Stefan Hunt spent much of his academic career trying to understand why people make lousy financial decisions.
Now the former Harvard and Yale economist is helping U.K. market regulators protect consumers from those who might profit from exploiting the biases, instincts and fears that prompt those poor choices.
“It’s not like we are completely irrational,” said Hunt, who leads a 25-strong research team at the Financial Services Authority. “We make some systematic and predictable mistakes.”
Regulators are attempting to use behavioral economics to better understand the mindset behind the improprieties plaguing Britain’s financial hub: from rogue trader Kweku Adoboli, who hid trades that cost UBS AG $2.3 billion, to improper sales of loan insurance, for which U.K. banks have set aside more than 10 billion pounds ($16 billion) to compensate consumers.
The 37-year-old said he hopes awareness of behavioral science will make for better rules and fairer markets as the FSA prepares to split its role and create a new consumer-protection agency next year.
Behaviorists challenge the notion in traditional economics that people weigh their options and pick the best outcome for themselves. Instead, they look at the psychology of choices.
“It’s a very different kind of approach for regulation,” said Dan Ariely, a professor at North Carolina’s Duke University and behavioral economist. “We need to understand what really drives human behavior.”
Before he joined the FSA in January 2011, Hunt completed a doctorate at Harvard, for which he spent 15 months in India with rural farmers studying whether having information about commodities futures changed their decision making. Before that, he worked for Prudential Financial Inc. for two years in Hong Kong, leaving in 2002 to return to academia.
Hunt heads the Economics of Financial Regulation team. He’s less than revealing about its work so far, because much of it isn’t yet public, and the FSA didn’t publicize Hunt’s hiring. It’s clear, however, that there is a strong focus on retail finance, a 1.2 trillion-pound industry in the U.K.
People “understandably make some wrong decisions in choosing and using financial products,” Hunt said in an interview at the FSA’s headquarters in London’s Canary Wharf.
The problems come from the difficulties in processing complex information, or from natural human tendencies like procrastination, and are made worse when products are opaque.
Hunt has spent the last two years meeting staff in various FSA departments encouraging them to consider behavioral economics, and inviting prominent academics to present their work to regulators. There’s a large body of academic research for Hunt to call on to determine how to change people’s choices.
Bank customers in South Africa, for example, accepted a higher rate of interest on loans when a photo of an attractive woman was included in the offer letter, according to a 2009 study by researchers from Yale and the University of Chicago Booth School of Business. Not linking the loan to a specific use also affected demand, as did the number of example loans.
“Small changes that you would not expect to have a massive effect can be important,” Hunt said.
The U.S. Consumer Financial Protection Bureau has already begun to put behavioral theory into practice in writing and enforcing rules for mortgages, credit cards and payday loans. Its assistant director of research, Sendhil Mullainathan, is, like Hunt, immersed in behavioral economics -- he was one of the authors of the paper on South African loan customers.
European regulators also looked to the behavioral theory field in drafting new rules for packaged investment products, known as PRIPs, a 9 trillion-euro ($11.7 trillion) market, according to Frederic Hache of Finance Watch, a public-interest lobbying group. The EU proposal will require that retail investors be shown an information document that is clear and easy to understand. The measure is to be debated by the European Parliament next year.
“I’ve seen what you can do with packaging,” said Hache, a former banker with Credit Suisse Group AG. “In most cases, it’s a way to embed big margins rather than promote innovation that benefits an investor.”
Next year, the U.K. FSA will be split up. The Prudential Regulation Authority will monitor bank stability and the Financial Conduct Authority will protect customers and regulate markets. Hunt’s team is to work within the FCA on issues ranging from punishing breaches to monitoring trading risks.
Next page: Cheating Incentives
Duke University’s Ariely, the author of the book “The (Honest) Truth About Dishonesty” and others on behavioral economics, conducts honesty experiments. In one he tempted participants to cheat in a series of tests by offering economic rewards, and monitoring their responses. He found that wrongdoing increased if something other than money was at stake -- in one case vouchers, though Ariely says the same principle could apply to securities or derivatives. Any cheating in the test made it more likely others would do the same, he said.
“The moment some bank starts playing with Libor or whatever it is, other banks think this is OK as well,” Ariely said, referring to allegations a group of banks including Royal Bank of Scotland Group Plc and Barclays Plc profited from manipulating the London interbank offered rate. Barclays admitted wrongdoing and paid 290 million pounds in fines.
For Ariely, his research shows that regulators are taking the wrong approach by focusing on punishing wrongdoing after the event. Rather they should be encouraging people to take the right path with clear regulations, ethical training and proper incentives.
“It’s not about bad people,” he said. “It’s about helping good people stay good.”