(PDF) Nudging: Information, Choice Architecture and Beyond

Investors are rational and that they consider all available information in portfolio investment decision process is the main assumption of standard finance and this holds true by Efficient Market Hypothesis (EMH), being an important theory of Standard finance. Over the years this assumption has been challenged by the psychologists and they argue that investors can’t be rational as their decisions are influenced by cognitive and psychological errors. The work done by the various prominent psychologists in this direction resulted in the development of a new branch of financial economics, known as Behavioural Finance. Behavioural finance considers how various psychological traits affect the way investors make their investment decisions. Against this backdrop, in present paper a modest attempt has been made to review various studies in this area so as to have clear understanding of the subject and to see how significant it is in financial decision making. From the review of literature i...

The findings of behavioural finance research have undoubtedly influenced the traditional understanding of the processes and patterns that allow the functioning of financial markets. Perceptions which used to be based on the assumptions of rational behaviour gradually allow for human flaws. Not only the structural information asymmetries between the various financial market participants interfere with the efficient allocation of capital; moreover, there is a need to address other factors that may substantially influence markets: for example, emotions, reference biases, overconfidence and inertia impair rational choice. Since such insights from the field of behavioural economics are often not in line with the common legislative model developed on the basis of the rational investor concept, the question arises which possible reactions of the law (especially of financial market law) to the insights provided by other disciplines might be valuable. Today’s approach towards the point-of-sale (POS) regulations for investment advisory and portfolio management services includes a mandatory assessment regarding the individual appropriateness and suitability of financial investments. The subsequent analysis of presently debated regulatory code-of-conduct-requirements fostering investor protection is based on behavioural findings.

Chapter 12 Nudging: Information, Choice Architecture and Beyond Theory and Applications in Financial Markets Law Rainer Baisch We would sign our lives away without reading, so people need protection from a lot that is legal. (Kahneman 2013, p. 1340.) Abstract The traditional disclosure-paradigm is based on the assumption that transparent and effectively processed information will enable the investor to make well-founded investment decisions. Having the type of a «homo oeconomicus» in mind, ﬁnancial market laws used to be designed for responsible and knowledgeable actors. Analysing human ﬂaws regarding the way we process information in the light of behavioural ﬁndings, the provision of data for consumers of ﬁnancial products should be further optimised. Despite the information overload the provision of information must not be condemned; this would mean throwing the baby out with the bath water. Disclosure can be used and function’s also as a nudge; thus the way information is framed matters a lot. However, inundating customers with too much information does not help. Valueing the positive outcome of simple rules of thumb might complement to an optimised cognition and perception of human behaviour as it should be imputed to individuals when designing regulation. Enhanced prevention based on smarter information requirements will give consumers a better chance to avoid human ﬂaws. Additionally, education could, at least partially, compensate negative outcomes of human ﬂaws. However, nudging should avoid weakening the motivation of individuals to actively inform themselves. Combined with a strict Code of Conduct at the point of sale, a Suitability Test including the real risk perceptions of the consumer leads to an enhanced level of investor protection. Nudging in combination with some more paternalistic elements can de-bias detrimental human shortcomings while distending paternalism should be avoided. R. Baisch (*) Rechtswissenschaftliche Fakultät, University of Zurich, Rämistrasse, 8001 Zurich, Switzerland e-mail: rainer.baisch@rwi.uzh.ch © Springer International Publishing Switzerland 2016 K. Mathis, A. Tor (eds.), Nudging - Possibilities, Limitations and Applications in European Law and Economics, Economic Analysis of Law in European Legal Scholarship 3, DOI 10.1007/978-3-319-29562-6_12 217 218 12.1 12.1.1 R. Baisch Introduction Point of Departure Neo-classical economic theory advocates investor protection aside from market abuse only if market failures – often based on information asymmetries – occur. However, additionally there are (i) various behavioural biases that inﬂuence the ﬁnancial decisions of individuals, combined with (ii) individual’s disability to manage information properly and (iii) the latent information overload; those facts call for an appropriate regulatory facet.1 On top of that, (iv) ﬁnancial intermediaries might be tempted to use common biases to sell products which are not in the best interest of the client.2 Financial innovation led to “an ever-widening set of ﬁnancial options from an expanding set of ﬁrms and accompanied by a sometimes dizzying amount of information”.3 While the complexity of the supply side confuses the consumer,4 the demand side is more and more becoming a ‘do-it-yourself’ activity.5 Many consumers are not aware of the fact that their performance regarding investment decisions is rather poor. Additionally, the supply side capitalises on human limitations by taking advantage of the way we process information.6 The question why consumers of ﬁnancial services products often make relatively poor decisions has been analysed by behavioural scientists; they blame cognitive shortcomings based on the use of heuristics or various subconscious biases.7 Accepting this cognitions as being true and having a negative impact on investment decisions (or at least, that there is a certain, latent and unwished menace for consumers) it should be discussed how that issue can be adequately addressed. Such a solution could also beneﬁt from the concept of nudging as introduced by Thaler and Sunstein.8 1 For a (critical) overview of the emergence of behavioural law and economics as a counterpart to orthodox law and economics with reference to the main literature see Mitchell 2014, pp. 167–168. See also Langevoort 1992 for a detailed analysis regarding the efﬁcient market hypotheses and the inﬂuence of behavioural research. 2 The paper carries forward and enhances ﬁndings that were presented at the 3rd Law and Economics Conference in Lucerne: Behavioural Law and Economics in April 2014; Baisch and Weber 2015. 3 Campbell et al. 2011, p. 91. 4 Libertarians prefer to talk about “investors”; the term “consumer” suggests and implies the need of a certain degree of protection. See Kingsford Smith 2010; Moloney 2012, and Sarra 2013. 5 Ryan et al. 2011, p. 462. 6 Akerlof and Shiller 2015. 7 See also World Bank Group, World Development Report 2015, Mind, Society and Behavior, December 2015. 8 Thaler and Sunstein 2008; Sunstein 2014a. 12 Nudging: Information, Choice Architecture and Beyond 219 Looking at retail investors the regulator must abandon the idea of decisionmaking based only on rational choice assumptions. Therefore, disclosure is necessary but will alone not lead to optimal investment allocation.9 In reality, behaviourally impairments inﬂuencing investment decisions are accompanied by herding, bubblebuilding and wrongly incentivised staff at the point-of-sale (POS); therefore, any kind of information provision as well as rules for a Code of Conduct must accept ﬁndings from behavioural research. Keeping in mind that the professionals from the ﬁnancial industry are also aware of these effects, it cannot be ignored that those biases might be capitalised. By looking at product ﬂyers with attractive recent return curves or highlighted assurance that the capital is protected, it is not farfetched to assume that at least some behavioural weaknesses are exploited (framing). Based on this premise, a closer look at the POS-regulation is inevitable. 12.1.2 Regulatory Activities In recent years the ﬁndings of behavioural ﬁnance research10 have inﬂuenced the traditional understanding of the processes and patterns that allow the functioning of ﬁnancial markets. In the meantime regulatory perceptions which used to be based on the assumptions of rational behaviour partially allow for human ﬂaws.11 For instance, the new PRIIP regulation12 deﬁning the KID13 which is going to “be further harmonised through Level 2 instruments that take into account existing and on-going research on consumer behaviour”.14 9 Ulen 2013 delivers a good overview of behaviourally informed investor protection regulation and also advocates augmented disclosure obligations. 10 A good collection of early key papers can be found in Kahneman et al. 982; see also Kahneman and Tversky 2000; legal implications stemming from behavioural ﬁndings are described by Korobkin and Ulen 2000. See also Moloney 2010, 67–74, regarding the irrational and uninformed investor. 