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April 24, 2014

In a speech last month to the Australian Securities and Investment Commission, the Chief Executive of the U.K.’s Financial Conduct Authority (FCA), Martin Wheatley, noted that behavioral economics (a branch of economics that marries psychology with economic decision making) was fast becoming a regulatory “game changer” for the authority.1  Wheatley discussed how insights into the irrationality of consumers and their “sub-optimal” economic judgments — for example, fearing the loss of an amount more acutely than valuing the same amount being gained — was paving the way for intervention in financial services markets in the form of economic “nudges,” with consumers being encouraged, in subtle ways, to make theoretically better choices. In this issue of Raising the Bar, we explore the use of behavioral economics in financial services, consider its likely efficacy compared with traditional economic solutions and discuss the benefits of, and risks inherent in, employing nudges of the nature apparently envisaged by the FCA for the regulation of the conduct of financial services firms in the United Kingdom.

Behaviorists and Their Critics
Wheatley is not alone in underscoring the mounting influence of behavioral economics. Last year’s Nobel Memorial Prize in Economic Sciences was won by Yale University Professor Robert Shiller,2 who is widely regarded as the founder of behavioral finance, a variant of the school focused on understanding speculative market bubbles. A 2011 behavioral book by psychologist Daniel Kahneman of Princeton University (a previous Nobel Memorial Prize winner for his work on behavioral economics),3 "Thinking, Fast and Slow," has become a worldwide bestseller, listed amongst the finest of the year by the New York Times, The Economist and the Wall Street Journal.4 Other recent titles, such as "Nudge" by Richard Thaler and "Freakonomics" by Steven Levitt and Stephen Dubner, have also gained widespread popularity. It would appear, therefore, that studying economic “errors” made by consumers is much in vogue and that the use of demand-side nudges to correct for them is being seen as a fresh and — crucially — credible means of regulating markets.

As always with economics, however, not every economist is buying into the behavioral school’s lessons. In a recent Financial Times article, columnist and author Tim Harford5 ("The Undercover Economist") draws attention to some of the concerns of behavioral critics, such as George Loewenstein and Peter Ubel, who consider that “behavioral economics is being asked to solve problems it wasn’t meant to address … [and] in some cases … is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics.”6 Harford gives the example of a May 2010 speech during which the soon-to-be British Prime Minister, David Cameron, suggested that a means of cutting electricity bills would be to show customers their own spending compared with that of energy-conscious neighbors. Harford goes on to point out that “… Cameron was mistaken. The single best way to promote energy efficiency is, almost certainly, to raise the price of energy. A carbon tax would be even better[.] … The appeal of a behavioral approach is not that it is more effective but that it is less unpopular.”7

Recent work of David Levine of Washington University is also apposite. In his 2012 book, "Is Behavioural Economics Doomed?",8 Levine explores the risks of overreliance on multiple psychological theories to explain facts that are patently economic in nature and that ought instead be explained by economic theory. The notion that a targeted remedy on the supply side may be better suited to a problem than a series of smaller demand-side nudges has also been brought into focus in a 2013 book of essays on behavioral public policy.9

Behavioral remedies have been submitted as particularly well suited to the challenges faced by regulators of retail financial services markets. In the United Kingdom, the sector has been plagued by a series of scandals including product mis-selling and other questionable sales tactics, most recently with respect to Payment Protection Insurance (PPI) and earlier in endowment mortgages and personal pensions.10 In turn, many providers have been seen as exploitative of customers of financial services products. This raises two pertinent questions:First, is it unambiguously the case that consumers of financial services products are making relatively poor choices and, if so, why might it be so; and, second, is nudging consumers the best way to improve the situation, or are more traditional economic solutions better suited?

How Savvy are Financial Customers?
Consumer research undertaken by the FCA provides some indication of poor decision making. In its short life, the regulator has announced five market studies under its newly gained powers in relation to the promotion of competition, with further studies to follow.11 As part of the first study, published last month and concerning add-on insurance,12 the FCA undertook a customer survey with relatively persuasive results: A large share of customers would appear not to have engaged explicitly with the purchase of add-on insurance at the point at which it was sold to them.13 The FCA noted that the methods by which providers append insurance products to engaging products (like a holiday or car), the complexity of the offering, and the lack of information around the insurance component serve to explain customers’ decisions. As a result, the FCA considers the majority of customers to have received poor value for money and low quality insurance products. Three other studies — on retirement income,14 cash savings15 and banking services for Small and Medium Enterprises (SMEs)16 — are in their embryonic stages but initial indications suggest the FCA envisages these likely to elicit similar evidence. In the case of retirement income, the FCA is already aware of customer inertia. With respect to cash savings, it considers there may be evidence that customers are not switching savings accounts as they do, say, credit cards. With respect to SMEs, the regulator is investigating the anecdotal bias of SMEs in approaching their “home” bank first when seeking additional services. The fifth study, launched by the FCA this month, is in respect of the U.K. credit card market.17 In launching the study, Martin Wheatley - speaking at the Credit Today Credit Summit in London - highlighted his expectation that the study would explore the extent to which behavioral economic biases “rub up against the design, pricing and distribution of credit card products.”18

