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Entrepreneurial regulators

It's time to intervene in lending markets

By Chris Gorst  

"Much financial innovation—think Payment Protection Insurance (PPI)— seems designed specifically to exploit flaws in human decision-making." Photo: TONY KYRIACOU/SHUTTERSTOCK

There are very few examples of prosperous economies and flourishing societies that don’t have well-functioning, competitive markets playing a major role in that success. Yet there are plenty of dysfunctional markets within otherwise prosperous economies, where the most disadvantaged citizens often suffer the consequences—this is the “poverty premium.”

The question is therefore: how can the state become more entrepreneurial (to use Marianna Mazzucato’s terminology), not only in its own direct investments in the economy but also in helping markets to work better?

This brings us to the role of regulation, which, over the past 40 years, has suffered an ideological onslaught. Regulation has at times become equated with negative sum bureaucracy, leading to an embarrassment of failed policies to get rid of it, such as red tape challenges and “one-in-two-out” rules. Such overzealous policing of regulatory overreach has undermined regulators’ critical role in making markets work for the public good, a vital role in any advanced economy. There are, however, still signs that regulators are finding ways of making markets work better.

UK retail banking is a case in point. Dysfunction in this market is the gift that keeps on giving, at least for policy-makers. There has been a steady pulse of investigations into the sector’s competitiveness over the past 20 years, starting with the Cruickshank report in 2000 and culminating recently in the Competition and Markets Authority’s (CMA) 2016 market investigation. On average, one comes along every two years. But somebody waking from a 20-year sleep would be forgiven for thinking not much had changed in the UK’s retail banking market. Four banks still provide 70 per cent of personal current accounts, for example.

But perhaps this is about to change. The recent CMA investigation is forcing through arguably the most radical and innovative regulatory remedy yet considered, in the form of “Open Banking.” The UK version of Open Banking (there are different flavours internationally) requires the largest banks to “open up” a customer’s account to third parties, where the customer has given consent.

Although this sounds drearily technical—and worrisome from a security standpoint—it starts to get to the heart of the matter. It means, for example, that a small business seeking a loan could share its financial data with providers who would then compete to provide that loan—a market working as it should.

“Regulators are finally being given more political license to consider bolder interventions to create better markets”

Despite the benefits this would bring, Open Banking has been delayed in many cases. It’s hard to tell how much of this is down to foot-dragging and how much is due to the enormous technical challenge. It is notable that, though many now claim to see the merits of Open Banking, none of the major banks were adopting it before the CMA’s investigation.

But what does this all have to do with financial inclusion? First let’s clarify terms, as too often the discussion about financial inclusion is confused. What exactly should “inclusion” include? The Financial Inclusion Commission, in its “Vision for 2020” (published in 2015), said it wanted every adult to have a current account, access to affordable credit, savings and insurance cover—essentially all the basic products and services that many of us take for granted. Who could reasonably take issue with that? But we are still a long way off achieving that aim.

And it begs the question of why the financial services industry, which has the incentive to serve as many customers as possible, has not solved this problem. It seems that there are conflicts between universal provision, fair and affordable provision, and profitable provision, and that the banks don’t know how to square this circle on their own.

Where and how are these conflicts best resolved? It’d be nice to think that the industry will somehow sort itself out, without the need for external intervention. Financial services providers often participate in—and fund—earnest discussions about how to tackle the financial inclusion problem. A remedy that’s often proposed is better financial education, the ultimate “kicking the can down the road” solution. Of course, better financial education and capability is needed, but that is a very long-term solution to an immediate problem.

There are two main issues. The first is that customers are different, not least in terms of credit risk. Riskier customers are costlier to serve and, in a well-functioning credit market, we would expect this to be reflected in the prices they face. A consumer credit market without price discrimination based on risk would not last long. But when does price discrimination veer into unfairness, or even exploitation? We can point to egregious examples. But many transactions are not so clear cut. Distinguishing between fair and unfair quickly veers into subjective territory—not comfortable ground for financial services providers or their regulators.

