Sunday, February 12, 2012

Financial Literacy & Consumer Behavior: Can a Nudge work better than a School Book--or a Government Regulation?

Advocates for improved financial literacy suffer from a clear dilemma. Almost everyone supports that idea that all consumers need to be financially literate so that they can make informed decisions. Yet very few of financial education programs have proven effective in improving the levels of financial literacy.

A comprehensive review of the success of financial literacy education programs was conducted by Lauren Willis, Professor of Law at Loyola Law School and published in 2008. In study after study, Professor Willis came to the conclusion that financial education is not worth the investment. She found that education in financial literacy did not make individuals better able to make sound decisions in their use of financial services. Furthermore in some cases, the training provided a false level of confidence, encouraging investment in speculative stock market deals.

However the real problem is that even financially literate consumers can make “bad” economic decisions.

It may therefore be time to think about alternative approaches. In their 2009 book, Nudge: Improving Decisions About Health, Wealth, and Happiness, Richard Thaler and Cass Sunstein show how “choice architecture” can be established to nudge consumers in beneficial directions without restricting their freedom of choice.

Decisions about retirement planning provide a good case in point. Most people do not save enough money for retirement. In the U.S., data was collected of households with a 401(k) retirement account and where the primary earner was between 60 and 62. The study found that median households had saved less than one-quarter of what is needed to maintain income at the 85% pre-retirement level (according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.)

However a 2007 paper by the Vanguard Center for Retirement Research found that where new employees are automatically signed up in employer-supported pension plans (i.e. the 401(k) defined-contribution matching plans found in the U.S.), 86 percent stay in the plan, even when they have the option to opt out and withdraw from the plan. By contrast, when new employees are informed about the corporate pension plan and merely invited to join, only 45 percent do so. However the employees that were automatically enrolled were three times more likely to allocate all of their contributions to the default investment fund than were those investing in voluntary plans (67% versus 21%).

The implications are obvious. Since almost everyone will need a pension plan when they retire, the “default” option should be to register all new employees in the plans. But more still will be needed. The U.K. provides some intriguing ideas.

With Professor Thaler and a U.K.-based research team, the U.K. Government has established a Behavioural Unit Team (BIT a.k.a. the Nudge Team). They have not yet started working on consumer protection in financial services but their annual report for the first year provides some interesting ideas that might be applicable for financial consumer protection.

On public sector reform, BIT proposes two approaches. First, BIT suggests using transparency and feedback loops from users. Comments from other consumers can have a powerful impact on selection of choices as anyone who has used eBay, Amazon or Yelp can attest. Safe and Fair Finance Blog suggests that the difficulty is to ensure that feedback loops are not abused—by disgruntled former employees or the marketing staff of competitors. However well-designed consumer feedback sites can help consumers express their views of the quality of the customer experience in buying and using financial services and products.

Second, BIT suggests that whistle-blowers be encouraged. Regulators can be blind to the problems that can only be seen from the inside of a business or service. Providing rewards to whistle-blowers can help bring the issues to the surface. The amount of the rewards should be based on evidence that allows for the identification of significant harm to consumers. Safe and Fair Finance Blog suggests that encouraging whistle-blowers in the mortgage brokers to come forward might have helped save millions of consumers from toxic subprime borrowings.

Cutting red tape and reducing regulation is a goal for all governments. Such efforts are more likely to succeed when policy-makers (and industry and consumers) can identify an alternative process that delivers the same result—or better.  Safe and Fair Finance Blog suggests that both ideas from BIT might prove to be powerful not just for public sector reform but also for improvements in consumer protection related to financial services.

Safe and Fair Finance Blog would like to thank Tim Harford (a.k.a. the Undercover Economist) of the Financial Times for his opinion article about the Nudge Team and their valuable work.

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Tuesday, February 7, 2012

Financial Education in Pakistan: Will it work to increase financial inclusion?

For all its popular support, financial education needs to be very carefully evaluated. As part of a nationwide program launched last month, the central bank of Pakistan (known as the State Bank) started a pilot financial education program targeting poor and marginalized populations. About 50,000 low-income households will receive training in six areas: (1) budgeting, (2) savings, (3) investments, (4) debt management, (5) financial products, including branchless banking, and (6) consumer rights and responsibilities. The training materials will be translated into the national language as well as the five main regional languages, Urdu, Sindhi, Punjabi, Pushto and Balochi. Following completion of an independent assessment, the program will be expanded to 500,000 beneficiaries.

The training programs will be complemented by consumer awareness campaign using such novel approaches as street theater, board games, comic strips and activity-based competitions. Website and media campaigns will also be used.

The issues are important for financial inclusion. The State Bank has found that only 12 percent of Pakistani households use formal financial services, with the balance relying on unreliable informal arrangements. Of those outside the formal financial system, 40 percent cite lack of understanding of financial products as the main reason for not using financial services.

