In 2014, ASIC started promoting the use of behavioural economics in its regulatory activities. First there was ASIC’s report on Regulating Complex Products, and then there were ASIC's submissions to the Financial System Inquiry (FSI). Both the report and the submissions referred to behavioural economics research that suggests that biases and short cuts taken in financial decision-making limit the effectiveness of disclosure as a regulatory tool.
The FSI Final Report also cited behavioural economics as part of its rationale for recommendations to introduce a product intervention power and suitability obligations in the design and distribution of financial products. The implementation of at least some of these FSI recommendations would require legislative change and it will be interesting to see how the Government responds.
Even if the recommendations aren't implemented, ASIC has made it clear that it is committed to using behavioural economics insights to better understand market and consumer behaviour.
Behavioural economics experiments and product and conduct regulation
ASIC has recently released two reports of behavioural economics research experiments. We think they provide clues as to how ASIC may approach its regulatory activities in the future.
The experiments were commissioned by ASIC and conducted by the Queensland Behavioural Economics Group (which is part of the QUT Business School).
The first, Report 427 Investing in hybrid securities: Explanations based on behavioural economics, outlines the findings of a behavioural experiment to gain an insight into the behavioural biases and risk attitudes that influence investments in hybrid securities over investments in shares and bonds. Conducted with university students, the experiment found that, broadly, there was a positive relationship between investors with certain behavioural biases and the degree to which they were attracted to hybrid securities. Specifically, the attraction to hybrid securities increased for investors that have:
- a false belief that they can exert control over their environment and influence outcomes (known as illusion of control bias); or
- an unwarranted belief in their abilities, intuition, and judgement (known as overconfidence bias).
There was also a positive relationship between these two biases. The suggestion in Report 427 is that illusion of control bias causes investors to think they can control the risk of investing in hybrid securities (eg by withdrawing their investment before suffering any loss). Overconfidence bias causes investors to underestimate risk and perceive hybrid securities to be safer than they are.
The second, Report 428 Improving communication with directors of firms in liquidation, outlines the findings of another behavioural experiment, also conducted with university students. In this case, the experiment was intended to test the effectiveness of minor changes to ASIC's communications that aim to 'nudge' directors of firms in liquidation to comply with their obligations. The experiment suggests that minor changes to letters from ASIC to directors (eg reordering information and including 'ambiguous fine amounts') could dramatically improve the reporting of information. It is suggested that ASIC undertake randomised control tests to test this further. The experiment also found that non-compliant directors fall into two categories: those that do not comply because they lack the necessary financial or other skills, and those that deliberately do not comply. The experiment suggests that those in the former category are more likely to respond to 'nudge-like' regulatory responses.
ASIC's media release about the reports suggests that the information from these experiments will be used 'to develop responses that are potentially less interventionist whilst having greater impact' and 'to help ASIC’s communication by presenting information in a way people can process more easily'.
It is clear that ASIC is planning to use the results of these experiments, and other behavioural economics work, to inform its regulatory activities. For so long as disclosure remains ASIC's primary regulatory tool, we think we can expect ASIC to use findings from behavioural economics to require or encourage disclosure in ways that are more likely to address investors' behavioural biases. This could serve as a 'nudge' for investors to improve their financial decision-making. For example, the findings of Report 427 about hybrid securities may mean ASIC will require information or warnings to be tailored to counteract behavioural biases of concern.
Given behavioural economics has already taught us that disclosure has its limits, we are sure that ASIC is conscious that these kind of changes may result in only marginal improvements in outcomes. However, if the FSI's recommendations to give ASIC product intervention powers are implemented, the findings of behavioural economics experiments like this will take on a new life. ASIC has noted in its media release that two-thirds of investors in hybrid securities are SMSF investors and that a desire for control was a key driver for these investors setting up an SMSF in the first place. If ASIC had the power, would it want to intervene in the distribution of hybrid securities to SMSF investors? Or could the mere threat of intervening serve as a 'nudge' for issuers to reconsider the design and distribution of hybrid securities?
The next question is: who is ASIC going to start 'nudging' with its behavioural economics research? Report 428 appears to acknowledge that directors are also imperfect humans and that they are susceptible to the same behavioural biases as the investors that ASIC is seeking to protect. Further, it is likely that ASIC's push for a review of the penalties under the Corporations Act is also at least partly grounded in behavioural economics about incentives. We are interested to see whether ASIC continues to examine ways in which behavioural economics is relevant to the conduct of ASIC's regulated population.
Finally, in an environment in which ASIC seeks and may soon get a new product intervention power, it is interesting to speculate about what behavioural economics might also tell regulators about their own behavioural biases. Specifically, if behavioural economics is a sound guiding principle, what safeguards could be put in place to counteract any overconfidence or illusion of control biases that regulators may have?