Behavioural insights for conduct supervision
Introductory Remarks by Luigi Federico Signorini
Deputy Governor of the Bank of Italy
Banca d'Italia/FinCoNet International Seminar
on Financial Consumer Protection
Rome, 15 November 2019
It is my great pleasure to open the International Seminar on Financial Consumer
Protection, jointly organized by Finconet and the Bank of Italy.
The theme of this seminar is the subject of much discussion and a driving force in
the evolution of business conduct regulation and supervision. Behavioural economics
has provided important insights. We would be well advised to take them into account
when framing regulations and performing supervisory tasks in the financial sector.
Understanding how people make economic choices is central to economics.
Economic models, however, will never be able to do justice to the full range of
motivations, reasoning and impulses behind human behaviour. Economics needs to
simplify and select. At the same time, it needs to remain open-minded enough to see
the pitfalls of simplifying assumptions. Economic models have always been challenged
over time, with new approaches subverting the conventional wisdom of the day; as in all
sound science, progress in economics has been driven by people challenging received
wisdom, pointing out its flaws, and proposing corrections. Yet it has always retained
the basic concept that agents will respond to incentives and that in most circumstances
the collective wisdom resulting from innumerable fallible individual choices is superior
to comprehensive top-down planning, enlightened as the latter may be. Adam Smith
did not have to invoke utility maximisation to conceive of the invisible hand, nor did
Ricardo to discover comparative advantage: two of the most counterintuitive, and most
enduring, cornerstones of economics. Ronald Coase famously stated that "there is no
reason to suppose that most human beings are engaged in maximising anything unless
it be unhappiness, and even this with incomplete success"; yet this (half tongue-in-cheek)
assertion did not prevent him from formulating a theorem about the superiority of private
contracts even with externalities, provided property rights are carefully laid down.1
Contemporary mainstream economics makes abundant use of formal models that
specify what precise quantity is being maximised, and assume that agents make efficient
use of whatever information is available. While such assumptions are extremely useful
for developing insights into how the world actually functions, nobody believes them
literally. "Utility" for instance, (sane) economists will accept, has no well-defined physical
counterpart. This means that, while recognising the usefulness of this or that formal
model in many cases, one should remain alert to its limits.
Consumer behaviour is a case in point. Utility maximisation by consumers has
proved to be a fantastic tool for developing compact, elegant models to describe many
interesting and crucial features of the real economy. Yet it cannot provide all the answers,
especially when you look at consumers' choices in a concrete environment and reflect
upon the best ways to regulate market conduct in legal detail. Converting a useful
simplifying modelling device into an article of faith about how the human mind works
would be nonsense. One does not need to throw away a century of economic thought to
recognise that human behaviour is much subtler and more elusive than that; one needs
only some reasonable human heuristics, as it were, and the ability to adapt one's tools
to the task at hand.
Nevertheless, it took a while for economists to recognise in full that actual consumer
decision-making is rather different from what is expected from a rational agent who
single-mindedly maximises a utility function - a major exception being the studies on
bounded rationality.2 By contrast, marketing experts developed an understanding early
on of how buyers actually make decisions, and found ways to profit from it. Regulators
that fail to recognise this asymmetry, and act upon it, would not do a good job.
This is not a theoretical point, and the audience today will need no convincing.
There is even a plausible claim that the delay in tackling certain financial consumer
protection issues contributed to the financial crisis ten years ago.3 Be that as it may,
the day-to-day task of ensuring the fair and efficient functioning of the market for
consumer finance requires a richer model of consumer behaviour than one based on
"utility" maximisation and the full use of information. Hence, the increasing attention
now devoted to behavioural economics by financial regulators and supervisors, with the
aim of designing and implementing policies that help consumers take financial decisions
they will not regret.
This seminar will benefit from contributions from the academy and from supervisors.
The Bank of Italy strongly supports this interaction.
Before leaving the floor to our speakers, let me briefly recall some well-known
insights from behavioural economics that have been significant in the evolution of
regulation in the field of financial consumer protection, and provide a quick overview of
the approach to financial consumer protection adopted by the Bank of Italy.
Behavioural economics relies heavily on the seminal studies by Daniel Kahneman
and Amos Tversky,4 two psychologists, one of whom (Kahneman) got a Nobel Prize in
economics for it (Tversky, sadly, did not live to get the share he deserved). This is, by the
way, not an isolated case; it bears witness to the fact that the economics profession, in its
best moments, is open to contributions from other disciplines to refine its understanding
of human behaviour and interactions.
