Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Unwarranted complacency about regulated financial entities

Two days back, the Securities and Exchange Board of India (SEBI) issued a public Caution to Investors about entities that make false promises and assure high returns. This is quite sensible and also well intentioned. But the first paragraph of the press release is completely wrong in asking investors to focus on whether the investment is being offered by a regulated or by an unregulated entity:

It has come to the notice of Securities and Exchange Board of India (SEBI) that certain companies / entities unauthorisedly, without obtaining registration and illegally are collecting / mobilising money from the general investors by making false promises, assuring high return, etc. Investors are advised to be careful if the returns offered by the person/ entity is very much higher than the return offered by the regulated entities like banks, deposits accepted by Companies, registered NBFCs, mutual funds etc.

This is all wrong because the most important red flag is the very high return itself, and not the absence of registration and regulation. That is the key lesson from the Efficient Markets Hypothesis:

If something appears too good to be true, it is not true.

For the purposes of this proposition, it does not matter whether the entity is regulated. To take just one example, Bernard L. Madoff Investment Securities LLC was regulated by the US SEC as a broker dealer and as an investment advisor. Fairfield Greenwich Advisors LLC (through whose Sentry Fund, many investors invested in Madoff’s Ponzi scheme) was also an SEC regulated investment advisor.

Regulated entities are always very keen to advertise their regulated status as a sign of safety and soundness. (Most financial entities usually prefer light touch regulation to no regulation at all.) But regulators are usually at pains to avoid giving the impression that regulation amounts to a seal of approval. For example, every public issue prospectus in India contains the disclaimer:

The Equity Shares offered in the Issue have not been recommended or approved by the Securities and Exchange Board of India

In this week’s press release however, SEBI seems to have inadvertently lowered its guard, and has come dangerously close to implying that regulation is a seal of approval and respectability. Many investors would misinterpret the press release as saying that it is quite safe to put money in a bank deposit or in a mutual fund. No, that is not true at all: the bank could fail, and market risks could produce large losses in a mutual fund.

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