Workshop on Consumer Workshop on Consumer Protection in the Retail Protection in the Retail

Financial Services SectorFinancial Services Sector

Rodney LesterRodney LesterWorld BankWorld Bank

Brussels, October 16, 2008Brussels, October 16, 2008

Basic themes

Main:CP regulation should be context sensitive -

work so far has been on reasonably similar EU accession countries

Sub:• Toolkit used needs to be tailored to nature of

product, stage of development of system, nature of consumer etc

• Tools used should not add to consumers investment in information acquisition

• Roles of prudential and CP rules should not be confused

Why CP regulation? - people Why CP regulation? - people have to make life cycle decisionshave to make life cycle decisions

Key life events that require prior planning (in Key life events that require prior planning (in particular in democratic and market-oriented particular in democratic and market-oriented societies) ...societies) ...• Children (if, when, how many, …)Children (if, when, how many, …)• Education and skills (initial, changing stream, Education and skills (initial, changing stream,

life long learning, …)life long learning, …)• Car, chattel purchasesCar, chattel purchases• Housing purchase (if, when, where, how, …)Housing purchase (if, when, where, how, …)• Retirement (if, when, where, how, …)Retirement (if, when, where, how, …)

Based on: Holzmann, R. WB presentation

… … and knowledge and skill for applying principals of and knowledge and skill for applying principals of economics to personal finance, e.g.economics to personal finance, e.g.

•Law of one price (no free lunch)Law of one price (no free lunch)•Present value of consumption cannot exceed Present value of consumption cannot exceed life time earningslife time earnings•Insuring and portfolio decision under Insuring and portfolio decision under uncertaintyuncertainty•Budgeting and basic numeric/quantitative skillsBudgeting and basic numeric/quantitative skills•Saving, investing, borrowing, lending, insuring, Saving, investing, borrowing, lending, insuring, diversifying, matching, …diversifying, matching, …

And these all involve financial planning and decisions for 90% of people

Source: Holtzmann, R. WB presentation

The Financial System is also seen to The Financial System is also seen to have key macro roles and positive have key macro roles and positive

externalitiesexternalities

Efficient allocation of consumption, risk and Efficient allocation of consumption, risk and investmentinvestment

Efficient transfer of assets/ ownership – Efficient transfer of assets/ ownership – investment becomes more secureinvestment becomes more secure

Mobilizes savingsMobilizes savings Pricing, hedging and transferring risk efficiently – Pricing, hedging and transferring risk efficiently –

reducing cost and risk of investmentreducing cost and risk of investment Source of information – ‘coordinating Source of information – ‘coordinating

decentralized decisions throughout the economy’decentralized decisions throughout the economy’

However an effective approach to consumer financial literacy training

remains elusive

So financial sector regulation So financial sector regulation has become a public goodhas become a public good

6 possible reasons for regulation:6 possible reasons for regulation:

Stop failure of financial institutionsStop failure of financial institutions Maintain consumer confidence in the Maintain consumer confidence in the

systemsystem Ensure consumers receive adequate Ensure consumers receive adequate

information and are treated fairlyinformation and are treated fairly To assure fair pricingTo assure fair pricing Protect consumers from fraud and Protect consumers from fraud and

misrepresentationmisrepresentation To prevent unfair discrimination and To prevent unfair discrimination and

other social objectivesother social objectives

* Consumer Protection as Justification for Regulating Financial-Services Firms and Products, Benston,J.B. Journal of Financial Services Research, pp 277- 301, 200

But BenstonBut Benston* argues only the first is justified (for argues only the first is justified (for banks, long term savings, 3banks, long term savings, 3rdrd party liability party liability

insurance ) and should be achieved through insurance ) and should be achieved through prudential rulesprudential rules

Why treated differently to other products?Why treated differently to other products? Create moral hazard – increases risk in the system?Create moral hazard – increases risk in the system? Competition will ensure proper market conductCompetition will ensure proper market conduct Most financial products are easy to understand and Most financial products are easy to understand and

comparecompare Consumers have legal recourse anywayConsumers have legal recourse anyway Regulators will be conservative and over-regulateRegulators will be conservative and over-regulate Regulation can be difficult to interpret and require ongoing Regulation can be difficult to interpret and require ongoing

modificationmodification Regulation can be used to entrench existing products and Regulation can be used to entrench existing products and

playersplayers

1. Why different? More scope for asymmetric information with

credence goods * :• Akerlof – role of private information in

distorting/ diminishing markets• Spence – use of signaling to overcome

information asymmetries• Stiglitz - use of screening to overcome

information asymmetries• Presence of ‘counteracting’ market institutions

* 3 types of good – search good (can be assessed in advance of purchase – piece of art), experience good (can be assessed relatively quickly with use – soap powder), credence good (attributes only discovered after a long delay or upon occurrence of contingent event or never – mutual fund).

