Regulatory strategy for savings/investment schemes, that would address ponzi schemes

by Suyash Rai and Smriti Parsheera

The first task in dealing with ponzi schemes is correctly defining the scope of financial regulation. Once a firm is classified as a financial service provider, the appropriate regulator must choose a regulatory strategy for it. Assuming SEBI had clear jurisdiction with Sahara or MMM, what would SEBI do?

Safety and soundness regulation (also called micro-prudential regulation) is an expensive form of regulation, which includes requirements relating to maintenance of capital, investment restrictions, corporate governance, risk management systems, etc. This type of regulation can not apply equally to every financial institution. For example, the regulator should be able to distinguish between small member-controlled chit funds and larger chit funds.

Differences also need to be drawn based on the nature of the activity being carried out. Micro-prudential regulation should be less stringent for investment schemes as compared to deposit-takers, given the difference in the nature of promises being made to consumers. However, at the very least, the scheme would require authorisation from the regulator. In the MMM India example, had the scheme sought such approval, its promoters would have to satisfy basic fit and proper person requirements. Given that the scheme has been floated by Sergey Mavrodi, a convicted fraudster and the man behind Russia’s largest Ponzi scheme, it is likely that the scheme would have failed on this count.

This points to the need for a sophisticated approach to ensure optimal regulation. The law should allow the regulators to apply safety and soundness regulation wherever required, but the decision can’t be left to the regulators unconditionally. The law must provide some guidance to them, to make them accountable. What could be the form of this guidance?

Consider the following examples:

  • A bank with Rs. 10,000 crores of deposits from 1 crore depositors.
  • A local chit fund with Rs. 10,000 from 20 members.
  • A chit fund with Rs. 1000 crores from 1 crore members.
  • A hedge fund investing Rs. 1,000 crores, from 50 investors.
  • A mutual fund investing 10,000 crores, from 1 crore investors.

Where should safety and soundness regulation apply, and what should be the intensity of the regulation? A closer look reveals a few distinctions on four dimensions.

The bank and the large chit fund are more opaque than the others – most of the important information about their asset quality is not visible. That is why we are often taken aback when they fail. In small chit funds, people have reasonable visibility, since the money is with one of the members and is distributed regularly. Hedge funds and mutual funds are also quite easy to monitor, as long as they report fairly, because they invest in securities that visible in the market on a real time basis.

Bank and the chit funds make promises that are inherently more difficult to fulfill – they must return money, irrespective of their financial position. Banks more so, because the deposits are callable at par. Hedge funds and mutual funds invest on behalf of investors, with no guaranteed rate of return and so the market risk stays with the investors. Institutions making promises inherently more difficult to fulfill are at a greater risk of failing to keep the promises.

There is a difference in the influence the consumers can wield over the institution. In a small chit fund, members have significant influence over each other. In game theory terms, they are in a repeated game over a long horizon – small amounts are saved over short periods, and this is repeated. When a few people become managers of funds for a large number of people, the moral hazard problem increases exponentially, and the consumers’ ability to influence the institution drops. Similar difference can be seen in the hedge fund (small number of high value investors), and the mutual fund (large number of small value investors).

The institutions differ in terms of consequences of their failure. If a bank or a chit fund fails, many poor and middle class people lose their savings and many suffer significant hardships. We are seeing this in Saradha’s case.

Each of these four distinctions is relevant for deciding where safety and soundness regulation should apply. They can be stated in terms of principles, but do not translate into a set of ex-ante rules in terms of institution-types. If the law states them in terms of rules, it may be gamed. The principles, therefore, must be in the law.

Section 151(1) of the Indian Financial Code provides four principles-based tests, based on the four distinctions discussed above, that will help the regulators decide where and to what extent safety and soundness regulation should apply. The regulators will use a combination of these principles to take the decision. For example, it is not enough that the promise is inherently more difficult to fulfill, the institution should score high on some other tests as well. From the five examples listed earlier, the bank and the large chit fund will be intensely regulated for safety and soundness, and the mutual fund would attract some regulation to ensure that it is acting prudently and reporting fairly. The small chit fund and the hedge fund may be largely exempt.

Handling failure

Even among the licensed and regulated deposit-taking institutions, some will become weak. In such situations, there are ways of stemming the decline, and if the institution fails, minimising the loss to depositors. Dealing with failure requires a sound resolution and deposit insurance system. Deposit insurance covers deposits, upto a limit, against the risk of failure of the institution.

At present, banks in India are covered by a deposit insurance system, which, as demonstrated by the experience of many urban cooperative banks, often takes a long time to settle claims. Bank-like institutions, such as deposit-taking NBFCs, are not covered by deposit insurance. Countries like US and Canada have elaborate systems of resolution, which may include sale of the firm, management through a bridge institution, and temporary public ownership. The agencies responsible for resolution are also empowered to take corrective action if a firm’s soundness declines. In India, there is no system for resolving failing firms, and no structured framework for corrective action.

Part VII of the IFC provides for a resolution corporation, which will provide deposit insurance to certain institutions, take corrective actions on firms becoming weak and resolve institutions before they become insolvent, by arranging a sale of the firm, managing it through a bridge institution, or facilitating temporary public ownership. Section 260 enables extension of deposit insurance to institutions taking deposits. The regulators, in consultation with the resolution corporation, will decide which institutions will be covered by deposit insurance. This decision will be taken based on tests like the ones proposed for deciding where safety and soundness regulation will apply.

Enhanced consumer protection

The operators of the MMM scheme claim to make full disclosures to their members about the uncertainty of returns and the risk to their funds. But is mere disclosure sufficient to absolve Ponzi scheme operators from all liability? Certainly not. While disclosure and transparency requirements are integral components of an effective consumer protection regime, research shows that when faced with complex financial decisions, consumers often suffer from cognitive biases which can result in sub-optimal decision making.

It is for this reason that IFC contains additional protections when retail consumers are advised on financial products. This is in the form of suitability assessment requirements that compel the managers and distributors of financial products to assess the relevant personal circumstances of individual scheme members and the suitability of the product for their purposes before advising them to join such schemes.

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