Introduction

“[Y]ou are still more likely to get divorced than switch from the bank which reeled you in with a free railcard at 18”

In a speech to the Regulatory Policy Institute on ‘Competition and conduct regulation in financial services’, Christopher Woolard (Director of Policy, Risk and Research at the FCA) explained what would be distinctive about the FCA’s new competition powers, to be exercised “in the interests of consumers”:

“The traditional economic model was that decision making was rational, and we could expect especially the more sophisticated customers, given the right information, would make the right decision.

“We shouldn’t rush to throw the baby out with the bathwater […] Classic models of competition analysis will be vital for our work, but we also need to consider new techniques.”

The most important new technique will be the use of behavioural economics: “regulators have been behind the pace of firms in thinking about how to apply these insights, but we are spending considerable time on this now.”

“The fact that switching rates are low in many financial products - that you are still more likely to get divorced than switch from the bank which reeled you in with a free railcard at 18 - can sometimes sound like blaming consumers. That, frustrating though this is for the traditionalists amongst us, they are not behaving as a rational economist would like them to."

“However, there are good reasons why that might be the case.”

Behavioural economics

As Woolard suggests, behavioural economics differs from conventional economics in that it abandons the traditional assumption that people always act with rational self-interest.

Instead, it substitutes a more realistic picture of human behaviour, based on experimental work in psychology which reveals not only that people are not as rational (or selfish, or self-controlled) as had previously been assumed; but also that when people are irrational and selfless and incontinent, they behave so in systematically predictable ways (known as ‘behavioural biases’).

It is not simply that individuals struggle with issues of numeracy and literacy; but rather that people in general tend to rely upon intuition and rules of thumb wherever they can, in order to save on ‘cognitive costs’. Given the complexity of financial products, the emotions involved and the difficult probability judgements – and the fact that many people frankly find them boring – consumers are particularly prone to making intuitive errors related to behavioural biases in this area. (The FCA notes that the effort of making people into better financial consumers by means of improved financial education is more properly the remit of the Money Advice Service.)

On 11 March 2014 the FCA published its first OFT-style Market Study, which made use of behavioural economics insights: MS14-1: General insurance add-ons market study: Provisional findings and proposed remedies. This was the subject of our report Competition problems in general insurance add-on sales.

How will the FCA use behaviour economics?

General

April 2013’s Occasional Paper No. 1: Applying behavioural economics at the Financial Conduct Authority (officially an independent piece of research) considered how the FCA might use behavioural economics.

Ultimately, it will be integrated into all FCA competition and consumer protection work, and will not just be limited to the applications suggested below.

Competition work

Behavioural economics is particularly relevant to the FCA’s new objective to promote ‘effective’ competition. The regulator interprets ‘effective’ to mean competition based on product price and quality, as opposed to competition based on manipulating consumers’ behavioural biases.

Behavioural biases are in themselves a failure of ‘effective competition’, but they also shine a light on other traditional forms of market failure – as well as the problems regulators face in trying to remedying them.

  • Market power: even where a market may appear competitive on the face of it (with an adequate number of competitors), ‘situational monopolies’ can arise where – for behavioural-related reasons – consumers do not shop around, thereby allowing market participants to charge monopoly prices.
  • Information asymmetries: behavioural economics reveals how and why existing information disclosure requirements sometimes have little beneficial effect; and it suggests how information might be presented to consumers in way that they will actually engage with (‘smart disclosure’).
  • Externalities and cross-subsidies: it is sometimes the case that unsophisticated consumers (who are more likely suffer from biases) effectively ‘cross-subsidise’ more sophisticated customers (who will avoid falling prey to biases): the latter obtain better offers, and prices kept artificially low by unsophisticated customers paying over the odds: e.g. free current accounts which are effectively subsidised by other customers’ overdraft charges. If the unsophisticated consumers are vulnerable persons – e.g. the poor or the elderly – the regulator could consider a case to intervene.

The early warning indicators

The Occasional Paper proposed the following structure for analysing potential behaviour-based problems:

  • look for specific early warning indicators (see below);
  • consider the different explanations for the presence of these indicators, which may be explicable for various reasons not connected with behavioural biases; and
  • obtain a set of ‘root causes’ that may or may not suggest particular regulatory remedies.