Explains

1. Why different? - continued

Managers respond to what is measured and what is rewarded:• 1946 to 1980 – technological management – the firm and its

constituents counted • 1980 to now – the ‘inside proprietor’ – stock options etc –

purely a value creating exercise for equity capital• More pronounced for financial sector – demutualization of life

insurers, separate managers for mutual funds/ unit trusts, investment banks began ti use own capital - - all creating conflicts of interest

Agency incentives more distorting:• Commission can influence product sold – not just product

characteristics• Volume incentives can distort advice given

CP laws are in fact in place for many experience goods • Health and safety regulations• Labeling requirements• Construction standards

3. Competition is not the full story3. Competition is not the full story

1960s/70s – emphasis on competition policy 1960s/70s – emphasis on competition policy (market failure) – regulation of concentration, (market failure) – regulation of concentration, resale price maintenance, tying, information resale price maintenance, tying, information asymmetry etcasymmetry etc

Now - more complex models of markets – impact Now - more complex models of markets – impact of policy interventions less clear:of policy interventions less clear:• No. of competitors is a poor measure No. of competitors is a poor measure • Cost of information is critical issueCost of information is critical issue• Bargaining power is context sensitive (even with same Bargaining power is context sensitive (even with same

skills) – e.g. role of sunk costsskills) – e.g. role of sunk costs• One time versus frequent transactionsOne time versus frequent transactions• Cannot apply a general CP framework – depends on Cannot apply a general CP framework – depends on

nature of marketnature of market

See: Hadfield,G.K. et al. Information-Based Principles for Rethinking Consumer Protection Policy, Journal of Consumer Policy 21, pp 131-169, 1998

3. Key questions3. Key questions

Identifying a CP problem – identify level of Identifying a CP problem – identify level of competition, and whether structural or competition, and whether structural or informational probleminformational problem

Deciding if government intervention is Deciding if government intervention is necessary – why is market not self necessary – why is market not self correcting?correcting?

Deciding on appropriate regulatory Deciding on appropriate regulatory instruments – minimize information instruments – minimize information acquisition and processing costs for acquisition and processing costs for consumers, decide whether proactive or consumers, decide whether proactive or reactivereactive

See: Hadfield,G.K. et al. Information-Based Principles for Rethinking Consumer Protection Policy, Journal of Consumer Policy 21, pp 131-169, 1998

4. Many FS products are not easy to 4. Many FS products are not easy to understand – not just annuities and life understand – not just annuities and life

insuranceinsurance

50% of those sold sub prime mortgages in 50% of those sold sub prime mortgages in the US were eligible for fixed rate loans the US were eligible for fixed rate loans

Consumer credit wordings can see Consumer credit wordings can see unsophisticated people lose their houses – unsophisticated people lose their houses – SlovakiaSlovakia

Bundled/ tied contracts can hide poor Bundled/ tied contracts can hide poor consumer benefits - Russiaconsumer benefits - Russia

5. Legal recourse is not cheap or 5. Legal recourse is not cheap or easy in all countrieseasy in all countries

Few countries have class action optionFew countries have class action option Legal fees up front are the normLegal fees up front are the norm Can take many years (9 to court of first Can take many years (9 to court of first

instance in Croatia) for a decisioninstance in Croatia) for a decision Lawyers can hide offers of settlement to Lawyers can hide offers of settlement to

draw actions outdraw actions out Courts can also discriminate against Courts can also discriminate against

supplierssuppliers Courts in many emerging markets do not Courts in many emerging markets do not

understand financial sector and are subject understand financial sector and are subject to ‘influence’.to ‘influence’.

But there are legitimate concerns But there are legitimate concerns about MC regulationabout MC regulation

1.1. Creates moral hazard – increases risk in the Creates moral hazard – increases risk in the system?system?

2.2. Regulators will be conservative and over-Regulators will be conservative and over-regulateregulate

3.3. Regulation can be difficult to interpret and Regulation can be difficult to interpret and require ongoing modificationrequire ongoing modification

4.4. Regulation can be used to entrench existing Regulation can be used to entrench existing products and players – inhibit innovationproducts and players – inhibit innovation

5.5. CP emphasis can detract from prudential CP emphasis can detract from prudential oversightoversight

Some basic criteria emergeSome basic criteria emerge

Simple, clear - does not add to cost Simple, clear - does not add to cost of consumer’s information acquisitionof consumer’s information acquisition

Does not distort the marketDoes not distort the market Government intervention as last Government intervention as last

resort - uses private sector resort - uses private sector mechanisms where possiblemechanisms where possible

Not expensive for suppliers to Not expensive for suppliers to implementimplement

Easily accessed by the average Easily accessed by the average ‘punter’‘punter’

So what are the core interventions So what are the core interventions for retail FS?for retail FS?

Capacity for cheap, efficient Capacity for cheap, efficient recourserecourse – cooling – cooling off for complex products subject to malign off for complex products subject to malign incentives, ADRincentives, ADR

Make sure the consumer knows at least the Make sure the consumer knows at least the basics of what they are buying – basics of what they are buying – key facts key facts documentsdocuments, ratios, warning labels etc, ratios, warning labels etc

Encourage private sector Encourage private sector information information intermediariesintermediaries as first option – media, rating as first option – media, rating companies, Choice etccompanies, Choice etc

Use Use prudential not CP regulation to deal with prudential not CP regulation to deal with systemic risksystemic risk – sub-prime, Alt- A, CDS could – sub-prime, Alt- A, CDS could have been mitigated with decent capital and have been mitigated with decent capital and reporting requirementsreporting requirements

More context sensitiveMore context sensitive

Deposit insurance/ guarantee fundsDeposit insurance/ guarantee funds – once in cannot remove– once in cannot remove

Default productsDefault products – who takes – who takes responsibilityresponsibility

The The intermediary - competentintermediary - competent to sell to sell the productthe product

Other contextual issuesOther contextual issues

Stage of development:Stage of development:• LIC – minimal regulation desirable – use fit LIC – minimal regulation desirable – use fit

and properand proper• MIC – heavier reliance on recourse (ex post MIC – heavier reliance on recourse (ex post

versus ex ante)versus ex ante)

Mandatory pensions/ insurance Mandatory pensions/ insurance managed by private sector – managed by private sector – • Use institutional structures plus g’tee fundsUse institutional structures plus g’tee funds