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Nudging: Information, Choice Architecture and Beyond

Theory and Applications in Financial Markets Law

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Nudging - Possibilities, Limitations and Applications in European Law and Economics

Part of the book series: Economic Analysis of Law in European Legal Scholarship ((EALELS,volume 3))

Abstract

The traditional disclosure-paradigm is based on the assumption that transparent and effectively processed information will enable the investor to make well-founded investment decisions. Having the type of a «homo oeconomicus» in mind, financial market laws used to be designed for responsible and knowledgeable actors. Analysing human flaws regarding the way we process information in the light of behavioural findings, the provision of data for consumers of financial products should be further optimised. Despite the information overload the provision of information must not be condemned; this would mean throwing the baby out with the bath water. Disclosure can be used and function’s also as a nudge; thus the way information is framed matters a lot. However, inundating customers with too much information does not help. Valueing the positive outcome of simple rules of thumb might complement to an optimised cognition and perception of human behaviour as it should be imputed to individuals when designing regulation. Enhanced prevention based on smarter information requirements will give consumers a better chance to avoid human flaws. Additionally, education could, at least partially, compensate negative outcomes of human flaws. However, nudging should avoid weakening the motivation of individuals to actively inform themselves. Combined with a strict Code of Conduct at the point of sale, a Suitability Test including the real risk perceptions of the consumer leads to an enhanced level of investor protection. Nudging in combination with some more paternalistic elements can de-bias detrimental human shortcomings while distending paternalism should be avoided.

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Notes

  1. 1.

    For a (critical) overview of the emergence of behavioural law and economics as a counterpart to orthodox law and economics with reference to the main literature see Mitchell 2014, pp. 167–168. See also Langevoort 1992 for a detailed analysis regarding the efficient market hypotheses and the influence of behavioural research.

  2. 2.

    The paper carries forward and enhances findings that were presented at the 3rd Law and Economics Conference in Lucerne: Behavioural Law and Economics in April 2014; Baisch and Weber 2015.

  3. 3.

    Campbell et al. 2011, p. 91.

  4. 4.

    Libertarians prefer to talk about “investors”; the term “consumer” suggests and implies the need of a certain degree of protection. See Kingsford Smith 2010; Moloney 2012, and Sarra 2013.

  5. 5.

    Ryan et al. 2011, p. 462.

  6. 6.

    Akerlof and Shiller 2015.

  7. 7.

    See also World Bank Group, World Development Report 2015, Mind, Society and Behavior, December 2015.

  8. 8.

    Thaler and Sunstein 2008; Sunstein 2014a.

  9. 9.

    Ulen 2013 delivers a good overview of behaviourally informed investor protection regulation and also advocates augmented disclosure obligations.

  10. 10.

    A good collection of early key papers can be found in Kahneman et al. 982; see also Kahneman and Tversky 2000; legal implications stemming from behavioural findings are described by Korobkin and Ulen 2000. See also Moloney 2010, 67–74, regarding the irrational and uninformed investor.

  11. 11.

    Cunningham 2002, p. 836, resumes that behavioural finance is “a marriage of cognitive psychology and the financial economics of market inefficiency”. See FCA papers: Kristine Erta et al., Applying Behavioural Economics at the Financial Conduct Authority, Financial Conduct Authority, Occasional Paper No. 1, April 2013, http://www.fca .org.uk/static/documents/occasional-papers/occasional-paper-1.pdf; Paul Adams/Stefan Hunt, Encouraging Consumers to Claim Redress: Evidence from a Field Trial, Financial Conduct Authority, Occasional Paper No. 2, April 2013, http://www.fca .org.uk/your-fca /documents/occasional-papers/occasional-paper-2.

  12. 12.

    Proposal for a Regulation of the European Parliament and of the Council on key information documents for packaged retail and insurance based investment products , PRI(I)Ps; http://register.consilium.europa.eu/doc/srv?l=EN&f=ST%208356%202014%20REV%201.

  13. 13.

    Key Investor Document .

  14. 14.