The second is the behavioural dysfunction that bedevils decision-making in financial services and allows for unscrupulous behaviour by providers. Consumers of financial services are far removed from the coolly calculating, fully-informed homo economicusrequired for competitive markets. Decision-making is plagued by bad heuristics and behavioural biases, not least short termism and hyperbolic discounting of the future. Consumers with poor financial capability are particularly vulnerable to the measures used by providers to encourage irrational decision-making where this suits the interests of the latter. Much financial innovation—think Payment Protection Insurance (PPI), or 125 per cent mortgages—seems designed specifically to exploit flaws in human decision-making. Combine poorly equipped consumers and amoral providers and we can expect to see plenty of unwholesome transactions.

So what would it take for us to be confident that the consumer credit market was working “fairly”?

A starting point would be to acknowledge that price discrimination is to be expected, and that profitable exploitation of consumers is a temptation for providers.

A second point would be to be sceptical of the idea that the market will address the problem. Even if good actors in the market were prepared to do so, this could simply create more space for bad actors. Action by the regulator is almost certainly needed to get to a satisfactory equilibrium.

But what kind of action? On “fairness,” we should be asking how competitive the market for consumer credit is, in particular for the worst off who face the highest prices. Are consumers able to access and compare competing offers? It is interesting, for example, that there is no online platform where providers can compete for the business of credit seeking consumers.

Technologically this is quite feasible—online advertising is built on this model, and there are digital platforms where small businesses can compare a range of different loan providers. Open Banking could make it possible for consumers to share verified financial information instantaneously, enabling different providers to make their own credit assessments and compete for that consumer’s business. If such a platform existed, with a thick market of buyers and sellers, we could be more confident that the market was at least competitive, though we might still conclude it was “unfair.”

Will such a platform emerge organically? If not, should the regulator see to it that it does? Are there better solutions for making the consumer credit market more competitive? Should the regulator create a market advantage for “responsible” providers, like credit unions, and if so, how can it be done effectively? These are hard questions without simple answers, but they are only just starting to be asked.

What about the systematic behavioural biases that lead to bad decision-making in financial services, and create the space for unscrupulous, albeit legal, practices? This issue confronts regulators, who are increasingly willing to oblige banks to
alert their customers, for example, when they are in or about to go into overdraft and incur charges. This welcome but belated intervention would surely have been branded unacceptable nanny statism not too long ago. Now it seems like common sense.

But so far, interventions of this kind have been quite modest. Compare text alerts with, for example, the bombardment of negative messaging that smokers now face. Might the harms created by consumer credit merit similar intervention? Regulators could, for example, deliberately slow down the process of getting a loan, creating more space for consumers to consider their options.

A more radical idea would be to oblige providers to show competing, possibly better, offers from alternative providers at the point of sale—a hard challenge but, if the regulatory and political will were there, achievable. Whether such approaches are justified depends on an assessment of how much harm these markets are currently creating. But the point is that creative, technologically-informed thinking by regulators opens up new opportunities for effective intervention.

Regulators are finally being given more political licence to consider bolder interventions to create better markets. The behavioural turn in economics, and the intellectual repercussions of the financial crisis are slowly shifting politicians’ and regulators’ frames of reference. Some are already thinking about how technological advances can be exploited to achieve regulatory goals—Open Banking is one such example. While regulators have traditionally considered themselves mere referees overseeing players in a game, increasingly they are willing to experiment with the rules and even the shape of the pitch. The temptation will persist not to rock the boat, but perhaps the time has come not only for the entrepreneurial state but an even more surprising oxymoron: the entrepreneurial regulator.

 

Read more from our financial inclusion supplement


Banking on Change is a publication which examines how we can develop a comprehensive policy approach towards financial inclusion. The report features contributions from the likes of John Glen MP, Peter Dowd MP, Anne Pieckielon, Chris Pond and Guy Opperman MP.

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