Safe and Fair Finance Blog supports this initiative by the State Bank of Pakistan but recommends that its impact be carefully evaluated. Research by Shaun Cole, Thomas Sampson and Bilal Zia on effectiveness of financial education programs show that low-income households benefit from basic financial training. However financial education is generally an expensive process with unclear results. Cole et al found that a more cost-effective approach is to give low-income households a small amount of money – if they open a basic bank account. All this suggests that the evaluation by an independent third-party will be a critical part of making the nationwide program as effective as possible. That assessment should look at more than just the issue of whether the trainees better understand financial products. The evaluation should also try to determine if households receiving training in personal and household finance are more likely to use formal financial services that those not receiving such training.

However financial education cannot solve problems due to weak regulation. Safe and Fair Finance Blog recommends that a systemic review of the financial consumer protection laws and regulations compared to international practice also be conducted and published.

* Cole, Shawn, Thomas Sampson, and Bilal Zia. 2009. “Financial Literacy, FinancialDecisions, and the Demand for Financial Services: Evidence from India and Indonesia”. Harvard Business School Working Paper 09-117
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Sunday, February 5, 2012

Is Facebook using your Personal Data?

Part of consumer protection in financial services relates to protection of personal data – how financial institutions use and share the data and how consumers can correct inaccuracies. Today’s The New York Times article, "Facebook is Using You", describes how data aggregators collect and share consumers’ data without advising consumers of the use of such data. If this happens with Google searches, email and Facebook pages, can consumers be assured that personal data is not similarly abused by financial institutions?
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Friday, February 3, 2012

Banks should not be allowed to use an Inaccurate Data-base to evict Homeowners

Earlier this week, Safe and Fair Finance Blog wrote about Hernando de Soto’s article on the need to clean up public registries of assets, in particular the US electronic registry of mortgages known as MERS. The registry remains a mess. It holds an estimated 60 percent of all residential mortgages in the U.S., i.e. about 70 million individual loans. Yet the MERS records are widely believed to be less than accurate.

On Friday, New York State Attorney General Eric Schneiderman filed a lawsuit against MERS and three banks -- Bank of America, J.P. Morgan Chase and Wells Fargo. The complaint accuses MERS and the banks of engaging in “deceptive and fraudulent practice.”

The complaint under the lawsuit identifies six specific ways in which homeowners and the public have been harmed by MERS.
  1. By bringing foreclosures without proper legal standing, MERS subjected homeowners to improper foreclosures;
  2. By submitting to the court invalid assignments of mortgages, MERS obtained foreclosure judgments through fraudulent and illegal means;
  3. By making misrepresentations regarding the identity of the holder of mortgage notes, MERS undermined the integrity of the court system and impeded the ability of homeowners to present legal defenses;
  4. By creating foreclosure  judgments for entities that did not hold the notes, the actions of MERS created invalid liens and clouds on title, thus subjecting foreclosure victims to the risk of monetary judgments by the true holders of the notes;
  5. By creating mortgage assignments by MERS employees who were not adequately trained or supervised, MERS misled and deceived homeowners and the courts; and
  6. By obscuring the identity of the beneficial owners of mortgages and the chain of title, MERS deprived homeowners and the public of the ability to determine true property ownership through publicly available records.
One wonders how it was the MERS was created – and allowed to continue to operate.

Financial innovation in the 1990s allowed residential mortgages to be easily bought and sold by financial institutions. The traditional way of recording changes in ownership was a visit to the county clerk, where for a fee of $30 or so, the seller could record the sale of the mortgage to a buyer. With the securitization of residential mortgages into mortgage-backed securities, such re-registrations became cumbersome. The major mortgage banks got together and created a private registry – Mortgage Electronic Registration Systems or MERS – to act as the holder of record of the mortgages. The problem was that MERS had weak governance. With a staff of under 100 employees, and no legal responsibility to ensure the accuracy of its records, MERS hired employees from its member firms to certify the loan documentation.

However MERS remains a private registry. Even homeowners cannot obtain reliable information from MERS on which financial institution legally holds their mortgage. So when it is time to try to find someone in the bank who is authorized to discuss a modification of the loan … there is no one to be found. More accurately, there is often no one who is sure which financial institution has the authority to modify the loan.

In this environment, no amount of financial incentives will be effective in helping homeowners renegotiate their home loans.

In the opinion of Safe and Fair Finance Blog, this is simply a mess. Surely as a starting point, a public registry should be established for all new residential mortgages. The registry should be run by a government agency, operating with clear rules of corporate governance and an electronic data-base accessible to the public at no charge.

For the existing mortgages, financial institutions should be obliged to accurately reconstruct the legal records before initiating any foreclosures. Alternatively financial institutions might be encouraged to offer all existing clients a discount on the monthly payment if they are willing to provide the legal documentation for the mortgage and submit it to the new public registry. Finally all mortgage lenders should be obliged to set up special departments to deal with existing murky mortgages until all have finally been repaid. 

If nothing is done, it is likely that the threat of foreclosures -- invalid or not -- will continue to hang over the residential real estate market. Such uncertainly makes it difficult for the real estate market to become efficient. It is also a question of fairness in the way that financial institutions treat their retail customers.