    Discussion Paper of the Joint Committee of European Supervisory Authorities (the ESAs: EBA European Banking Authority, EIOPA European Insurance and Occupational Pensions Authority, and ESMA European Securities and Markets Authority), Key Information Documents for Packaged Retail and Insurance-based Investment Products (PRIIPs), 17 November 2014, p. 17.

  15. 15.

    A good overview is delivered by Reiss 2013, pp. 278–302. See also Bovens 2009.

  16. 16.

    However, it is also possible that “sometimes firms might not know that their customers are making mistakes. What looks like deliberate exploitation may actually just be firms responding to observed consumer demand without realising that it is driven by biases.” See FCA, Occasional Paper No.1, Kristine Erta, Stefan Hunt, Zanna Iscenko and Will Brambley, Applying behavioural economics at the Financial Conduct Authority, April 2013, 7 and 21; http://www.fca .org.uk/your-fca /documents/occasional-papers/occasional-paper-1.

  17. 17.

    Add-on-insurance sale; see FCFCA, Market Study, General insurance add-ons: Provisional findings of market study and proposed remedies, March 2014; https://www.fca .org.uk/static/documents/market-studies/ms14-01.pdf.

  18. 18.

    Some authors criticise the approach from Thaler and Sunstein ; e.g. White 2013, xiii, states that policies based on nudges are “ineffective, unethical, and dangerous to individual choice, interests, and autonomy ”. See also Whitman and Rizzo 2007, Rebonato 2012. Sunstein 2005, p. 201 seq., already addresses some major lines of criticism: (i) slippery slope (resist the beginnings – nip it in the bud), (ii) mistrust in the abilities of the planner or choice architect and (iii) enthusiastic paternalists dislike the non-mandatory nature of nudging. See also Conly 2013.

  19. 19.

    Hausman and Welch 2010, p. 136.

  20. 20.

    George Loewenstein and Peter Ubel, Economics Behaving Badly, The New York Times, July 14, 2010, http://www.nytimes.com/2010/07/15/opinion/15loewenstein.html.

  21. 21.

    Dodd-Frank Act, 2010; 12 U.S. Code § 5511 – Purpose, objectives, and functions.

  22. 22.

    Dodd-Frank Act, 2010; 12 U.S. Code § 5532 – Disclosures.

  23. 23.

    Similar to the U.S. (Social and Behavioral Sciences Team) and Great Britain’ Nudge-Unit (Behavioural Insights Team) also the German Chancellery is setting up an interdisciplinary team to apply empirical evidence from behavioural economics in public policy making. See Steinbeis, Maximilian: ‘Nudging’ arrives in Germany, VerfBlog, 27 August 2014, http://www.verfassungsblog.de/en/nudging-kommt-nach-deutschland/#.VNsrbWNATbM.

  24. 24.

    Kahneman 2013, p. 1340.

  25. 25.

    See Dworkin 2013.

  26. 26.

    Sunstein 2014c addresses the ethical aspects of nudging and related criticism. Trout 2005, 408, argues that biases damage peoples autonomy not institutional remedies.

  27. 27.

    Camerer et al. 2003, p. 1218.

  28. 28.

    Van Aaken 2016, explores the legal limits of paternalistic nudging under the German Constitution and discusses the (typical German) proportionality assessment which consists of a quadrinominal test: (i) legitimate aim, (ii) suitability, (iii) neccessity (least restrictive means tests) and (iv) proportionality . It is important to distinguish whether a nudge targets preferences and autonomy (end paternalism) or just cognition (means paternalism ); while the first needs to be subjected to greater scrutiny the latter is true for informational nudges .

  29. 29.

    Libertarians prefer the freedom of choice , while condemning paternalism; see e.g. Boaz 1997; on the other side, paternalists mistrust freedom of choice and argue against some occurrences of libertarianism; see e.g. Goodin 1991.

  30. 30.

    See ESA-DP (fn. 15), p. 17.

  31. 31.

    Blumenthal-Barby 2013.

  32. 32.

    Thaler and Sunstein 2008, p. 11

  33. 33.

    Thaler and Sunstein 2008.

