Those of us who work in the financial industry — or study it as financial economists — know how important finance is to the functioning of a modern economy. People need finance to make payments, to smooth spending in the face of fluctuating income, to finance expensive higher education and housing, to take risks where they are rewarded and lay off risks where they are not, to save for retirement and fund a comfortable old age. Society, too, needs finance to guide investment in the most productive direction and assign control to the most competent managers.
But despite its vital role, the financial industry is remarkably unpopular. Public respect for banks and other large financial institutions has plummeted during this century; a recent Edelman Trust Barometer report shows that financial firms are ranked among the least trusted types of business organizations.
Trust deficit
Public distrust of finance arises from a toxic relationship between financial firms and their retail customers. As Tarun Ramadorai and I argue in our recent book, Fixed: Why Personal Finance Is Broken and How to Make It Work for Everyone, the problem begins with the struggles ordinary people have with financial decisions. Many people have low financial literacy and general numeracy. Untrained intuition often goes astray in the financial context, and learning from experience is far too slow to be useful. Knowing how ill-equipped they are to evaluate options, people dislike shopping for financial products and often rely on familiar brands without asking too many questions. After buying a product, people frequently mismanage it, making expensive mistakes such as incurring bank overdraft charges or credit card late fees, allowing life insurance policies to lapse or paying interest on an old, expensive mortgage rather than refinancing it.
Faced with incompetent customers, it is often more profitable for financial firms to exploit mistakes rather than correct them. If customers ignore some costs of financial products, why not raise those fees to increase revenue without losing market share? If customers are reluctant to shop around, why not charge them premium prices? To make it even harder for customers to compare prices, why not bundle financial products and add custom features? If some customers make expensive mistakes that generate revenue for the industry, why not use the revenue to cover the cost of competing for market share by offering other customers free checking accounts, credit card rewards, low insurance premiums or low mortgage rates? That strategy benefits sophisticated consumers at the expense of those who mismanage their financial affairs.
‘Faced with incompetent customers, it is often more profitable for financial firms to exploit mistakes rather than correct them.’
Many people are naive about the conflicts of interest that exist in any commercial relationship. They don’t understand that brokers are financially rewarded for recommending expensive mutual funds that pay sales commissions, and they assume banks and insurance companies will treat a longtime customer well — when in fact a long relationship with a financial firm often tells the firm that the customer is paying no attention to fees and can safely be charged a premium price.
Such naivete can have life-changing consequences. Tarun and I started our book with the stories of real people: an American student who was persuaded by a college in need of tuition revenue to borrow for higher education she was unable to complete, leaving her burdened by unmanageable debt; an Enron employee who was encouraged to invest his retirement savings in company stock that lost all its value when the company collapsed; a Briton in poor health who was sold expensive payment protection insurance that would never have paid out given his preexisting health condition; and an Indian retiree who was steered by a broker into an investment product bundled with an insurance policy that was so expensive its premiums ate up his life savings within five years. While such horror stories are not the norm, they are common enough that many people have friends and family with experiences like these.
Leaving the system
When people hear such stories, it is not surprising they become mistrustful and angry. Some people seek alternatives to the formal financial system, keeping their savings in cash or gold, borrowing from friends and family, turning to loan sharks or moneylenders or investing in cryptocurrencies. Unfortunately, this amounts to jumping out of the frying pan into the fire: cash pays no interest; gold and cryptocurrencies are highly volatile, speculative investments; the resources of family and friends are easily tapped out; while loan sharks charge exorbitant interest and are ruthless in collecting it.
How can this situation be remedied? The evolution of the US medical marketplace provides clues. A century ago, that marketplace was like the Wild West. Competitive and unregulated, it was tricky to distinguish the outlaws from legitimate medical professionals. Perverse incentives produced now unthinkable spectacles — like doctors publicly endorsing cigarette brands.
Today, the medical marketplace looks very different. Muscular government regulation by the Food and Drug Administration separates complex remedies requiring examination by a physician and a prescription from over-the-counter medications, a set of tried and trusted remedies for the most common ailments. These medicines are widely available and sold in standardized form, so it’s easy for shoppers to understand the prices they pay — which leads providers to compete to keep prices low. While there are undoubtedly still problems in the pharmaceutical industry, the situation is now far better.
A starter kit for finance
Personal finance has much to learn from these early moves to improve public health through regulation. To create a personal finance system that is simpler, cheaper, safer and easier to use, we propose what we refer to as a starter kit of basic financial products that financial institutions should be required to offer to all comers. Just like over-the-counter drugs, the starter kit should be a working default from which households can strike out on their own as they develop more complex financial needs, or as they grow in experience and financial sophistication. Starter-kit products should be standardized, and their fee structure should be simple and transparent. Comparing starter-kit products from different providers should be as easy as comparing the prices of over-the-counter medications like headache or allergy remedies. The goal is to make shopping for starter-kit financial products headache-free.
Some elements of the starter kit are so essential that we believe that all adults should be required to employ them, with changes to the products that make them more universally useful. For example, basic banking services are a necessity to facilitate transactions and savings, but the way most bank accounts are currently structured leaves much to be desired. Checking accounts facilitate transactions and usually carry few if any explicit fees, but that often hides the implicit fees they charge by paying no interest on balances. Banks essentially pocket the rates they earn on deposits in these accounts.