It would, however, be prudent to regard the jury as still being out on the continued inability of consumers to make rational decisions with respect to financial products. While there may have been non-trivial cases of mis-selling previously, ongoing evidence would need to be collated by the FCA on whether different cohorts continue to make unequivocally poor choices across the financial board. Indeed, poor choices for large financial outlays would be remarkable in the current climate, when most household incomes are under strain. Customers are increasingly savvy purchasers in an array of markets, making decisions on such complex offerings as mobile phone packages (which combine inclusive minutes, call charges and handset subsidies), holidays (which involve travel costs, car hire and accommodation) and personal homes (which, among other costs, involve agent fees, stamp duty and mortgage fees). Consumers are now also prolific users of price comparison websites, rely on an assortment of smart phone apps to avail of price-matching offers, and share product experiences with online communities. In this context, it would not be unreasonable to expect increasing numbers of customers, across the spectrum of financial knowledge and sophistication, to probe the costs to them of financial products, their need for them and the value for money they afford. In this context, effective data gathering and careful survey design will be germane for the FCA. Collating sufficient and robust customer-level information will be important prior to proposing complex behavioral remedies.

What of Traditional Remedies?
Turning to the second question, it is the FCA’s view that requiring financial services providers to make subtle changes to sales processes may help to ensure that, on the whole, consumers make more rational economic decisions? By tackling individually such issues as product complexity, marketing and firms’ communications with customers, the FCA has noted that it may be able to help households discipline the markets more effectively. Selective trials undertaken by the FCA appear to show that a handful of changes to sales processes or marketing can lead to customer decision making that would appear more rational.19

The FCA acknowledges that in some ways such remedies can represent a form of regulatory “paternalism” in protecting customers from their own mistakes.20 Customers in other markets have tended to be left to their own devices, to make and to learn from their mistakes. Competition is generally regarded as a sufficient means of protecting consumers as rivalrous firms offer cheaper, more innovative products that reflect customers’ needs and wants. Ex-post (i.e., after the fact, complaint driven) competition legislation has been in place to protect customers from flagrant abuses of competition rules and manifest consumer harm.

By proposing complementary behavioral remedies, the FCA is in essence suggesting that the traditional model of free and open competition, while necessary, may be insufficient in itself to constrain the behavior of providers. The FCA has taken behavioral lessons to go further still, proposing more radical changes to the manner in which products are sold (such as a point of sale ban of add-on insurance). Traditionalist economists might argue that the FCA should exercise caution before effecting remedies that shape so deliberately the course of markets, especially when there may be alternative, potentially less intrusive, economic solutions. For example, if the concern is that customers are failing to shop around, given informational asymmetries and that, as Wheatley suggests, they are “faced with the ‘black box’ of finance,”21 then traditionalists might argue that operators be required to open up the proverbial black box. Firms should be required to provide information but, importantly, regulators should fall short of prescribing the precise manner in which it is made available, lest that lead to the unintended take-up of one product over another. By effectively nudging customers toward, or away from, certain products, traditionalists might argue that the FCA could inadvertently over-engineer markets and shift the focus of competition, with unintended consequences. At an extreme — perhaps with one nudge too many — shifts might even risk leaving some demand unmet or customer groups unserved. Significantly, undoing unintended effects is extremely difficult, if not impossible.

The FCA will need to consider carefully the impacts of each proposed remedy along with the overall effect of remedies being proposed across the board. Remaining mindful of its objective to promote effective competition, the FCA will no doubt also be concerned with the impact on financial service providers’ own books, the margins available on products and the level of regulatory certainty providers are afforded, in order to ensure that market entry, both real and potential, remains uncurtailed. Finally, while trials of remedies may prove helpful in predicting outcomes, as with surveys, ensuring they are appropriately designed and executed will be important. All in all, the FCA will have to expend considerable resources, testing proposed remedies before rolling them out.

The FCA is in the unenviable position of having to formulate defensible solutions to apply to a wide range of providers, against the backdrop of widespread consumer distrust. In this regard, the expanding of its toolkit to include behavioral solutions is to be welcomed. However, every new sandbox of toys brings with it the complication of choosing which ones to play with, along with the risks of unknown harm they may impart. Throwing out the old at this stage would be ill advised, not least when some of the old favorites are well-tested, simple and known to work. The FCA’s challenge is a balancing act that market observers and economists alike will be watching with interest. Either way, as Wheatley himself concludes, “… tomorrow is unlikely to look like today.”22