Essay – Rethinking consumer policy theory

Policymakers, regulators and consumer campaigners seem to be continually clearing up after misselling scandals or trying to address chronic market failure in financial services. If we want to avoid repeating the mistakes of the past, then we need to change the approach to policymaking and regulation.

Rethinking consumer policy theory is becoming even more important with the dominant role big tech/big data and recently artificial intelligence now plays in financial services. Many of the problems we see now happen at the ‘intersection’ between financial services and technology. The tech/ data tools that are made available to the financial services industry to indentify and exploit consumer behaviour and psychological weaknesses and biases are a real cause for concern.

There are three priorities:

  • Rethinking competition policy and financial innovation
  • Understanding the respective roles of the state, civil society and financial sector to tackle chronic financial exclusion and underprovision
  • Assessing the true cost of market based provision of core needs (pensions, health and social care, and social security)

Rethinking competition policy and financial innovation – less is more

To make financial markets work for consumers, we need to change the way we think about competition policy and innovation. This is not some abstract, academic debate. In the UK, the permissive approach to regulation has been dominant. Permissive regulation is built on the premise that:

  1. allowing loads of choice and competition combined with information disclosure will ensure the market meets consumers’ needs; and
  2. markets shouldn’t face too many constraints on innovation with regulators only intervening ex-post to clean up after the event when there is overwhelming evidence of market failure.

But this dominant, permissive approach has not been effective in key financial sectors and has simply allowed thousands of products of questionable social utility to come to market at a huge cost to consumers and the industry (in the form of huge redress costs). It may sound heretical but consumer campaigners should stop worrying about the number of products and providers on the market and levels of switching.  Conventional competition indicators (numbers of providers and products, price disparities, entrants and exits etc) don’t actually tell us whether markets are working.  What matters is whether the market produces the right outcomes and consumers’ needs are met.

With thousands of products and firms, consumers are certainly not short of choice in financial services. But too many products can be just as damaging to consumers’ interests as too few products. In certain cases, having a limited number of choices leads to more efficient markets and better  value – the NEST pension scheme is a case in point.

Over the years, there has been a great deal of new product development and ‘innovation’ and furious competitive activity. But this is very different to true innovation and competition that works in the interests of consumers.  Financial providers have competed fiercely to acquire market share but that is not the same as competing to meet the needs of consumers.

Product proliferation increases the level of product development and marketing costs. It also increases search, distribution and advice costs. This results in poor value and reduced access and greater financial exclusion as products are more costly to distribute to consumers. Product proliferation goes hand in hand with confusion marketing which undermines the ability of consumers to understand product risks and undermines consumers’ ability to make effective financial choices and decisions. This increases the risk of misselling or consumers being persuaded into making unsuitable choices and decisions. The pervasive application of tech/ data and now artificial intelligence exacerbates these risks.

Many of the arguments against tougher regulation are based on claims that regulation stifles innovation to the detriment of consumers. Of course, regulation shouldn’t inhibit true innovation. But the question is: how do we judge real, socially useful innovation?

We use six tests to judge whether a financial innovation is socially useful (or competition is working well to produce markets that work in the interests of financial users). The tests are – does competition and innovation:

  • reduce costs/ enhance value for consumers;
  • make markets safer/ reduce risk/ help manage risk better;
  • improve access for consumers;
  • result in consumers making better choices and decisions including appropriate usage of products[1];
  • meet a hitherto unmet need for consumers;
  • result in more efficient allocation of resources within the financial system to the benefit of the real economy?

Much of the ‘innovation’ and product development we have seen in financial markets over the past few decades would not have passed those tests.

There is a lesson here for policymakers and regulators. To judge whether markets are working, policymakers need to use a more deliberative approach to measure whether the primary consumer outcomes[2] are being met rather than use conventional competition indicators.

Over time, the aim should be to streamline the number of products on the market, get rid of the socially useless products, and end up with fewer, simpler, safer, better value, well designed products that meet consumers’ needs. This of course has implications for the financial services industry. It means employing fewer staff in marketing and associated activities and more ‘compliance’ staff whose job is to ensure that products are safe. Compliance is often seen as a burden by the financial services industry or a drag on corporate performance. This is the wrong attitude. In other industries – airlines, nuclear industry etc – they would called safety engineers and be seen as an integral part of getting the product right and protecting the reputation of the firm.

To make markets work, the permissive, ex-post approach to regulation may need to be replaced with a more precautionary, ex-ante approach with policymakers having the confidence to consciously shape markets to ensure consumer needs are met. This is all the more important given the dominant role tech/ data and artificial intelligence plays in financial services.

