The Taiwan Banker

Recent popularization of the behavioural science has undermined the traditional economic theory that consumers consistently reach most rational decisions which reflect their best interests. Governments and regulators around the world are increasingly cognizant that human decision-making is in fact affected by predictable flaws and seek to adjust their policy to improve consumers’ financial lives.There is little doubt today that homo economicus – a person who makes rational decisions in all circumstances – does not actually exist. Instead, the world is populated by human beings with their biases and prejudices that invariably subject the decision-making process to flawed perceptions and analysis. According to a widely quoted estimate, we make about 35,000 decisions every day . Evidently, there are not enough hours in a day for full and comprehensive inquiry and we cannot be experts in every field, so we often rely on ‘shortcuts’ or ‘rules of thumb’ to get to a quick solution. This is groundbreaking because for decades governments around the world based their policies on the assumption that individuals have a super-human ability to undertake impartial analysis of all available information while ignoring their personal preferences and judgements. Behavioural economics has thus become a source of inspiration for policymakers looking for cost-effective ways to encourage individuals to make better decisions. Richard Thaler, a US economist who received Nobel Prize for his contributions to the field in 2017 , has described such interventions as libertarian paternalism, since they nudge individuals towards a more optimal choice without compromising their freedom of choice. YOU ARE NOT AS RATIONAL AS YOU THINKBehavioural economics is hardly a new topic for academic publications; however, it has truly gained interest among wider audience in the last decade or so. A book by Daniel Kahneman, another Nobel Prize laureate, Thinking, Fast and Slow, is an international bestseller and summarises years of research into our cognitive biases and their impact on our decisions. It describes two systems of thought which interact to drive our thinking and decision-making. Whilst system 1 is fast, automatic and intuitive and derives from millennia of human experience, system 2 requires effort and concentration to address more complex tasks. It might come as a surprise but it is the former, not the latter, that we utilize most to reach our decisions. The downside is that we often make biased judgements since system 1 does not effectively manage our cognitive limitations. On the one hand, this saves time where extensive research and analysis would be disproportionate to the task (buying an ice-cream, for example); on the other, this can lead to detrimental outcomes, especially in the context of life-defining decisions, such as taking out a mortgage or buying a life insurance policy. Consumers purchase financial services infrequently, which limits their opportunity to learn from mistakes but – when mistakes do happen – they can have devastating consequences. Relying on a rule of thumb is simply too dangerous. The most quoted application of libertarian paternalism is the automatic pension enrollment, which turns consumers’ inertia to their advantage. In their bestselling book Nudge, Thaler and his co-author Cass Sunstein pointed out that about 30% of eligible employees failed to join retirement schemes. Simply changing the default option whereby all new employees become automatically enrolled into the pension scheme (but could easily opt out should they wanted to do so), could achieve significant improvement in coverage, the economists argued. In the UK, for example, pension reforms introduced in 2012 required employers to automatically enrol eligible staff which has so far resulted in over 9 million subscriptions . Impressive results were recorded in the US too. Behavioural economics has been deployed across various fields, from fighting obesity to encouraging prudent energy consumption to increasing timely tax submissions. Recognising significance of this new approach where ‘small changes can make a big difference’, the UK government set up a Behavioural Insights Team (BIT) in 2010 to inform the policymaking process. Often described as a Nudge Unit, it has transformed over time into a global social purpose company which now exports its expertise worldwide with over 750 projects to-date . According to the Organisation for Economic Co-operation and Development, over 200 institutions worldwide are now applying behavioural insights to public policy .YOU’VE BEEN FRAMED!Interaction between consumers and financial institutions is characterised by the information asymmetry since firms have significantly better understanding of what their products do and how they perform. Consumers are also easily influenced by the way the information is presented and the emotional response this encourages, something that is often exploited in financial promotions. As the UK’s Financial Conduct Authority (FCA) put it: ‘Problems can occur if customers do not understand what they are buying, think they are buying something that they are not or buy something unsuitable, especially in circumstances where they are encouraged not to think carefully about it’ . As a result, regulators have become interested in the so-called framing effect where consumers change their decisions when identical information is presented in different ways. Behavioural scientists point out that we dislike losses disproportionately more than we like gains. In the context of financial promotions, advertisers might therefore engage this bias by highlighting that your current product loses you money rather than pointing out the savings you can make on replacing it with a different one. Research also highlights that consumers find it difficult, if not impossible, to discard the first piece of information seen in relation to a particular financial promotion and categorize this knowledge as a ‘fact’ even where the claim was expressed with caveats or was subsequently proven to be wrong. Defined as anchoring, it describes our tendency to make judgements and decisions by reference to a particular point, for example, the advertisement’s headline message. One of the FCA’s reviews concluded that ‘it may not be enough to supply a risk warning or balancing message which is less prominent than the headline, or