Manufacturers of cars or microwave machines are duty bound to ensure that their products are safe for use. Why can’t financial regulation introduce a similar obligation to ensure financial products and services are not negligently developed and sold, causing harm to consumers?
About 90 years ago in the Scottish town of Paisley, Mrs Donohue sat down to share a ginger beer bought by her friend Minchella. The pub was run by Mr Stevenson, who brewed, packed and sold the beer. By routine courtesy, Minchella served the beer first to her guest, Mrs Donohue, before pouring some into her tumbler.
To Mrs Donohue’s horror, the liquid poured into Minchella’s tumbler wasn’t exactly the ginger beer that she was already sipping. What came out was ginger-beer laced with — as later described in the landmark case of Donohue v Stevenson — “decomposed remains of a snail,” which Mrs. Donohue argued in her legal action against Stevenson, caused her “shock and severe gastro-enteritis.”
Fast forward to 2019. I’m seated in a Nairobi restaurant, ready to have my tortilla that has just been served. Suddenly, I hear a loud clang. A waitress has dropped some glass crockery, splintering broken glass all over. Immediately, she reaches out to my meal, insisting that I cannot eat my tortilla until she confirms there is no glass in it.
The duty of care and its essence
These two incidents – decomposed slugs in beer, glass splinters in a tortilla – illustrate “the duty of care,” a fundamental duty that must be observed whenever there’s an exchange of goods and services. Since the landmark Stevenson case, the duty of care has been extended to other fields, including proposals to extend it in financial services.
The duty of care holds that a manufacturer would be liable if a consumer is harmed in the course of safely using their product, if it is proved there was negligence or failure to reasonably anticipate that the product would be harmful in some way.
In other industries, manufacturers give a warranty: an undertaking that if the product fails within a specified period, the customer can be made good either by compensation, or by getting another product at no cost. In a nutshell, duty of care is about a provider’s willingness to place the customer interest alongside theirs, and deal with the customer on the basis of competence, integrity and trust.
The duty of care can be imposed through two ways. Firstly, when two parties agree to trade a service or product in exchange for payment (i.e. through contract). Secondly, is when the actions (or omissions) of the manufacturer of a product, bought by party A, causes harm to a party B (the final customer), even though there was no direct relation between the manufacturer and the final customer (i.e. through operation of law; or the so called “vicarious liability”).
In other industries, manufacturers are required by regulators to recall faulty products. For example, Germany’s Federal Motor Transport Authority forced Volkswagen to do a massive recall due to faulty emissions systems in their cars, and again when its seatbelts were found to be faulty. Recently, America’s Federal Aviation Authority grounded Boeing’s 737 Max aircraft following two fatal air crashes, which cast the safety of the aircraft in doubt.
If such action can be taken in these sectors, why shouldn’t this duty extend to finance?
Financial services and the duty of care
The 2019 FinAccess survey shows that in 2006, only three out of every 10 Kenyans (29%) had access to some form of financial service. In 2018, more than eight in every 10 adult Kenyans (83%) had financial access. Banking, insurance, payments and other financial services have become central to people’s daily lives. Witness the kind of disruption that is caused whenever there is an M-Pesa service disruption, as was the case when the government ordered a probe following an outage.
Yet at a time when financial services are becoming central to everyone’s life, complaints are increasing, either in number, severity, or both. According to the FinAccess, in 2018, an average of 6.3% adult Kenyans reported having experienced consumer protection problems with their bank (challenges with transparency, security and system failure); the figure was 24% with mobile money.
Four weaknesses of the “willing customer” principle
The main defence by industry would be caveat emptor: consumers willingly buy services and are solely to blame if things don’t go as expected. For those done under contract (a loan agreement or insurance policy) customers assess suitability at the point of sale, or via terms and conditions. This approach of regulating financial services based on the private law principle of caveat emptor has major weaknesses.
First, caveat emptor is riddled with major issues on the asymmetry of power between the provider (often a large corporate) and individual consumers. This was elaborated fully in an earlier blog. Second, disclosure and transparency are grossly inadequate in financial services. Even when some disclosure is given, one has to be a lawyer to understand the fine print, or the barely legible terms and conditions.
Third, some financial products hugely depend on providers who are not prioritizing their commercial interests exclusively at the expense of the customer’s long-term interest; so-called ‘experience’ goods. Take the example of products underpinned by long-term financial contracts. They’re analogous to a medical surgery. You can have all the disclosure before the intervention, but once you’re on the operating table, you’re at the mercy of the doctor. The efficacy of the intervention only takes place after you’ve paid for it. Mortgages, long-term insurance and pension products depend on putting the customer interest first. If the provider is conflicted and sells bad products, it becomes nearly impossible for customers to reverse these purchases as mostly, like a surgery gone bad, the harm has already taken place. In this type of products, the standard of dealing with customers has to be based on a principle of duty of care: if you cock up, you pay up!
Fourth, even when the terms are clear, providers will always know more than the customer. They sell products that do not meet the need of the customer, or “lemons” as christened by the economist Joseph Stiglitz whose analysis of this issue earned him a Nobel Prize in economics. This problem is common in retail financial markets, where agents are incentivised to sell quantities for commissions, rather than quality for product suitability.
Certainly, financial regulation must allocate obligations fairly across financial institutions, intermediaries and consumers. Similarly, consumers must take responsibility for their choices. Ultimately though, the purpose of regulation is to balance between commercial and public interests, whether in aviation, motoring, or in this case, finance.
How would the duty of care improve consumer outcomes?
First, it would make providers deal and only sell products which are designed with the customers’ needs in mind. In the jargon, shifting the incentive. Customer-centricity is weak in the financial sector. For example, consumers pay a lot of sign-up fees for products that simply end up not working. Obtaining a refund or redress is like pulling teeth from a child; they can resist till the end of time.
Secondly, the duty of care would ensure that providers conduct themselves not only in a way that ensures their business will continue as a going concern (the domain of prudential regulation), but that they also act with due skill and expertise when dealing with consumers (conduct regulation). For example, it would prevent cases where incorrect credit information may cost someone a job interview which depended on a clean report.
Thirdly, the duty of care would make enforcement easier. Wrongdoings in the financial sector often go unpunished because they’re hard to prove; in the current system, consumers and regulators shoulder a very high burden of proof. Imposing a duty of care would for example mean that an institution that quickly sells a mortgage just to get business could be held responsible if that transaction took place without a proper assessment of the client’s goals and circumstances.
Fourthly, a duty of care can incentivise players to have responsible business practices. For example, due to the integration of telecommunications and banking, a SIM card has become a de facto debit card; one can hold and send money through it. Yet it is common to find SIM cards being loosely sold around, some without proper due diligence that is required as part of know your customer processes.
Eventually, when providers do not take responsibility for safe product design, the duty of care provides a water-tight standard to ensure that they shoulder the consequences of their actions, as the aircraft industry is now realising. It is estimated that the grounding of the Max 737 is costing the industry about $4 billion (about Sh412 billion) per quarter in losses. Since 2011, regulators in the UK have forced financial companies to refund up to £35.7 billion (about Sh4.5 trillion) to consumers as a result of mis-selling poorly designed payment protection insurance. A duty of care is a vanguard which would say that such costs of poor product design should never be externalised to consumers.