Applying Behavioural Economics at the Financial Conduct Authority
78 Pages Posted: 9 Mar 2017
Date Written: April 9, 2013
People often make errors when choosing and using financial products, and can suffer considerable losses as a result. Using behavioural economics we can understand how these errors arise, why they persist, and what we can do to ameliorate them.
Behavioural economics uses insights from psychology to explain why people behave the way they do. People do not always make choices in a rational and calculated way. In fact, most human decision-making uses thought processes that are intuitive and automatic rather than deliberative and controlled.
Academic literature identifies ‘behavioural biases’—specific ways in which normal human thought systematically departs from being fully rational. Biases can cause people to misjudge important facts or to be inconsistent, for example changing their choices for the worse when essentially the same decision is presented in a different way. In other words, our normal human thought processes can lead us to make choices that are predictably mistaken.
Market forces left to themselves will often not work to reduce these mistakes, so regulation may be needed. A good example is payment protection insurance (PPI). Firms were able to earn large profits on PPI products because many buyers fundamentally misunderstood PPI pricing and the limitations in its coverage. High PPI prices allowed sellers to attract more customers by offering mortgages at cheaper rates (which consumers focused on when choosing a provider). As a result, no firm had an incentive to advertise that PPI was a poor product for many people and charge appropriate mortgage and PPI prices. This would have made the firm’s mortgage more expensive and the firm uncompetitive. Intervention was needed to solve this problem.
While it is common sense that people make mistakes, behavioural economics takes us beyond intuition and helps us be precise in detecting, understanding, and remedying problems that arise from consumer mistakes. Integrating behavioural economics into the FCA can therefore help it be an effective regulator.
This paper has two parts. In Part I we summarise the main lessons from behavioural economics for retail financial markets:
• how consumers make predictable mistakes when choosing and using financial products; how firms respond to these mistakes, and
• how behavioural biases can lead firms to compete in ways that are not in the interests of consumers.
In Part II we describe how behavioural economics can, and should, be used in the regulation of financial conduct.
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