11 Cunningham 2002, p. 836, resumes that behavioural ﬁnance is “a marriage of cognitive psychology and the ﬁnancial economics of market inefﬁciency”. See FCA papers: Kristine Erta et al., Applying Behavioural Economics at the Financial Conduct Authority, Financial Conduct Authority, Occasional Paper No. 1, April 2013, http://www.fca.org.uk/static/documents/occasional-papers/ occasional-paper-1.pdf; Paul Adams/Stefan Hunt, Encouraging Consumers to Claim Redress: Evidence from a Field Trial, Financial Conduct Authority, Occasional Paper No. 2, April 2013, http://www.fca.org.uk/your-fca/documents/occasional-papers/occasional-paper-2. 12 Proposal for a Regulation of the European Parliament and of the Council on key information documents for packaged retail and insurance based investment products, PRI(I)Ps; http://register. consilium.europa.eu/doc/srv?l=EN&f=ST%208356%202014%20REV%201. 13 Key Investor Document. 14 Discussion Paper of the Joint Committee of European Supervisory Authorities (the ESAs: EBA European Banking Authority, EIOPA European Insurance and Occupational Pensions Authority, and ESMA European Securities and Markets Authority), Key Information Documents for Packaged Retail and Insurance-based Investment Products (PRIIPs), 17 November 2014, p. 17. 220 R. Baisch The assessment of the prospect, options, scope and effectiveness of a regulatory approach based on the outcome of behavioural research in the area of ﬁnancial market law through techniques like nudging is a growing ﬁeld of research.15 The fact that some actors in the ﬁnancial industry have shown exploitative activities in their interaction with customers of ﬁnancial services products is another reason why regulators see themselves forced to provide preventive measures based on behavioural research.16 Market behaviour that cannot be subsumed under market abuse or fraud but which still has to be regarded as cheating the customers because it capitalises on human ﬂaws is an issue on the regulative agenda.17 Opponents of this change lament a loss of freedom accusing such kind of policy and regulation as too paternalistic.18 However, in principle, “nudges are in many cases not paternalistic at all, but instead largely cases of rational persuasion”.19 Admittedly, already some years ago behavioural economics were rightly considered as a ﬁeld that naturally has its limits20: As policymakers use it to devise programs, it’s becoming clear that behavioural economics is being asked to solve problems it wasn’t meant to address. Indeed, it seems in some cases that behavioural economics is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics. In the U.S. the Consumer Financial Protection Bureau is authorized to ensure that “consumers are provided with timely and understandable information to make responsible decisions about ﬁnancial transactions”.21 More precisely, the bureau may prescribe rules to ensure that the features of any consumer ﬁnancial product or service, both initially and over the term of the product or service, are fully, accurately, and effectively disclosed to consumers in a manner that permits consumers to understand the 15 A good overview is delivered by Reiss 2013, pp. 278–302. See also Bovens 2009. However, it is also possible that “sometimes ﬁrms might not know that their customers are making mistakes. What looks like deliberate exploitation may actually just be ﬁrms responding to observed consumer demand without realising that it is driven by biases.” See FCA, Occasional Paper No.1, Kristine Erta, Stefan Hunt, Zanna Iscenko and Will Brambley, Applying behavioural economics at the Financial Conduct Authority, April 2013, 7 and 21; http://www.fca.org.uk/yourfca/documents/occasional-papers/occasional-paper-1. 17 Add-on-insurance sale; see FCFCA, Market Study, General insurance add-ons: Provisional ﬁndings of market study and proposed remedies, March 2014; https://www.fca.org.uk/static/documents/market-studies/ms14-01.pdf. 18 Some authors criticise the approach from Thaler and Sunstein; e.g. White 2013, xiii, states that policies based on nudges are “ineffective, unethical, and dangerous to individual choice, interests, and autonomy”. See also Whitman and Rizzo 2007, Rebonato 2012. Sunstein 2005, p. 201 seq., already addresses some major lines of criticism: (i) slippery slope (resist the beginnings – nip it in the bud), (ii) mistrust in the abilities of the planner or choice architect and (iii) enthusiastic paternalists dislike the non-mandatory nature of nudging. See also Conly 2013. 19 Hausman and Welch 2010, p. 136. 20 George Loewenstein and Peter Ubel, Economics Behaving Badly, The New York Times, July 14, 2010, http://www.nytimes.com/2010/07/15/opinion/15loewenstein.html. 21 Dodd-Frank Act, 2010; 12 U.S. Code § 5511 – Purpose, objectives, and functions. 16 12 Nudging: Information, Choice Architecture and Beyond 221 costs, beneﬁts, and risks associated with the product or service, in light of the facts and circumstances.22 In Europe, the UK installed a similar consulting team and especially the FCA (see later Sect. 12.4.2) avows oneself to consider behavioural ﬁndings; recently Germany also takes similar steps in this direction.23 12.2 Regulatory Design Nudges are ways to make it easy for people (…) compatible with their values and (…) with their desires.24 12.2.1 Paternalism Paternalism25 is widely accepted to protect lives (mandatory use of seat-belt) or minors (sale of alcohol). However, a latent phobia can be observed amongst market liberals being afraid of too much paternalism with respect to the outcomes of behavioural research. According to common understanding, paternalism limits the liberty or autonomy of individuals but does so for that person’s own good – based on its Latin origin – in a fatherly manner but restricting individual freedom and responsibilities; however, the addressee is not a child anymore.26 The assumption that a father is normally acting in the best interest of his child might not be true in the regulatory world where no family ties come into play; in fact there is no guarantee that policy makers are acting altruistic and/or in the best interest of consumers – whether by accident or design, unconsciously or deliberately. In addition, initially as a precondition the insight and comprehension have to be acquiesced, we as individuals need such kind of assistance. Polemically phrased an important cognition based on behavioural research is a widening of the category of idiots requiring protection. To avoid a proliferation of paternalism, good regulation will impose minimal restrictions on those who behave rationally, but will guide the others.27 22 Dodd-Frank Act, 2010; 12 U.S. Code § 5532 – Disclosures. Similar to the U.S. (Social and Behavioral Sciences Team) and Great Britain’ Nudge-Unit (Behavioural Insights Team) also the German Chancellery is setting up an interdisciplinary team to apply empirical evidence from behavioural economics in public policy making. See Steinbeis, Maximilian: ‘Nudging’ arrives in Germany, VerfBlog, 27 August 2014, http://www.verfassungsblog.de/en/nudging-kommt-nach-deutschland/#.VNsrbWNATbM. 24 Kahneman 2013, p. 1340. 25 See Dworkin 2013. 26 Sunstein 2014c addresses the ethical aspects of nudging and related criticism. Trout 2005, 408, argues that biases damage peoples autonomy not institutional remedies. 27 Camerer et al. 2003, p. 1218. 23 222 R. Baisch Thus, paternalistic regulation will not be in conﬂict with constitutional limits like the right to freedom of action and self-determination in a liberal state.28 One of the elementary topics regarding ﬁnancial market regulation culminates in the question as to which degree paternalistic emphasis would be inevitable.29 Is there just the necessity to have criminal law against fraud in place? What kind of private law design is best suited for settlement and compensation? Are people entitled to make their own choices despite the fact that they err and, thus, might inﬂuence the general welfare in a negative way? Therefore, in some areas, remedies representing a form of regulatory paternalism to protect customers from their own mistakes appear to be the better alternative avoiding that households become too dependent on their own devices and, in consequence, have to learn from their own mistakes. Anyhow, unfortunately learning effects might come into fruition only very rarely for many consumers, since ﬁnancial decisions are undertaken seldom and their outcomes are delayed, sometimes for decades (endowment insurance). Regarding long-term investments, consumers might not even realise how the investment is performing or whether they have been mis-sold a ﬁnancial product until many years have been passed. Anyhow, consumers often will not be able to learn from experience given the infrequency with which they often act as investors.30 Due to other traditions in Europe it might not be necessary to add euphemistic attributes ending up with Libertarian or Asymmetric Paternalism. Because any kind of limitation regarding choices or restriction of alternatives interfering with someone’s liberty must be regarded as paternalistic, such kind of regulation also should be named paternalistic31; without any negative undertone however, public and mandatory pension insurance systems which are common in Europe are clearly paternalistic like all other compulsory insurances. Any kind of tax deduction incentives or tax concessions are at least a soft paternalistic nudge. According to Thaler and Sunstein32 paternalism does not always have to involve coercion and could also be based on coaxing reactions out of individuals. For them, even the sequence in which food is presented in a cafeteria could be (softly) paternalistic. 