Behavioral Economics
and Financial Regulation
David S. Evans
November 14, 2011
Privileged and Confidential
BEHAVIORAL ECONOMICS (AND
WHY YOU SHOULD CARE)
November 14, 2011
Behavioral Economics Combines
Economics and Psychology
How do people actually behave?
Why do they behave that way?
What are the implications for
markets?
November 14, 2011
Behavioral Law and Economics
Applies BE to Regulation
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
November 14, 2011
Behavioral Economics Has
Come to Town
Cass Sunstein
Sendhil Mullainathan
Director, OIRA, White House’
“Chief Economist” CFPB
Founder of Behavioral Law
and Economics
Leading behavioral economist
Co-author of “Nudge”
November 14, 2011
Co-author of leading paper on
BE regulatory intervention in
financial markets
Why Should You Care?
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
November 14, 2011
KEY FINDINGS OF BEHAVIORAL
ECONOMICS
November 14, 2011
After Several Million Years
You’d Think We’d Be Smart
November 14, 2011
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
• People are overconfident in ability to stick to
plans such as saving
• People are overly optimistic about themselves
and their futures
“Cross-cutting Biases”
“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
• 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
“Price and Valuation
Biases”
November 14, 2011
“Preference Biases”
Cross-Cutting Biases
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
November 14, 2011
Expectation Biases
People are overconfident in
ability to stick to plans such as
saving
People are overly optimistic
about themselves and their
futures
November 14, 2011
Price and Valuation 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
November 14, 2011
Preference 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
November 14, 2011
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.”
November 14, 2011
BEHAVIORAL ECONOMICS BASED
REGULATION
November 14, 2011
Helping People Help
Themselves
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
November 14, 2011
Soft Paternalism
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
November 14, 2011
Hard Paternalism
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
November 14, 2011
Reasons to be Skeptical of BEBased Regulation
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
November 14, 2011
Not so Easy Problems Perhaps
400% Payday loans
Advertisements for gold coins
Nudges to invest in 401-k plans
November 14, 2011
CFPB AND APPLICATION TO
FINANCIAL MARKETS
November 14, 2011
Behavioral Foundations of CFPB
Regulation
November 14, 2011
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 “evidencebased
regulatory”
analysis
Sample “Problems” in Financial
Services
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
November 14, 2011
Preemptive Design Principles
Transparency:
Make It Clear
Simplicity:
Keep It Simple
Helpfulness:
Help People
Help
Themselves
November 14, 2011
Honesty: No
Tricks and
Traps
Research: Test
for the Best
CONCLUSION
November 14, 2011
Concluding observations
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
November 14, 2011
THANK YOU!
devans@globaleconomicsgroup.com
www.globaleconomicsgroup.com/
November 14, 2011