Behaviorally Informed Financial Services Regulation

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. 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. This paper explores a different approach, based on insights from behavioral economics on the one hand, and an understanding of industrial organization on the other. At the core of the analysis is the interaction between individual psychology and market competition. This is in contrast to the classic model, which relies on the interaction between rational choice and market competition. The introduction of richer psychology complicates the impact of competition. It helps us understand that firms compete based on how individuals will respond to products in the marketplace, and competitive outcomes may not always and in all contexts closely align with improved decisional choice and increased consumer welfare.

The paper adopts a behavioral economic framework that considers firm incentives to respond to regulation. Under this framework, outcomes are an equilibrium interaction between individuals with specific psychologies and firms that respond to those psychologies within specific market contexts. Regulation must then address failures in this equilibrium. The model suggests, for example, that in some contexts market participants seek to overcome common human failings (as for example, with under-saving) while in other contexts market participants seek to exploit these failings (as for example, with over-borrowing). Behaviorally informed regulation needs to take account of these different contexts. The paper discusses the specific application of these forces to the case of mortgage, credit card, and banking markets. The purpose of this paper is not to champion policies, but to illustrate how a behaviorally informed regulatory analysis would lead to a deeper understanding of the costs and benefits of specific policies. To further that understanding, in particular, the paper discusses ten ideas:

• Full information disclosure to debias home mortgage borrowers.
• A new standard for truth in lending.
• A "sticky" opt-out home mortgage system.
• Restructuring the relationship between brokers and borrowers.
• Using framing and salience to improve credit card disclosures.
• An opt-out payment plan for credit cards.
• An opt-out credit card.
• Regulating of credit card late fees.
• A tax credit for banks offering safe and affordable accounts.
• An opt-out bank account for tax refunds.

The full text of this paper is available below as a PDF. Click here for a short video of the authors discussing their findings, or see the Oct. 17 event for additional information.