  34. 34.

    Sunstein and Thaler 2003.

  35. 35.

    Thaler and Sunstein 2008, 6. Regarding choice architecture see also Thaler et al. 2013; Johnson et al. 2012.

  36. 36.

    According to Hansen and Jespersen 2013, pp. 20–23; based on the dual process theory which underpins Thaler and Sunstein 2008, pp. 19–22, and is also fundamental to Kahneman 2011.

  37. 37.

    FCA Press release, 5 August 2014, http://www.fca .org.uk/news/fca -restricts-distribution-of-cocos-to-retail-investors. CoCos are hybrid bonds that currently offer attractive yields but their value can be written down or converted into equity if the issuing bank’s capital drops below a certain minimum level.

  38. 38.

    CoCos may still be sold to investors for whom they are more likely to be suitable, including professional investors or retail investors who are high net worth or sophisticated. Sophisticated investors are defined by the FCA as retail clients with extensive investment experience and knowledge of complex instruments, able to understand and evaluate the risks and potential rewards of unusual, complex and/or illiquid investments. To be classed as high-net-worth, investors need to have an annual income of more than £100,000 or have investable net assets of more than £250,000; see Temporary product intervention rules, Restrictions in relation to the retail distribution of contingent convertible instruments, August 2014, http://www.fca .org.uk/static/documents/temporary-product-interventions/restrictions-in-relation-to-the-retail-distribution-of-cocos.pdf.

  39. 39.

    FCA started a consultation in October 2014 (CP14/23: Restrictions on the retail distribution of regulatory capital instruments) and published rules in June 2015 permanent rules are in place since 1 October 2015 when the temporary product intervention rules for CoCos expired (PS15/14).

  40. 40.

    Sunstein 2013, p. 9.

  41. 41.

    See Davidoff and Hill 2013.

  42. 42.

    Black 2013, p. 1507.

  43. 43.

    Paredes 2003, p. 484.

  44. 44.

    OECD 2007, Roundtable of Economics for Consumer Policy: Summary Report, 26 July 2007, p. 13.

  45. 45.

    Sunstein 2014b, p. 727.

  46. 46.

    Opening statement of Steven Maijoor, Chair of ESMA , at the ESMA Investor Day, 12 December 2012, Paris; http://www.esma.europa.eu/system/files/2012-_818.pdf.

  47. 47.

    The role of psychology in economics was already discussed by Keynes 1936, p. 315, referring to animal spirits (162) and unrealistic optimism or pessimism as causes for booms and busts.

  48. 48.

    Overconfidence could have many positive effects. Looking at retirement savings the expectation to live longer than average should motivate individuals to higher savings. Baisch and Weber 2015, pp. 167–171, with further references.

  49. 49.

    The debate regarding akrasia (the Greek ἀκρασία means a lack of command over oneself) is quite an old one: Socrates argued in Plato’s Protagoras (Plato, 380 B.C., Platon: Protagoras 345 d9-e4) that akrasia does not exist, because no one acts willingly against one’s better judgment. Aristotle countered more empirically and acknowledged that individuals behave intuitively (Aristoteles, The Nicomachean Ethics VII 3, 1145 b22–24).

  50. 50.

    Gal 2006.

  51. 51.

    Regret aversion bias is the tendency to avoid making a decision due to the fear of the later probability to experience the pain of regret; in consequence, people will avoid taking decisive actions because they fear that, in hindsight, whatever action they may have selected could prove less than optimal.

  52. 52.

    Thaler 1980, p. 44.

  53. 53.

    Sunstein 2011, p. 1350.

  54. 54.

    Just one of many: Madrian and Shea 2001. See also EIOPA-report, Good practices on information provision for DC schemes, Enabling occupational DC scheme members to plan for retirement, 24 January 2013.

  55. 55.

    Sunstein 2011, p. 1353.

  56. 56.

    The problem of shrouded attributes comes into play; Gabaix and Laibson 2006; see also Sunstein 2015, p. 316.

  57. 57.

    Sunstein 2011, p. 1357.

