The Securities and Exchange Board of India has proposed that the distributors of mutual funds should only be allowed to sell financial products and not act as financial advisers for customers. Drawing analogies from the regulatory frameworks for driving on public roads and practising medicine, Gurbachan Singh contends that this is a step in the right direction but much more needs to be done to regulate financial advice.
It is often said that stock prices basically follow a ‘random walk’1. However, this is true primarily in the short term. In the long term, returns can be somewhat predictable, given the current valuations (Berg 2015, Campbell and Shiller 1998) - provided stock prices and the ‘fundamentals’ are regularly monitored. This is where sound financial advice for an ordinary investor on a somewhat regular basis can be very useful. Financial advice is, of course, good for an investor. But it is interesting that it is useful even from the viewpoint of macro-financial stability; this is the focus here.
In the absence of sound advice, there can be ‘herd behaviour’ and ordinary investors can take wrong decisions, thereby affecting stock prices. This can cause negative pecuniary externalities2. For example, investment demand by firms in the real sector can get affected (Blanchard et al. 2013); this, in turn, makes aggregate output and employment unstable. Hence, sound financial advice is crucial.
On 22 June 2017, the Securities and Exchange Board of India (SEBI) issued ‘Consultation paper on Amendments/Clarifications to the SEBI (Investment Advisers) Regulations, 2013’. SEBI is mulling over imposing a restriction on the distributors of mutual funds. It is proposed that the distributors should only be allowed to sell financial products, and not act as financial advisers for customers as a conflict of interest is involved (similarly advisers cannot sell financial products). This is a step in the right direction but there is a need to go much further. To see this, consider an analogy.
Financial adviser’s licence and an automobile driver’s licence
A person needs to obtain a driver’s licence before s/he can drive as there are possible negative externalities due to driving on public roads. Such a restriction can be socially useful; it can expand rather than contract the size of the automobile industry. By making driving safer, the restriction encourages people to commute using automobiles, buy automobiles, and drive on roads. We may say that we have here a case of expansionary restriction.
Drawing a lesson from the above analogy, we can have an expansionary restriction in finance as well. Anybody who wishes to become a finance practitioner (or adviser) needs to obtain a licence for which there is a need to pass an examination in finance and related subjects. At present, however, the syllabi and examinations for aspiring financial advisers are not adequately rigorous3.
All this raises the question: How does a restriction on driving as a policy towards externalities fit in with the economics literature?
Externalities, Pigouvian taxes, and restrictions
Following the standard treatment in textbooks, a solution to the problem of the possible negative externalities of driving could have been a Pigouvian tax4 on those who are identified as bad drivers! However, such an idea would be unacceptable to the society (even if the victims of road accidents are compensated financially). So, there is a need for an alternate policy, which is that those who have not cleared the driving test will not be allowed to drive at all on public roads. We may say that we have here a policy of restrictions as a substitute for Pigouvian taxes (Singh (2017) and the references therein).
The purpose of both Pigouvian taxes and restrictions is to reduce negative externalities. While taxes are suitable in some situations, restrictions are required in others. If a factory emits smoke, then a Pigouvian tax is, as textbooks explain, suitable. But in case of driving an automobile, the requirement of a licence is appropriate.
In financial markets, less informed or irrational traders and investors can, as mentioned earlier, cause pecuniary externalities. So, in accordance with the standard theory, the government may impose Pigouvian taxes on them. Alternatively, the regulators may simply ban their participation.
At present, there are two difficulties. First, a huge proportion of investors have not passed a test in finance; they essentially act on the basis of their own knowledge which can be inadequate, outdated, or simply irrelevant. Second, though financial advisers have passed a test in finance, the test is not rigorous enough. Hence, I propose that: (a) ordinary investors are banned from participating unless they have obtained a financial prescription from a financial adviser, and (b) the standards for examining financial advisers are raised substantially.
Let us consider another analogy.
