On April 1, 2013, the U.K. embarked on the twin peaks model of financial regulation, with the Financial Conduct Authority regulating the securities industry and professionals and the Prudential Regulation Authority regulating the banking industry and financial institutions. In remarks at the London School of Economics, FCA Chief Executive CEO Martin Wheatley indicated that the Authority will employ behavioral economics in its regulatory tool kit. He noted that one of the most significant challenges for modern financial regulators is to recognize that they operate within a very human environment in a fallible world governed and directed by psychology.
Despite this human element, one of the features of regulation historically was that it was all about compliance. In his view, financial regulation had become a robotic exercise focusing on whether a particular set of rules were followed and a particular set of boxes ticked. The question was whether a firm could demonstrate and document that it had followed those rules to the letter. If companies were able to tick those boxes and confidently hold up their product’s terms and conditions in court, he noted, they were assumed safe from regulatory scrutiny.
But in many cases, said the FCA head, this reliance on rules, processes and disclosure simply encouraged firms to hand over more information to customers who were already confused. It resulted in more text, more figures, and more legalese.
The FCA rejects the idea that risk should squarely sit with the consumer. This is the buyer beware or caveat emptor approach that says poor decision making by customers is not the responsibility of businesses. While noting that consumers should take personal responsibility for decisions, the FCA CEO said that buyer beware becomes hard to defend when customers are buying seriously complicated derivatives and other complex financial products.
The senior official said that the FCA will not be afraid to shine a light on the murkier psychological enticements and entrapments that exist in financial services. The pushes and pulls, the frames and biases that are sometimes used to entice customers to buy financial products they may not need or that might be wholly unsuitable for them.
The FCA will be looking across markets to see where and how behavioral economics might support its regulatory activity, such as areas like information disclosure and product complexity. For example, the FCA could use behavioral economics to understand why some consumers do not switch from one savings product to another after a teaser rate expires.
Behavioral economics could also be used to weed out products that are too complex for their target market, and may even be specifically designed to benefit from consumer mistakes. Many structured products fall into this category, noted Mr. Wheatley, products with too many moving parts; products that are almost impossible to take a rational decision on.