28 Van Aaken 2016, explores the legal limits of paternalistic nudging under the German Constitution and discusses the (typical German) proportionality assessment which consists of a quadrinominal test: (i) legitimate aim, (ii) suitability, (iii) neccessity (least restrictive means tests) and (iv) proportionality. It is important to distinguish whether a nudge targets preferences and autonomy (end paternalism) or just cognition (means paternalism); while the ﬁrst needs to be subjected to greater scrutiny the latter is true for informational nudges. 29 Libertarians prefer the freedom of choice, while condemning paternalism; see e.g. Boaz 1997; on the other side, paternalists mistrust freedom of choice and argue against some occurrences of libertarianism; see e.g. Goodin 1991. 30 See ESA-DP (fn. 15), p. 17. 31 Blumenthal-Barby 2013. 32 Thaler and Sunstein 2008, p. 11 Nudging: Information, Choice Architecture and Beyond 223 this figure will be printed in b/w 12 Fig. 12.1 Matrix classifying nudges (Mullane and Sheffrin 2012) 12.2.2 Nudging Thaler and Sunstein developed their concept of nudging33 which has its roots in their understanding of Libertarian Paternalism.34 A nudge, as they use the term, is any aspect of the choice architecture that alters people’s behaviour in a predictable way without forbidding any options or signiﬁcantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.35 Following this deﬁnition, it is not really convincing (or coercive) to call the concept of nudging paternalistic because such kind of potentially helpful treatment or interaction is not restricted only within the relationship to a father ﬁgure. However, the right combination of regulative measures from paternalistic to libertarian is a challenging task. It should not be questioned that nudges may be beneﬁcial in many regulative areas. But there are important challenges regarding the best way of implementation. Therefore, nudges belong in the “toolkit for regulation, but with a considered humility. They are not a panacea.”36 Besides disclosure as a nudge, nudges like default rules (e.g. opting in/out as professional or retail client) could work well in ﬁnancial regulation. Nudging should not happen in secrecy. Figure 12.1 also identiﬁes non-transparent types of nudging. Such interventions should come with some kind of information; 33 Thaler and Sunstein 2008. Sunstein and Thaler 2003. 35 Thaler and Sunstein 2008, 6. Regarding choice architecture see also Thaler et al. 2013; Johnson et al. 2012. 36 According to Hansen and Jespersen 2013, pp. 20–23; based on the dual process theory which underpins Thaler and Sunstein 2008, pp. 19–22, and is also fundamental to Kahneman 2011. 34 224 R. Baisch e.g. a rearranged cafeteria could be tagged with a respective indication somewhere at the entrance. Looking to other ﬁelds of regulation, e.g. food labelling obligations, it must be conceded that there is not a real effect against obesity. There might be a need to consider taxes on unhealthy food, but instead of changing the price of junk food, the focus should be on consumer behaviour. Are there similar facts and implications regarding ﬁnancial regulation? Because there are (i) some doubts whether nudging consumers is the best way to improve their situation, and there is also (ii) a call for more traditional legal and economic solutions, this topic generates interesting research questions. 12.2.3 Example: Product Ban vs. Product Warning To highlight the difference in the regulatory approach based on paternalism from the point of view of nudging, the following example shall help to clarify the understanding as adapted in this paper. In the ﬁrst use of its new consumer protection powers, the UK’s Financial Conduct Authority (FCA) restricted ﬁrms from distributing contingent convertible securities (CoCos) to the mass retail market.37 However, based on the UK regulation professional, high-net-worth and sophisticated investors as well as individual investors via execution-only dealing platforms are still able to buy CoCos.38 Given such kind of exceptions, would it not be better just to make assertive warnings compulsory?39 A ban might be too rigid, while product warnings could be sufﬁcient. On the other hand, it is also still permitted to buy shares and plain bonds of ﬁnancial institutions. The problem is that with CoCos, investors do not have control over if and when this type of bond converts to an equity; however, in comparison to a share, an interest is paid and the share-value will fall similarly in the case of a trigger event. Mandatory suitability tests and restrictions to allow the distribution of 37 FCA Press release, 5 August 2014, http://www.fca.org.uk/news/fca-restricts-distribution-ofcocos-to-retail-investors. CoCos are hybrid bonds that currently offer attractive yields but their value can be written down or converted into equity if the issuing bank’s capital drops below a certain minimum level. 38 CoCos may still be sold to investors for whom they are more likely to be suitable, including professional investors or retail investors who are high net worth or sophisticated. Sophisticated investors are deﬁned by the FCA as retail clients with extensive investment experience and knowledge of complex instruments, able to understand and evaluate the risks and potential rewards of unusual, complex and/or illiquid investments. To be classed as high-net-worth, investors need to have an annual income of more than £100,000 or have investable net assets of more than £250,000; see Temporary product intervention rules, Restrictions in relation to the retail distribution of contingent convertible instruments, August 2014, http://www.fca.org.uk/static/documents/temporaryproduct-interventions/restrictions-in-relation-to-the-retail-distribution-of-cocos.pdf. 39 FCA started a consultation in October 2014 (CP14/23: Restrictions on the retail distribution of regulatory capital instruments) and published rules in June 2015 permanent rules are in place since 1 October 2015 when the temporary product intervention rules for CoCos expired (PS15/14). 12 Nudging: Information, Choice Architecture and Beyond 225 CoCos only to customers who use advisory or portfolio management services are the better option. Nudging by means of information and warnings are preferable. 12.3 Behavioural Insights Disclosure requirements should be designed for homo sapiens, not homo economicus.40 12.3.1 Information: Capacitance, Processing, and Evaluation Based on the research from behavioural economics on cognitive failings the artiﬁcial construct of a “reasonable investor” – resulting in a lack of protection for investors – is at stake. Today, even in countries with a tradition of reliable social systems, unsophisticated retail investors are forced to invest in the market to save for their retirement; the long phase and partially ongoing zero interest-rate policy in important economic regions led to an additionally reinforcing effect. Consumers have to care for their retirement despite their cognitive failings and their lack of training for the task; therefore, regulators have to widen their perspective.41 Obviously, in Europe similar to the U.S. “disclosure is not the panacea that drafters of federal securities laws may have thought it to be”.42 Additionally, it is not really questionable that nudges may be beneﬁcial in many regulative areas. And there are important challenges regarding the best way of implementation. One of the key pillars undergirding the federal securities laws – that investors effectively process information – is under pressure. An extensive literature shows that investors and other securities market participants are subject to cognitive biases and, because of bounded rationality, adopt heuristics in making investment decisions.43 The traditional disclosure-paradigm is based on the assumption that transparent and effectively processed information will enable the investor to make well-founded investment decisions. Having the type of a «homo oeconomicus» in mind, ﬁnancial market laws used to be designed for responsible and knowledgeable actors. After the ﬁnancial crisis culminating in the collapse of Lehman Brothers we should not condemn information; this would mean throwing the baby out with the bath water. Failures resulting from consumer biases or suboptimal information lead to similar regulatory challenges, like shown in the regulatory framework in Fig. 12.2.44 40 Sunstein 2013, p. 9. See Davidoff and Hill 2013. 42 Black 2013, p. 1507. 43 Paredes 2003, p. 484. 44 OECD 2007, Roundtable of Economics for Consumer Policy: Summary Report, 26 July 2007, p. 13. 41 R. Baisch this figure will be printed in b/w 226 Fig. 12.2 OECD 2007, decision tree Disclosure can function also as a nudge.45 However, customers should not be inundated in too much information. It can be criticised that the design of legal measures for transparency does not sufﬁciently take into consideration whether an investor is capable and (under the behavioural aspects) willing to assimilate the information made available to him. Therefore, it must be assumed that the provision of information alone is not sufﬁcient, since the capacity and willingness to handle information might be limited. Swamping disclosure requirements used to misjudge the abilities of retail investors. The new European regulation leads to the mandatory provision of basic leaﬂets. It remains to be seen whether such kind of information is properly processed by the consumers. Behavioural ﬁnance exempliﬁes that many biases cannot be prevented through disclosure. “Disclosure has considerable attractions as a retail market tool, but the challenge for regulators is to resist the temptation to make disclosure the panacea for investor protection.”46 What is the target of regulation, the empowered investor or the irrational and uninformed investor? The fact that even experienced investors are prone to irrational decisions should deliver some food for thought. 