The indicators are based on seven high-level warning signs from ‘Making financial markets work for consumers: an open letter to America’s first consumer protection czar’ by a number of Harvard professors:

  1. ‘Rip-offs’: excess profitability; and a high penetration rate for high-margin, inessential add-ons;
  2. ‘Suckers’: concentrated profits from a small group of consumers; cross-subsidies (see above);
  3. ‘Bargains’: ‘too good to be true’ prices or returns; and hidden or underemphasised costs;
  4. ‘Traps’: teaser rates; cancellation charges; and opt-outs;
  5. ‘Regret’: reports of consumer regret; and where products are purchased rarely with little scope to learn;
  6. ‘Folly’: purchases inconsistent with consumer’s stated preferences; sometimes clearly poor value;
  7. ‘Confusion’: consumers cannot describe key product features or recall prices; or an unnecessarily complicated product structure or options.

The first two warning signs might be useful during Business Model and Strategy Analysis (and perhaps even at the firm authorisation stage); the third and fourth signs would be most relevant when considering product design and sales processes; and the final three signs could be looked at while reviewing consumer market research.

What are behavioural biases?

Some examples of specific behavioural biases that are particularly relevant to financial services are:

  • problems with self-control, and the urge for immediate gratification (‘present bias’);
  • a tendency to feel the impact of losses more than gains (‘loss aversion’);
  • a desire to avoid ambiguity and stress, and other emotional influences on decision-making;
  • overconfidence about future events, and about the accuracy of one’s own judgement;
  • a generally poor ability to calculate risks and uncertainty;
  • the tendency to make predictions on the basis of a misleadingly small number of observations (‘over-extrapolation’);
  • underestimating the possibility of changes to one’s future circumstances (‘projection bias’);
  • approximate mental accounting, which leads to errors and inconsistencies (e.g. putting money into a low-interest savings account rather than paying off high-interest credit card debt);
  • being influenced by how information is presented, and in particular by which product details are either emphasised or downplayed (‘framing’ and ‘salience’);
  • being influenced by the apparent trustworthiness or likeability of salesmen or financial advisors (‘persuasion and social influences’); and
  • other errors caused by decision-making rules of thumb (e.g. mistakenly using the question of ‘how easy can I think of an occasion of X happening?’ as a shorthand way of estimating ‘how likely is it that X will happen?’) (‘heuristics’).

Economic function

Another approach would be for the FCA to look for mismatch between what a financial product issupposed to be used for and how consumers actually use it in practice. Product governance processes for complex products should be able to demonstrate alignment between ‘declared purpose’ and actual usage.

Economic function

Another approach would be for the FCA to look for mismatch between what a financial product issupposed to be used for, and how consumers actually make use of it in practice. Product governance processes for complex products should be able to demonstrate alignment between ‘declared purpose’ and actual usage.

‘True’ preferences and inconsistencies

There is a broader philosophical problem with the concept of behavioural biases. Some ‘biases’ are obviously mistakes: e.g. miscalculating the cost of an item. Other ‘biases’, however, are not so clear cut: for example, it is beyond the cold economic function of insurance to give a cautious person peace of mind; but if an insurance policy does do that, then the policy might be worth more to a particular consumer than its simple actuarial value would suggest. On the other hand, consumers’ emotions are of course susceptible to being manipulated at the point of sale by salespeople, advertising, framing, and so on.

Nevertheless, the regulator can try and look for inconsistencies between consumers’ ‘true preferences’ and the choices consumers actually make.

Market researchers can, of course, directly ask consumers what they want: these are their ‘stated preferences’. Research suggests, however, this is not always a reliable guide to consumers’actual, ‘true preferences’. For this reason, in the GI add-ons Market Study, the FCA supplemented the use of consumer surveys with a novel behavioural research experiment into how consumers actually buy insurance online.