  58. 58.

    Sunstein 2011, pp. 1358 et seq.

  59. 59.

    IOSCO report, Suitability Requirements With Respect To the Distribution of Complex Financial Products, January 2013, p. 6 et seq.

  60. 60.

    Market in Financial Instruments Directives, 2004/19EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments, 30.4.2004, OJ L 145/1-44 MiFID II 2014/65/EU of 15 May 2014 repealing Directive 2004/39/EC, 12.6.2014, OJ L 173/349–496.

  61. 61.

    Moloney 2008 (2nd ed.), 614; Moloney 2014 (3rd ed.) gives a good overview of the discussion considering issuer-disclosure, the Efficient Market Hypothesis and behavioural insights, pp. 54–59.

  62. 62.

    Already Rapp 1998, p. 189, stated in relation to financial industry standards of conduct that none is “more frequently cited, and least objectively applied, than the ‘suitability’ requirement”.

  63. 63.

    See http://finra.complinet.com/en/display/display_viewall.html?rbid=2403&element_id=9859&print=1.

  64. 64.

    Rule 2310 is the former (since 1939) Article III, §2 of the NASD Rules of Fair Practice.

  65. 65.

    Trout 2005, p. 433, repudiates this approach: “Anyone who assumes the adequate efficiency of debiasing through individual training is either ignoring the magnitude of institutional intervention required for such educational programs, or ignoring the cognitive costs to the individual of correcting such biases. Either way, these strategies of individual training do not take seriously the best available science.”

  66. 66.

    Cunningham 2002, p. 797. At p. 788: “It also means that such investor education must include not only tutelage in the principles of finance and insights from behavioral finance , but also explanation of how these axioms may collide.”

  67. 67.

    NASD (National Association of Securities Dealers) is the former name of the American self-regulatory organization for broker-dealers, which is now consolidated with the member regulation, enforcement and arbitration functions of the New York Stock Exchange FINRA (Financial Industry Regulatory Authority). Founded and registered with the SEC in 1939 the NASD was based on the 1938 Maloney Act amendments to the Securities Exchange Act of 1934. NASD as the one and only Registered Securities Association supervised the conduct of its members under the oversight of the SEC. Section 15A of the Securities Exchange Act of 1934 was enacted in 1938 to extend regulatory authority under the federal securities laws to the over-the-counter securities markets. NASD created a system of cooperative regulation of broker-dealers and was responsible for the adoption and enforcement of the rules to protect investors and the public interest.

  68. 68.

    ESMA criticised: (i) the failure to ask clients the right questions; (ii) the failure to collect the necessary and relevant information ; (iii) the failure to interpret correctly the information provided by the client; and (iv) even where the right information is collected, the failure to recommend a suitable investment; http://www.esma.europa.eu/system/files/2012-387.pdf.

  69. 69.

    ESMA , consultation paper, May 2014, p. 132 et seq.; www.esma.europa.eu/system/files/2014-549_-_consultation_paper_mifid_ii_-_mifir.pdf.

  70. 70.

    EIOPA (fn. 56), p. 7.

  71. 71.

    PRIIP: Packaged retail investment and insurance-based investment products. On 9 December 2014, the Regulation (EU) No 1286/2014 of the Europe an Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs) has been published in the Official Journal of the European Union.

  72. 72.

    The regulation covers structured deposits, structured products, insurance products with an investment element (but not pension products) and funds; Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs), OJ L 352/1, 09.12.2014.

  73. 73.

    UCITS: Undertakings for Collective Investment in Transferable Securities; Directive 2001/107/EC and 2001/108/EC; AIFMD: The Alternative Investment Fund Managers Directive 2011/61/EU.

  74. 74.

    PRIIPs regulation, pn. (1).

  75. 75.

    PRIIPs regulation, pn. (18): “A product should be regarded as not being simple and as being difficult to understand in particular if it invests in underlying assets in which retail investors do not commonly invest, if it uses a number of different mechanisms to calculate the final return of the investment, creating a greater risk of misunderstanding on the part of the retail investor or if the investment’s pay-off takes advantage of retail investor’s behavioural biases, such as a teaser rate followed by a much higher floating conditional rate, or an iterative formula.”