which is presented at a later stage’ . For this reason, its guidance on social media and customer communications states that short adverts, such as those made on Twitter or Facebook, should be independently compliant with financial promotions rules without having to refer to information provided elsewhere .Our biases are evident not just in advertising but also in other aspects of financial decisions. Consumers with credit card debt might be influenced by the minimum repayment amount suggested by their bank without considering how higher instalments could reduce the overall cost of the loan. One of the proposed solutions put forward by the UK’s Financial Capability Lab – which was set up in 2016 to develop and test behaviourally informed ideas for better money management– included a repayment interface that enables consumers to view their repayment options by using a slider. For example, consumers who were looking to clear their debt in six moths’ time could easily calculate the required monthly payments to meet their chosen deadline. Run as an online experiment, it demonstrated significant increases in repayment amounts and associated reductions in borrowing costs . Human ability to make rational decisions is limited in multiple ways, including our inherent difficulty interpreting numbers. Numerous behavioural publications point out that consumers consistently make errors when processing percentages. Mental accounting bias also results in situations where consumers avoid drawing on their low interest savings to pay off loans taken out under higher interest rates. In other instances, we are encouraged into action by some irrelevant emotional triggers, such as attractiveness of the sales agent or an emotive image. Adverts often seek to prompt an emotional response to encourage a purchase which might make little economic sense, such as insurance against low frequency low severity events, but which offers a sense of protection and security. TERMS AND CONDITIONS APPLYFinancial regulators consider behavioural economics to be particularly helpful in designing optimal product disclosure requirements. Financial services are complex necessitating lengthy terms and conditions with multiple warnings and exclusions which consumers tend to overlook or misunderstand. However, the widely adopted ‘the more, the better’ approach is showing its limitations. New Zealand’s Ministry of Business, Innovation & Employment considered in 2015 how financial product disclosure can benefit from behavioural science and highlighted certain tools that may maximise consumer engagement and understanding. For instance, it highlights the importance of standardizing disclosures to reduce differences in perceptions and responses to the information . In Europe, policymakers are drawing similar conclusions. The European Commission’s Study on consumers’ decision making in insurance services suggested that information should be provided in a concise, salient and user-friendly way by presenting it in short sections and utilising icons to make comprehension easier . Standardized information disclosure is a popular regulatory tool in the EU where specific templates exist for a number of retail investment and insurance products . One of the major challenges that policymakers and firms face, however, is encouraging consumers to engage with the disclosure information as experience time and time again points to individuals simply ‘accepting’ terms & conditions without reading, let alone understanding, them. A recent guide to businesses developed by the UK’s BIT suggested some simple adjustments to the customer journey which research indicates can make significant improvements. For example, telling customers how long it takes to read a document increased the number of people opening it up by 105%. Using Q&A format for key terms or summarizing them and using icons to illustrate the message improved understanding by over 30% . PAUSING FOR THOUGHTThe digital revolution is unfolding with unstoppable force offering financial transactions at unprecedented speed and convenience. Consumer credit has become ubiquitous and can be made available to fund a purchase of that new iPhone or holiday with just a few clicks on the mobile devices. Policymakers are getting concerned that borrowing is too accessible today playing on multiple biases, including desire for immediate gratification (a wish to own the item without considering consequences) or fear of missing out on a good offer (a sense of urgency caused by potentially limited availability of the product). The European Commission’s recent Behavioural study on digitalisation of the marketing and distance selling of retail financial services highlighted that a purchasing process which is too fast can have a detrimental effect on the consumers’ decision-making as they do not have enough time to pause and consider features, risks and alternatives. The paper says that deliberately slowing down the process by introducing ‘friction points’, such as a pop-up box or an additional click, has strong positive impact; it warns, however, against creating too many steps as this would eliminate most of the benefit . Integration of behavioural economics in policy work has not been without criticism. Some say that it is used to solve problems it was never meant to address and warn that it cannot (and should not) replace traditional economic tools by itself . The challenge for policymakers is also to determine which areas merit intervention, what shape mitigation measures should take and – an equally important question - where interference is simply inappropriate. Critics point out that freedom of choice is important because it allows consumers to learn from their mistakes; regulatory action should not seek to limit their responsibility to make own judgement. To do otherwise would be damaging for everyone concerned. Acknowledging the field’s limitations, Thaler once told The New Yorker magazine: ‘We can’t take on some big problems, like climate change, and solve them entirely with nudges’ . He is reportedly signing his books with the ‘Nudge for good’ appeal as history shows that our biases are often exploited against our interests. Understanding our cognitive limitations might therefore help financial regulators shift the balance and be more effective at preventing consumer detriment as well as encouraging firms to consider their clients’ best interests.