The regulator can try and infer consumers’ ‘true preferences’ by:

  • comparing the behaviour of sophisticated and unsophisticated consumers, on the assumption that the former are less likely to make mistakes;
  • comparing the outcome of passive (opt-out) and active (opt-in) choices;
  • seeing whether behaviour is self-contradictory (e.g. borrowing at a higher while saving at a lower rate);
  • looking at how choices are affected by the way in which information is presented, which should be an irrelevant factor;
  • identifying where consumer choices are based on a clear misunderstanding of the facts: e.g. where a consumer thinks a product has a particular feature, when clearly it does not; and
  • using other “very reasonable and rather uncontroversial assumptions about what people value”, such as a preference for higher returns and lower prices, all other things being equal.

Remedies

The Paper identified four sorts of intervention that might be relevant where there has been abuse of behavioural biases:

  • Providing additional information: although, as noted above, this will need to be ‘smart’ disclosure;
  • Restricting the sale, marketing or promotion of products (e.g. to certain channels, or types of client);
  • Banning or restricting certain products or features; and
  • Changing the choice environment: i.e. changing how information is presented; being mindful of consumer behaviour and the rules of thumb consumers use. One important example of this is changing the presented default options. (See also the section on ‘Nudging’, below.)

For example, the Market Study on GI add-ons proposed using several of these remedies: additional information (publishing the claims ratio for different insurance products); restricting the sale of GAP insurance so consumers cannot buy this at the point of sale; a ban on ‘opt-out’ pre-ticked boxes for GI add-ons; and with further work planned on how and when price comparison websites present add-on price data.

Nudging

Changing the ‘choice architecture’ of decisions – presenting people with choices in such a way that they will be more inclined to choose the ‘right’ option – was first suggested by Thaler and Sunsteinin Nudge (2008).

‘Nudges’ – described by the Paper as “small, well-designed prompts, rather than constraints, [which] can trigger behaviour that is well-aligned with policy goals” – were a popular subject in 2008-10; a Cabinet Office Behavioural Insight Team (known as the ‘Nudge Unit’) was even set up, reporting to Steve Hilton.

‘Nudging’ offers a potential solution to the philosophical problem described above: “‘soft’ paternalistic measures [to] encourage consumers to choose options that are more likely to be beneficial for them and make mistakes less likely”, without strong regulatory intervention; in Thaler’s term, “libertarian paternalism”.

The FCA Occasional Paper suggests that the idea might be “explore[d]”, although the “overall success rate of nudges is, however, still not clear”. As noted above, the recent work on GI add-ons made several proposals for changing choice architecture; beyond this, it is difficult to say what further use might be made of nudges. According to gov.uk, the Behavioural Insight Teamhas only published seven items since its inception, and as long ago as August 2010 the FT asked“Whatever ever happened to nudging?”

Conclusion

The FCA’s new-found interest in behavioural economics is an important development that could have major consequences for the financial services industry.

Between traditional FSA-style enforcement of conduct rules on one hand, and traditional OFT-style competition work on the other, the FCA has discovered a broad new basis for intervention in the name of consumer protection. It is a basis that fits in with the regulator’s new tendency towards proactive supervision, and also with wider scepticism about the efficiency of markets.

Behavioural economics does raise fundamental questions about how far regulators can second-guess what it is consumers really want (e.g. determining the worth of an insurance policy beyond its pure economic value) or, indeed, tell consumers what it is they should want.

The FCA will probably want to see a clear case of consumer detriment before intervening – especially if consumers themselves are not consciously aware of any detriment. It is likely, however, that the FCA will be more proactive – and more paternal – where poor or vulnerable consumers are being affected.

Behavioural economics also warns that remedial actions can often easily backfire. This is especially true of ‘hard paternalistic’ interventions – which would include most traditional regulatory powers. The alternative is to use ‘nudges’ - ‘soft paternalistic’ interventions, which are primarily about changing ‘choice architecture’. Sometimes these are extremely novel[1]; but in the conservative world of financial regulation it is likely that we will see a small number of (relatively) proven nudges being applied across different countries and sectors[2].

It is possible, however, that a new interest in ‘smart’ disclosure, prompted by the insights of behavioural economics, might lead to the FCA revisiting its requirements on disclosure and/or marketing promotions.