BackCapability ousts financial literacy
Our market structure is a 'buyer beware' one, where information empowered consumers will sort through various options that competing firms will offer, and make the best decision that maximises their economic utility
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When in the space of one month you get three calls all asking for inputs on the same issue, you know that the dollar pipeline behind the question is green and flush. The callers wanted to better understand ‘financial capability’. What happened to financial literacy? That used to be the buzz word till recently. It seems that after the spectacular and expensive failure of financial literacy efforts, the new thing that is soaking up attention, effort and, of course, money, is building financial capability. I think we’ll see marginally better results in this, but five years and millions of dollars later, they will move onto something else. But let’s understand why literacy became the buzzword, why it failed and why building capacity is doomed.
Our market structure is a ‘buyer beware’ one, where information empowered consumers will sort through various options that competing firms will offer, and make the best decision that maximises their economic utility. This buyer beware model, where the responsibility sits on us as consumers for choosing the right product, is based on the twin pillars of full disclosure by firms and of literate consumers who are able to decode these disclosures.
Real life is far from this and it has taken western academia decades to accept the fact (some people still live in the Ayn Rand elitist utopia and refuse to believe that reality bites) that markets fail because disclosure is legalese and consumers are not actually capable and don’t actually choose rationally. The easiest regulatory cop-out has been to keep pushing responsibility onto consumers. This has been done by pushing for more financial literacy. Financial firms were thrilled because they could now spend money on literacy camps that had little or no effect on the real ability of people to choose financial products. Helaine Olen’s book, Pound Foolish: Exposing the Dark Side of the Personal Finance Industry (https://bit.ly/290kVyV ), is a must read for knowing how this works.
Financial literacy efforts have failed. There is enough research out there to show that they have negligible impact on financial decisions and behaviour. Worse, with time, the efficacy of what was learnt in the classroom reduces. The learning from the failure of financial literacy has been the rise of a new buzz word: “financial capability". The JPMorgan Chase funded report, A Change in Behaviour: Innovations in Financial Capability, from the Center for Financial Inclusion (CFI) defines financial capability as: “the combination of knowledge, skills, attitudes, and behaviours a person needs to make sound financial decisions that support well-being".
We need to be very careful of managing our expectations from building financial capability specially now when millions of excluded people are joining formal finance. For example, the CFI report begins by saying: “Successful financial inclusion requires financially capable consumers who use products actively for their own benefit". The premise is that enough intervention can build ‘financially capable’ consumers who will then maximise benefit. This is the next pie in the sky. Think about it. We need at least 10 financial products in an average life to solve our problems. Each product will be manufactured by at least 20-30 firms. Each firm will have at least 10-50 product options. Try bending your brain around how much you need to read to get to your final product of choice. It is like saying: here are the parts of a car; go build it. When we think about the 500-600 million excluded in India from formal finance entering the market that is based on this premise, we should worry if building financial capability is our regulatory solution to mis-selling.
The capability enthusiasts are closer to the solution than the literacy advocates. But the real solution is still far away. India flagged the failure of this approach in 2009 in a report titled Financial Well-Being: Report of the Committee on Investor Awareness and Protection. Read it here: https://bit.ly/28ZIp4h . (Disclosure: I was the principal author of this report in my role as a consultant to the Swarup committee). We had argued for targeted interventions at the point of sale. We had argued that the person buying is the most open at the time he buys a product to solve a problem.
The best person to impact literacy and build capability is the person who sells the product. And this leads us to a seller beware market place for retail finance. In this market, products are designed so that costs and benefits are clearly visible and can be evaluated by fintech algorithms. The sales incentives are so designed that they work for all parts of the market—consumers, sellers and producers. And finally, the punitive pressure is so high that firms find it less costly to build in seller beware than pay the fines and compensation. In such a market, making sellers responsible for what they vend has a much higher chance of working than in the current form of the market. But let’s not let go of the financial capability idea.
It is useful for policymakers, regulators and financial firms to know what the current stage of financial capability is. If a majority of the population has trouble understanding basic issues such as real returns, compound interest and effective cost, then pushing more and more complicated products in the mass market may not be the way forward. Financial sector regulators need to come together to carry out a financial capability study to map the current state of the nation. This should be done regularly to map changes, if any, and the need for intervention in specific groups of people. Interventions, if any, need to be designed after this work is done. Else, it is just another few million dollars spent on keeping think tanks going.
Monika Halan works in the area of consumer protection in finance. She is consulting editor, Mint, consultant NIPFP, member of the Financial Redress Agency Task Force and on the board of FPSB India. She can be reached at monika.h@livemint.com.
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