  76. 76.

    ESA-DP (fn. 15).

  77. 77.

    ESA-DP (fn. 15), p. 17 et seq.; with reference to Sunstein 2011.

  78. 78.

    According to Art. 24 (4) (b) MiFID II the information to be provided to client shall include guidance on and warnings of the risks associated with investments in financial instruments or in respect of particular investment strategies. ESMA ’s MiFID Consulting Paper from May 2014 (311 pages, additionally ESMA published in May 2014 a Discussion paper regarding the future technical standards with 533 pages, meanwhile the consultation paper was published in December 2014, 645 pages) specifies in Section 2.13 that Article 31 (2) MiFID Implementing Directive (2006/73/EC), relating to the description of risks, should specifically address the risk of financial instruments.

  79. 79.

    Baisch and Weber 2015, pp. 174–180.

  80. 80.

    In the OECD G20 High-Level Principles on Financial Consumer Protection , published in October 2011, http://www.oecd.org/regreform/liberalisationandcompetitioninterventioninregulatedsectors/48892010.pdf,) the principle Disclosure and Transparency is stressed in section 4; the following formulation exemplifies that this principle is clearly understood in a comprehensive manner: “Financial services providers and authorised agents should provide consumers with key information that informs the consumer of the fundamental benefits, risks and terms of the product. They should also provide information on conflicts of interest associated with the authorised agent through which the product is sold.” Addressing risks it is stated: “The provision of advice should be as objective as possible and should in general be based on the consumer’s profile considering the complexity of the product, the risks associated with it as well as the customer’s financial objectives, knowledge, capabilities and experience. Consumers should be made aware of the importance of providing financial services providers with relevant, accurate and available information .”

  81. 81.

    According to Rapp 1998, p. 212, “the most common characterization offered is that suitability is an amorphous concept, with no accepted definition, and bereft of case law guidance”.

  82. 82.

    Baisch and Weber 2015, pp. 172–174 and pp. 182–187.

  83. 83.

    CP May 2014 (fn. 71), p. 132 et seq.

  84. 84.

    Available at http://www.fca.org.uk/your-fca/list?ttypes=Occasional+Papers&ssearch=.

  85. 85.

    FCA-OP 1 (fn. 17).

  86. 86.

    FCA-OP 1 (fn. 17), p. 51.

  87. 87.

    Making competition king – the rise of behavioural economics at the FCA, Speech by Martin Wheatley, Chief Executive, the FCA, at the Australian Securities and Investments Commission (ASIC), March 2014; available at http://www.fca.org.uk/news/making-competition-king.

  88. 88.

    EIOPA (fn. 56).

  89. 89.

    EIOPA (fn. 56), p. 9.

  90. 90.

    Helleringer 2015.

  91. 91.

    Available at eur-lex.europa.eu/resource.html?uri=cellar:33cb1b95-b6c8-11e3-86f9-01aa75ed71a1.0002.01/DOC_1&format=PDF.

  92. 92.

    EIOPA (fn. 56), p. 8.

  93. 93.

    Sunstein 2014b, p. 727.

  94. 94.

    See Article 33 of the level 2 MiFID -ID (MiFID Implementing Directive, Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, 2.9.2006, OJ L 241/26–58) regarding the obligation to inform clients about costs.

  95. 95.

    ESA-DP (fn. 15), p. 21 et seq.

  96. 96.

    Sunstein 2014b, p. 728.

  97. 97.

    Sunstein 2014b, p. 729.

  98. 98.

    Walther 2015, p. 145.

  99. 99.

    “Traditional failures are often addressed by information provision or disclosure: to mitigate asymmetric information , to reduce search costs and limit market power, and to remedy the underprovision of a public good. But mandated information provision may be an ineffective remedy if consumers either do not understand the information or believe that it is not relevant to their decisionmaking. For example, if consumers mistakenly believe that they will pay their credit bill on time every month, clear and transparent disclosure of late fees and interest rates may not change behavior because consumers deem the information irrelevant at the time they make a purchase.” See Campbell et al. 2011, p. 95.