Safe and Fair Blog would be interested to hear your views on how to solve this problem in a way that helps financial consumers while maintaining the soundness of the financial sector. This is a problem that certainly will not go away very easily.
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Have Financial Markets Colluded once Again against Consumers?

Advocates of protection of financial consumers might be interested in recent news about the Swiss probe of LIBOR rates. Today the Swiss Competition Commission, COMCO, announced that it has opened an investigation against 12 international banks asking about possible manipulation of LIBOR rates.

The London interbank offered rate (or LIBOR) has been used for decades as a reference rate for short-term bank loans to businesses. With the growth of consumer finance, particularly over the last twenty years, LIBOR has also become the most commonly used base rate for the calculation of variable rate residential mortgages, particularly in the U.S.

Originally LIBOR was calculated by asking (at 11 am London time each day) a group of about eight major banks what they would charge to lend to each other. The highest and the lowest rates were thrown out and an average was calculated using the remaining six banks.

In the early 1980s, traders also started using LIBOR to calculate interest rate swaps and other “derivatives” of financial instruments. In 1984, the British Bankers Association (to its credit) stepped in and developed a more formal system for calculating LIBOR rates. Since then the market for financial derivatives has exploded into $615 trillion, according to the Bank for International Settlements. Gazillions in laypersons' terms.

In its official statement, COMCO said that, “Collusion between derivative traders might have influenced” Libor and its Tokyo-based equivalent, Tibor, “coordinating their behavior, thereby influencing these reference rates in their favor.”

COMCO further noted that, “Market conditions regarding derivative products based on these reference rates might have been manipulated too… Derivative traders might have colluded to manipulate the difference between the ask price and the bid price of derivatives based on these reference rates to the detriment of their clients.” In total, 12 banks have been named including UBS and Credit Suisse

This is serious stuff.

It is also potentially very important for anyone who has borrowed – or plans to borrow – a residential mortgage at adjustable interest rates. Collusion among market traders could result in borrowing rates that are higher than the market would otherwise determine – and this hurts anyone who is planning to sell their house or struggling to pay off a home loan.

Safe and Fair Blog argues that financial markets should safe, fair and competitive. Collusion among traders in the marketplace undermines competition. It just ain't fair.

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Thursday, February 2, 2012

Can Financial Education save Capitalism? The View after Eight Centuries of Financial Folly

Readers of Safe and Fair Finance Blog will be pleased to see intellectual support from an unexpected source. Kenneth Rogoff was formerly head of economic research of the International Monetary Fund. He is now professor of economics at Harvard University. In 2009, he co-authored with Carmen Reinhart the ground-breaking book on financial crises, This Time is Different: Eight Centuries of Financial Folly. Their book has become the bible of economic long-term forecasters.

In his February 1st letter to the Financial Times, Professor Rogoff comments on recent commentaries about the future of capitalism. He notes that. “Entrepreneurs who have earned billions, world leaders who have spent trillions, journalists, academics, and even ‘Occupiers’ have all weighed in.”

He notes that even China’s recent economic successes are not sustainable. “Creating impressive infrastructure eventually runs into diminishing returns, as evidenced by the history of Japan and the Soviet Union,” and he might have noted the U.S. in the 19th century.

Professor Rogoff also emphasizes the point made by Martin Wolf that “contemporary capitalism, which does such an extraordinary job of generating a cornucopia of private goods, is far less effective at generating public goods, whether it be education, infrastructure, environment or financial stability.”

The question is how to strike a balance that creates a wealth of both private and public goods. His solution is education. He points to the arguments made by David Rubenstein of the current inadequacies of primary and secondary education, as well as the need to re-educate and retrain adults.

However Professor Rogoff goes much further, arguing that, “Societies need to find ways to make adult education, including economic and financial literacy, far more available and far more compelling… The idea that the masses are indifferent to education, and that any broader notion of literacy beyond the three R’s (reading, writing and arithmetic) is a hopeless cause, is nonsense.” He further notes that, “As someone who has spoken to all kinds of people in the wake of the financial crisis, my sense is that most citizens are starved of information, and would consume it hungrily if offered in a palatable form.”

Starved of information on economic issues and personal finance—that is the plight of the vast majority of the population is today’s economies. However it need not be the case.

Professor Rogoff lays out a few suggestions: (1) attractive web learning platforms, (2) expanded public radio and television, and (3) greater educational choice for children. These are all useful programs but far more is needed. Follow Safe and Fair Finance Blog for more ideas.

Safe and Fair Finance Blog argues that financial education, contributing to improved levels of financial literacy, is an essential element in staving off the next financial crisis. Without both improved financial literacy and financial consumer protection, the next decade will become the subject of Professor Rogoff’s next book, How we Failed to Learn the Lessons of the Last 80o Years of Financial Crises.

As Professor Rogoff concludes, “Improved education alone will not resolve the flaws inherent in today’s capitalism, but it is an essential first step down any path to a solution.” Safe and Fair Finance Blog can only agree.
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