Two Cheers for Behavioural Economics: The case of

consumer credit

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Sunstein 2013 on be

• ’transformed our understanding of regulation and its consequences. They are also providing instructive lessons about the appropriate design of ‘nudges’ –low cost, choice preserving, behaviourally informed approaches to regulatory problems, including disclosure requirements, default rules, and simplification’

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Be and consumer policy making

• Moved rapidly from fringes to corridors of power

• From consumer protection/consumer choice-- to shaping consumer choice (empowering)

• Consumer becomes a regulatory subject who will police ‘internalities’ which may result in obesity, over-indebtedness or poverty in old age

Primary points

• Behavioural analysis is useful in consumer credit policy making but it is not simple to apply

• Greater attention should be paid to regulating supply side (business) rather than demand (consumers)

• Its findings make it more difficult to use revealed consumer preferences as a guide for policymaking—because they may be structured by context, institutional framework

• Greater attention therefore to institutional ground rules and market framework (not just default rules)

• Use PPI and high cost credit in UK

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BE as policy paradigm

• Mixture of scholarly and political thought

• Scientific and normative

• Ideas become part of bureaucratic common sense---underpinning technical expertise

Scientific

• Large number of heuristics and biases related to consumer preferences, beliefs and decision making (see e.g. FCA, 2013)

• Central ideas-- utility by reference to gains and losses from a reference point—status quo

• Framing of choice

• Preferences structured by institutional context—and individuals may not have well defined preferences

Normative

• “Libertarian paternalism”—respect consumer choice and avoid paternalism

• Policy menu---better disclosures, cooling-off periods, default rules, exploiting framing effects

• Generally opposed to product bans

• Attractive because promises large gains from small changes e.g. opt in v opt out.

Normative approach?

• Implications of ‘absence of clear preferences’ and effects of institutional context?

• Can we take revealed preferences as expressing what people want?

• Changing ground rules (institutional context) shapes choices

• All markets have ground rules and have patterning effects and therefore no neutral position.

Policy guides

• MINDSPACE

• NUDGES

• SEVEN STEPS

• TEST LEARN ADAPT

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Examples

• In a service economy where individuals make different uses of services (e.g. mobile phones, credit cards) disclosures might aim to help consumers understand their patterns of use (e.g. UK, annual credit card statement disclosure) (RECAP) + website to compare.

• More effective disclosures e.g. ‘Key Facts’: SECCI+ (warnings etc. which exploit loss aversion)

Minimum payments UK

• “Minimum payments

If you make only the minimum payment each month, it will take you longer and cost you more to clear your balance.”

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Minimum payments US CARD Act

• If you make only the minimum payment each period, you will pay more in interest and it will take longer to pay off your balance. For example…

• Only the minimum payment---11 years….$4745

$103-------------------------------------3 years-----$3712 (Savings =$1033)

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Consumer credit

• Consumer credit—since 1970s households as important profit centres for financial institutions.

• Role of credit? Smoothing function, loans for wages? Method of redistribution?

• Consumer credit generally regressive

Two contemporary issues

• High cost credit (short term loans)

• Payment Protection Insurance---systemic scandal in the UK: Banks paying £20 billion in compensation for misselling of insurance

PPI

• The ‘scandal of the decade’ but part of a series of ‘waves of major customer detriment’ since 1980s eg mortgage endowment, pension misselling and structured products to small business’

• Single premium life, disability and involuntary unemployment

• Sold at point of sale

PPI

• Super-complaint by Citizens Advice to OFT (2005) Reference to Competition Commission

• Competition Commission report 2009:market uncompetitive: consumer detriment.

• Changes in 2006 amendments to CCA: require opt in (formality)

• FSA investigates from 2005--- significant concerns re selling practices. 24 cases brought against financial institutions for misselling.

• Ultimately (2011) ban on single premium ppi and restrictions on point of sale

PPI

• A product that is sold not sought out by consumers. Underwriters compete to sell by offering higher commissions not lower prices to consumers

• Often bundled with credit: assume that consumer wants it unless objects

• Led consumers to believe that need to take it to get credit. Many consumers believe that will be easier to get credit if agree.

• ‘single premium’ insurance.

PPI

• Firms often did not check whether consumers were eligible (eg. Pre-existing medical condition)

• Misleading as to benefits

• Remarkably low claims ratio

• Failure to disclose that interest would be payable on a single premium policy. Refund would be limited where refinancing

New cases PPI at FOS

• 2013 378,699

• 2012 157, 716

• 2011 104,597

• 2010 49,196

• 2009 31,066

• 2008 10,652

• 2007 1,832

• 2006 1,315

FSA approach

• Ex ante supervision—firms must respect high level principles and not create unreasonable risk of misselling

TCF Enforcement examples : HFC Bank 2008

• Finance company – sells secured and unsecured loans & PPI—primarily lower middle/lower income consumers

• HFC used advised PPI Sales, predominantly single premium policies; high level of penetration of insurance (75% of loans)

• HFC bank failed “to take reasonable care to ensure that it gave its customers suitable advice and to have in place adequate systems and controls for PPI sales” and that the consequences of these breaches was a failure to treat its customers fairly.

