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Behavioural economics: a powerful tool

Behavioural economics has been accepted in financial services for many years. I’ve heard it being described in a number ways, such as “where psychology meets economics”, and by cynics as “a technique economists use to explain why people don’t behave the way economists believe they should”.

But, whatever you think of it, since the industry became aware of Shlomo Benartzi, behavioural economics has been steadily developing from an intellectually interesting idea into a useful, practical tool.

A clear working example is auto enrolment and overcoming the apathy which descends on most people when they are confronted with pensions. Put them in a pension scheme automatically, set the level of contributions, invest contributions in a default fund – et voila! You’re on the way to a step change in savings. A very powerful and positive tool.

It’s interesting then that the FCA have published a paper on behavioural economics. Not a policy paper, but a think piece to inform their policy making. And with a personal foreword from Martin Wheatley, we can expect the paper will have serious influence at Canary Wharf.

Equally as interesting is the approach that the paper takes. It reads: “Some errors made by consumers are persistent and predictable. This raises the prospect of firms designing business models that do not focus on price and quality.”

The FCA’s starting point is that behavioural economics can not only help explain why consumers make predictable mistakes, but can also influence firms to compete in ways that are not in the interests of consumers.

The paper then lists the biases that affect the financial decisions which consumers make. These are:

  • Preferences – what people want
  • Beliefs – what people believe are the facts (which may not be correct)
  • Decision making – which option, given their beliefs (which may be wrong) gets people nearest to their preferences

It goes on to talk about errors consumers make which could be exploited by firms – for example, not searching for the best deal – and outlines strategies the regulator could adopt to prevent or remedy any such exploitation.

It’s an interesting and thought provoking paper. But while it is certainly true that biases can and do lead consumers to poor outcomes, I do hope that FCA take on board that behavioural economics can be and is used to improve customer outcomes.

There are already examples of the industry using the predictability of potentially harmful consumer behaviour not to exploit consumers, but to block behaviours that could result in bad decisions. Removing annuity application forms from retirement communications comes to mind.

Conduct regulation is changing; both in its day to day application and in the thinking behind it. It’s clear from this paper that FCA will use behavioural economics as part of its regulatory tool kit. The industry must do the same and we must ensure that the behavioural economics techniques in our tool kit are used in ways that are designed to lead to positive outcomes for consumers.

For more information on conduction regulation, see the ABI Website.

Last updated 29/06/2016