Download FCA: Competition and Behavioural Economics

PROMONTORY INSIGHTS
June 2014
FCA: Competition and Behavioural Economics
The Challenge to Firms’ Business Models
The FCA’s explicit competition objective – to promote effective competition in the interests of consumers – is a
key difference between it and the FSA, which was only required to have regard to competition. The FCA has a
duty to promote effective competition when addressing its consumer protection and market integrity objectives.
The regulatory style and approach is still evolving, but already the FCA has committed itself to an extensive
programme of market reviews which will examine whether financial services markets are working well for consumers and if action, aimed at improving consumer outcomes, is justified. From April next year, its scope and
powers will become more extensive and be closely aligned with those of the new Competition and Markets
Authority (CMA). The FCA will have a seat at the table with competition regulators in other UK markets and
will have a voice in competition policy and enforcement at the EU level.
The potential implications for firms are significant, affecting business model development as well as the nature
of their relationship with the regulator. As Martin Wheatley recently noted, “Competition will be king as we
move forward. And that means tomorrow is unlikely to look like today”.
As the FCA’s approach to achieving its competition agenda continues to unfold, firms can benefit from maintaining a close eye on the drivers of its thinking as they emerge. This will enable a better understanding of
potential regulatory actions and therefore inform firms’ business planning.
Competition is King
The FCA has given some general indicators where it has immediate competition concerns. These include expected issues such as supplier market power and information asymmetries between market participants, as
well as problems in the way consumers make decisions. A series of publications and announcements from the
FCA is starting to illuminate its approach to competition:
• in February, the FCA’s Thematic Review of Annuities pointed to a lack of effective competition in the
traditional annuities market – 80% of consumers who purchased their annuity from their pension plan
provider could get a better rate in the open market, many by over 6%. This preceded the significant
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changes in the March Budget which largely removed the compulsion for pensioners to purchase an annuity; and
• in March, the FCA’s first market study, on General Insurance (GI) add-ons, found the markets for several products were not working well for consumers and the add-on mechanism had a clear impact on
consumer behaviour and decision making. This enabled firms to, in effect, take advantage of consumer
behaviour to charge higher prices for the GI add-ons, than if sold separately. Importantly, the FCA did
not accept overpayment by consumers for add-on products was likely to be offset by reduced prices for
the underlying or core product (e.g. the car or home insurance). The FCA’s proposed remedial action
focuses on breaking the point-of-sale advantage to firms, and requiring them to publish claims ratios so
as to shine a light on the difference between what consumers pay and the amount they can expect to
claim.
The GI add-ons market study, as well as highlighting concerns around the sale of secondary products, also
suggested the FCA may not look favourably on cross-subsidy between products. While in this case the crosssubsidy was between a regulated product and an unregulated product, there are many examples across financial services where cross-subsidisation might occur.
The FCA’s 2014/5 Business Plan sets out a programme of further work related to its competition mandate,
including:
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a market study into the effectiveness of competition in the credit card market;
the completion of the market study on cash savings accounts;
a market study of competition in the wholesale sector;
the imposition of a price cap on payday lending; and
further developing consumer profiling, using insights from behavioural economics, to enhance supervision of financial promotions activity.
The Importance of Behavioural Economics
Behavioural economics is a key input to the FCA’s assessment of competition issues. The FCA wants to understand better how consumers behave in practice, and understand what ‘nudges’ can be and are used to
influence consumers’ decisions – for better or worse. By questioning whether consumers always behave as
“rational calculators”, it is likely to challenge approaches solely based on providing consumers with more information.
The FCA has published two recent papers which present findings on consumer experiments conducted with
behavioural economics at the forefront:
• Occasional Paper 2 provides an example of the use of behavioural economics outside of competition issues. It looked at how different versions of a customer letter (in relation to potential remediation for misselling) led to different response rates and found certain characteristics could lead to significant increases in response rates. For example, the research found that putting the key messages as bullet
points at the top of the letter led to a significant increase in responses. The FCA has been using the
findings from this research to assess and revise, communications firms send to customers. We are seeing examples of this in recent work with clients; and
• Occasional Paper 3, which also explored competition aspects, has been pivotal in proposing the remedial options as part of the FCA’s review of GI add-ons. The research examined how consumer behaviour is affected when GI is sold as an ‘add-on’ to a primary product. It demonstrated the GI add-on
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weakens consumers’ ability to influence firms by shopping around and comparing products, and led to
the FCA’s proposals, which are intended to change the way products are sold.
What are the Implications for Firms?
The FCA’s approach to its new competition mandate, and its use of insights from behavioural economics, will
have significant implications for financial services firms. They will affect the way firms are expected to approach their customers and this, in turn, will require those firms to consider whether their present business
models are robust to these changes. The changes will affect the way the FCA approaches its supervision responsibilities; its approach to market studies; and the way in which it intervenes.
There will be more focus on thematic work and analysis of products and markets, and an increased reliance
on behavioural insights, in the FCA’s supervision of individual firms. The FCA’s use of market studies, starting
with GI add-ons followed by cash savings, retirement income (annuities) and credit cards, is exemplifying this
change. Many of the FCA’s interventions aimed at improving effective competition will directly focus on the
behaviour of consumers. In some cases, the FCA’s remedy will be more disclosure, but generally we expect
the FCA to use other remedies. The range of the FCA’s potential interventions will be wide, including from
next year, sanctions for breach of competition law.