Instead of unfettered competition, a bounded competition or managed markets approach is more appropriate for complex markets such as financial services.  This means changing the default position on competition and financial innovation to a more sceptical, precautionary approach with: product governance interventions to ensure products meet minimum standards and are designed and sold to the right target audience; constraining (or even prohibiting) detrimental behaviours and business models and shepherding firms into adopting good practices (that is ‘bounding’ market behaviours);  and positively encouraging financial innovations that pass the six tests outlined above.

The need for a new consensus between the state, civil society and financial sector to tackle chronic financial exclusion and underprovision

Tackling the chronic financial exclusion and underprovision seen in the UK requires long term solutions, not short term fixes. In turn, to identify and implement the right solutions, we need two things:

  • the proper analytical framework to understand the underlying causes of exclusion and identify the most effective interventions (including whether a market based approach is appropriate in the first place); and
  • the right ‘political’ framework to provide clarity around the respective roles of the financial services industry and the state and other providers (charities, social housing providers etc) and long term thinking and consensus to provide a degree of certainty for the stakeholders involved.

The table below summarises the root causes of chronic financial exclusion and underprovision along with the potential interventions that may be selected to tackle the problem identified.

Causal factors Description Potential interventions
External socio-economic factors Low/ unpredictable incomes and other socio-economic factors means households are not economically viable for commercial financial services Mandated provision,alternative provision, social justice interventions (eg USOs), cross subsidies, mutual provision
Demand side factors Low levels of financialcapability, lack of awareness, confidence and trust means consumers may be unwilling or unable to engage effectively with financial services Financial capability initiatives,information disclosure, public information
Supply side factors Market inefficiencies, weak ordistorted competition, pricing strategies, product design, sales practices and behaviours, training and competence of agents/ staff, poor risk assessment means the industry cannot serve hard-to-reach or lower income households fairly or efficiently Structural/ marketinterventions, regulatory interventions, product interventions, campaigns to improve confidence and trust (addresses demand side problem above) etc


Regardless of which sector we look at, if a market based approach is the default option, the priority is to try to ensure the market is as efficient as possible (as well as treating customers fairly). In theory, the more efficient the market is, the lower the unit costs of distribution which in turn extends the potential number of households which can be reached on commercially viable terms.

In the UK, it is the job of the financial regulator to ensure markets are competitive and efficient, and to protect consumers who are in the market. UK financial regulators have tended not to have social justice objectives. In other words, if the market can’t deliver for certain groups, regulators do not mandate provision. That is seen as the preserve of government policy

But this still leaves two key problems to be resolved.

Firstly, even if the industry achieved optimum efficiency, this still leaves a large number of households who are not commercially viable or attractive for commercial financial institutions on any terms.

Secondly, market based systems are amoral and allocate value according to economic power and/ or influence not according to rights. This means those consumers with the greatest bargaining power (in terms of being more profitable or being in the position to exercise pressure on financial firms) will get a better deal than those in a more vulnerable position. This can lead to price discrimination and/ or ‘unfair’ cross subsidies.

There are several responses to these problems. The state can provide some form of cross subsidy to improve the viability of those excluded households[3]. Alternative, non-market based provision can be developed (but note this may have been the most appropriate solution in the first place)[4]. The state can mandate that the market provides a service on certain terms to excluded households (for example through a universal service obligation[5] or investment in communities[6]) or it can mandate non-discriminatory access[7] . Or the state can work with the industry to persuade it to offer services to excluded households on a voluntary, self-regulation basis.

The appropriate solution will vary depending on the nature of the problem identified and particular product or service involved. For example, given the infrastructure required to ensure consumer access to a functioning, transactional banking network, it is sensible to mandate a role for the major clearing banks. In other areas – for example, access to affordable credit – it may be more effective to develop and promote alternative providers such as community lenders. Similarly, creating a collective pension solution in the form of NEST was always going to be more effective than trying to make the individual, personal pension model work for lower-medium income savers.

A more difficult ‘political’ problem is how to deal with cross-subsidies which may be distorting markets. For example, concerns have been raised for some time about the potential distortions caused by the free-in-credit banking model prevalent in the UK. In theory, not charging customers for operating high volume standard bank accounts means banks have to recoup revenue elsewhere. The concern is that this revenue is being recouped from less visible areas of banking operations and from consumers who don’t have the same degree of influence and representation. If this is the case, the banking sector could work better if we had a simpler, more transparently priced banking model with standard accounts charging a reasonable monthly administration fee and basic bank accounts charging a minimal or zero fee.  But, current accounts are a very visible product and attract much attention from media and consumer groups so there is considerable pressure to maintain this model. As a result, there may be significant reputational risk involved for a major bank who wanted to end the free in credit model. So, we do not think we will make much progress on this issue unless we achieve some form of consensus on what is fair and reasonable.