45 Sunstein 2014b, p. 727. Opening statement of Steven Maijoor, Chair of ESMA, at the ESMA Investor Day, 12 December 2012, Paris; http://www.esma.europa.eu/system/ﬁles/2012-_818.pdf. 46 12 Nudging: Information, Choice Architecture and Beyond 12.3.2 227 Inertia, Overconfidence and Emotions Not only information but other factors such as inertia, overconﬁdence and emotions substantially inﬂuence decisions and whole markets.47 Based on emotions, humans do not like to regret a former decision, overconﬁdence48 inﬂuences the assessment of probabilities and due to inertia49 decisions are refused. Inﬂuenced by reference biases and the manner how information is framed and anchored, non-rational factors are having a major impact on the way information is processed. The interrelation of inertia50 and the regret aversion bias51 hinders investors to act. In consequence goods (or investments) which are already in someone’s possession (Thaler worded it “included in the individual’s endowment”) are valued higher than those for which money would have to be spent.52 Sunstein identiﬁes four categories (Fig. 12.3) in which central ﬁndings with particular importance to regulatory policy of recent social science research can be related to for purposes of regulation.53 1. Default rules, rules that determine the result if people are too lazy or even refuse to make a choice at all, are quite common to encounter inertia. Especially, in the domain of retirement savings default rules can be extremely important to overcome the power of inertia.54 Default rules can balance the lack of self-control. 2. Widely recognised is the ﬁnding that people can be inﬂuenced by how information is presented or framed.55 Emotions instead of rational behaviour come into play. For any kind of information, salience greatly matters. If key facts like fees 47 The role of psychology in economics was already discussed by Keynes 1936, p. 315, referring to animal spirits (162) and unrealistic optimism or pessimism as causes for booms and busts. 48 Overconﬁdence could have many positive effects. Looking at retirement savings the expectation to live longer than average should motivate individuals to higher savings. Baisch and Weber 2015, pp. 167–171, with further references. 49 The debate regarding akrasia (the Greek ἀκρασία means a lack of command over oneself) is quite an old one: Socrates argued in Plato’s Protagoras (Plato, 380 B.C., Platon: Protagoras 345 d9-e4) that akrasia does not exist, because no one acts willingly against one’s better judgment. Aristotle countered more empirically and acknowledged that individuals behave intuitively (Aristoteles, The Nicomachean Ethics VII 3, 1145 b22–24). 50 Gal 2006. 51 Regret aversion bias is the tendency to avoid making a decision due to the fear of the later probability to experience the pain of regret; in consequence, people will avoid taking decisive actions because they fear that, in hindsight, whatever action they may have selected could prove less than optimal. 52 Thaler 1980, p. 44. 53 Sunstein 2011, p. 1350. 54 Just one of many: Madrian and Shea 2001. See also EIOPA-report, Good practices on information provision for DC schemes, Enabling occupational DC scheme members to plan for retirement, 24 January 2013. 55 Sunstein 2011, p. 1353. R. Baisch this figure will be printed in b/w 228 Fig. 12.3 Sunstein’s four categories or risks are not sufﬁciently salient to people, this results in limited attention.56 Therefore, vivid displays are more effective than abstract presentations of statistical risks. 3. The third category, social inﬂuences, is less relevant for ﬁnancial market regulation but could be seen as partially interesting in view of compliance to code-ofconduct-regulations shown by advisors. Social norms can help to create a phenomenon of ‘compliance without enforcement’ like wearing a helmet while biking or skiing even if it is not mandatory to do so. A similar phenomenon is that people are willing to cooperate with one another or to contribute to a solution, despite the fact that standard economic theory predicts other optimal results57 4. Finally, the optimism bias or overconﬁdence based on difﬁculties assessing probabilities, combined with the ignorance regarding not known facts and other inﬂuences like the conﬁrmation bias must always kept in mind when it comes to decision making.58 12.3.3 Intermediate Conclusion: Suitability as a Cornerstone of Investor Protection According to IOSCO, suitability requirements aim at ensuring that ﬁnancial intermediaries only make suitable recommendations and that customers have the necessary expertise, knowledge and ﬁnancial capacity to trade in the respective ﬁnancial 56 The problem of shrouded attributes comes into play; Gabaix and Laibson 2006; see also Sunstein 2015, p. 316. 57 Sunstein 2011, p. 1357. 58 Sunstein 2011, pp. 1358 et seq. 12 Nudging: Information, Choice Architecture and Beyond 229 instruments and to understand associated risks given their investment objectives; thereby the risk tolerance including the risk of loss of capital must also be assessed.59 In Europe the introduction of suitability requirements in 2004 with MiFID60 changed the retail investor protection regime signiﬁcantly, setting a new “highwater mark of the extent to which the new regulatory strategy for the retail markets intervenes paternalistically in the investor’s decision”.61 But obviously the ﬁnancial crises tsunami surpassed that high-water mark and the dam is now heightened not only by strengthening the requirements regarding the investor’s individual risktolerance within the suitability assessment. Today the mandatory assessment regarding the individual appropriateness and suitability of ﬁnancial investments at the POS is widely accepted.62 In the U.S. with the standards set by the industry, suitability requirements are established already a long time ago (since 2012, the FINRA Rule 211163 replaces NASD Suitability Rule 2310).64 It was quite common to accept some of the behavioural ﬁndings, however, often the traditional approach preferring education – often named investor empowerment – was followed instead of enhancing investor protection.65 Investor education rather than investor regulation is probably the best way to respond to the increasing recognition of the substantial role that cognitive biases play in investor behaviour. Nevertheless, the insights from behavioural ﬁnance do suggest a couple of areas where existing legal rules should change.66 59 IOSCO report, Suitability Requirements With Respect To the Distribution of Complex Financial Products, January 2013, p. 6 et seq. 60 Market in Financial Instruments Directives, 2004/19EC of the European Parliament and of the Council of 21 April 2004 on markets in ﬁnancial instruments, 30.4.2004, OJ L 145/1-44 MiFID II 2014/65/EU of 15 May 2014 repealing Directive 2004/39/EC, 12.6.2014, OJ L 173/349–496. 61 Moloney 2008 (2nd ed.), 614; Moloney 2014 (3rd ed.) gives a good overview of the discussion considering issuer-disclosure, the Efﬁcient Market Hypothesis and behavioural insights, pp. 54–59. 62 Already Rapp 1998, p. 189, stated in relation to ﬁnancial industry standards of conduct that none is “more frequently cited, and least objectively applied, than the ‘suitability’ requirement”. 63 See http://ﬁnra.complinet.com/en/display/display_viewall.html?rbid=2403&element_id=9859 &print=1. 64 Rule 2310 is the former (since 1939) Article III, §2 of the NASD Rules of Fair Practice. 65 Trout 2005, p. 433, repudiates this approach: “Anyone who assumes the adequate efﬁciency of debiasing through individual training is either ignoring the magnitude of institutional intervention required for such educational programs, or ignoring the cognitive costs to the individual of correcting such biases. Either way, these strategies of individual training do not take seriously the best available science.” 66 Cunningham 2002, p. 797. At p. 788: “It also means that such investor education must include not only tutelage in the principles of ﬁnance and insights from behavioral ﬁnance, but also explanation of how these axioms may collide.” 