KEY TAKE OUTS
- Research in behavioural economics indicates that investors and consumers are prone to behavioural biases that leads to poor decision making.
- ASIC is increasingly adopting behavioural economic theory and empirical research to shape its approach to regulatory reform.
- This area is particularly important in the design and disclosure of complex financial products, but also extends to a variety of contexts where ASIC sees consumer biases leading to vulnerability and a requirement for enhanced consumer protection.
From hybrid securities to digital disclosure and financial calculators, ASIC is increasingly forming its regulatory approach by considering real, rather than theoretical, human behaviour in the face of economic decisions.
In its Strategic Outlook for 2014-2015, ASIC announced its focus on the relationship between the design and disclosure of retail products and consumer decision making, behaviour and outcomes.
ASIC followed through on this Outlook with a number of reports published in 2015 with the central theme of behavioural economics. Behavioural economics and its implications for financial institutions and regulators will be central to the regulatory debate and are now firmly embedded in the Australian Government’s agenda.
ASIC explored consumer behaviour in its submission to the Murray Financial System Inquiry (FSI). ASIC submitted that the assessment of the performance and quality of financial products and services is becoming increasingly difficult, especially in retail markets.
ASIC discussed the limits of disclosure and challenged the assumption that disclosure was always the best tool to fix market failure. According to ASIC, research in behavioural economics, as well as its experience of regulating retail financial markets, indicates that investors and consumers are prone to behavioural biases that mean decision making is often not instrumentally rational. ASIC has raised the potential to improve regulatory design with a better understanding of consumer behaviour and decision making.
As with many other instances of increased focus, ASIC has followed in the footsteps of the UK Financial Conduct Authority (FCA), which has released a series of papers since 2013 on behavioural economics and the psychological heuristics which affect financial decision-making.
As leading experts in economics, psychology and behavioural sciences continue to advance our knowledge of retail investor behaviour, global regulators are taking note. Financial institutions and product issuers should explore opportunities to adopt and apply this research to offer financial products and services to clients in an innovative and intuitive way.
The rise and fall of homo economicus
Since the introduction of modern financial services regulation, the regulatory framework for the offering of financial products has essentially had two pillars:
1. Conduct obligations: such as to act honestly, efficiently and fairly, and obligations to manage conflicts of interest appropriately; and
2. Disclosure: namely financial product and financial services disclosure.
These pillars, and disclosure in particular, have traditionally been forged with homo economicus in mind, an entirely mythical creature with the infinite ability to make rational decisions to optimise its own interests.
So far, disclosure regimes in Australia have typically relied on the assumption that if you can address an information imbalance through disclosure, this will allow consumers to become informed, so that they can (and will) make rational decisions.
Flesh and blood human beings, however, are not entirely rational creatures. We are ‘nudged’ in various directions by complex social and personal influences. This behaviour undermines the effectiveness of some traditional regulatory tools, notably disclosure.
Financial products with new settings (i.e. complexity, risk, uncertainty and a long-term nature) exacerbate the tendency to fall back on these behavioural biases. As financial products and services with complex designs become increasingly and more readily available to retail clients, ASIC has a growing view that disclosure of itself is insufficient to provide consumer protection.
Of course, ASIC will continue to keep disclosure in its arsenal to promote consumer protection. ASIC’s recent reforms to facilitate digital disclosure and the Government’s response to the final report of the FSI - in which it adopts recommendations to facilitate innovative disclosure and to amend priority areas of legislation to make it technology neutral - makes it clear that disclosure is far from dead.
And so, whilst for example ASIC has already gone down the path of imposing enhanced disclosure benchmarks for certain products, it is now pursuing empirical studies on human behaviour and actively incorporating the results of those studies into regulatory outcomes beyond disclosure.
Protecting consumers from themselves
Behavioural economics uses insights from psychology to explain why people behave the way they do. People do not always make choices in a rational, calculated and optimal way. Most decision-making uses thought processes that are intuitive and automatic rather than deliberate and controlled.
Some examples of thought processes are:
Heuristics, or decision-making or thinking shortcuts. Often thought of as a ‘rule of thumb’ or, when applied in a less deliberate manner, ‘gut instinct’.
