behavioral economics and financial regulation
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Behavioral Economics and Financial Regulation. David S. Evans. Privileged and Confidential. Behavioral Economics (and Why you Should Care). Behavioral Economics Combines Economics and Psychology. Behavioral Law and Economics Applies BE to Regulation. Behavioral Economics Has Come to Town . - PowerPoint PPT PresentationTRANSCRIPT
Behavioral Economics and Financial Regulation
David S. Evans
Privileged and Confidential
November 14, 2011
BEHAVIORAL ECONOMICS (AND WHY YOU SHOULD CARE)
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Behavioral Economics Combines Economics and Psychology
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How do people actually behave?
Why do they behave that way?
What are the implications for markets?
Behavioral Law and Economics Applies BE to Regulation
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Consumers make mistakes
Businesses take advantage of consumer mistakes
Government can help consumers by preventing consumers from making mistakes or businesses from relying on these mistakes
Behavioral Economics Has Come to Town
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Cass SunsteinDirector, OIRA, White
House’Founder of Behavioral
Law and EconomicsCo-author of “Nudge”
Sendhil Mullainathan“Chief Economist” CFPB
Leading behavioral economist
Co-author of leading paper on BE regulatory intervention in financial
markets
Why Should You Care?
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Provides regulators new set of tools
Lawyers will be dealing with behavioral economics at regulatory agencies
Businesses will need to consider behavioral economics based regulations
KEY FINDINGS OF BEHAVIORAL ECONOMICS
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After Several Million Years You’d Think We’d Be Smart
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But Behavioral Economics Finds People Aren’t So Smart…
• People are influenced by baselines (inertia)• People have limited attention and make
mistakes as a result of simplifying complex problems.
• People aren’t very good at math
“Cross-cutting Biases”
• People are overconfident in ability to stick to plans such as saving
• People are overly optimistic about themselves and their futures
“Expectation Biases”
• People have trouble doing present value calculations
• How choices are framed heavily influences decisions
• The presence of other options can bias choices• People reject all choices if there are too many
“Price and Valuation Biases”
• People “live for today” expecting to be more patient tomorrow but then tomorrow is today
• People place more value of items in their possession than the same item not in their possession
“Preference Biases”
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Cross-Cutting Biases
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People are influenced by baselines and are subject to inertia
People have limited attention and make mistakes as a result of simplifying complex problems.
People aren’t very good at math
Expectation Biases
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People are overconfident in ability to stick to plans such as saving
People are overly optimistic about themselves and their futures
Price and Valuation Biases
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People have trouble doing present value calculations
How choices are framed heavily influences decisions
The presence of other options can bias choices
People reject all choices if there are too many
Preference Biases
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People “live for today” expecting to be more patient tomorrow but then tomorrow is today
People place more value of items in their possession than the same item not in their possession
Perhaps Its All Been Said Before• An 1884 editorial in Scientific American
discussed “the curious processes of reasoning” that women used in deciding to buy a sewing machine on an installment plan. The author discovered the “psychological fact, possibly new,” that women “will rather pay $50 for a machine in monthly installments of five dollars rather than $25 outright, although able to do so.”
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BEHAVIORAL ECONOMICS BASED REGULATION
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Helping People Help Themselves
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Make sure people have the right information for basing decisions
Make people get that information in a way that reduces their costs of making right decisions
Make sure information is presented in a way that requires the least math etc. skills
Soft Paternalism
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Figure out what the “right” decision is--the one a “rational well-informed” person would make)
Nudge people towards making the decision “WE” think is right
Hard Paternalism
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Figure out what the “right” decision is--the one a rational well-informed person would make
Prevent businesses from offering options that would result in consumers making the “wrong” decision
Preventing consumers from making “wrong” choices
Reasons to be Skeptical of BE-Based Regulation
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Existence and degree of biases still controversial
Market importance of cognitive failures disputed
Regulatory cures may be worse than disease
Regulators are imperfect humans too
Not so Easy Problems Perhaps
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400% Payday loans
Advertisements for gold coins
Nudges to invest in 401-k plans
CFPB AND APPLICATION TO FINANCIAL MARKETS
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Behavioral Foundations of CFPB Regulation
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People have “systematic
cognitive failures”
Market incentives drive business to offer
products designed to
“exploit” these failures
Regulatory response favors products that
minimize consumer
“mistakes” from those failures
Experiments, surveys, and
statistical analysis can help guide “evidence-
based regulatory”
analysis
Sample “Problems” in Financial Services
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Consumers make impulsive borrowing decisions
Consumers overly optimistic about paying things off
Consumers borrow too much and pay too much because they underestimate cost of financing
Financial institutions frame choices, add complexity and provide defaults to encourage people to make “bad” decisions
Competition among financial institutions can’t fix these problems
Preemptive Design Principles
Transparency: Make It Clear
Honesty: No Tricks and Traps
Research: Test for the Best
Helpfulness: Help People
Help Themselves
Simplicity: Keep It Simple
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CONCLUSION
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Concluding observations
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Behavioral economics is probably here to stay
Can provide useful tools to regulators and business people
Should come with all the “buyer beware” warnings as any part of economics
Opens door for very paternalistic regulation which raises both economic, legal and political issues
THANK YOU!
www.globaleconomicsgroup.com/
November 14, 2011