230 R. Baisch This statement reﬂects this cognition but the need for some rules to be adjusted was already recognised with reference to NASD 2310.67 With the adoption of MiFID II in Europe, the potential of shortcomings which ESMA has found regarding the implementation of the MiFID I suitability requirements is going to be reduced.68 Based on supervisory experience of the provisions included in Article 35 of the MiFID Implementing Directive, ESMA suggested expanding these provisions in a number of key areas reﬂecting the expectations on ﬁnancial intermediaries already communicated in the ESMA suitability guidelines.69 The ﬁnancial intermediary does often evaluate in his own interest whether a customer is able to bear the risk of an investment. Whether a certain consumer is really aware of the risk of a particular investment or his portfolio and, in consequence, actually is really willing to tolerate this risk, is much harder to assess. A speciﬁc often missing level of ﬁnancial literacy might be inevitable to allow for such kind of evaluation. For instance, ESMA makes demands on robust processes for assessing the risk a client is willing and able to take (including their ability to bear the investment risk). The suitability process should also respect that based on behavioural research rational-choice-presumptions are to be challenged. The various biases regarding the perception of information and the validating of facts inﬂuencing investmentdecisions must be taken into account: (i) many investors are not focused on maximising proﬁt but looking for security and conservation of value; (ii) the past performance orientated marketing instruments are leading to immoderate expectations. A responsible advisor will take care of these facts and not ignore his client’s level of risk awareness to make sure that the potential losses will be tolerated. But how regulation should look like in a clearly non-advised environment? Should there be regulatory space allowing for a playground attracting gamblers and speculators? Action against abusive behaviour is by far the better approach. Even in a paternalistic world there should be scope for a niche of online-brokerage protected by appropriate warning and caution symbols – instead of prohibitive signs and bans – to avoid unintended actions of investors. 67 NASD (National Association of Securities Dealers) is the former name of the American selfregulatory organization for broker-dealers, which is now consolidated with the member regulation, enforcement and arbitration functions of the New York Stock Exchange FINRA (Financial Industry Regulatory Authority). Founded and registered with the SEC in 1939 the NASD was based on the 1938 Maloney Act amendments to the Securities Exchange Act of 1934. NASD as the one and only Registered Securities Association supervised the conduct of its members under the oversight of the SEC. Section 15A of the Securities Exchange Act of 1934 was enacted in 1938 to extend regulatory authority under the federal securities laws to the over-the-counter securities markets. NASD created a system of cooperative regulation of broker-dealers and was responsible for the adoption and enforcement of the rules to protect investors and the public interest. 68 ESMA criticised: (i) the failure to ask clients the right questions; (ii) the failure to collect the necessary and relevant information; (iii) the failure to interpret correctly the information provided by the client; and (iv) even where the right information is collected, the failure to recommend a suitable investment; http://www.esma.europa.eu/system/ﬁles/2012-387.pdf. 69 ESMA, consultation paper, May 2014, p. 132 et seq.; www.esma.europa.eu/system/ﬁles/2014549_-_consultation_paper_miﬁd_ii_-_miﬁr.pdf. 12 Nudging: Information, Choice Architecture and Beyond 12.4 231 Examples of Changes in Financial Market Regulation This implies that providing all relevant legal and technical information is not sufﬁcient by itself.70 12.4.1 European Regulation From the UCITS-KIID to PRIIPS-KID The latest procreation of Europe’s ﬁnancial markets policy makers is called PRIIPKID71 (Key Information Document) and intends to improve the quality and comparability of information provided to retail investors in the EU.72 A mandatory disclosure document, the ‘Key Information Document’, has to be supplied to retail consumers before they take the decision to invest in a ﬁnancial product. UCITS and retail AIF73 that are required by national law to provide the UCITS-KIID (Undertakings for Collective Investment in Transferable Securities, Key Investor Information Document) are exempt from the new regulation during 5 years. The intention is that then the PRIIP KID is being used for all types of products. The rules require the ﬁnancial services industry to provide basic information about their investment products, the risk and return that can be expected as well as the overall aggregate cost that will arise in making the investment. The EU proposal is a regulation on key information documents for packaged retail and insurancebased investment products (PRIP). The new regulation follows the introduction of a standardised disclosure document for investors investing in UCITS funds. The regulation states: “… retail investors have often made investments without understanding the associated risks and costs and have, on occasion, suffered unforeseen losses.”74 For products which are not simple or which are difﬁcult to understand, the KID must also include a comprehension alert which reads: “You are about to purchase a product that is not simple and may be difﬁcult to understand.”75 70 EIOPA (fn. 56), p. 7. PRIIP: Packaged retail investment and insurance-based investment products. On 9 December 2014, the Regulation (EU) No 1286/2014 of the Europe an Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs) has been published in the Ofﬁcial Journal of the European Union. 72 The regulation covers structured deposits, structured products, insurance products with an investment element (but not pension products) and funds; Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs), OJ L 352/1, 09.12.2014. 73 UCITS: Undertakings for Collective Investment in Transferable Securities; Directive 2001/107/ EC and 2001/108/EC; AIFMD: The Alternative Investment Fund Managers Directive 2011/61/EU. 74 PRIIPs regulation, pn. (1). 75 PRIIPs regulation, pn. (18): “A product should be regarded as not being simple and as being difﬁcult to understand in particular if it invests in underlying assets in which retail investors do not commonly invest, if it uses a number of different mechanisms to calculate the ﬁnal return of the 71 this figure will be printed in b/w 232 R. Baisch Risk label low risk A A B C high risk D E for a more detailed explanation of this official label, please go to wikifin.be Fig. 12.4 Belgian risk label (Financial products marketed in Belgium to retail clients, as from 12 June 2015, have to be assigned a standardized risk label. The technical requirements for the label are laid down in a Regulation by the Financial Services and Markets Authority (FSMA). Royal Decree of 25 April 2014, published in the Belgian Ofﬁcial Gazette (Moniteur belge/Belgisch Staatsblad) on 12 June 2014) The KID provides on no more than three pages the nature of the product, the risks including performance scenarios, all initial, ongoing and exit costs and certain other information. ESA’s Discussion Paper (ESA-DP)76 highlights many issues that need to be addressed in order to balance the desire for conciseness and simplicity facing the complexity of investment product’s risks and costs. An important task is to allow for comparability. Most of the document is dedicated to the especially tricky areas of risk and return disclosure and costs disclosure, which become even more difﬁcult for products that offer multiple options and/or are linked to insurance contracts. For the presentation of risk and return the ESA-DP discusses general types or ways of presenting information, considered in abstract rather than speciﬁc terms. Various concrete examples implemented or on its way in different European countries are shown to illustrate visual elements. Figures 12.4 illustrates the Belgian style: The ESA’s address consumer behaviour as one of the issues for retail investors and “in order for the KID to be easy to use by the retail investor”, they envisage that “the KID should have a clear behavioural purpose for the retail investor”77: Given this, a traditional approach to disclosures focused solely on information and with little regard to its presentation, is in being superseded in policy making by an approach that is more informed by insights into consumer behaviours. For instance, the framing of information can be considered, so as to counter cognitive biases which may distort perceptions and provide information in a way that is both simple to understand but also salient for the investment, creating a greater risk of misunderstanding on the part of the retail investor or if the investment’s pay-off takes advantage of retail investor’s behavioural biases, such as a teaser rate followed by a much higher ﬂoating conditional rate, or an iterative formula.” 76 ESA-DP (fn. 15). 77 ESA-DP (fn. 15), p. 17 et seq.; with reference to Sunstein 2011. 