Monday, November 17, 2014

Redefining Conduct Regulation to Include Behavior Is Critical to Improving Market Outcomes

[This story previously appeared in Securities Regulation Daily.]

By Joanne Cursinella, J.D.

In a Beasley lecture at The Institute of Directors in London, Martin Wheatley, chief executive of the Financial Conduct Authority (FCA), emphasized that technology, data, and advances in economic techniques, which allow regulators to test behavioral interventions with much greater confidence and integrity than ever before, now redefine the future of conduct regulation. He argued in his prepared remarks that the use of economics by regulators is more significant than ever to the future of the financial sector.

The shift in “behavioural economics.” Over the last three years there has been significant debate among economists over why products like PPI in the U.K., currency swaps in Korea, and mini-bonds in Hong Kong were able to scale up in to such significant events, Wheatley said.

All the policy talk pre-crisis focused on letting the “invisible hand” do its work. But post-crisis, the emphasis has been on determining why these cases seemed to defy that logic, he said. What do the characteristics common to each of these cases tell us, he asked. The response in the U.K. at least, has been a significant intellectual distancing from interventions that rely on self-stabilization, equilibrium, and efficiency in the financial markets or the arch-rationality of consumers, he said.

To address better consumer outcomes, “we’re enhancing traditional economic analysis by integrating it with behavioural techniques. Considering the demand-side as well as supply-side of competition – how real people interact with markets,” Wheatley said. This is important for policy makers because the potential to materially improve consumer outcomes and because it can potentially increase competitive pressure on incumbents by reducing barriers to contestability like complexity and consumer inertia, he added.
According to Wheatley, the obvious question is why we are still seeing apparent breakdowns in price efficiency and rationality so often. He says it is because people aren’t very good at making “on-the-hoof “calculations of probability – or at assessing risk. So we make mistakes.

Data and processing power. “There is confidence today among economists that we can, this time, improve consumer outcomes and stimulate more effective competition,” Wheatley said. Technology, data, and advances in economic techniques have now allowed testing of behavioral interventions with much greater confidence and integrity than ever before, he added. In fact, he argued it is the specific combination of behavioral science, data, and technology that has turned economics in to such an important feature of conduct regulation.

In the U.K., for example, the government’s Behavioural Insights Team found they could improve the number of people who paid their taxes on time by making non-payers aware that their neighbors were completing their returns. Yet when the same team tested the use of social norms to nudge people to sign the organ donor register, the effect was far more nuanced, he said. Behavioral changes in complex markets are especially difficult to predict, and regulators have been criticized before over the ineffectiveness of interventions or the impact of unintended consequences, Wheatley added. Policy makers have relied on relatively unsophisticated techniques like focus groups to test interventions.

But now instead of relying on intuition and guesswork, “we combine trials, behavioural economics, and competition analysis, to work out what’s going on in each market – real markets, not just theoretical constructs,” Wheatley said.

Price cap analysis. “Today, regulators use vastly more advanced technology than Neil Armstrong used to reach the moon, “Wheatley claimed, and this processing power has been matched by a “similar scaling up in the amount of information we have at our disposal.” During their price cap analysis work, cost, revenue, and repayment information for some 2.3 million anonymized borrowers, covering a total of 16 million transactions, were analyzed along with loan information from a credit reference agency for another 4.6 million anonymized individuals, covering 50 million products purchased. So a detailed picture of borrowing patterns, costs, and financial circumstances in this market was constructed. Modeling behavior under different scenario allows regulators to narrow policy options more effectively and set a more authoritative cap level.

For Wheatley, there is no doubt that improvements in technology like this offer regulators some important possibilities. Not least for Wheatley in reducing the impact of unintended consequences, technology improvements have become “an imperative” for that critical question: how do you make sure regulatory intervention becomes socially useful intervention? Not just mere “activity.”

Add-on products. The key issue here for Wheatley was the fact that consumers were paying far more than the costs of providing many add-on products. A competition study focused on whether there are significant challenges around how competition is working for consumers across the different markets for add-ons and found that, among other things, the later the price is shown, the less likely the customer is to shop around for alternatives. The controlled experimental setting allowed the experimenters to “dig deeper” to find that it was not just the lack of transparency in revealing the price later that drove consumer error but one in five consumers did not choose the cheapest bundle on the main and add-on product, even if both prices were presented up front. In the case of general insurance add-ons, this means challenges like inertia and complexity are handled on what works in a particular market and interventions are guided by serious analytical research and data into what works, and doesn’t work, in that particular market, Wheatley said.

Cash saving and overdrafts. Wheatley also reported on the results of a market study on cash savings. “The large majority of us pay little or no attention to alternative accounts on offer. We cling to what we have,” he said. But again, a significant opportunity in this study is for regulators to use econometric techniques, technology, and big data alongside behavioral economics to better understand how the market works, he added.

With respect to overdraft analysis, Wheatley said they have been able to analyze the anonymized personal current account activity of about 500,000 customers, with more than 621,000 accounts between them collecting monthly information on transactions dating back to 2011. The data allows them to assess the customers who are most susceptible to overdraft charges and they have found considerable differences in the effectiveness of market initiatives to help consumers avoid unexpected charges.

The key issue for Wheatley is for global regulators to embrace modern, 21st century economics to try and remove the guesswork from interventions.