READ - Making the financial industry more like a health service.
12 Minute Read
Your advice today is coming from Paul Kofman. Professor Paul Kofman holds a PhD in Economics (1991) from Erasmus University Rotterdam, the Netherlands. He came to Australia in 1994 as a Lecturer in Econometrics at Monash University. After subsequent positions at UNSW and UTS, he was appointed as Professor of Finance at The University of Melbourne in 2001 and was Head of Department from 2006 until 2010. Following two years as Deputy Dean (Faculty), he became Dean of the Faculty of Business and Economics in May 2012.
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The unethical conduct in financial services being exposed by Australia’s Royal Commission is the latest wake up call for the industry to refocus on the well being of its customers.
Earlier this year the chief of a major financial planning firm collapsed in the witness stand during Australia’s ongoing inquiry into misconduct in the financial services industry. He had to be carried out and taken to hospital in an ambulance – some would say a fitting metaphor for the state of the industry.
Fortunately for him the health industry doesn’t operate like the financial planning industry, otherwise he might have been ‘treated’ according to what was most profitable for the ambulance service rather than his own physical well-being.
Australia’s Royal Commission into the financial industry is exposing unethical misconduct – customers are being charged fees for services that they never get or ever need, they are getting inappropriate advice, being offered irresponsible loans and being sold worthless insurance contracts.
It shows up an industry riddled with conflicts of interest and obsessed with extracting profits from customers in any way conceivable.
Sound familiar? The 2007-09 Global Financial Crisis was in large part caused by the same “profit-at-all-costs” culture that fuelled high-risk home lending to ordinary people who couldn’t afford it.
Why haven’t things changed?
Despite the lesson of the GFC and despite a regulatory crack down, the central problem with the global financial services industry is that, unlike the health industry, it has long stopped really caring about the well-being of its customers.
Financial services, such as payments and basic forms of credit and insurance, are one of the essential services society relies on – like health care, electricity and clean water. Without them, our economy would come to a grinding halt and society would disintegrate. For this reason, the large financial services firms often receive privileges such as market protection and implicit government guarantees worth billions of dollars, underwritten by tax payers.
So how has the bar been allowed to sink so low?
At the heart of the problem lies the mental model that the finance industry applies to itself and to the world around it. This thinking is dominated by the neoclassical model of economics in which people are ‘rational actors’ who always do what is best for them, and interact with each other through perfect markets, leading to the efficient allocation of resources in society.
While everyone understands this as an idealised abstraction, the impact of this working assumption is profound.
It has led to an ‘input-oriented’ model. Banks and other financial services companies are exclusively concerned with providing whatever inputs – in the form of financial products and services – their customers demand. This has led to a proliferation of products that are sold to customers using state-of-the-art marketing techniques, irrespective of any concerns over whether the customer actually needs them.
In this rationalist world, undesired outcomes are often considered to be the responsibility of the customer. If the customer ends up with too much credit card debt, possibly as a result of aggressive marketing, then don’t blame the bank.
Regulatory and public policy responses are also premised on this model. The dominant approach in financial regulation is focused on disclosure, requiring financial firms to provide more and more information about the financial products they supply.
This has led to product disclosure statements that are often hundreds or thousands of pages long and littered with legal and financial jargon that is often incomprehensible even to experts.
Rather than clarifying the nature of financial products, disclosure requirements have only made them more opaque.
This rationalist approach has led the industry and regulators to promote financial literacy education as a way to address the problem. Here, the goal is to educate consumers about financial products and services to help them navigate the financial system.
The Australian government spent tens of millions of dollars on its MoneySmartprogram, aimed at educating both children and adults in finance. The Bank of England has recently launched econoME, a program with very similar aims.
But this rationalist model ignores a core aspect of finance. Many financial problems that consumers face are highly complex, even for the more financially literate among us.
For example, determining a person’s optimal lifetime savings and investment strategy to provision for an adequate level of income in retirement is a formidable problem, even for a finance expert with a supercomputer.
It is beyond the capability of the average person to work out many financial decisions on their own, and we shouldn’t expect people to do so – just as we don’t expect the average person to perform brain surgery.
If we accept that many aspects of finance are hard, we will need to give up on the rationalist model. Instead we need to switch to an outcome-focused model in which the primary concern is for people to reach a set of outcomes or goals – a certain level of financial well-being for example.
Services offered by banks and regulations imposed by governments would then be evaluated on the extent to which they offer to improve people’s financial well-being. Banks would only offer services that have been shown to improve one or more dimensions of their customers’ financial well-being, aligning their interests more closely with those of their customers.
Financial services and their regulation would look radically different. For example, fewer decision options and simpler products would be more effective in improving financial well-being.
New technologies such as artificial intelligence could likely play an important role in facilitating this new world of finance.
Importantly, both the development of services and their regulation should be based on scientific evidence and delivered under a set of professional standards monitored by an independent standards-setting body, similar to the processes and institutions used in the health system. Providers of financial services would then be subject to both a fiduciary duty and product liability.
The future of finance doesn’t lie in more regulation, or in the use of ever more sophisticated technology to squeeze higher margins out of legacy products.
The future of finance lies in the rediscovery of what is finance is for – to improve the financial and economic well-being of society.