12 Nudging: Information, Choice Architecture and Beyond 233 consumer (i.e. capable of drawing the consumers’ attention and appearing important for the decision to be made). The PRIIPs Regulation reﬂects these considerations already at ‘level one’. With the adoption of the MiFID II/MiFIR-package there is additionally regulation in place addressing also aspects of communication with clients.78 While MiFID II at level 1 (accompanied by level 2 implementing directives and level 3 regulatory as well as implementing technical standards) focuses on suitability and conﬂicts of interests the PRIIP regulation addresses the KID. Risk Tolerance Assessment within the Scope of Suitability Requirements Already the European regulatory approach within MiFID provides for such tests; however, this was not preventing European private investors (not aware and properly informed about the issuers default risk) from losing money with Lehman certiﬁcates.79 Assessing investment suitability requires the right set of questions to cope with diverging experience, personal investment objectives as well as with individual risk-capabilities and risk-tolerances. International politics have picked up these issues as well.80 The assessment of suitability shall determine, on an individual basis, whether a client has not only the necessary expertise to trade in the speciﬁc ﬁnancial instrument, but also whether he can understand and can take the associated risks – and all of that in line with the individual ﬁnancial status and investment objectives.81 Investors are looking for predictable returns and they hate losses. Therefore, the downside-potential should be clariﬁed during the conduct with the customer; under 78 According to Art. 24 (4) (b) MiFID II the information to be provided to client shall include guidance on and warnings of the risks associated with investments in ﬁnancial instruments or in respect of particular investment strategies. ESMA’s MiFID Consulting Paper from May 2014 (311 pages, additionally ESMA published in May 2014 a Discussion paper regarding the future technical standards with 533 pages, meanwhile the consultation paper was published in December 2014, 645 pages) speciﬁes in Section 2.13 that Article 31 (2) MiFID Implementing Directive (2006/73/EC), relating to the description of risks, should speciﬁcally address the risk of ﬁnancial instruments. 79 Baisch and Weber 2015, pp. 174–180. 80 In the OECD G20 High-Level Principles on Financial Consumer Protection, published in October 2011, http://www.oecd.org/regreform/liberalisationandcompetitioninterventioninregulatedsectors/48892010.pdf,) the principle Disclosure and Transparency is stressed in section 4; the following formulation exempliﬁes that this principle is clearly understood in a comprehensive manner: “Financial services providers and authorised agents should provide consumers with key information that informs the consumer of the fundamental beneﬁts, risks and terms of the product. They should also provide information on conﬂicts of interest associated with the authorised agent through which the product is sold.” Addressing risks it is stated: “The provision of advice should be as objective as possible and should in general be based on the consumer’s proﬁle considering the complexity of the product, the risks associated with it as well as the customer’s ﬁnancial objectives, knowledge, capabilities and experience. Consumers should be made aware of the importance of providing ﬁnancial services providers with relevant, accurate and available information.” 81 According to Rapp 1998, p. 212, “the most common characterization offered is that suitability is an amorphous concept, with no accepted deﬁnition, and bereft of case law guidance”. 234 R. Baisch the regime of MiFID II and PRIIPS regulation this issues are addressed. Most investors will be more than happy to surrender part of the up-side potential when this can be combined with a cap of any potential losses. The customers risk attitude matters; therefore, the focus should not be on their risk absorbing capacity.82 The draft technical advice in ESMA’s Consulting Paper83 recommends that Art. 35 of the MiFID Implementing Directive is expanded to clarify that the investment ﬁrm should be required to provide for a suitability report to the retail client that must include how the recommendation provided is suitable for the retail client, including how it meets the client’s objectives and personal circumstances with reference to client’s attitude to risk and capacity for loss. 12.4.2 FCA and Behavioural Economics Since the FSA (Financial Services Authority) split into the PRA (Prudential Regulation authority) and FCA (Financial Conduct Authority), the idea of Behavioural Economics gained in importance. The FCA publishes occasional papers addressing also aspects of behavioural economics and argues that behavioural economics can help the regulator understand the mistakes consumers make and how ﬁrms respond to these mistakes to help FCA consider appropriate interventions. The ﬁrst of a series of meanwhile ten occasional papers84 is focused on and applies behavioural economics at the FCA, summarises the main lessons from behavioural economics for retail ﬁnancial markets and describes how to use behavioural economics in the regulation of ﬁnancial conduct.85 Effectively, this paper opened up the debate around the use of interventions like nudges in ﬁnancial services. Behavioural biases have marked effects on how people make economic decisions. These effects are particularly pertinent in ﬁnancial services where products are particularly complex, where consumers may not have much opportunity to learn about products, and where decisions often involve assessment of risk and uncertainty, trade-offs between the past and the future and emotions such as anxiety or regret.86 Especially, in the last two years the FCA embedded behavioural economics in its regulatory practice. This happened because of the perception that, with the help of sophisticated analysis of consumer behaviour, problems in markets can be identiﬁed and then those ﬁndings will help to design policy interventions. Behavioural experiments are one of the tools regulators can use to support practical behavioural analysis. This methodology makes it possible to study how consumer behaviour 82 Baisch and Weber 2015, pp. 172–174 and pp. 182–187. CP May 2014 (fn. 71), p. 132 et seq. 84 Available at http://www.fca.org.uk/your-fca/list?ttypes=Occasional+Papers&ssearch=. 85 FCA-OP 1 (fn. 17). 86 FCA-OP 1 (fn. 17), p. 51. 83 12 Nudging: Information, Choice Architecture and Beyond 235 varies across different contexts, and to identify the causes of these variations with far higher level of conﬁdence than simply observing consumers’ choices in the market. The FCA chief executive Martin Wheatley clariﬁed the role behavioural economics is playing in assisting the FCA advance its competition objective by saying “…what we’ve had over the years is a perfect storm of conditions eroding competitive pressure” and mentioning “bounded willpower and rationality” on the buy side as well as “moral failures on the sell side – knowingly exploiting consumer biases”. With the help of behavioural economics FCA aims to break the “link between poor products and high ﬁnancial reward”.87 Instead of the traditional FSA-style enforcement of conduct rules, the FCA has developed a new basis for intervention in the name of consumer protection based on a wider scepticism about the efﬁciency of markets. Therefore, the means of smart disclosure accepting the insights of behavioural economics led to a revisiting of requirements on disclosure and marketing promotions like demonstrated with the PRIIP regulation. 12.4.3 Good Practices on Information Provision for DC Schemes The EIOPA report88 found that substantial improvements can still be made to information a provision that is meant to support members in their retirement planning; the provision of sufﬁcient legally and technically relevant information has proven to be ineffective. Information requirements are discussed based on the exploration of good practices in different member states as well as the translation of insights from behavioural economics and communication science. Because of the tendency of governments to reduce public pension schemes and the shift from DB (designed beneﬁt) to DC (designed contribution) employer schemes, increasingly risk and responsibility for individual retirement planning are passed onto the consumers. In some countries ﬁrst pillar pensions (often ﬁnanced pay-as-you-go) tend to become less generous due to the age pyramid and demographic change. Simultaneously second pillar pensions tend to become more risky (bringing less interest). The report clearly states that the provision of information is not sufﬁcient by itself because people tend not to cope rationally with risks and, therefore, have great difﬁculty planning for retirement. The report postulates a shift towards the insight that a legal purpose of information provision is inadequate because people need ﬁrst and foremost key information. The new approach to information provision is neither focusing on the perspective of 87 Making competition king – the rise of behavioural economics at the FCA, Speech by Martin Wheatley, Chief Executive, the FCA, at the Australian Securities and Investments Commission (ASIC), March 2014; available at http://www.fca.org.uk/news/making-competition-king. 88 EIOPA (fn. 56). 236 R. Baisch the market nor just aiming to comply with legal purposes. Legal information is necessary, and has to be disclosed in an appropriate way, however, information should support people in making ﬁnancial decisions. Therefore, less is more and the format is essential, because many readers will turn away from information if they do not quickly understand how it is relevant to them and how they should translate the information into ﬁnancial decisions.89 The information provider has to realise and accept that the readers lack motivation and time.90 On the way to IORP II (institutions for occupational retirement provision) it will have to be seen how much of these insights remain in the ﬁnal text. In March 2014, the European Commission published a proposed revision of the IORP Directive, IORP II.91 Smart information matters regarding the PBS (pension beneﬁt statement). The proposal would introduce a standardised PBS at EU level with simple and clear information about the individual pension entitlements to support informed decision-making about pension adequacy (answering the question and investment strategy. The PBS will contain both personalised and generic information about the pension scheme according to a standard template of two pages with a view to helping individuals take decisions regarding their retirement planning. 