Investor Missteps Studied by FCA in Quest for Better Rules

Britain’s Financial Conduct Authority will tap into behavioral economics to bolster regulation of markets through better knowledge of common blunders by financial consumers, such as overconfidence in their ability to pick winning stocks.

The FCA, which replaced the Financial Services Authority on April 1, released two reports today signaling its intention to apply the discipline to its work, including the results of its first field study. The new regulator said that blaming consumers for poor decisions has limits.

“‘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,” FCA chief executive Martin Wheatley will say in a speech tonight. “There are questions that many investors simply will not ask because they are humans, not automatons.”

Regulators on both sides of the Atlantic have applied behavioral economics to improve their understanding of people’s financial choices. Behaviorists reject the assumptions in conventional economics that people always choose the best option for themselves, and study what motivates good and bad decisions.

Payday Loans

The FCA’s research team includes former Yale and Harvard behaviorist Stefan Hunt, while the U.S. Consumer Financial Protection Bureau has put the field to work when writing rules for mortgages, credit cards and payday loans. Hunt was one of the authors of the two FCA papers released today.

The first FCA paper, “Applying Behavioral Economics at the Financial Conduct Authority,” outlined trends that regulators can spot. Those include projection bias or the difficulty consumers have in working out their future ability to repay loans; and overconfidence, an “excessive belief in one’s ability to pick winning stocks,” researchers wrote.

Recognizing such biases can help the FCA ban products that are exploitative, or force firms to provide information that allows consumers to make an informed choice. U.K. banks have had to repay consumers billions of pounds for misselling loan insurance and interest-rate derivatives following probes by regulators.

Persistent Errors

“Some errors made by consumers are persistent and predictable,” Wheatley will say. The field “can help the FCA assess problems in financial markets better, choose more appropriate financial remedies and be a more effective regulator.”

The second paper revealed the results of a so-called randomized controlled trial, examining how customers responded to real letters informing them of a company’s sales failures.

Letters with clear bullet points and simplified language increased responses, while including an executive’s signature reduced them, according to researchers. They didn’t identify the firm concerned. “Subtle changes to the presentation of information can have large effects,” they said.

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