Consumer optimism, or over confidence in one’s own self-control or ability to understand a product, or use that product optimally.
Poor financial literacy and confusion about how to choose and use a product.
Choice overload leading to poor investment or purchasing decisions.
Biases which affect our preferences, beliefs and decision making.
In a 2013 paper, the UK FCA identified 10 biases in particular to which retail financial markets are susceptible:
- Present bias (e.g. spending on a credit card for immediate gratification);
- Reference dependence and loss aversion (e.g. believing that insurance added on to a base product is cheap because the base price is much higher);
- Regret and other emotions (e.g. buying insurance for peace of mind);
- Over-confidence (e.g. excessive belief in one’s ability to pick winning shares);
- Over-extrapolation (e.g. extrapolating from just a few years of investment returns to the future);
- Projection bias (e.g. taking out a payday loan without considering payment difficulties that may arise in the future);
- Framing, salience and limited attention (e.g. overestimating the value of a packaged bank account because it is presented in a particularly attractive way);
- Mental accounting and narrow framing (e.g. investment decisions may be made asset-by-asset rather than considering the whole investment portfolio);
- Decision-making rules of thumbs (e.g. investments may be split equally across all funds in a pension scheme, rather than making a careful allocation decision); and
- Persuasion and social influence (e.g. following financial advice because an adviser is likeable).
Market forces left unto themselves will not often work to reduce these mistakes. In fact, the tendency remains for financial institutions to apply predictable customer behaviour in product design or distribution in a way which is potentially advantageous to the product issuer. For example, teaser rates, honeymoon periods, cash back rewards, questionable comparisons, loyalty programs and other seemingly advantageous but rarely used product features.
Regulators are increasingly aware of this tendency and are stepping in where consumers risk being unfairly exploited by their own biases.
The perils of complex financial products
ASIC continues to hone in on the development, distribution, point-of-sale and post-sale management of complex financial products. In ASIC’s view these include interests in agribusiness managed investment schemes, exchange-traded options strategies, hedge funds, hybrid securities, leveraged derivative products, managed funds with non-standard or non-linear payoffs, structured products and warrants.
In March 2015, ASIC commissioned a study by Queensland University of Technology’s Behavioural Economics Group (QuBE) regarding the behavioural biases and risk attitudes that influence investment in hybrid securities. The report sets out the results of research into how behavioural biases may influence preferences towards hybrid securities over the less complex financial products of bonds and shares.
The researchers studied the degree to which certain behavioural biases affected an investors appetite for hybrid securities. Two biases were found to be positively correlated with attraction to hybrid securities:
- Illusion of control bias: a false belief that investors can exert control over their environment and influence outcomes; and
- Overconfidence bias: an unwarranted belief in an investor’s abilities, intuition, and judgement.
There was also a positive relationship between these two biases. That is, the illusion of control bias causes investors to think they can control the risk of investing in hybrid securities. Overconfidence bias causes investors to underestimate risk and perceive hybrid securities to be safer than they are.
ASIC noted that the results of the pilot study can inform conversations with industry, assist in the development of regulatory interventions and contribute to improvements in ASIC’s programs to advise and educate investors to make more informed decisions (such as via the MoneySmart programs).
ASIC to nudge directors into compliance
While ASIC seeks to protect consumers from vulnerability to cognitive biases, it is also exploring how to use those same biases as a tool to promote compliance.
In another ASIC-commissioned report prepared by QuBE, researchers explored ways to increase compliance of directors of companies in liquidation with their obligations to cooperate with the liquidator’s investigations. The researchers recommended design changes to the letters issued by ASIC to the directors, including:
- Re-arranging the order of information to reduce cognitive overload;
- Sharing information about compliance trends, to trigger ‘follow the herd’ behaviour;
- Increasing the sense of control felt by directors in the compliance process; and
- Disclosing a non-specific penalty, based on experimental evidence that compliance is higher when the punishment is uncertain.
More recently, ASIC released Consultation Paper 249 in respect of remaking its class order on generic financial calculators (i.e. calculators to estimate the value or growth of superannuation, savings or other investments).
ASIC again referred to behavioural economics, in this case research which supported giving providers greater flexibility on where and how to make relevant disclosures clear and prominent. ASIC also cautioned providers on the use of default settings and the potential for consumer confusion if calculators adopt out-of-date statutory assumptions.
