunday, March 20, 2016

(Digital) Financial Inclusion and Microfinance: The Need for An Independent Client Protection Agency! (PART 1)

Ramesh S Arunachalam

Financial inclusion and digital financial inclusion are the new buzz words in the financial sector industry. Indeed there has been a lot of innovation in the area of financial inclusion and digital financial inclusion and the number of products on offer as well as the stakeholders who have deliver these products have increased significantly - both of which have contributed to immensely enhancing the complexity of financial inclusion and digital financial inclusion products and services. So, it’s naturally follows that protection of the end user clients - of financial inclusion and digital financial inclusion products and services - becomes very necessary. There can be no two doubts about that!

Now if you look at financial inclusion, traditionally, the suppliers of these products/services have been MFIs, banks and other institutions, some of which are regulated and supervised and others are not. Thus, while some of these institutions come under the purview of the central bank, others do not. However, when digital financial inclusion services come into play, service providers typically include TELCOS and a whole range of merchants, agents and intermediaries. Technically, while these stakeholders come under RBI REGULATIONS in India, their supervision is most certainly not as it SHOULD be, especially from a client protection perspective. Therefore, for both financial inclusion and digital financial inclusion services, it would be appropriate to argue that, at best, client protection services and client redressal mechanisms are at their infancy.

This is because if you look at central banks (like the Reserve Bank in India), especially in large diverse countries like India, even for the fewer institutions that they regulate/supervise, they don’t have the wherewithal to provide dispersed, decentralised and grass-roots level client redressal mechanisms and client protection services, which is very much required for low-income and bottom of pyramid (BoP) clients. And mere delegation of supervision and client protection issues to SELF-REGULATORY ORGANIZATONS (SROs) does not and will not work as self-regulation is an oxy-moron. Member controlled SROs cannot self-regulate and we have innumerable examples over the last 11 years, since the Krishna district crisis of 2005.

That being the case, the only feasible option is for clients to approach the banking ombudsman and use other existing mechanisms.  However, the transactions costs associated with going to a banking ombudsman can be huge and prohibitive for the low income and BoP clients. I am saying this with strong conviction because even somebody like me who is educated and “tech savvy” and belongs to what we call as the middle class (in an economic sense in India) found it very difficult to approach the banking ombudsman. Believe me when I say it is indeed very difficult to reach the banking ombudsman. I did try some years ago and in fact, I needed all kinds of references before I could even get an official audience with the regional director of RBI, who also happened to be the banking ombudsman in my area! So, not to sound like a broken record but low income and BoP clients will almost find it impossible to reach the banking ombudsman...let us be absolutely clear on that aspect...

And then of course you have other frameworks that attempt to protect the end user customers like the customer protection act or the outdated MRTP or the competition commission which has replaced MRTP and so on[1]. Accessing these is also extremely difficult, even for a person like me. I am therefore certain that low-income and BoP clients will find it extremely difficult to access these bodies and avail their services. Thus, the larger point that I am trying to make is the huge difficulty that low income and/or BoP clients face in accessing currently available client redressal mechanisms, whether be it the banking ombudsman scheme and/or other alternatives that presently exist.

The sum and substance of my argument is that low income and/or BoP clients - like the ones I have reported about from eastern UP, Bihar and Madhya Pradesh and similar places - face huge hurdles in reaching out to concerned people who POSSESS the executive powers to take action against those financial inclusion/digital financial inclusion stakeholders, who, may have violated consumer protection norms and guidelines in the first place.

Another aspect that has to be kept at mind is that India is a great country for legislative enactment and framing of rules and regulations but when it comes to actual implementation of laws/regulations/rules in real time, the record is rather poor. And implementation of laws/regulations/rules gets poorer and weaker, the more distant and remote the place is - like for example, eastern UP, Bihar and Madhya Pradesh. So, when you are talking of remote districts in Eastern UP, Bihar and Madhya Pradesh (and similar places) which are now experiencing burgeoning growth of (digital) financial inclusion services and where huge violations of client rights are taking place, the question that arises is “How do clients living in these areas protect themselves and how can they access client redressal mechanisms easily and quickly?”

And as it stands, the truth of the matter is that it is going to be very, very difficult for the Reserve Bank of India or any present regulator to even know the client protection violations that are happening on the ground. And unless they are aware that violations are occurring and the specific nature of these violations, they will not be able to regulate because I think the ability of low-income or bottom of pyramid clients to bring client protection issues back to the regulator (sitting in a faraway place and/or even state capital) is almost next to impossible. And there is of course, the issue of intimidation that these low income and BoP clients face for various reasons, because of which they are less likely to approach a far away located regulator.

So I think the case for having an INDEPENDENT client protection regulator (with a deeply entrenched grass-roots network) becomes very strong. With all due respect, I think that the Reserve Bank of India should regulate financial institutions with regard to prudential and non prudential norms and also look at institutional/organisational issues and other aspects. However, when it comes to the issue of client protection, just as it happened in the case of 2010 Andhra Pradesh microfinance crisis, somebody else will have to take charge of that. In (erstwhile) Andhra Pradesh in 2010, it was the state government which took on client protection because there was no such (national client protection) agency available. However, I feel that a state government taking on the client protection role is certainly not the most desirable option, just as we saw in (erstwhile) Andhra Pradesh where the state government intervention led to chaos on the ground and ultimately, turned out to be counter-productive.

So I think client protection requires a new PAN India independent agency (regulator) with a strong grass-roots presence. And it must be an agency which is neither involved in the development of (digital) financial inclusion and microfinance nor concerned with regulating other aspects of these (digital) financial inclusion/microfinance stakeholders. In other words, this client protection agency (regulator) should have a single minded focus on customer protection and look at everything from the perspective of the end user clients with regard to (digital) financial inclusion/microfinance. This single minded focus is required and only then will this regulator be able to do justice and ensure client protection at the grass-roots, which has far ranging and far reaching consequences for the (digital) financial inclusion and microfinance industry in the long-term!

Will that happen in India anytime soon? Your guess is as good as mine and this is a question that time only can answer...

Have a great start into the week!

[1] Then you have draft proposals like in the Financial Sector Legislative Reforms Commission, which I am sure will not see the light of the day, anywhere in the near future!