12.5 Practical Applications Whereas it is assumed that information leads to understanding, to the willingness to act and subsequently to appropriate actions, this appears most often not the case.92 12.5.1 Key Investor Document: Disclosure as a Nudge The EU regulatory response to the insights how information should be presented to consumers can be seen within the PRIIPS regulation (Sect. 12.4.1 above). This development was inﬂuenced by the behavioural research. As mentioned in the beginning nudges may make their appearance in various forms and for ﬁnancial products a well-designed leaﬂet is essential. Sunstein explores 89 EIOPA (fn. 56), p. 9. Helleringer 2015. 91 Available at eur-lex.europa.eu/resource.html?uri=cellar:33cb1b95-b6c8-11e3-86f9-01aa75ed71a1. 0002.01/DOC_1&format=PDF. 92 EIOPA (fn. 56), p. 8. 90 12 Nudging: Information, Choice Architecture and Beyond 237 the uses of disclosure as a behaviourally informed regulatory tool. It is important to distinguish between summary disclosure, often provided at the point of purchase, and full disclosure, typically provided on the Internet. A central point is that disclosure policies should be based on an understanding of how people process information.93 Looking at necessary information for the evaluation of ﬁnancial product risk and cost jut out. The regulatory efforts in Europe foster a clear disclosure of any kind of administrative cost in connection with the purchase of an investment product94 and present an answer on how to present risk and return.95 Sunstein stresses the importance of “plain language, clarity, and simplicity”.96 And this is important regarding not only risk and return, but also the cost structure of a product. However, “accurate disclosure of information may be ineffective if the information is too abstract, vague, detailed, complex, poorly framed, or overwhelming to be useful”.97 Whether the three-page A4 standard format KID really helps (i) to understand and compare PRIIPs, (ii) to estimate the total cost of the investment as well as (iii) to raise awareness of the risk-reward proﬁle will depend on the consumer’s willingness to process this information. Perhaps the most challenging task will be to ﬁnd a solution to the question how the complex structures that may sit behind PRIIPs can be broken down and explained in order to correctly state their likely return and risks in a consistent manner. However, this is being left to the Level 2 or 3 measures. Presumably, the KID will optimise the documentation for ﬁnancial products sold to retail investors and, hopefully, this is the way how to regulate disclosure avoiding information overload but using it as a nudge. However, analyses have revealed that there is still a large fraction of investors that is not able to understand the information presented.98 In the face of information overload and the widespread unwillingness of investors to take note of information, EU-regulators introduced the KID. The scepticism remains: will a retail investor really process that information? And based on the behavioural ﬁndings: may things go wrong anyway?99 93 Sunstein 2014b, p. 727. See Article 33 of the level 2 MiFID-ID (MiFID Implementing Directive, Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment ﬁrms and deﬁned terms for the purposes of that Directive, 2.9.2006, OJ L 241/26–58) regarding the obligation to inform clients about costs. 95 ESA-DP (fn. 15), p. 21 et seq. 96 Sunstein 2014b, p. 728. 97 Sunstein 2014b, p. 729. 98 Walther 2015, p. 145. 99 “Traditional failures are often addressed by information provision or disclosure: to mitigate asymmetric information, to reduce search costs and limit market power, and to remedy the underprovision of a public good. But mandated information provision may be an ineffective remedy if consumers either do not understand the information or believe that it is not relevant to their decisionmaking. For example, if consumers mistakenly believe that they will pay their credit bill on time every month, clear and transparent disclosure of late fees and interest rates may not change behavior because consumers deem the information irrelevant at the time they make a purchase.” See Campbell et al. 2011, p. 95. 94 238 12.5.2 R. Baisch Classification of Customers The EU-regulation distinguishes between professional and retail investors allowing for opting in and out. This categorisation can be seen as a default rule; default rules are another good example how nudging can ease choices. Further classiﬁcations based on income, fortune and experience are conceivable. Part of the complexity of effective retail market regulatory intervention is to identify the typical retail investor and to look at the approach to investment decisions. As mentioned (above Sect. 12.2.3) the FCA has introduced additional investor types, the sophisticated investor and the high net worth investor. Due to the fact that self-certiﬁcation is allowed, it is possible to opt out from the tighter investor protection regime for normal retail investors.100 The introduction of sub-divisions to further classify retail investors and then to scrutinise ﬁnancial products to ﬁnd out which product should be made available to which category might not seem to be preferable because clients are too disparate to be pigeonholed.101 The question is whether a national ﬁnancial authority or for instance ESMA in Europe is capable enough to act against hazardous ﬁnancial products, which anyhow should not pass the suitability test.102 Therefore, it could be argued that the regulator should focus on conﬂict of interest issues and proper suitability-tests with simultaneous consideration of ways to optimise disclosure and appropriate actions to avoid unfair advertising practices. 12.5.3 Automatic Enrolments and Active Choice With regard to pension schemes the question arises how much a state shall rely on individual decisions to avoid poverty among the elderly. Many states know mandatory schemes but often such funds hardly cover even basic needs. A lot of research has been done to ﬁnd out what helps to motivate individuals to save for their retirement.103 Reduced or downstream taxation is quite common to incentivise saving. Various combinations of active or passive choices can be found. Subsidies for any kind of retirement accounts rely on individuals to take action and save on a regularly basis. What might happen is that this only induces individuals to shift assets from taxable accounts to retirement accounts. Policies that raise retirement contributions if individuals take no action such as automatic employer contributions to 100 Financial Services and Markets Act (Financial Promotion) Order 2005 Art. 48 and 50A. In other areas than investment decisions the so-called choice architecture may help more. In the U.S. the automatic enrolment in pension schemes is widely discussed. See with further references Lusardi and Mitchell 2014, 34. 102 However, the grey capital market, closed-end funds and investment companies will remain a challenge. 103 See references in Benartzi et al. 2013. 101 12 Nudging: Information, Choice Architecture and Beyond 239 retirement accounts increase wealth accumulation substantially.104 In contrast, tax incentives often are motivating especially those who would anyhow save. Traditional policy incentives like tax deductions address rational actors maximising their utility. The behavioural approach adds incentives which are nudging biased individuals.105 Therefore, to increase saving ratio from low and average earners often only paternalistic rules will ensure the wanted result.106 While defaults may have a positive inﬂuence on consumer decisions, a practical alternative to defaults, requiring individuals to make mandatory explicit choices might be better in many cases. To make active decisions mandatory is optimal when consumers have a strong propensity to procrastinate because savings preferences are highly heterogeneous.107 It ﬁts well in this picture that an analysis of the recognised Swedish pension system observes that major changes in retirement savings behaviour require clear signals and relatively intrusive instruments to affect behaviour and suggests strong penalties for non-compliance rather than just nudges.108 12.5.4 Nudging the Advisor Against the background of independent advice, retrocessions and similar payments from product produces towards investment advisors or portfolio managers were getting more and more disreputable.109 Slack regulation was common in the problematic ﬁeld of inducements, which are causing conﬂicting interests; the effect of utility maximisation – thereby motivating bankers to create and sell products which are not in the best interest of their clients – was misjudged. Certainly the consumer needs clear information about the cost structure of products to compare them. However, there are other areas, where rational behaviour must be intensively kept in mind: advisors will always be tempted to sell a product when they can maximise their compensation. All kinds of inducements and incentives like trailer fees, retrocessions and other commissions used to be common as means of sales promotion in the banking and fund industry. Conﬂicts of interest are to be monitored to the extent such payments may inﬂuence investment advisory and portfolio management services. Long-term considerations should actually lead to recommendations triggered by the hope for satisﬁed customers, while short-term temptations might result in preferring a good salary and high bonuses. What is true for an individual advisor himself at the POS is also true for banks and other ﬁnancial intermediaries as a whole or for a certain division. Especially MiFID II strengthens the independence of investment advice 104 Chetty et al. 2013. Cartwright 2014, p. 519. 