The study of behavioural economics is coming to the regulatory realm.

Traditionally, economics has focused on theoretical models that assume individuals make financial decisions rationally. The reality, of course, often is much messier. Now, economists who use insights from psychology to explain why logic often fails are gaining influence with policy-makers, who, in turn, are realizing the importance of both default options and how choices are framed when it comes to public policy.

Now, this approach is coming to the world of regulation. In mid-April, the new regulator that has been created in the U.K., the Financial Conduct Authority (FCA), published a pair of papers spelling out how the regulator plans to use behavioural economics to enhance regulation.

The FCA wants to understand the sorts of mistakes that clients of financial services make, how financial services firms might exploit those mistakes and how all this affects competition within the financial services industry, among other things. The FCA hopes to use this knowledge to improve regulation, which may affect the types of remedies that regulators demand when they find firms to be offside.

This strategy could create more effective regulation for clients without necessarily being more costly. For example, regulators recognize that traditional disclosure just isn’t very effective with retail investors. In Canada, that recognition has led to initiatives that aim to simplify disclosure, such as the introduction of Fund Facts documents in place of prospectuses for the mutual fund sector.

Research into behavioural economics can take things a step further by going beyond the simple intuition that current disclosure is ineffective to test empirically how small changes in the presentation of information can have a large impact on client understanding.

One of the FCA’s papers details a real-world experiment it conducted to examine response rates to letters offering redress to clients. According to the paper, in some cases, clients don’t respond to offers of redress even when it is in their financial interest. This may be because the communications aren’t clear enough or because clients can’t be bothered.

Because firms don’t have any real incentive to try to improve response rates, the regulator set out to test how different tweaks in the form and content of such letters may affect response rates. The FCA found that “subtle changes to the presentation of information can have large effects.”

The FCA conducted a randomized trial with a firm that was planning to write to 200,000 clients to offer redress, testing seven changes to these letters – such as simplifying the letter and cutting its text by 40%, putting in a sentence explaining the claim process in bold type and sending reminders a couple of weeks after the initial letter.

The FCA found that simplifying the text and boldfacing the claims process each had the effect of almost doubling the response rate. Making the text more salient more than tripled response rates. Sending reminders boosted response rates, too – and reminders sent three weeks after the initial letter were much more effective than reminders sent six weeks later.

Other changes that the FCA tested – such as having the firm’s CEO sign the letter, putting the regulator’s logo on the letter and highlighting the contents on the envelope – had little effect.

The most useful changes were to make the text as clear and concise as possible, which promoted client engagement.

The FCA now intends to follow up with further research. It plans to test different delivery methods, such as email and text messages. The regulator also aims to look at improving its own communications with financial services firms; and, it suggests, these insights may be useful in product disclosure requirements.

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