  100. 100.

    Financial Services and Markets Act (Financial Promotion) Order 2005 Art. 48 and 50A.

  101. 101.

    In other areas than investment decisions the so-called choice architecture may help more. In the U.S. the automatic enrolment in pension schemes is widely discussed. See with further references Lusardi and Mitchell 2014, 34.

  102. 102.

    However, the grey capital market, closed-end funds and investment companies will remain a challenge.

  103. 103.

    See references in Benartzi et al. 2013.

  104. 104.

    Chetty et al. 2013.

  105. 105.

    Cartwright 2014, p. 519.

  106. 106.

    Bronchetti et al. 2013.

  107. 107.

    Carroll et al. 2009, p. 1669.

  108. 108.

    Weaver and Willén 2014.

  109. 109.

    Baisch and Weber 2015, p. 161 and pp. 171–172.

  110. 110.

    Art. 24 MiFID II.

  111. 111.

    According to Hens and Rieger 2008, 27 most of the common structured products do not “follow rational guideline, but instead use behavioral factors, like loss-aversion or probability misjudgement to be attractive in the eyes of potential investors”.

  112. 112.

    Shefrin 2014, p. 19.

  113. 113.

    While suitability contains a link to present as well as future aspects, appropriateness mainly reflects the past. Based on detailed conduct of business rules for investment firms in combination with the just discussed transparency requirements these tests are realising the general obligation to act fairly, honestly and professionally and in accordance with the best interests of the client – previously known as fiduciary duty.

  114. 114.

    Speech Wheatley (fn. 90).

  115. 115.

    See Jolls 2006, pp. 39–40.

  116. 116.

    Moloney 2010, p. 243, advocates mystery shopping. For a practical example see FSA, Assessing the quality of investment advice in the retail banking sector: A mystery shopping review, February 2013, <www.fca.org.uk/static/pubs/other/thematic_assessing_retail_banking.pdf>.

  117. 117.

    IOSCO, Suitability Requirements With Respect To the Distribution of Complex Financial Products Final Report, January 2013, Principle 5.

  118. 118.

    Campbell et al. 2011, p. 95.

  119. 119.

    Ulen 2014, p. 120.

  120. 120.

    See also Mitchell 2014, pp. 182–184, regarding the interaction of behavioural law and economics with legal norms.

  121. 121.

    Glaeser 2006, p. 156.

  122. 122.

    Carlin et al. 2013.

  123. 123.

    Kahneman 2011. Neuroscientist Gazzaniga 2011 tackles the question, why individuals feel so in control despite the range of automatic and deliberative factors that underlies their choices.

  124. 124.

    Gigerenzer 2014 (2013), p. 30; see also his comment in chapter 2 fn. 14.

  125. 125.

    System 1 (fast, instinctive and emotional), as Kahneman describes it, might lead in some cases even to better solutions then System 2 (deliberative and logical) because System 2 is susceptible to the misjudgement of probabilities due to limited working memory and brain power and a widespread simple lack of statistical knowledge and mathematical ignorance.

  126. 126.

    Gigerenzer 2014 (2013), chapter 1 fn. 14, argues that “poor cognitive abilities are not written into our genes, but are largely a consequence of the lack of an intellectually stimulating environment”.

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Acknowledgement

This contribution was written within the University Research Priority Program Regulation of Financial Markets from the University of Zurich.

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  1. Rechtswissenschaftliche Fakultät, University of Zurich, Rämistrasse, 8001, Zurich, Switzerland

    Rainer Baisch

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    Klaus Mathis

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    Avishalom Tor

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Baisch, R. (2016). Nudging: Information, Choice Architecture and Beyond. In: Mathis, K., Tor, A. (eds) Nudging - Possibilities, Limitations and Applications in European Law and Economics. Economic Analysis of Law in European Legal Scholarship, vol 3. Springer, Cham. https://doi.org/10.1007/978-3-319-29562-6_12

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