Complex vs simple financial instruments: What is in best interest of customer?

Several financial advocates and regulators have argued forcefully for simplicity in the design and pricing of financial products so that customers can fully comprehend what they are buying and can compare multiple pricing options across different providers. This focus on simplicity intensified after the 2008 global financial crisis which exposed the world to complex financial products and their supposedly inherently harmful nature, directly leading to, for example, the creation of the Consumer Financial Protection Bureau (CFPB) in the US. In light of these events, simplicity in the design of financial products and services have become inextricably linked to the regulators’ view of customer protection.

An overly zealous enforcement of the principle of simplicity on financial products and services, combined with a consumer product-led FMCG style marketing associated with these products by providers and the inability of regulators to keep pace, has ensured that this principle has crept into the very design of financial products, often at the cost of optimal financial outcomes for the consumer. As Professor Zywicki argues, “an undue focus on simplification risks sacrificing functionality in order to fit the product’s attributes into the straitjacket of the preferred disclosure format, rather than fitting disclosure regulation to the product’s substantive attributes”.

In a well-functioning market, there is a strong need for customers to understand exactly what the functionality of a product is and whether the price charged for any improved functionality is consistent with the value that it provides to them. For instance, a customer looking to buy a mobile phone would understand the benefit she could get from additional features such as higher storage or processing power even while she may not fully understand the details of their technical working. She would also be able to estimate the incremental value to her, of these features above that of the basic operating model, and her choices (and in aggregate, the very behaviour of the market) would be guided by it. Likewise, for financial services and products, the product attributes need to be communicated through a disclosure regime that emphasizes clarity, comprehensibility, and completeness but it is not at all clear that it is in the interests of the customer to take a reductionist approach towards product design itself by reducing its complexity and therefore its associated functionality merely so that the customer can understand how the product is constructed.

A farm loan of Rs.12,000 with a monthly repayment schedule of Rs 1,000 and a fixed interest rate on a reducing balance of 10 percent is, for example, a simple product for a farmer. However, in an environment where the farmer is already exposed to high levels of rainfall and commodity price risks, this amounts to adding leverage to an already volatile situation, thus, exacerbating the impact of the volatility on the farmer’s income. Instead, offering the farmer a more complex product with embedded rainfall and commodity price derivatives would be much safer and more suitable for her.

Simplicity as a principle has also been employed in financial and market regulations too. A case in point is the Reserve Bank of India’s framework for asset provisioning, which require banks to set aside provisions based on exact rules relating to how long the advances have experienced payment delays. Such a simplistic approach does not consider the underlying riskiness of the asset class level variations due to aspects such as borrower characteristics and product design. It instead forces providers to design products to fit into these mechanical rules irrespective of what would be most suitable for the borrower.

An oversimplification of product design and financial regulation impedes the fulfilment of the role of finance, which is to provide the consumers with an ability to offset risks that they face in their engagements with the real sector. While opaque in their construction details due to the underlying mathematical principles, complex financial instruments and products can allow for consumers to meet their precise financial needs.

Regulators need to understand that restricting complexity in design is not in the best interests of the consumer, and they must strive to equip themselves with the capacity to deal with and regulate such complexity. Regulations need to strive to ensure that consumers have access to suitable even if complex financial products and not force providers to offer simple but entirely unsuitable and risk-enhancing products.

There are sometimes situations in which the underlying building blocks to construct suitable financial products simply do not exist in the market. Instead of preventing providers from offering suitable products, the regulator could instead enable the development of such tools by, for example, encouraging the development of an index like the S&P Case-Shiller Home Price index and the trading of derivatives on it, thus allowing the development of mortgage products that shift home price risk away from consumers. A regulator like the Reserve Bank of India, with substantial market operations, could use its presence to also act as a market maker in some of these underlying building blocks to ensure liquidity and good price discovery.