Retail financial services
Speech by Callum McCarthy, Chairman, FSA
Office of Fair Trading's European Competition and Consumer Day
15 September 2005
Any sensible regulator should be seeking first to encourage efficient markets, as the best means of providing goods and services to consumers. Only after market solutions have been exhausted should regulatory initiatives be contemplated. On that basis, the FSA has a prime interest in making the retail market for financial goods and services an efficient market. This morning I want to discuss not structural questions affecting the market (these are the responsibility of the Competition Commission, not of the FSA; for what my views are worth, I do not believe that structural issues are particularly significant). Instead, I want to discuss the behavioural issues which make the retail financial market inefficient.
In terms of behaviour, any efficient market requires three conditions to be satisfied: first, there must be customers, actual and potential, who are equipped to make the decisions required of them; second, information must be available in comprehensible forms which can be accessed without excessive cost, whether of money or of time; and third, the providers of goods and services must meet standards of responsible behaviour. All three of these conditions pose problems for the retail financial services market – particularly for investment products. Let me describe these problems, and what we at the FSA are seeking to do to solve them.
Financial capability
We live in a society where individuals are being asked to make more and more financial decisions, many of which were previously taken for us (in relation to health, or education, or pensions). But against this increasing requirement for financial capability, the actual capability of those who need to make financial decisions is too often inadequate, in terms of basic literacy and numeracy, as well as in respect of specific financial knowledge. Among the adult population in the UK, 23 per cent, if presented with the Yellow Pages and asked to name a plumber, cannot do so. More than 20 per cent, if asked to choose between receiving £30 or 10 per cent of £350, choose the lower figure. Put in another way, more than one in five of adults would not have understood either of the last two sentences. Yet an understanding of percentages is an essential requirement for comprehending many savings products. On financial specifics, the position is comparably worrying: a study by the Institute of Financial Services showed that eight from ten people did not correctly identify the term APR as describing the interest rate and other costs of a loan; five from ten people admit to not understanding financial products such as mortgages or ISAs. A survey done for the FSA asked the question: "if the inflation rate is 5 per cent and the interest rate you get on your savings is 3 per cent, will your savings be worth as much in a year's time?" – one in five gave the wrong answer. The problem of financial capability is immense, in terms of both the basic requirements of literacy and numeracy which underpin financial capability; and in terms of specific financial knowledge.
We at the FSA are seeking to deal with this problem by initiating a programme, involving government, employers, schools and colleges, banks and insurance companies, designed to improve the present very poor level of financial capability. We can play a part of co ordinator, and of catalyst. But the task is much larger. The principal responsibility for a society with literate and numerate citizens clearly lies with government, and with the education system, not with the financial services regulator. The government's spend on primary and secondary education runs at some £32 billion annually. The FSA's total expenditure on all our responsibilities is some £260 million. But within that figure we are taking our responsibilities for financial capability seriously. Our annual plan for 2005-06 shows that our spend on financial capability this year will be approximately double that which we spent last year – which was in turn twice that which we spent in the previous year. For all that increase, this year's spend of £8 million is insignificant in comparison with the government's spend on education, or in comparison with the financial services industry's spend on marketing at £1.4 billion. The challenge for the FSA is to identify where our efforts can have most effect, and where our expenditure has most leverage.
Information
The second problem is information. Many financial services are complex, only occasionally tested or even capable of being tested. I recognise that information will often be a problem. But there has undoubtedly been unnecessary obfuscation and complexity. Let me give an example. With profit life insurance products have been a major investment product in the UK. Central to understanding that product is what has been described as the "reversionary bonus" – yet I have never found an audience, whether of economic students, or lawyers, or other reasonably informed people where one in ten has been capable of explaining even in rough terms what is meant by the term "reversionary bonus". More generally, I would say that with profits products have too often been characterised by doubt about what is meant by "smoothing", and by lack of clarity as to what has been guaranteed. But the problems of information go wider than with profits products, or even wider that investment products.
Information is a problem about which the FSA can and does act: through a basic principle that information should be fair, clear and not misleading; through an emphasis on key facts, aimed at making it easier for consumers to compare products by requiring essentially the same parameters to be covered, in as short and understandable way as possible; or by more product specific information requirements, such as an explanation of the principles and practices which lie behind with profits products.
I would make only two comments on information requirements. First, they are most powerful when the product is relatively standard, and price the most significant factor. It is no accident that motor car insurance has become such a competitive sector, with over 50 per cent switching in a five-year period; nor that the average life of a mortgage has shrunk in the UK to five years. Nor is it an accident that 79 per cent of bank customers have never switched current accounts (since the product offering and the pricing are both indistinct), whereas usually half of retail energy customers in Britain, who have only had choice in the last six or seven years, have switched. Second, we need in both national and EU initiatives to guard against not information overload but data overload – more and more data which has less and less chance of being read, or if read understood. We at the FSA plan to review next year the ten or so documents which are required to be given to a prospective client for advised investment products, with a view to seeing how they can be simplified and the number reduced.
Responsible behaviour
Last, and in concept simplest, there is a problem of providers of financial services who behave irresponsibly – in an extreme form (as with illegal boiler room selling of securities) dishonestly, more often because of a breakdown in internal systems and controls (as with mis selling of precipice bonds to customers who were seeking a secure investment). There has been too much of this historically.
Again, the FSA can and does act against misbehaviour, by first of all advice on how to prevent it happening (a central aim of our treating customers fairly work) and, in selected cases where we have failed to prevent it, through enforcement action.
Conclusion
If we succeed in solving these three behavioural problems, we will have made an important step towards an efficient market in retail financial products – and have the opportunity, which the FSA would welcome, to reduce our regulatory activities.