106 Bronchetti et al. 2013. 107 Carroll et al. 2009, p. 1669. 108 Weaver and Willén 2014. 109 Baisch and Weber 2015, p. 161 and pp. 171–172. 105 240 R. Baisch and portfolio management services.110 Gone are the times when undisclosed fees were helping to line one’s pockets. However, looking at international regulatory activities, huge differences exist; some regulators aim to eliminate such kind of payment ﬂows at all for independent advice, others just demand a full disclosure approach. While for many investment products like shares or bonds an efﬁcient formation of prices – liquid markets presumed – is at least not impossible based on Modern Finance Theory, in contrast, many of the structured products do not facilitate a clear price evaluation.111 Additionally, the advisor and the advised have both to cope with human limitations. Shefrin argues112: Kahneman (2011) might say that the judgments of portfolio managers and analysts reﬂect subconscious System 1 (intuitive) thinking, even though the principles they articulate reﬂect System 2 (conscious) thinking. Elements of the planning fallacy, also discussed by Kahneman (2011), strike me as being part of this story. These elements involve underweighting or ignoring base rate information (…) when making predictions about future returns, and overweighting singular (ﬁrm speciﬁc) information. What kind of additional nudges at the point of sale are possible? Salience and simpliﬁcation embedded in of a Code of Conduct could lead to better investor protection to establish a fair treatment of customers. The approach towards POSregulation for ﬁnancial intermediaries should be based on the enforcement of a Code of Conduct, assuming that a biased behaviour is shown by retail investors. Particularly the mandatory suitability or appropriateness tests113 prior to any investment advice as well as an on-going assessment of the suitability of the recommended ﬁnancial instruments embracing also loss-aversion and attitude towards risk features is an area where the outcomes of behavioural research can be applied. The need to counteract conﬂicts of interest is also part of the sales process regulation. 12.6 Conclusion One word of caution, however. Human behaviour and nudges, in particular, are a notoriously complex equation. Inputs and outputs do not always correlate. 110 Art. 24 MiFID II. According to Hens and Rieger 2008, 27 most of the common structured products do not “follow rational guideline, but instead use behavioral factors, like loss-aversion or probability misjudgement to be attractive in the eyes of potential investors”. 112 Shefrin 2014, p. 19. 113 While suitability contains a link to present as well as future aspects, appropriateness mainly reﬂects the past. Based on detailed conduct of business rules for investment ﬁrms in combination with the just discussed transparency requirements these tests are realising the general obligation to act fairly, honestly and professionally and in accordance with the best interests of the client – previously known as ﬁduciary duty. 111 12 Nudging: Information, Choice Architecture and Beyond 241 Nor are they predictable.114 Regulatory requirements and industry standards establishing an environment where customers are treated according to their individually assessed risk attitude constitute the best precaution against negative outcomes of human ﬂaws when making ﬁnancial decisions. However, there is a potential barrier to obtaining acceptance with this approach to suitability because the widespread rejection of paternalistic regulation which still has the model of a reasonable investor in mind. Therefore, any kind of provision should be avoided which too paternalistically overrides people’s ability to make choices. Recognising human limitations because of the complexity of ﬁnancial decision making should not lead to a reduction of choices and investment opportunities for those customers who can handle the complexity or just like to gamble.115 Despite the fact that suitability requirements are problematic in terms of supervision and enforcement,116 it should be possible to protect those deserving protection without harming the others. To comply with sound governance structures reputable market participants will behave accurately and in line with the requirements like it is stated in the respective IOSCO principles: Whenever an intermediary recommends the purchase of a particular complex ﬁnancial product, including where the intermediary advises or otherwise exercises investment management discretion, the intermediary should be required to take reasonable steps to ensure that recommendations, advice or decisions to trade on behalf of such customer are based upon a reasonable assessment that the structure and risk-reward proﬁle of the ﬁnancial product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.117 Given that many consumers struggle to maximize their own welfare, the question remains whether regulators can do better. When regulating code of conduct requirements, the presumed preferences of the majority of consumers should be reﬂected. The challenging question is: what would they do were they fully informed and well advised?118 This is the challenging task for the law. Ulen119 phrased it this way: “Law – by taking due account of these predictable, routine deviations from rationality – can better inﬂuence behaviour to realize both social goals and to help individuals better enhance their well-being.”120 (Fig. 12.5) This is not only true for any kind of choice architecture but also for more paternalistic forms of regulation. Focusing on areas where there is strong evidence of 114 Speech Wheatley (fn. 90). See Jolls 2006, pp. 39–40. 116 Moloney 2010, p. 243, advocates mystery shopping. For a practical example see FSA, Assessing the quality of investment advice in the retail banking sector: A mystery shopping review, February 2013, <www.fca.org.uk/static/pubs/other/thematic_assessing_retail_banking.pdf>. 117 IOSCO, Suitability Requirements With Respect To the Distribution of Complex Financial Products Final Report, January 2013, Principle 5. 118 Campbell et al. 2011, p. 95. 119 Ulen 2014, p. 120. 120 See also Mitchell 2014, pp. 182–184, regarding the interaction of behavioural law and economics with legal norms. 115 this figure will be printed in b/w 242 R. Baisch Fig. 12.5 Geared to consumer’s needs self-harm (including ﬁnancial losses) while limiting the inﬂuence of political beliefs and encouraging active and lively discussions will help to improve ﬁnancial market regulation.121 Additionally, the potential trade-off should be kept in mind which might occur undesirably if defaults reduce the incentive to gather information.122 Kahneman’s analysis of human thinking can give the impression that human naivety and simple-mindedness is overemphasised.123 Therefore, Gigerenzers’s approach to value the positive outcome of simple rules of thumb or similar mental shortcuts might complement to an optimised cognition and perception of human behaviour as it should be imputed to individuals when designing regulation.124 Pushing it a bit, according to Kahneman individuals are desperate in thrall to all kinds of fallacies, which fosters the call for paternalism. Nudge theory should not weaken the motivation of individuals to actively inform them. It must be said that education could, at least partially, compensate negative outcomes of human ﬂaws. Gigerenzer proposes that with the teaching of critical thinking about statistical probability and heuristics individuals can get more risk savvy.125 Based on such an enhanced level of ﬁnancial literacy consumer then are better able (i) to comprehend investment risks, (ii) to accept that a certain level of it is unavoidable in combination with given return expectations and ﬁnally (iii) tolerate potential losses. 121 Glaeser 2006, p. 156. Carlin et al. 2013. 123 Kahneman 2011. Neuroscientist Gazzaniga 2011 tackles the question, why individuals feel so in control despite the range of automatic and deliberative factors that underlies their choices. 124 Gigerenzer 2014 (2013), p. 30; see also his comment in chapter 2 fn. 14. 125 System 1 (fast, instinctive and emotional), as Kahneman describes it, might lead in some cases even to better solutions then System 2 (deliberative and logical) because System 2 is susceptible to the misjudgement of probabilities due to limited working memory and brain power and a widespread simple lack of statistical knowledge and mathematical ignorance. 122 12 Nudging: Information, Choice Architecture and Beyond 243 Enhanced prevention based on smarter information requirements will give consumers a better chance to avoid human ﬂaws. Combined with a strict Code of Conduct at the point of sale, a Suitability Test including the real risk perceptions of the consumer leads to an enhanced level of investor protection. 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