As we can see, selecting the most appropriate and effective solutions for tackling financial exclusion doesn’t just involve objective economic analysis and financial innovation. It involves difficult ‘philosophical’ questions regarding the respective roles of markets and the state (or its agents in the form of regulators), and issues of fairness and equity between different groups of consumers.

This is why we argue that a new consensus or ‘social contract’ is needed between the state, civil society, and the financial services industry to:

  • provide a framework setting out the roles, responsibilities, and expectations of stakeholders; and
  • set out principles of fairness and equity so we can establish when it is appropriate for regulators to intervene on grounds of social justice not just consumer protection.

We do not see much progress being made on developing long term solutions to chronic financial exclusion and underprovision until and unless these issues are addressed.

Is rolling back the state a false economy? Assessing the cost of market based provision of core needs (pensions, health and social care, and social security)

One of the most important (but less obvious) policy issues we must face up to relates to the way the costs of meeting critical needs through state/ collective provision or market based/ private sector are analysed and compared.

Why is this important? Major economic, demographic, and social forces are putting pressure on the costs of providing security in retirement, decent health and social care, and housing. Many experts have used this opportunity to argue that the state can no longer ‘afford’ to play the same role and that there must be a bigger role for private/ market based provision. This creates a potentially much bigger role for the financial services industry and its products. Therefore, it is critical that we assess how the efficiency of these mechanisms for meeting priority needs.

The UK faces major public policy decisions about how it funds the critical public policy challenges including:

  • Decent, secure, good value pensions
  • Funding the NHS/ healthcare
  • Good quality long term care
  • Meeting childcare costs
  • Affordable housing – especially social housing and affordable rented housing
  • A decent level of social security or a ‘safety net’ to protect people from financial shocks caused by losing their job or seeing wages reduced, or ill-health.

Of course, it costs money to fund meet these challenges. Depending on the need the costs of funding are to varying degrees shared between the state and the individual.

At the risk of being over-simplistic, the total funding required (from public and private sources) depends on two main factors:

  • The quality of provision we expect for citizens (for example, the target pension/ earnings replacement ratio, quality of housing, access to and quality of health and long term care, replacement value of social security safety net compared to earnings); and
  • Selecting the most efficient mechanism for funding these challenges. Choosing a less efficient mechanism means it costs more to provide the same level of provision which means that unnecessary costs are borne by citizens including future generations who do not have a say in the matter.

Therefore, when thinking about public policy, the key decisions to be made are:

  1. How should the costs be allocated between different groups of citizens in society?
  2. How much should be shared between the individual and the state?
  3. What proportion should be funded on a pay-as-you-go (PAYG) or pre-funded basis?
  4. Which type of mechanism should be used – state/ collective or market based/ private?

The answer to the first question is a political decision so we do not address this. Therefore, the key financial services policy decisions concern the balance between state and individual, between PAYG and pre-funding, and which type of mechanism should be used to prefund costs.

As we explain (see Funding Long Term Care cost) these needs can either be paid for on a pay-as-you-go basis (out of current taxes) or ‘pre-funded’ in some way (prefunded hypothecated tax, through savings accumulated over time, some form of insurance or releasing equity from property).

In terms of prefunding mechanisms, there are a number of possible options available including through the state/local government (that is the state could require citizens to pay into what would be a hypothecated national insurance fund/ council tax), other forms of collective provision (similar to the NEST pension scheme), or individual private sector financial services products (long term care insurance, income protection insurance, private pension products/ equity release schemes etc).

With regards to increasing the supply of social housing/ rental properties, similar choices apply – it could be funded by government borrowing/ taxes or mechanisms such as allowing institutional investors to fund through infrastructure funds (this is in effect borrowing from institutional investors rather than the government borrowing direct from the markets using gilts).

Many experts believe that we should try to prefund a large proportion of the future costs as this would protect future generations of citizens. But this is a more difficult question than first appears. The comparative efficiency of pre-funding versus pay-as-you-go depends on whether the growth in the economy (out of which PAYG costs must be met) is greater than the return produced by the alternative pre-funding mechanism. But assuming that the most efficient prefunding mechanisms can be found, it seems sensible to prefund a meaningful proportion of the future liabilities to protect future generations.