Behavioural economics has provided evidence that, when taking decisions, people
regularly deviate from certain accepted canons of rationality, as intuition often prevails
over reasoning.5 Such deviations are not random. Laboratory experiments, though mostly
confined to simulated environments, do provide rather convincing evidence that biases
affect the decisions of consumers in a systematic way.
For financial services providers, knowledge of this can make competing on quality
and prices less attractive relative to leveraging on these biases in their marketing activity
using opportunistic business practices.
The list of biases is an evolving one; here, I will only mention a few of those that are
most relevant from a financial consumer protection perspective and represent a common
background for business conduct supervisors. They include:
I) mental shortcuts used to generate approximate answers to questions (heuristics);
II) the influence of the way information is presented on the way decisions are taken
(framing effect)
III) the fact that outcomes are usually assessed against a reference point (reference
dependence/anchoring effect), implying that different reference points affect the
perception of gains and losses;
IV) a preference for immediate gratification, resulting in decisions that do not maximise
long-term net effects (present bias) - e.g. people overestimate their ability to repay
loans, resulting in over-indebtedness;
V) the fact that people often demand much more to give up an object than they would
be willing to pay for it (endowment effect); this helps explain, e.g., why switching
rates among products from different financial services providers are low even when
there are no legal obstacles to or monetary costs in doing so.
While biases are deeply embedded in the human mind, they have not prevented
humans from becoming (for better or for worse) the dominant species on Earth. In fact,
in many circumstances, biases and mental shortcuts will "do the trick" and help us to
take decisions instantly and without effort that we would not later regret, by and large.6
However, the jungle of finance is in many ways different from the environment where
humans have evolved over hundreds of thousands of years. When it comes to financial
decisions, mental shortcuts that were efficient for escaping lions or capturing gazelles
may prove inadequate to make (say) choices on long-term financial retirement plans.
They may prompt consumers to take decisions that they would not have taken based on
a more thorough assessment.
The evidence from behavioural economics should be enough to convince regulators
and supervisors that it is crucial to complement the traditional regulatory approach
- based on pre-contractual disclosure to overcome information asymmetries - with
behavioural insights. Policy makers have started testing new instruments, examples of
which include:
I) standardising pre-contractual documents, so that they selectively provide (or
highlight) only those pieces of information that are most relevant to the consumer;
II) prescribing the use of the most effective channels for interacting with customers:
for instance, evidence exists that text alerts and mobile banking apps are much
more effective than periodic reports for attracting the attention of consumers that
are incurring overdraft charges;7
III) focusing on the overall fairness of contractual relationships, e.g. in order to limit any
over-indebtedness induced by present bias;
IV) establishing cooling-off periods, i.e. the possibility for consumers to withdraw from
contracts, especially in the event of cross-selling practices and distance selling
(thus neutralising possible temporary emotional effects), to allow for legitimate and
sufficiently timely regret.
All these tools are mainly intended to remove information and cognitive asymmetries,
and their undesired consequences for the proper functioning of financial consumer
markets. In this sense, one could say that they do not depart from the traditional paradigm,
whereby the individual's choices should not ultimately be replaced or unduly influenced
by those of the regulator. The aim is to supply consumers with the necessary tools to
make informed judgments, rather than to supplant their ability to decide for themselves.
Some go further. Proponents of libertarian paternalism maintain that regulators,
while still refraining from direct coercion, should endeavour to influence the choices of
affected parties in a way that is expected to make them better off8 - an approach also
commonly referred to as nudging.9
This view also provides a strong argument (not the only possible one) for regulators
to exploit the alternative between the "opt-in" and "opt-out" approaches for financial
schemes; when the regulator considers one alternative to be in the best interests of
consumers, it can "nudge" them in that direction by making it the default (or "inertial")
choice. The opt-out approach has proved to be quite effective in promoting participation
in pension schemes, for example, where it is seen as an effective tool against "present
bias".
How far one would go along this road will ultimately depend on one's view of
society. Some would balk at the idea of treating citizens as perennial minors, to be gently
prodded, or "nudged", by a benevolent regulator, to do whatever the regulator considers
to be in the consumer's own best interest. Yet even if one thinks that the individual must
remain ultimately responsible for his or her own choices, the insights of behavioural
economics remain central for framing those choices in a way that is consistent with known
cognitive bias, so as to empower the consumer to make such choices in full awareness.
Whatever your approach, the landscape is evolving rapidly. A growing body of
experimental research is developing on the effectiveness of regulatory initiatives based on
behavioural insights. At the frontier, a series of studies is flourishing on the physiological
reaction of financial consumers to external stimulus (neurofinance). What will come out
of that, and what one is to do with whatever the results might be, must be the subject of
future reflection.
