Behavioral Economics and Financial Regulation David S. Evans Privileged and Confidential November 14, 2011

BEHAVIORAL ECONOMICS (AND WHY YOU SHOULD CARE) November 14, 2011

Behavioral Economics Combines Economics and Psychology November 14, 2011 How do people actually behave?Why do they behave that way? What are the implications for markets?

Behavioral Law and Economics Applies BE to Regulation November 14, 2011 Consumers make mistakes Businesses take advantage of consumer mistakes Government can help consumers by preventing consumers from making mistakes or businesses from relying on these mistakes

Behavioral Economics Has Come to Town November 14, 2011 Cass Sunstein Director, OIRA, White House’ Founder of Behavioral Law and Economics Co-author of “Nudge” Sendhil Mullainathan “Chief Economist” CFPB Leading behavioral economist Co-author of leading paper on BE regulatory intervention in financial markets

Why Should You Care? November 14, 2011 Provides regulators new set of tools Lawyers will be dealing with behavioral economics at regulatory agencies Businesses will need to consider behavioral economics based regulations

KEY FINDINGS OF BEHAVIORAL ECONOMICS November 14, 2011

After Several Million Years You’d Think We’d Be Smart November 14, 2011

But Behavioral Economics Finds People Aren’t So Smart… People are influenced by baselines (inertia) People have limited attention and make mistakes as a result of simplifying complex problems. People aren’t very good at math “Cross-cutting Biases” People are overconfident in ability to stick to plans such as saving People are overly optimistic about themselves and their futures “Expectation Biases” People have trouble doing present value calculations How choices are framed heavily influences decisions The presence of other options can bias choices People reject all choices if there are too many “Price and Valuation Biases” People “live for today” expecting to be more patient tomorrow but then tomorrow is today People place more value of items in their possession than the same item not in their possession “Preference Biases” November 14, 2011

Cross-Cutting Biases November 14, 2011 People are influenced by baselines and are subject to inertia People have limited attention and make mistakes as a result of simplifying complex problems. People aren’t very good at math

Expectation Biases November 14, 2011 People are overconfident in ability to stick to plans such as saving People are overly optimistic about themselves and their futures

Price and Valuation Biases November 14, 2011 People have trouble doing present value calculations How choices are framed heavily influences decisions The presence of other options can bias choices People reject all choices if there are too many

Preference Biases November 14, 2011 People “live for today” expecting to be more patient tomorrow but then tomorrow is today People place more value of items in their possession than the same item not in their possession

Perhaps Its All Been Said Before An 1884 editorial in Scientific American discussed “the curious processes of reasoning” that women used in deciding to buy a sewing machine on an installment plan. The author discovered the “psychological fact, possibly new,” that women “will rather pay $50 for a machine in monthly installments of five dollars rather than $25 outright, although able to do so.” November 14, 2011

BEHAVIORAL ECONOMICS BASED REGULATION November 14, 2011

Helping People Help Themselves November 14, 2011 Make sure people have the right information for basing decisions Make people get that information in a way that reduces their costs of making right decisions Make sure information is presented in a way that requires the least math etc. skills

Soft Paternalism November 14, 2011 Figure out what the “right” decision is--the one a “rational well-informed” person would make) Nudge people towards making the decision “WE” think is right

Hard Paternalism November 14, 2011 Figure out what the “right” decision is-- the one a rational well-informed person would make Prevent businesses from offering options that would result in consumers making the “wrong” decision Preventing consumers from making “wrong” choices

Reasons to be Skeptical of BE- Based Regulation November 14, 2011 Existence and degree of biases still controversial Market importance of cognitive failures disputed Regulatory cures may be worse than disease Regulators are imperfect humans too

Not so Easy Problems Perhaps November 14, % Payday loansAdvertisements for gold coinsNudges to invest in 401-k plans

CFPB AND APPLICATION TO FINANCIAL MARKETS November 14, 2011

Behavioral Foundations of CFPB Regulation November 14, 2011 People have “systematic cognitive failures” Market incentives drive business to offer products designed to “exploit” these failures Regulatory response favors products that minimize consumer “mistakes” from those failures Experiments, surveys, and statistical analysis can help guide “evidence- based regulatory” analysis

Sample “Problems” in Financial Services November 14, 2011 Consumers make impulsive borrowing decisions Consumers overly optimistic about paying things off Consumers borrow too much and pay too much because they underestimate cost of financing Financial institutions frame choices, add complexity and provide defaults to encourage people to make “bad” decisions Competition among financial institutions can’t fix these problems

Preemptive Design Principles Transparency: Make It Clear Honesty: No Tricks and Traps Research: Test for the Best Helpfulness: Help People Help Themselves Simplicity: Keep It Simple November 14, 2011

CONCLUSION November 14, 2011

Concluding observations November 14, 2011 Behavioral economics is probably here to stay Can provide useful tools to regulators and business people Should come with all the “buyer beware” warnings as any part of economics Opens door for very paternalistic regulation which raises both economic, legal and political issues

THANK YOU! November 14, 2011