Rodney Lester

Workshop on Consumer
Protection in the Retail
Financial Services Sector
Rodney Lester
World Bank
Brussels, October 16, 2008
Basic themes
CP regulation should be context sensitive work so far has been on reasonably
similar EU accession countries
• 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
Why CP regulation? - people
have to make life cycle decisions
Key life events that require prior planning (in
particular in democratic and market-oriented
societies) ...
• Children (if, when, how many, …)
• Education and skills (initial, changing
stream, life long learning, …)
• Car, chattel purchases
• Housing purchase (if, when, where, how, …)
• Retirement (if, when, where, how, …)
Based on: Holzmann, R. WB presentation
And these all involve financial planning
and decisions for 90% of people
… and
knowledge and skill for applying principals of
economics to personal finance, e.g.
•Law of one price (no free lunch)
•Present value of consumption cannot exceed
life time earnings
•Insuring and portfolio decision under
•Budgeting and basic numeric/quantitative skills
•Saving, investing, borrowing, lending, insuring,
diversifying, matching, …
Source: Holtzmann, R. WB presentation
The Financial System is also seen to
have key macro roles and positive
Efficient allocation of consumption, risk and
Efficient transfer of assets/ ownership –
investment becomes more secure
Mobilizes savings
Pricing, hedging and transferring risk efficiently –
reducing cost and risk of investment
Source of information – ‘coordinating
decentralized decisions throughout the economy’
However an effective approach to
consumer financial literacy training
remains elusive
So financial sector regulation
has become a public good
6 possible reasons for regulation:
Stop failure of financial institutions
Maintain consumer confidence in the
Ensure consumers receive adequate
information and are treated fairly
To assure fair pricing
Protect consumers from fraud and
To prevent unfair discrimination and
other 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 Benston* argues only the first is justified (for
banks, long term savings, 3rd party liability
insurance ) and should be achieved through
prudential rules
Why treated differently to other products?
Create moral hazard – increases risk in the system?
Competition will ensure proper market conduct
Most financial products are easy to understand and
Consumers have legal recourse anyway
Regulators will be conservative and over-regulate
Regulation can be difficult to interpret and require ongoing
Regulation can be used to entrench existing products and
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).
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
• 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 story
1960s/70s – emphasis on competition policy
(market failure) – regulation of concentration,
resale price maintenance, tying, information
asymmetry etc
Now - more complex models of markets – impact
of policy interventions less clear:
• No. of competitors is a poor measure
• Cost of information is critical issue
• Bargaining power is context sensitive (even with same
skills) – e.g. role of sunk costs
• One time versus frequent transactions
• Cannot apply a general CP framework – depends on
nature 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 questions
Identifying a CP problem – identify level of
competition, and whether structural or
informational problem
Deciding if government intervention is
necessary – why is market not self
Deciding on appropriate regulatory
instruments – minimize information
acquisition and processing costs for
consumers, decide whether proactive or
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
understand – not just annuities and life
50% of those sold sub prime mortgages in
the US were eligible for fixed rate loans
Consumer credit wordings can see
unsophisticated people lose their houses –
Bundled/ tied contracts can hide poor
consumer benefits - Russia
5. Legal recourse is not cheap or
easy in all countries
Few countries have class action option
Legal fees up front are the norm
Can take many years (9 to court of first
instance in Croatia) for a decision
Lawyers can hide offers of settlement to
draw actions out
Courts can also discriminate against
Courts in many emerging markets do not
understand financial sector and are subject
to ‘influence’.
But there are legitimate concerns
about MC regulation
Creates moral hazard – increases risk in the
Regulators will be conservative and overregulate
Regulation can be difficult to interpret and
require ongoing modification
Regulation can be used to entrench existing
products and players – inhibit innovation
CP emphasis can detract from prudential
Some basic criteria emerge
Simple, clear - does not add to cost
of consumer’s information acquisition
Does not distort the market
Government intervention as last
resort - uses private sector
mechanisms where possible
Not expensive for suppliers to
Easily accessed by the average
So what are the core interventions
for retail FS?
Capacity for cheap, efficient recourse – cooling
off for complex products subject to malign
incentives, ADR
Make sure the consumer knows at least the
basics of what they are buying – key facts
documents, ratios, warning labels etc
Encourage private sector information
intermediaries as first option – media, rating
companies, Choice etc
Use prudential not CP regulation to deal with
systemic risk – sub-prime, Alt- A, CDS could
have been mitigated with decent capital and
reporting requirements
More context sensitive
Deposit insurance/ guarantee funds
– once in cannot remove
Default products – who takes
The intermediary - competent to sell
the product
Other contextual issues
Stage of development:
• LIC – minimal regulation desirable – use fit
and proper
• MIC – heavier reliance on recourse (ex post
versus ex ante)
Mandatory pensions/ insurance
managed by private sector –
• Use institutional structures plus g’tee funds