The Economics of Mis-selling: Why Disclosure Alone Is Not Enough
Admissions Enquiry
Mis-selling of complex financial instruments cannot be explained simply as a failure of investors to understand risk. It is often a consequence of information asymmetry, weak incentives and gaps in regulatory oversight. Recent concerns surrounding the alleged mis-selling of Credit Suisse AT1 bonds to NRI clients through HDFC Bank's offshore branches highlight why merely providing investors with disclosure documents may not be sufficient to protect them.
The issue is important because AT1 bonds are fundamentally different from conventional fixed-income products. They are perpetual and unsecured instruments issued by banks to strengthen their capital. They can absorb losses before depositors and senior creditors and their coupons can be skipped without constituting a default. Under specified regulatory conditions, the principal can also be written down. These characteristics make AT1 bonds substantially riskier than ordinary deposits or conventional fixed-income investments.
Why Complex Financial Products Are Vulnerable to Mis-selling
The problem becomes more serious when such instruments are sold to retail investors with assurances that they offer the safety of familiar savings products. The Credit Suisse episode already brought forth the consequences of this risk earlier. During the 2023 rescue of Credit Suisse by UBS, approximately USD 17 billion of AT1 bonds were written down. The episode highlighted the possibility that investors may hold instruments whose risks are very different from what they perceive at the time of purchase.
The Economics Behind Mis-selling: Information, Trust and Incentives
The mis-selling of such bonds by large banks raises a broader economic question: why would investors purchase products whose contractual terms contain substantial risks? The answer lies partly in information asymmetry. The financial institution distributing a complex product possesses considerably more information about its characteristics and risks than an ordinary investor. As George Akerlof's classic analysis of the "market for lemons" demonstrates, such information asymmetry can distort market outcomes because the less-informed party cannot adequately assess the quality or risk of what is being offered.
But information asymmetry alone does not explain mis-selling. Investor behaviour also matters. Individuals may focus on the headline return of a product rather than the contractual conditions determining that return. They may also rely on the reputation of the institution recommending the product. A trusted banking relationship can therefore become an important signal of safety, even when the underlying financial instrument carries considerable risk. In such circumstances, regulatory disclosure may not be sufficient in the presence of ineffective communication.
The incentive structure of financial distribution creates another layer of opportunistic behaviour. If employees are rewarded primarily for the volume of products sold, their incentives may not be aligned with the long-term health of the financial relationship with customers. The resulting conflict is structural rather than merely behavioural. A salesperson can be rewarded for completing a transaction even when the product is unsuitable for the investor.
Why Disclosure Alone Cannot Protect Investors
This raises an important limitation of disclosure-based regulation. Providing a lengthy risk document assumes that investors can understand, evaluate and act upon the information provided. That assumption is unrealistic for highly complex financial instruments. Disclosure can therefore become a compliance exercise rather than an effective mechanism of investor protection. The problem is further amplified when distributors can influence what information receives attention or when investor classifications affect the level of protection available.
Beyond Disclosure: What Better Regulation Could Look Like
A stronger regulatory response should therefore operate at three levels. First, banks distributing complex loss-absorbing products should strengthen independent internal oversight. An empowered internal ombudsman with the authority to question or stop unsuitable sales could provide a meaningful institutional check on distribution practices. Second, regulatory protection should not disappear simply because a transaction is routed through an offshore branch.
Differences between jurisdictions can create opportunities for regulatory arbitrage. Indian banks operating internationally should therefore remain subject to effective suitability and governance standards, with appropriate coordination between home and host regulators. Third, disclosure itself needs to change. Instead of relying primarily on technical documentation, regulators could require concise, plain-language explanations that clearly communicate the most important risks, the perpetual nature of the instrument and the conditions under which principal can be written down. The objective should be meaningful understanding at the point of sale rather than documentation that primarily protects the institution after a dispute arises.
From Investor Protection to Trust in Financial Markets
The broader lesson is not that complex financial instruments should be prohibited. AT1 bonds perform an important function in bank capital structures. The challenge is to ensure that such instruments reach investors who understand their risks and can bear them. Regulation should therefore focus not only on the product but also on the incentives, suitability assessments and institutional arrangements governing its distribution.
Mis-selling ultimately reflects a deeper problem of trust in financial markets. When sophisticated institutions repeatedly exploit information advantages or poorly aligned incentives, the costs extend beyond individual investors. For India, the erosion of confidence among NRI investors can also affect trust in formal banking channels and the broader financial system.
The central question, therefore, is not whether disclosure exists. It is whether the financial system is designed to make investors understand the risks they are taking before they commit their money. If regulation addresses only disclosure and not incentives, suitability, governance and accountability, it may manage the consequences of mis-selling without addressing its economic causes.