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Behaviorally Informed Financial Services Regulation

posted by Adam Levitin

A new policy paper issued by the New America Foundation and authored by Michael Barr, Sendhil Mullainathan, and Eldar Shafir argues that we need to move toward "behaviorally informed financial services regulation." By this the authors mean that financial services regulation should incorporate the insights of behavioral economics and cognitive psychology, regarding things like default rules, framing of information, and hyperbolic discounting.

This paper comes on the heels of Richard Thaler and Cass Sunstein's book Nudge, the culmination of their work in developing what they call "libertarian paternalism"--a soft-form version of paternalism that instead of mandating outcomes, such as requiring retirements savings, sets default rules and menu choices in a way that encourages them, such as making workers opt-out of retirement savings plans, rather than opt-in.

There's much to commend about this work (Barr et al., as well as Thaler & Sunstein), and the incorporation of behavioral economics into law has been an important development in the last decade or so of legal scholarship. I do not doubt that behaviorally informed financial services regulation would be an improvement over our current model. But I am dubious about its ultimate efficacy for three reasons.

First, I worry that embracing a libertarian paternalist approach my lead us to using a lighter touch than is really necessary to solve market problems. I also worry that it might only be partially effective, and that partial effectiveness would reduce the inclination for serious and thorough regulatory reform. We should, of course, aim for the least invasive form of regulation necessary. If a nudge works, great. But I worry that with the emphasis on nudging we might forget that sometimes a sharp elbow is needed too.

Second, behavioral economics is a developing field. I worry about trying to regulate based on what is essentially still work-in-progress, especially as the field of scholars attempting to apply behavioral economics insights to financial services regulation is very small and the same field is rarely plowed twice, meaning that we often have to rely on a single study. Even if such a study is peer-reviewed, academic work is an art, not a science (sorry social scientists!), and there are lots of judgment calls involved in creating models or doing empirical work. And what are we to do with conflicting studies (such as on the impact of payday lending)? The risk of looking to behavioral economics research as applied to financial services is that we are placing a lot of faith in the quality of the research. I say this as a researcher in the field, so this should not be taken as a criticism of anyone else's work, merely an acknowledgement of the limitations of our endeavors.

Third, behavioral economics has trouble addressing the core regulatory problem: regulated industries are constantly looking for ways to circumvent regulation when doing so would be profitable. Just as current disclosure requirements can be gamed, so too can behaviorally informed ones which would create opt-outs or opt-ins or frame menu choices in a particular way. Sometimes, the more effective method of regulation is not about framing or ordering of menu choices, but of limiting what's on the menu.

Limiting what's on the menu, however, does not necessarily mean restricting consumer choice in a material way. Looking at credit cards, for example, we see lots and lots of different types of fees and interest rates. The sheer number of credit card price points makes it impossible for consumers to know what it will cost to revolve a balance on a credit card, and therefore makes it impossible for consumers to know whether to use a credit card or which card to use. Because of the multiplicity of price points, TILA disclosures actually help obfuscate credit card pricing by overwhelming consumers with information that they cannot process (and when they try to process, are likely to misweight because of behavior factors, as Oren Bar-Gill has shown).

As a result, consumers cannot help but to use credit cards inefficiently and irresponsibly. All the disclosure in the world cannot help cure this, as consumers cannot process the information. There is simply too much of it, and it is too complex. While consumers are good at making simple comparisons, such as those between different size containers of milk, thanks to unit-pricing in grocery stores (literally an apple-to-apple comparison), or even with relatively simple credit products, like auto loans, consumers cannot make good comparisons with complex credit products like credit cards (or some mortgages).

There is no behavioral solution to the complexity problem. Behavioral regulation can help prevent consumers from misweighting particular price points. But it cannot help them synthesize complex pricing structures into meaningfully comparable prices. Moreover, regulators cannot themselves determine what card usage would be best for consumers because there are several different patterns of card usage, and their benefits depend on the total picture of a consumers' economic situation. For example, it might be better to make a mortgage payment and revolve a credit card balance, than vice-versa. Product-by-product behavioral regulation ignores that there is an interplay between consumers use of different financial products, and creating incentives to use one a certain way can have cross-cutting effects on consumers' use of another.

So how do we solve the complexity problem? With credit cards, as I argue in an article in progress, the first step is to recognize that all of the fees and interest rates can be reduced, economically, to three core price terms: an availability fee (annual fee), a per-transaction fee (interchange, international transaction fees, other transaction fees), and a single interest rate (various interest rates, late fees, overlimit fees).

This suggests that credit card regulation should aim at limiting credit cards to these three price points, which consumers can easily compare and understand. Issuers would be free to price however they wanted within these price points, but would be limited to three, standardized prices points, and forbidden from charging any other fees or bundling services. Once this happens, there will be clear and transparent pricing in the card market, and we can expect efficient pricing. If after that we still see evidence of behavioral skews in card usage, then it is time to think about behaviorally-based regulation. But to jump ahead with behavioral regulation in a market where there is no price transparency is to put the cart before the horse.

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