Financial consumers – not as daft as they look (to regulators)

Our financial regulators are not known for their incisive economic analysis, but more for tying up in red tape sectors of the economy that were hitherto performing tolerably well – normally with disaster following in its wake. That is the story of insurance regulation. Until 1980, there had been only two life insurance failures in over 100 years in a largely unregulated market. Neither of the failures affected customers unduly. Then, after the industry came under much heavier regulation, there was a series of failures culminating in The Equitable. This should make us worry somewhat about the mortgage sector. The regulator has only recently been given the power to regulate mortgages and it responded with a consultation document of over 500 pages followed by the most intrusive red tape imaginable. This is also a sector that has been largely untroubled hitherto but we should perhaps now fear for the future.

Given this background, to see a letter in The Economist from the Chief Executive of the Financial Services Compensation Scheme (nominally, it should be noted, an independent body but with powers to place levies on firms sanctioned by the regulator to fund a statutory compensation scheme) arguing in favour of regulatory mechanisms on the grounds of consumer ignorance was not surprising. However, just as regulators believe we need discerning consumers, it would be helpful to have discerning regulators – though that is not something I expect ever to see.

Mark Neale argued in the letter that it would be a good thing if significant numbers of consumers had the interest or ability to determine whether banks were creditworthy but because they did not, his body was necessary. Of course, there is much evidence that consumers were able to make the necessary distinctions before statutory regulation and deposit insurance (which is a relatively new innovation in Britain). Consumers used to choose between highly capitalised building societies, banks and the trustee savings banks which were, for all intents and purposes, 100 per cent secure. They chose not on the basis of detailed analysis of balance sheets, but on the basis of commonly held basic knowledge and the simple signalling of different types of institution and reputation. Regulation and deposit insurance eliminated the value of prudence for financial institutions and removed the relative advantage held by particular types of financial institution that had a reputation for prudence because of their business models. We now have a completely uniform financial scene with customers delegating responsibilities to the regulator. The most important relationships that firms have are with regulators and there is, essentially, no value from a bank or insurance company establishing a reputation for prudence. Perhaps our financial regulators would do well to read Jonathan Macey’s excellent book The Death of Corporate Reputation.

I wonder where we would be if Mark Neale regulated the hotel industry. All the market mechanisms that help ensure quality would disappear. Gone would be Trip Advisor. The distinction between hotel chains (Best Western being reliable but cheaper and somewhat lower quality than Hilton, and so on) would become meaningless as all hotels had to provide the same level of service to customers who were regarded as incapable of carrying out due diligence and being discerning.

Secondly, Neale argued that Northern Rock showed that we need deposit insurance to head off runs such as the one on Northern Rock. These arise, he suggested, because of the lack of the ability of consumers to do due diligence. This is a rather basic point but runs are rational. They do not arise from the lack of consumer due diligence but from its presence. Consumers thought (correctly) that, if Northern Rock were not to be given lender of last resort assistance, it might run out of liquid funds. Given that funds are provided on demand on a first-come-first-served basis it is rational to try to be first. That is precisely what causes a run. The fact that customers called Northern Rock correctly (even if it turned out to be solvent it was still illiquid) and they have not started a run on another high street bank in living memory is the best indication of consumer discernment you could need.

Finally, Neale asserts as fact that deposit insurance schemes contribute to financial stability. He is entitled to his opinion and he is entitled to interpret the evidence that way. However, he should not present opinions as fact: there is another point of view.

The underlying problem is not just the poor level of economic analysis within financial regulators, it is their cognitive biases. Regulators are all-too-quick to attribute cognitive biases to consumers. The implicit assumption of regulators is that consumers are not discerning or equipped to make decisions; that market institutions do not develop to help consumers; and that regulatory action does not stop market institutions from developing. The main problem is that you cannot see what does not exist. So regulators cannot see the market institutions that might arise to resolve problems within markets if they themselves did not stop them from doing so. For that reason, they need to go beyond the textbooks; they should go beyond the markets they regulate to look at how other markets work; and they should consider how financial markets worked before statutory regulation (largely very well). In other words, we need discerning regulators.

In unregulated, or lightly regulated, markets consumers have an incentive to find out which providers of goods or services can be trusted. And they usually seem to be able to learn from experience (though admittedly this may not work well with one-off large-ticket items). As Philip Booth never tires of pointing out, it can often be unsatisfactory for providers of goods or services to feel that they are essentially accountable to regulators rather than to customers. That removes the incentive for consumers to take responsibility for their own decisions. Moreover it leaves us hoping (but not expecting) regulators to learn from their experience.
It is a pity that Philip Booth and the IEA weren't so keen on the other point of view when it came to judging the Brexit prize. No competition in ideas there.

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