Requiring firms to only sell financial products we can use is good, but not enough

The government’s financial system inquiry^[1], on which I sat, reported five years ago.

It recommended that the creators of financial products be subject to a design and distribution obligation (DDO), which would mean the products they sold had to not only make money for them, but also meet the needs of the people buying them.

An insurance policy that couldn’t be claimed on would fail the test, as would a product that charged fees for advice that wasn’t given, as would any number of products later detailed in the 2018 report of the financial services royal commission^[2].

It’s the first half of 2020, and the Australian Securities and Investments Commission is seeking input into how the obligation will work. It has asked for comments by March 11^[3].

Requiring products to be useful is good…

There ought to be nothing controversial about the idea. It reflects the fundamental premise upon which the free market economy is founded – that transactions should provide gains to both the seller and buyer.

Reputable financial institutions, seeking to meet community expectations, ought to already meet such obligations, although they are likely to incur some (hopefully minor) administrative costs.

However, as history and the royal commission have reminded us, even reputable institutions’ procedures can go awry and lead to badly designed products that exploit consumers.

Read more: CommInsure proves the need for a banking royal commission^[4]

Less reputable firms exploit consumers anyway, leading to a race to the bottom in terms of product quality.

…but not enough

Unfortunately, even if a financial product meets the DDO requirements, which means it is suitable for its intended consumers, it can be a bad purchase for consumers who aren’t aware of its true worth. Retail customers who overpay for a “suitable” product can lose just as much (if not more) as those being sold one that’s unsuitable.

Many financial products (actually, most financial products) have characteristics that make them hard to value accurately. When product outcomes depend on future events – as do insurance products – accurate valuations can be almost impossible even for customers who are financially literate.

For example a consumer might assume that there is a 10% chance of an event happening, when the true probability is less than 1%. Not only would they overpay on insurance (perhaps repeatedly), they would be unlikely to ever know about it.

It’s hard to tell when prices are bad

Suppose a producer can supply a financial product profitably for any price over $6. Suppose that buying it for any price under $8 would would benefit the consumer, but that the consumer is unable to tell what it is really worth.

Since the supplier’s profits increase as the selling price increases, what is there to stop the supplier increasing the price to more than $8 and harming consumers, in part because some would never get the product?

Standard answers talk about competition, disclosure, financial advice and financial education.

But if consumers don’t have the information they need (or the time they need) to do the calculations, what’s likely to happen instead is that competition will cut the worth of the products in ways that are not obvious to consumers.

As important as disclosure, advice and education are, they haven’t been able to stop this happening in the past.

What we are seeing are first steps

Plans by the Australian Prudential Regulation Authority to make banks and other deposit-taking institutions designate an accountable executive as responsible for the “end-to-end” creation and delivery of each product under a Bank Executive Accountability Regime (BEAR^[5]) would be an important step.

The government has announced plans to extend it to all financial institutions, making it a FAR^[6] (Financial Accountability Regime).

But there is nothing in either the BEAR or FAR rules that that would require the executives to price their products fairly.

Read more: HILDA Survey reveals striking gender and age divide in financial literacy. Test yourself with this quiz^[7]

DDO’s, together with the Securities and Investments Commission’s new temporary banning powers, should help to rid the financial sector of the most egregious types of consumer abuse. But will they do nothing to prevent profit seeking institutions setting prices for “suitable” products that cause poorly informed consumers harm.

It is not clear what could, short of instilling a sense of “fairness” into corporate cultures. While welcome, DDO’s are only the start.

References

1. ^{^} financial system inquiry (treasury.gov.au)
2. ^{^} financial services royal commission (financialservices.royalcommission.gov.au)
3. ^{^} March 11 (asic.gov.au)
4. ^{^} CommInsure proves the need for a banking royal commission (theconversation.com)
5. ^{^} BEAR (www.apra.gov.au)
6. ^{^} FAR (treasury.gov.au)
7. ^{^} HILDA Survey reveals striking gender and age divide in financial literacy. Test yourself with this quiz (theconversation.com)