This leaves the questions of how to decide the balance between the state and individual and which type of mechanism – state/ collective or market based/ private – should be used to fund these policy needs.

Currently, the dominant view amongst policymakers and experts seems to be that demographic trends and pressures on public finances mean that:

  1. the state cannot afford to provide the same level of services; and
  2. an increased share of the funding costs needs to borne by the individual and less by the state.

As a result of this received wisdom, there is an attempt to transfer greater risk and responsibility from the state to the individual and/ or from state funded to private sector funding mechanisms.

The financial services industry and others have taken advantage of these fears about the perceived unsustainability of the state to promote private sector replacement solutions such as health insurance, long term care insurance, income protection insurance, or infrastructure funds to allow pension funds to fund housing. The argument goes that this would have the effect of transferring the costs and risks of funding future liabilities off the state balance sheet and saving the taxpayer money.

But the big question is: does using private sector replacement funding mechanisms actually save money or is it an illusion? The answer is that just because the state reduces the share (or actual amount) it spends on important issues such as health, long term care, social security, or housebuilding doesn’t mean the cost disappears – it is simply displaced and citizens pay for it in other ways.

This might be acceptable if it was just a one-for-one replacement – that is, if society ended up paying the same through private sector mechanisms to produce the same outcomes as they were through state funding. It would be more acceptable – indeed it would make sense to do this – if using private sector replacement mechanisms were more efficient than public funding and saved money overall (although there would still issues around fairness and equity as market based mechanisms allocate value according to economic power not needs or rights).

However, with regards to these important public policy areas – pensions, health and long term care, social security, social housing – evidence would suggest that state/ collective funding is likely to be more efficient than private/ market based funding.

For example, the NEST collective pension scheme is more cost effective than individual personal pensions because of the economies of scale and paradoxically the absence of competition which drives up costs. The same principles are likely to apply to long term care insurance products and income protection insurance.

The UK’s publicly funded and operated NHS is £ for £ is considered to be one of, if not the, most efficient health system amongst the major economies.

Similarly, the financial services industry is pushing infrastructure funds as a way of attracting institutional capital to be used for housebuilding and other infrastructures. This might be a good idea in theory but in practice this would be much more costly than funding the same infrastructure through government borrowing – that is, through gilts or even National Savings and Investments. Institutional investors would expect a risk premium (that is a higher return) and/ or expect to see some element of cash flows underwritten. In effect, infrastructure funds could be the new private finance initiative (PFI).

So, as we can see, the cost savings claimed by capping or reducing state spending and moving funding costs to private or market based funding, is in all likelihood an illusion and produces a false economy. As a nation, we still have to fund these core needs (unless of course we reduce the level of care available, our expectations of what constitutes a decent income in retirement, decent housing etc – but that’s a political decision). The likelihood is that, as a society, collectively we would end up paying more to provide the same ‘unit’ of pension, healthcare, housing, and social security due to the inherent inefficiencies of the private, market based replacement mechanisms.

There is a real problem in the way we account for public spending and the cost of replacement provision. If politicians manage to get the costs of funding core needs off the state balance sheet into the private sphere, this is presented as the prudent thing to do. But national accounts or other official analysis do not show the consolidated replacement costs of funding the equivalent needs through private/ market based mechanisms – which, as explained, is often higher than state funding.

But, why does this matter? It matters for two reasons. Firstly, it means as a nation, the UK is not having a fully informed, frank debate about the costs of meeting these core needs in the face of demographic and economic forces reshaping our society. It means there is an increased risk that, rather than saving money, society pays more. Secondly, with regards to specific financial services issues, it means that consumers could end up relying on more costly financial products and investments to meet their needs.

So let’s hope that this year we see a more honest and frank debate about the sustainability of the state and efficiency of using private sector replacement mechanisms to meet citizens’ needs – or else there will be a price to pay.

[1] Such as avoiding overconsumption of credit and underconsumption of savings

[2] The consumer outcomes are: access; safety and resilience; fairness and integrity; efficiency and true innovation; appropriate consumer behaviours; redress and accountability; justified confidence and trust; and limited externalities.

[3] For example, through matched savings

[4] For example, building capacity amongst community lenders such as credit unions

[5] Or providing a legal right of access to a basic bank account – which will happen as a result of recent EU legislation

[6] For example, similar to the community reinvestment requirements in the USA

[7] for example, not allowing insurers to use risk based pricing or gender as a factor for calculating premiums