Have you ever wondered why consumers tend to make suboptimal financial decisions, and why financial firms are often in a position to exploit them? Clearly, this is due in part to consumers’ biases and limited rationality. As consequence, even well-meaning policy interventions have often regulated for rational consumers and made them worse rather than better off. However, recent developments in behavioral science and economics seem to have made their way to traditional regulatory interventions. And while the combination of behavioral insights and big data analysis is raising issues relating to privacy and equality before the law, it is also opening up the possibility of tailoring the regulation of financial market behavior to more empirically valid characteristics.
Consuming Financial Products
Retail clients, you, me, we all engage with the financial system in various ways. We open accounts, we get personal loans, we may even be tempted to invest in bonds or shares. Some of the opportunities in the financial market are believed to dramatically improve our well-being. Pension-related products are one striking example: they help up save effortlessly for times when we will not have an income anymore.
However, financial markets are complex and also expose consumers to greater risks than other marketplaces. Some risks are product specific and derive from the speculative nature of the instrument. Other risks are more general and related to consumers’ pattern of behavior. Even products such as insurance products that are not indexed to the ups and downs of the financial market do expose financial consumers to ill-suited or expensive choices.
Decision-making and the Human Brain
It is now widely recognized that individual cognitive processing has limited capacity. The human brain deploys mechanisms to economize on cognitive processing in decision-making: this saves time but results in systematic errors in decision-making, which might not happen if the person was given unlimited time and the analytic resources to make these choices. Therefore, consumers make predictably costly mistakes in financial markets: they buy high and sell low, invest in attractively presented instruments they do not understand, and pay excessive fees.
The Myth of Rules of Thumb and the Rational Consumer
If we want to protect and empower the financial citizens that we are, close attention should be paid to consumers’ behaviors, to their imperfect analyses and distorted judgments. Let us not forget that many existing rules are written with a fictional (rational) consumer in mind: someone who reads labels and disclosures, takes the time to scrutinize contracts, and checks the terms and conditions. In reality, we are nothing like the fictional consumer. Instead, we use shortcuts to make decisions, relying on intuition rather than deliberation. Thus, many potential errors, anomalies or biases in consumer decision-making may be explained by the use of rules of thumb leading to incorrect beliefs.
We are unlikely to make an active choice when one option is a default (‘inertia’). An example of this is automatically renewable contracts, such as are often found in banking services. It has also been established that we can only deal effectively with a limited amount of information (‘information overload’). For this reason, it is not sensible to throw into the terms and conditions of loan agreements more information than consumers can process. Another example is present bias. This causes us to discount costs that seem distant in the future (‘hyperbolic discounting’). For example, a credit card with a low introductory teaser interest rate and high long-term interest rate is regarded as attractive, irrespective of the total cost. A last example, ‘optimism bias’ can lead us to misjudge the amount of use we make of a service: thus we might believe that we will never be in a situation where we need an expensive overdraft. Errors of this kind can result in choosing a contract that does not suit our needs.
Leveraging Big Data and Technology to Personalize Protection
Businesses have long been aware of this set of behaviors and regulations have started to take into account and incorporate insight from behavioral studies. What would be useful is to bridge the gap with Big Data, which is just another key to understanding consumer behavior.
The power of Big Data and associated predictive analytics could be used to improve the efficiency of consumer law. While heterogeneity among consumers often means that regulations are over- and under-inclusive, the rise of Big Data has significantly decreased the costs associated with creating and administering personalized legal rules tailored to specific individual profiles or circumstances. This is just one example out of many more.
In short, the combination of behavioral economics and Big Data analysis opens up the possibility of tailoring the regulation of market behavior to more empirically valid characteristics, and to personalize it. This exciting prospect also opens up major questions, relating in particular to how privacy can be ensured and how justice can be achieved. Nevertheless, private law can potentially embrace and harness these insights, and use them to solve problems such as unfair terms or debt payment issues.