If the previous 12 months are any indication, we anticipate seeing ASIC rely on behavioural research in a variety of contexts and use the results of that research to form its regulatory approach.
We expect to see over the next 24 months or so the introduction of the following reforms, which arguably seal the fate of homo economicus and present a shift towards reform guided by actual human behaviour and empirical research:
- The introduction of a targeted and principles-based product design and distribution obligation, to make issuers and distributors more accountable for the design and distribution of products and ensuring their suitability for the relevant target customers; and
- A proactive product intervention power that would enhance the regulatory toolkit available to ASIC where there is risk of significant consumer detriment. This will of course be subject to industry consultation but appears to be intended to empower ASIC to modify or if necessary, ban ‘harmful’ products in specific circumstances.
These represent an important shift away from consumer responsibility supported by a disclosure regime - or ‘buyer beware’ - to a system in which financial institutions bear additional responsibility for treating customers fairly.
In the context of the proposed new product design obligation, we expect ASIC to apply behavioural economics when providing regulatory guidance to, product issuers and manufacturers.
In its reviews of new or existing products, ASIC is likely to apply behavioural economics to determine whether those products are indeed suitable for the customers they are sold and marketed to.
There are a few areas we can identify which offer scope for ASIC to apply behavioural reasoning:
- The design of certain reverse mortgage products, in light of the average age and cognitive abilities of likely customers for these products (noting the growing theme of ‘elder financial abuse’);
- Complex product design features such as hybrids which, based on ASIC’s research on the impact of behavioural economics, are particularly appealing to self-managed superannuation investors (who are particularly susceptible to the illusion of control and overconfidence biases); and
- The increasing emphasis on culture and conduct in financial institutions, and the application of behavioural economics to concepts such as reward and remuneration schemes as compared to penalties or fines in the case of poor behaviour.
The UK FCA’s active progress in this area may also foreshadow ASIC’s intentions. The FCA has published numerous papers, exploring such topics as:
- How to encourage consumers to obtain redress following the mis-selling of financial products or services;
- Investigating whether the inherent structure of transactions, where insurance is offered as an add-on, impacts consumer decision making;
- Encouraging customers to take advantage of higher interest rates by switching savings accounts;
- How well consumers understand and value structured deposits; and
- The impact of annual summaries, text alerts and mobile banking apps on customer behaviour.
What can product issuers do now?
As with any regulatory trend, there can be benefits for early adopters. For financial institutions and product issuers, considering behaviourial economics internally in their product design and disclosure can:
- Reduce ‘red flags’ for ASIC: for example, these may comprise remuneration models that risk driving undesirable behaviour;
- Minimise the risk of regulatory intervention or interference: for example, issuers may undertake product ‘stress-testing’ for features that encourage poor-decision-making in some or all of target customers; and
- Demonstrate a commitment to putting the customer first in product design and seek to ensure that products are suitable for the customers they are directed at with a reduced risk misalignment between how retail products are designed, distributed and marketed.
In November 2015, Professor Cass Sunstein, co-author of Nudge, author of its follow-up, Why Nudge? and a leading scholar in law and behavioural economics, spoke at Henry Davis York to senior executives from industry leading institutions on the concepts of ‘nudges’, choice architecture, human errors and the drive towards simpler and better disclosure.
Based on Professor Sunstein’s work, we anticipate seeing a trend towards machine-readable disclosure, simplified forms, intuitive communication processes and a reduction in complex products designed to take advantage of cognitive biases.
Professor Sunstein’s talk coincided with the announcement that the Turnbull Government has created a behavioural economics team (BETA) to be housed inside the Department of the Prime Minister and Cabinet. BETA will be headed by Professor Michael Hiscox of Harvard University. At the launch, Assistant Cabinet Secretary Scott Ryan commented that: “Behavioural sciences, particularly as they apply to economics, can provide fascinating insights into how current policy settings drive and deliver particular responses and results.”
The establishment of BETA is the most recent step towards the Government adopting a behavioural approach to policy and regulation. While consumer advocates might say this is a nudge in the right direction, financial services providers will want to maintain innovation and healthy competition in product design and distribution.