Compliance with the letter of existing FCA conduct of business requirements will be necessary but not sufficient to avoid FCA action. Firms operating in markets where competition is not thought to be functioning well
are likely to have their business models challenged.
So what should Firms do now?
Firms who understand where the FCA is heading with its competition agenda, and prepare early for potential
change, will be at significant advantage by getting ahead of the FCA analysis and action. Firms should seek to
understand the various ways in which the FCA approach to achieving its competition objectives might develop
(the FCA is candid this is work in progress: keeping abreast of developing FCA thinking will be important) so
they can better assess risks to their business models, and take appropriate action pro-actively. The types of
questions firms should be asking themselves include:
STRATEGY
Which markets are they active in where there may be features of the sort identified by the FCA, which could
inhibit or distort competition, such as supplier market power, disincentives to switching, or features that could
point to potential obstacles to competition? Of these, which areas have already been highlighted by the FCA
for action (only general insurance add-ons so far) or further study (including credit cards)? Taking into account
the FCA’s interest in behavioural economics, in which markets could the Firm be considered to rely excessively on consumer biases? How is customer vulnerability considered and used in the Firm’s target market segmentation?
PRODUCTS
Which products are earning relatively high rates of return that may attract the attention of the regulator, with a
risk of intervention? To what extent are the types of constraint on competition highlighted by the FCA in its
work on competition, including those relating to consumer behaviour, contributing to high returns?
How does the Firm articulate the business rationale for each of its current products, for example, expressed in
terms of the balance between customer needs, value for money offered and the anticipated financial returns?
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How is the target market identified and segmented, and what would a distribution of product returns look like
across different customer segments, especially those that could be considered vulnerable? What economic
costs are there for consumers to terminate a product? How well do customers understand that and at what
points in the customer journey? How reflective are these of the true costs to the Firm? Where is the company
applying cross-subsidies between closely-related products? Will the FCA be persuaded by arguments that the
overall outcome for customers is positive, particularly for those considered vulnerable?
How well do the Firm’s periodic product reviews, value-for-money testing and governance mechanisms equip
it to respond to the FCA’s competition objective and the use of behavioral economics as an input? How does
the Firm consider its legacy products? Is any difference from current products justifiable?
MARKETING
How clear is the Firm on its responsibilities for ensuring good customer understanding? What evidence is
there to support that? Is the approach any different towards those customers who could be considered vulnerable? Is that affected by the Firm’s view on the competitiveness of the market (i.e. how much is it assumed
that good customer outcomes are delivered by well -functioning competitive markets)? If so, how does the
Firm judge that markets are well functioning?
DISTRIBUTION
How much should the Firm be responsible for good customer outcomes where the provider is not giving advice? How much does that change where the product is, for example, relatively complex, long-term in nature,
sold via intermediaries, sold non-advised, or aimed at vulnerable customers?
How much of the gross product returns are absorbed by distribution costs? Is competition sufficiently effective
amongst distributors to ensure good consumer outcomes? What action should the Firm take if it believes distribution structures are limiting the likelihood of good customer outcomes being achieved?
CUSTOMER SERVICE
What is the Firm’s ongoing engagement strategy for ensuring customers are achieving good outcomes? How
does the Firm articulate its responsibilities for identifying and dealing with customers whose circumstances
may have changed such that they are unlikely to achieve a good outcome from the product, either through
change of circumstances or the product not performing as intended?
How Promontory can help
Promontory will continue to monitor developments as the FCA takes forward its competition agenda and will
provide updates to clients. We will be running a seminar involving Professor George Yarrow and industry
practitioners to provide an opportunity to engage with this important issue, including specific examples of actions being taken in response to the FCA’s evolving agenda. We will also focus on proactive steps firms can
take to manage the risks the FCA’s new competition objective will undoubtedly bring.
Promontory can work with you to help identify where FCA intervention in pursuit of its competition objective
may have an impact on your business model and strategy and can assist in answering the questions we are
suggesting firms ask themselves about the implications of the FCA’s new mandate.
We are also seeing a greater demand from clients for advice and assistance on how to build thinking on the
implications of behavioural economics into their operating model, particularly in the product design and distri-
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bution areas. Promontory can provide assistance in how far firms should be embedding the new thinking into
their work, while the FCA’s thinking and practice develops.
Contact Promontory
In the meantime, we would be happy to discuss any queries you may have around the FCA’s approach, and
the potential implications for your firm with you. For more information, please contact:
Stuart King
Managing Director, London
[email protected]
020 7997 3402
Michael Bartholomeusz
Director, London
[email protected]
020 7997 3428
Adam Bedi
Associate, London
[email protected]
020 7997 3476
Promontory is a leading strategy, risk management, and regulatory compliance consulting firm for the financial services industry.
Promontory’s professionals have deep and varied expertise gained through decades of experience as senior leaders of regulatory
bodies and financial institutions. Promontory assists clients in meeting regulatory requirements and in enhancing governance, risk
management, strategic plans, and compliance programs.
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Telephone 020 7997 3400
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