British regulator to employ behavioural economics

The first paper reviews how consumers choose and use financial products, and how behavioural biases can lead to firms competing in ways that are not in the interests of consumers. The second paper looks at ways to improve redress for consumers through communications.

“Regulating to reduce consumer errors will pose significant challenges as there are relatively few precedents,” the first paper concludes. However, it says these challenges can be overcome.

“The FCA will need to learn how to design and implement behaviourally informed remedies, possibly when there remains uncertainty about underlying consumer biases and their relationship with other market features. This implies that the FCA will need to test remedies before implementation more frequently than previously and conduct research to gain deeper insights into specific markets,” it notes.

The second paper reveals the results of a real-world experiment into how to improve response rates to letters offering consumer redress. It notes that in some cases, customers don’t respond to offers of redress, even when they have been mis-sold a product, and when it would be in their interest to act. “One reason may be that the relevant information is obscured or more complex than necessary, or that consumers suffer from inertia,” it says.

So, the regulator experimented with a number of ways of improving consumer response rates in a real case, with a firm that was voluntarily writing to almost 200,000 customers about sales process failure. It tested different potential improvements to the firm’s letter to customers, and found that “subtle changes to the presentation of information can have large effects.”

“Of the three broad areas our research tested, our results show that tailoring the letters to increase the readability of letters is the most effective,” it says. “Reminding people helps and we think this is likely to work as a prompt as well as a signal of importance.” However, personalising the message by having the firm’s CEO sign it, or placing the regulator’s logo on the letter too, did not help response rates.

The paper suggests that the findings from this experiment will lead the FCA to test further changes to consumer communications, “in particular methods to help consumer reduce procrastination and the effect of different channels of communication (such as emails or text messages).”

“Where possible, we also aim to test and improve our own communications to firms to understand how firms respond to our letters. We also believe that applying the same methods to disclosures about products could also make this information more effective and ensure that financial consumers are informed, and therefore empowered, as best as possible,” it says.

The FCA’s chief executive, Martin Wheatley, is to speak Wendedsay at the London School of Economics in his first speech since the FCA came into operation on April 1. In that speech, he will further explain its effort to utilize behavioural economics.

“One of the most significant challenges for modern financial regulators and financial services alike is to recognise that we operate within a very human environment. A fallible world – not just of ratios and complex models but also responses, sometimes flawed, that behavioural economics helps us understand,” he will say.

He will also explain the limits to the concept of ‘buyer beware’, saying, “Buyer beware becomes hard to defend when unsophisticated customers are buying seriously complicated financial products, where the risk of failure is far more dangerous than a decision in the supermarket to buy three bananas instead of one. There are questions that many investors simply will not ask because they are humans, not automatons.”

And, he will outline his vision for how behavioural economics will be used by the FCA, and how he hopes firms will act in future. “I want the FCA to bring a more human face to the regulation of financial services; a more pragmatic approach to regulation. Not only to defend against sharp practice but also to encourage better decision making among consumers,” he is to say.

“The FCA wants to make sure customers are far more easily able to compare product prices and to assess their value. We want the regulatory system to use behavioural economics to ascertain whether people are being put off switching products through inertia, inattention or even the simple fear of regret from making a wrong decision,” he plans to say.

However, he’ll also acknowledge that behavioural economics is no magic bullet, and that it’s use will not be straightforward. “There is no mechanical routine to follow when we apply behavioural economics to regulation. It will require us to change the way we identify risks, diagnose problems and troubleshoot,” he is to say. “It’s also worth pointing out that behavioural economics is not enough, on its own, to guarantee good regulation or strong financial products. It is a part only of the new FCA’s identity.”