For the framework of consumer protection to be effective, it needs more than
regulation alone. It must be complemented with supervision, enforcement, and financial
education. Let me elaborate briefly on the approach of the Bank of Italy.
Based on the understanding that too much information is as potentially harmful
as too little information, and that such "information overload" can lead consumers to
take financial decisions that they will consider inappropriate in retrospect, the traditional
regulatory approach based on a full disclosure regime has evolved. Reflecting changes in
the EU legal framework too, regulation of the most common products now provides for
standardised pre-contractual information that makes key information adequately salient.
The regulator plays a delicate role in selecting the most relevant information, based
for instance on the size of the revenues from certain fees and tariffs, and finding ways
to increase its visibility. One application of this concept is to require banks to disclose
standardised cost indicators for the simplest forms of bank accounts and the most
common types of consumer loans.
Again on the regulatory side, recognising that biases are always in action, and
that financial services providers - including banks - may actively seek to exploit them,
has led us to introduce - in compliance with the applicable EU legislation - certain
business conduct requirements, aimed at increasing the overall fairness of contractual
relationships. We abstain, however, from interfering directly with individual decisions of
consumers or firms. A few examples of such requirements are:
I) provisions concerning the assessment of creditworthiness, to address
overindebtedness;
II) product governance requirements, concerning the design of new products,
consumer-testing activities, as well as distribution;
III) sound remuneration policies for sales staff, to mitigate the risk of perverse incentives
for misleading the consumer.
As regards supervision, since the establishment of a dedicated Directorate in 2014,
the Bank of Italy has been moving steadily from the assumption that more information is
always better to a focus on salience as opposed to sheer quantity; from mere disclosure
to a broader range of issues (including governance and strategy); and from a box-ticking
approach to an approach that includes cooperation and guidance.
We have thus complemented our supervisory action by issuing Guidelines to clarify
supervisory expectations. This approach has proved to be fruitful in addressing issues that
are highly significant for consumer protection, such as the remuneration of overdrafts
and overrunning, the unilateral variation of contracts, the handling of complaints, and
the conditions for consumer credit.
For enforcement, we start from the assumption that customers harmed by unfair
business conduct and non-compliance with regulatory requirements should be in
a position to seek redress in a way that is simple, fast, and inexpensive. To this end,
in 2009, the Bank of Italy established an alternative dispute resolution mechanism for
the banking sector (the Arbitro Bancario Finanziario or ABF), which has proved to be
effective, has become increasingly popular with customers, and has somehow become
a benchmark for other regulated sectors. While the ABF's decisions are not binding,
"naming and shaming" is applicable in the event of non-compliance and has proven
an effective deterrent. Furthermore, as financial services providers are required to take
the ABF's decisions into account when dealing with complaints from their customers,
this enforcement system contributes to increasing the overall fairness of contractual
relationships in the banking sector.
Finally, a few remarks on financial education. While regulation and supervision
may help to address indirectly some of the major flaws in consumers' choices, there is
broad consensus that the empowerment of consumers also requires strategies aimed at
increasing their basic financial knowledge.
Nowadays people are probably facing increasingly complex financial decisions
more often than at any other point in humankind's history. Ageing and the evolution
of welfare imply an enhanced role for life insurance and private pension schemes. The
increased range of financial investment choices provides better potential opportunities,
but may appear baffling to non-experts. Technological development in payments
are transforming, beyond recognition, the way we conduct even the most common
transactions. Individuals need to take financial decisions throughout their life, including
decisions inherently involving long-term outcomes that are very difficult to predict and
assess (e.g., investing early for one's retirement), which are exactly those where the usual
mental shortcuts are most likely to fail.
Neither pre-contractual information, nor business conduct requirements will
provide the desired policy outcomes if people are not able to grasp at least the
fundamentals of finance. International evidence shows that this ability, while perhaps
generally unsatisfactory, is even less developed in Italy than in many other countries. This
is why the Bank of Italy has devoted a great deal of effort to designing and implementing
financial literacy programs. These strive to take into account behavioural biases and to
make consumers aware of how they influence their decisions.
The Bank also supported the establishment of a National Committee in charge of
steering and coordinating financial education initiatives, where we cooperate with many
other public and private institutions providing financial education schemes.
***
Effective business conduct supervision is challenging. Insights from behavioural
economics contribute to its theoretical foundations, and provide useful suggestions for
improving the regulatory and supervisory framework. The lessons we are going to learn
today will be of great help in shaping our financial control architecture to make it more
effective and to contribute to a financial system that is fairer, sounder, and safer for
consumers.
I wish you all a fruitful discussion and a pleasant stay in Rome. Thank you!