Behaviorally Informed Financial Services Regulation

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Financial services decisions can have enormous consequences for household well being. Households need a range of financial services — to conduct basic transactions, such as receiving their income, storing it, and paying bills; to save for emergency needs and long-term goals; to access credit; and to insure against life’s key risks. But the financial services system is exceedingly complicated and often not well-designed to optimize household behavior. For example, choosing a mortgage is one of the biggest financial decisions an American consumer will make, but it can be a complicated one, especially in today’s environment where the terms and features of mortgages vary in multiple dimensions. Similarly, credit card contracts now often involve complicated terms and features that may encourage sub-optimal borrowing behavior. And it has long been remarked that households fail to optimize in their savings decisions.

In response to the complexity of our financial system, there has been a long-running debate about the appropriate role and form of regulation. Regulation is largely stuck in two competing models—disclosure, and usury or product restrictions. Disclosure regulation, embodied in the Truth in Lending Act (TILA), presumes one market failure: the market will fail to produce a clear and comparable disclosure of essential product information needed by consumers. TILA responds, potentially, to two types of problems.

First, firms will not reveal all information, for example, regarding the desirability of various features, that borrowers should understand and be able to analyze in determining whether to take out a loan. Second, firms will not reveal information in a way that facilitates comparability across products. The first concern speaks to consumer knowledge, “solving” the problem through the provision of information; the second concern addresses consumers’ ability to process the information, “solving” the problem through coordination of terms and definitions.

Homo economicus is very much the intellectual basis for disclosure regulation. The model relies on fully rational agents who make intelligent choices. But these neoclassical assumptions are misplaced and in many contexts consequential. In particular, behavioral research has shown that the availability of data does not always lead to communication and knowledge; understanding and intention do not necessarily lead to action; and contextual nuances can lead to poor choices. Individuals consistently make choices that, they themselves agree, diminish their own well-being in significant ways.

H/T Barry Ritholtz

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