The Theory of Consumer Protection – Part I

By Anand Sahasranaman, IFMR Finance Foundation

IFMR Finance Foundation is working on the agenda of consumer protection in finance as part of its mandate on financial systems design. We will be regularly showcasing our learnings on this front as a part of this new blog series called “Consumer Financial Protection”. We start off by delving into the theoretical underpinnings of consumer protection and its relevance to the provision of financial products and services.

Consumer protection is widely viewed as one of the two critically important functions of financial regulation, the other being maintenance of the financial system’s stability. While the need for consumer protection regulation seems to make intuitive sense, it is useful to dig a little deeper so as to better understand the need for consumer protection in competitive financial markets.

The basic questions that we seek answers for are these: In the case of a well-functioning market with multiple financial product and service providers, should not competition lead to optimal consumer outcomes? Why then do we need the intervention of public regulators to protect consumers of financial products?

A survey of the literature on consumer financial protection throws up a number of insights into the market failures that necessitate the need for regulation.

1. Informational Asymmetry and the problem of “lemons”:

A fundamental problem characterising the market for financial products and services is that of information asymmetry. Because of the expertise that is required for the development of most financial products and strategies, the seller of a financial product is always at an “informational” advantage over the buyer (who generally lacks expertise). This information asymmetry has the potential to adversely incentivise the seller to mis-sell the product, which could lead to poor financial outcomes for the buyer.

Akerlof’s seminal study on the information asymmetry between sellers and buyers in the market for used-cars in the US concludes that the uncertainty over product quality will progressively drive away owners of better quality cars from the market. Over time, this leads to a consistent decline in the average quality of used cars in the market and a corresponding downward adjustment of the price that buyers are willing to pay – until a “no-trade” equilibrium is reached. Such a situation minimises the welfare of buyers and sellers in the market.

In the case of financial markets, such sub-optimal outcomes on account of information failures can be prevented through suitably designed regulations (such as on information disclosure) that enable the creation of a more equitable market for buyers and sellers.

2. Nature of financial decisions and outcomes:

Many important financial decisions such as investing in a mortgage or saving for retirement are undertaken very infrequently in the course of a lifetime. The outcome of many financial investments and strategies becomes obvious only in the long term, and not immediately upon product purchase. Financial product outcomes are also complicated by the fact that market movements can have a substantial impact on product performance, and it can be difficult to pin-point the reasons behind poor outcomes: was it primarily on account of product mis-sale or the consequence of random shocks?

The unfolding of consequences over prolonged time-periods thus distinguishes consumer protection in finance from consumer protection for other products. In case of physical products (such as biscuits or soap) the outcome of the purchase becomes obvious upon immediate usage and high-quality producers can distinguish themselves through signalling devices such as warranties on their products. Financial products are, in a sense, more akin to medical services, where the treatment is administered upfront and the consequences become obvious only with the passage of long periods of time.

Financial consumer protection regulation therefore requires specialised responses (and could perhaps learn from medical consumer protection) considering the nature of manifestation of outcomes. This also opens up the debate for whether consumer financial protection regulation should sit within an umbrella consumer protection regulator that is responsible for consumer welfare across sectors or be situated in an entity specifically created for the purpose of the financial sector.

3. High Search Costs and Price Dispersion:

Despite the fact that financial service providers provide almost identical products, there can be substantial price differences between them. These price variations across sellers of similar financial products can be attributable to high search costs that consumers have to incur to meaningfully compare products and as a result, lead them to pay higher prices than they should. On the one hand, this is because of the lack of a repository of reliable information to enable price comparison and, on the other, the tendency of product sellers to market their products as being different from others in the market, even in the absence of any substantive differentiating features between them. In such a scenario, the consumer is likely to forgo her own welfare by sticking with her existing financial service provider and paying the price determined by them, thus giving them a modicum of market power, which, in a transparent market they would not be able to enjoy.

While transparent, comparable information on prices is obviously desirable from a consumer welfare point of view, there also needs to be clarity on detailed terms and conditions that can have a material impact on the usage of the financial product. This is especially so in the case of decisions which are infrequent and have long-term implications. Consumers are not in a position to generate information on their own or to get together and jointly generate information with other consumers – a classic case of co-ordination failure because of the public-good nature of the endeavour.

Well-designed financial regulation that requires financial services providers to provide access to material, meaningful and reliable information is therefore critical in maximising consumer welfare.

4. Behavioural Characteristics of Consumers:

In the past few years, there have been many new insights from the field of behavioural economics that could significantly impact the design of consumer protection regulation in the future. We will discuss these in the next blog post in this series.

This blog post draws heavily from the following sources:
Campbell, John, Howell Jackson, Brigitte Madrian, Peter Tufano, “Consumer Financial Protection”, Journal of Economic Perspectives, Vol 25, #1
Backstrom, Hans, “Financial Consumer Protection – Goals, Opportunities and Problems”, Economic Review 03/2010
Goodhart, Charles, “How should we regulate the financial sector?”, The Future of Finance, Centre for Economic Performance, London School of Economics
Lumpkin, Stephen, “ Consumer Protection and Financial Innovation: A few basic propositions”, OECD Journal: Financial Market Trends, Vol 2010, #1

  • Anand Sahasranaman

    Thanks Elisabeth. As you rightly point out, the financial crisis has highlighted the importance of consumer protection as a critical function of regulation.

    In trying to develop appropriate models of consumer protection for the Indian financial system, we felt that it was best to go back to first principles – to the theory behind consumer protection. An understanding of the traditional rationale for consumer protection (based on the rational, utility maxmising cosumer) as well as the new insights from behavioural economics will be critical to developing comprehensive and relevant mechanisms for consumer protection.

    We should have the insights from behavioural economics up on the blog in the next few days.