HFC

• Failed to take into account customers needs and circumstances– e.g. fact that many loans would be refinanced

• Alternative means to protect loan

• Pre-existing medical conditions

• Essentially PPI sold to consumer unless she objected

HFC Bank continued

Absence of procedures that required staff to take sufficient information into account when considering suitability.

No procedures to require staff to explain their recommendations fully or to identify to customers any demands and needs which the policy would not meet.

• According to the FSA decision, “these and other failings meant that HFC put its customers at an unacceptable risk of being sold PPI when it was not suitable for them”

HFC cont’d

No effective systems to train and monitor its staff; Failure to ensure that its procedures for monitoring sales

staff identified and investigated potentially unsuitable sales (nb because sales staff on commission)

Inadequacies in management information system prevented HFC's senior management identifying problems with the sale of PPI;

records could not sufficient demonstrate that sales were suitable.

HFC

• Unfairness built into normal structure of transactions: part of business model not an aberration

• Maximise profits at expense of consumers who may not be aware of what is happening

• Historical continuity

• Do corporations learn? Capital One settlement with CFPB (2012) technique for selling ‘payment protection product’

• Capital One (20007) fined by UK FSA for having inadequate systems and controls for selling PPI.

Why did competition not address: Baker and Siegelman?

• Shrouded pricing (Gabaix and Laibson)

• Myopics and sophisticates

• Competitors offering cheaper insurance will not attract the sophisticates who will be educated about the high costs

• Myopics will not be affected

• Competition will not be effective

• Situational monopoly with strong incentive to pressure consumer to purchase

Remedies

• Disclosures—form, how to prevent firms undercutting the effects?

• Formality—but it already existed in the UK

• Ban on single premium at point of sale

• Break the situational monopoly

• See Baker and Siegelman, Protecting Consumers from Add-On insurance products: New lessons for Insurance Regulation from Behavioural Economics (ILE, Research Paper No 13-1, University of Pennsylvania Law School)

PPI

• Focus on supply side rather than demand side? Greater ex ante monitoring, supervision of business models of firms.

• Could it have been prevented through financial literacy? i.e.create more sophisticates?

High Cost Credit

• Devising and assessing remedies for high cost credit credit

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High cost credit market and social fund 2010-11

Social Fund £670m 0%

Home credit £4bn APR 300-400

Payday loans £1-2bn APR 2500

Pawnbroking £1-2Bn APR 100%

Bills of Sale £30-40m APR 400-500

Payday loans as sharks?

Payday loans in UK

•Osborne announces late 2013 that FCA must introduce price controls on short term high cost credit

•Overruling position of the FCA in its consultation document

•Controversy over price controls for many years in the UK

Rollovers

• £300 for 30 days at £30 per 100= 390 pays £90

• Rollover..60 days……………….= 390 paid £180

• Rollover 90 days………………..= £390 paid £270

• 120 days pays off £390…has paid total of £660 for borrowing £300

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FCA October 2013

• Limit to 2 ‘rollovers’

• Limit the use of CPA

• Require risk warnings + provision of free information on debt advice

• Disclosures tested on focus groups

Disclosures

• Think! Is this loan right for you?

Over 2 million short-term loans were not paid off in 2011/12. This can lead to serious money problems.

If you’re struggling, go to …for free and impartial debt advice.

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Impact analysis of these proposals on payday users

• ‘Payday copers’

• ‘Moderate risk borrowers’

• ‘High risk borrowers’ (34%)

• 18-30 percent would be denied access to credit

• Protect high risk through exclusion but may reduce access of payday copers and moderate risk

• Is this optimal policy?

Assumptions about lower income consumers

• Vulnerable---less able to protect themselves –why?---may be disabled, sick, rural..

• Act ‘irrationally’…e.g. less able to process information, more impulsive

• Rational actors ‘given the insecurities which they face’

• “understand the life of mean streets from the perspective of mean streets’ Johnson (1985)

Schafir and Mullainathan Scarcity

• Poor well informed but have much smaller room for errors

• Scarcity of ‘bandwidth’ –many immediate pressures on decision making cause ‘tunneling’ of vision.

• Expand bandwidth through e.g reducing unpredictability, and difficulties in planning.

• Change institutional context

Conclude

• Yes---be is a useful science

• May not be simple to apply---and role of normative policy---particularly since it is difficult to determine whether credit over or under supplied ie what is the appropriate level of consumer credit in economy?

• But attention to ground rules of market broadly defined.

• Existing ground rules v new ground rules. Not market v intervention.