Worse still, this can create disparities, as more sophisticated customers are quick to move balances into interest-bearing accounts when money market rates rise, leaving less sophisticated customers to pay high implicit fees. The design also disadvantages banks when money market rates fall, to the extent that the implicit fees fall below the costs of providing transaction services.
‘The goal is to make it easy for ordinary people to compare and choose banking service providers as well as to give banks the incentive to innovate to reduce transaction costs.’
To replace this system, starter-kit checking accounts should pay money market interest rates, paired with a fixed upfront fee and a small per-transaction fee. Since overdraft charges can be extremely expensive for unwary consumers, these accounts should have capped overdraft charges or prevent overdrafts altogether, along the lines of the simple “Basiskonto” account that banks must offer in Germany. The goal is to make it easy for ordinary people to compare and choose banking service providers as well as to give banks the incentive to innovate to reduce transaction costs.
Retirement savings accounts are another important element of the starter kit. The United States, for example, offers a profusion of accounts: IRAs and 401(k)s and 403(b)s, in traditional and Roth varieties, with different tax incentives and contribution limits. But too many people — particularly those who are self-employed or work for small businesses — end up using none of them. Profusion all too easily leads to confusion. Instead, we believe all adults in the US should be required to choose a standardized low-fee retirement account with an easy-to-understand tax benefit in which they are enrolled at the date of first employment — and which they can keep throughout their working lives, even if they change jobs. The goal is to make it as easy as possible to begin retirement saving, and to continue retirement saving even through changes in employment circumstances.
From the ground up
Checking and retirement savings accounts are just two examples of our broader theme. We can create similar no-frills starter-kit templates for a range of personal finance needs, such as term life insurance, self-refinancing mortgages and deferred-payout annuities by thinking hard about the basic functions we need these products to serve. The medical marketplace once seemed broken beyond repair. But thoughtful reforms helped improve citizens’ day-to-day experiences in that marketplace and restored trust in a broken system. We believe the same transformation is possible in personal finance.
We acknowledge that our proposal flies in the face of current deregulatory trends in both the United States and the United Kingdom. The US has all but abolished the Consumer Financial Protection Bureau, and the UK chancellor, Rachel Reeves, has promised to lift the “boot on the neck” of financial regulation by loosening mortgage payment-to-income restrictions, delaying the implementation of Basel III banking regulations and abolishing the payment systems regulator.
These moves are ostensibly to spur economic growth. The awfulness of the 2008 financial crisis is receding from memory, which partly explains why institutions such as the CFPB — set up in its aftermath — are viewed as less relevant. We believe another important reason for the backlash against consumer financial regulation is that it has been poorly designed and implemented during the last 15 years. It is too broad, overly reliant on stringent fiduciary obligations placed on banks and firms in the US, or the Kafkaesque “consumer duty” imposed by the UK’s Financial Conduct Authority that requires firms to “act to deliver good outcomes for retail consumers.”
Yet all too often, regulation is simultaneously too narrow — intrusively monitoring the specific details of how firms manage flows of personal financial data in the US or directly attempting to engineer workplace dynamics in financial firms with the “senior managers regime” in the UK. Such regulation has a chilling effect on financial innovation — and ultimately increases the costs while reducing the quality of financial products and services offered to the public.
We advocate an alternative approach to consumer financial regulation, one which is more precisely focused on product design and contractual form. Design-focused financial regulation can be complemented by active moves to “shove” (rather than weakly “nudge”) households and firms towards beneficial financial products and services. Shoves can, for example, reward products that comply with the starter-kit template by indemnifying their providers against lawsuits. Combined with forceful regulation to drive unsuitable products out of the marketplace, this provides strong incentives for the financial industry to offer a more suitable menu of product options.
‘Such regulation has a chilling effect on financial innovation — and ultimately increases the costs while reducing the quality of financial products and services offered to the public.’
Our proposal respects the benefits of technology and innovation in finance. Unlike Paul Volcker, we do not believe the apex of financial innovation in modern times was the ATM, and we appreciate the power of technology to improve personal finance by making customized financial products cheaply available to all. But technology is a double-edged sword that, in the absence of regulation, can easily be used to promote destructive financial behaviors such as day trading of meme stocks rather than sound investments in financial security. Beginning with a simple and easy-to-use starter-kit of financial products will engender trust and help households develop an appreciation for the critical importance of finance. This in turn will expand the market for more sophisticated financial products, including those that rely on the latest technology.
We also limit the demands on regulatory organizations. Finance is a technology-intensive industry, and large government technology projects are notorious for delays, cost overruns and design flaws. For this reason, we do not advocate direct government provision of financial services but instead advocate regulations that set a few parameters of product design and then allow private-sector competition to deliver quality financial products at a reasonable cost.
By thinking hard about the essential design features that can help ordinary people efficiently achieve their basic financial objectives, we can create the guardrails between which financial innovation can flourish in the personal finance system of the future.
