Sunday, July 15, 2018

Behavioural Economics and Financial Services

My Sunday Business Post article is available here. A rougher and un-gated version is below.

Nudging consumers for better and worse

The awarding of the Nobel prize in Economics to the Chicago-based economist Richard Thaler last year underlines the extent to which behavioural economics has become an important part of modern thinking on policy. Thaler is one of the leading figures in integrating psychology into economic models, and has been at the forefront of a widespread change in Economics that has increasingly come to have real-world effects.

A central idea in behavioural economics is that markets do not necessarily work to satisfy consumer demand in the way traditionally outlined by economists, particularly for complex contractual products. People find such products difficult to engage with and often delay key financial decisions. Furthermore, companies exploit consumer biases through several mechanisms, meaning that people often purchase products not suited to them in a meaningful sense. For this reason, consumer financial markets are far more unstable than they would otherwise be, and household finances across life are more precarious than one would expect just from income levels alone.

The literature in this area has increasingly pushed for more active government policy and regulation in consumer finance. A key area for this has been pensions. As much of the world has moved towards people making provision for themselves with defined contribution products, understanding how people engage with such products has become more urgent. Thaler and several of his colleagues have argued that some form of auto-enrolment is needed to make this a relevant choice for many consumers, and that auto-escalation (making the contributions rise over time in line with salary) should also be a feature of pension provision to ensure that people don't simply stick at a low level of default contribution. This thinking has been influential in Ireland also with proposals to introduce auto-enrolment having been part of the debate for years and now moving into an implementation phase.

Pension auto-enrolment potentially will solve one key problem for Irish consumers, namely the difficulty in getting a pension sorted out early enough in life to build up a decent retirement income. But there are many other aspects of consumer finance that are affected by behavioural factors. The ESRI's behavioural economics unit have shown that many Irish consumers find a whole range of consumer contractual products too confusing to make meaningful choices of the type envisioned by economic models. This is a problem for consumers but also for the industry more generally, as it means firms have incentives simply to find better ways of exploiting confusion rather than competing on price and product quality.

All of this has the potential to be made worse by the development of "big data" models that allow firms to target consumer biases at an individual level using transactions and other related data. While such models open up the potential to improve consumer outcomes by better matching consumers to products, they also open up substantial potential to develop algorithms that simply figure out how to charge more for the same product to confused consumers. A recent paper by Harvard legal scholar Oren Bar-Gill argues that such algorithms that target consumer biases have a strong potential to create harmful outcomes, and that regulators should "fight fire with fire" and examine how to counteract this. More generally Bar-Gill has warned about the potential for consumer detriment in complex contractual markets, including in his widely read book "Seduction by Contract" which dissects the various features of contractual services that make them difficult for consumers.

One of the main contributions of behavioural economics will be to recognise these features of markets and to encourage more active regulation by governments. Financial education is certainly one tool to improve consumer outcomes but it is a very limited response of itself and should not be seen as taking the place of direct regulation to improve the product environment. The book "Nudge", published ten years ago by Thaler and his colleague Cass Sunstein, argued for a shift towards making decisions easier for consumers and pushed regulators to examine all aspects of the "choice architecture" of complex products. UK regulators such as the Financial Conduct Authority have led the way in experimenting with disclosure requirements for products, explaining to consumers what they are purchasing in a manner they are likely to understand, and work of this nature is also underway in Ireland. There are many potential applications in this area, including experimenting with how costs of products like mortgages, credit cards, and personal loans are communicated to people to ensure they fully understand them, to shaping pension offerings to make them a more active part of people's lives.

The ideas in this area have also started to have a major influence on how governments interact with citizens, including in areas such as energy efficiency, environmental change, revenue collection, and a vast range of other areas. For example, the Irish Revenue have been using behavioural economics ideas to design more effective communication tools to improve tax compliance, and the Sustainable Energy Authority have recently established a small team to use this area to improve the roll-out of energy efficiency schemes.

The literature is also not limited to looking at consumer decision making. The extent to which the risk-taking culture of providers might itself create potential for poor financial outcomes for consumers and firms has increasingly been examined in this area. Most large private institutions have explicit codes to communicate to employees the importance of appropriate risk-taking behaviour and concern for customer outcomes. However, the implicit culture engendered in competitive "team-sport" type environments has increasingly been studied, particularly when compounded with review cultures that stress short-term targets. While it is important to understand the incentives of financial institutions in the traditional economics sense, the role of such institutional cultural factors need also to be part of an improvement in consumer finance, as recognised by recent bank culture reviews. If nudging consumers has become a widespread form of public policy making, it should not be a substitute for understanding that the providers are also subject to human pressures.

Overall, this more psychological approach to looking at markets has now firmly established itself in academia and policy-making, and will increasingly impact on how governments, regulators, and firms behave. In an optimistic scenario, markets will become more active through regulation that is more grounded in actual evidence on human decision-making and consumers will be empowered to make more sensible choices. Furthermore, government policy may also become much more responsive to psychological features that affect policy administration. However, advances in data and technology also open up avenues for consumer exploitation not yet widely understood by regulators. "Caveat emptor" may be a hollow motto when behaviour is being shaped by factors hard to understand for the majority of people.

Liam Delaney is Professor of Behavioural Economics in UCD. Disclaimer of Conflict of Interest: Funding was provided to UCD from AIB to form the Professorship in this area. They have no role in screening research or influencing public submissions.

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