Finance and medicine
It is true that in the field of medicine, unlike the case of driving or investing, there are hardly any externalities (except in cases of infectious diseases, which may be ignored here). So, the comparison between the regulatory framework for financial markets and that for the medical industry is not very appropriate. However, there is another aspect. The regulation for financial markets being proposed here is that those who aspire to practise finance or become financial advisers must clear a rigorous examination. This examination in finance can be the counterpart of the examination used before conferring a degree like MBBS (Bachelor of Medicine, Bachelor of Surgery) or MD (Doctor of Medicine). These examinations in the field of medicine are very rigorous: regulators like to ensure that medical doctors are competent enough to look after the health of the people. Similarly, there is a need to be strict when it comes to ‘money doctors’ (or financial advisers) who look after the wealth of the people.
There is another important lesson for finance from the regulatory framework for medicine. It is typically mandatory for patients to consult a medical practitioner and obtain a medical prescription before buying most medicines. Similarly, in finance, the regulator can make it mandatory5 for an investor to obtain a financial prescription before s/he can invest. The basic premise is that finance is not an easy subject for anyone not educated adequately in the area; it is another matter that it may often seem to be somewhat straightforward.
It is true that in the past money doctors have been often a part of the problem rather than the solution (Gennaioli et al. 2015); this may seem to negate the thesis in this article. However, money doctors (and even the certifying and licensing agencies) operate the way they do, given the prevailing regulatory framework. Once that framework is changed, it is plausible that the outcomes change./p>
The regulatory framework for driving on public roads and that for practising medicine is not perfect. But there are, as discussed here, important lessons to be learnt from both of these very different fields, for financial advice.
The regulations on financial advice that SEBI is considering at present are a step in the right direction. However, SEBI needs to move much further. The examination for obtaining a financial adviser’s licence needs to be far more rigorous than it is at present. Next, obtaining financial advice before investing should be made mandatory. These steps are not going to be easy but there is hardly any quick solution to the old, persistent problem of possible mispricing and excess volatility in financial markets.
- The theory of random walks implies that a series of stock price changes has no memory - the past history of the series cannot be used to predict the future in any meaningful way (Fama 1965).
- A negative pecuniary externality occurs when the actions of an economic actor cause an ‘unpaid for’ adverse effect on others. The externality operates through prices rather than quantities.
- See, for example, a sample question paper for NISM Series XB: Investment Adviser (Level 2) Certification Examination: http://nism.ac.in/certification/images/pdf/Sample-Questions_IA-Level-II_23.1.2017.pdf (NISM is National Institute for Securities Management, the body that conducts the examination).
- A Pigouvian tax is a tax levied on any market activity that generates negative externalities (costs not internalised in the market price). The tax is intended to correct an inefficient market outcome, and does so by being set equal to the social cost of the negative externalities.
- Singh (2017) allows for, what is called in the paper, quasi-mandatory financial prescription, which is less restrictive.
- Berg, T (2015), ‘Quicksilver markets’, OFR Brief Series, Office of Financial Research, 15-02, 17 March 2015.
- Blanchard, O, A Amighini and F Giavazzi (2013), Macroeconomics: A European Perspective, Pearson Education Limited.
- Campbell, John Y and Robert J Shiller (1998), “Valuation Ratios and the Long-Run Stock Market Outlook”, The Journal of Portfolio Management, 24(2):11-26. Available here.
- Fama, Eugene F (1965), “The Behavior of Stock-Market Prices”, Journal of Business, 38(1):34-105. Available here.
- Fama, Eugene F (2014), “Two pillars of asset pricing”, The American Economic Review, 104(6):1467–1485. Available here.
- Gennaioli, Nicola, Andrei Shleifer and Robert Vishny (2015), “Money Doctors”, Journal of Finance, 70(1):91-114. Available here.
- Singh, G (2017), ‘Policy towards the financial markets: a paradigm shift’, Working Paper.