My principal objective in writing this book has been to correct a fallacy of composition, namely that the current regulatory route has made individual firms safe but in so doing has actually increased the whole financial system’s fragility. Casualties among ordinary consumers in a systemic crash are high. If we can make the system safer, this should give them greater protection. Often, proposals presented as making the system safer are really about better consumer protection. Examples of these include measures that encourage or ban certain instruments, the choice of discouraging bad behavior through either civil or criminal law, and the rearrangement of regulatory institutions. I address these questions over the next few chapters.

Even in a safe system individual firms can and will fail and individual consumers can and will fall victim to wrongdoing. In this chapter, I focus on those aspects of consumer protection that are independent from systemic risk concerns. Those only interested in new ideas on systemic risks may wish to skip this chapter.

In a departure from the rest of this book, I do not assert that there needs to be a complete reinvention of existing regulation when it comes to consumer protection. The current regime is inadequate but not heading in the wrong direction or unhelpful. My aim is to offer thoughts on how we can push beyond the existing regulations. The framework of consumer protection I present mirrors my approach to systemic safety—particularly in applying the risk capacity concept used with regards to banks in Chapter 5 and insurers in Chapter 6. Readers may be interested to see how far this idea can be extended, in this case to ordinary consumers. Let us begin by briefly reminding ourselves why consumers in the financial industry need extra protection.

Why Do Financial Consumers Need More Protection Than Other Consumers?

In most industries, consumers make repeat purchases. They can quickly identify inferior quality and easily take their business elsewhere. Purchasing an unsatisfactory product does not incapacitate them. Consequently, purveyors of consistently sour orange juice go out of business and consumers expect the remaining providers to offer a tried and tested product. Market incentives generally work in the interests of consumers. When markets fail, product liability laws step in to protect consumers’ rights and enforce the responsibilities of sellers and producers. Public and private consumer advisory and information bodies can also facilitate optimum protection of consumers’ interests.¹

Buying financial products is completely different. We do not shop for and change our mortgages, life insurance, pensions, and car loans on a weekly basis. These are products that you have for a long time, sometimes a lifetime. A savings instrument, like an endowment policy, can run for more than twenty years. It can take years to realize you have bought a lemon² by which time the original seller may no longer exist, leaving you without a remedy to correct the situation. The consequences of buying an inadequate pension or a too-costly mortgage can be catastrophic—including old-age penury and even homelessness. The plight of those holding subprime mortgages in the United States will still be fresh in the minds of readers. In Australia, the collapse of HIH Insurance in March 2001, with losses of approximately A$5.3 billion,³ affected over one million policyholders. It left an estimated 50,000 people facing severe financial difficulties. Many were the seriously ill with income protection policies, car accident victims, and those with defective homes. British readers will recall the disastrous end of the world’s oldest mutual insurer, the Equitable Life Assurance Society, which was closed to new business in December 2000. Its near 1.5 million members suffered a £4 billion loss, ameliorated somewhat when the UK Government stepped in with £1.5 billion in compensation a decade later. Similarly, when the Executive Life Insurance Company, California’s largest life insurance firm, went bust in 1991, those who had paid annual premiums for life insurance and pension policies would have lost everything had the US Government not taken over the ­company’s liabilities.

The average buyer of retail financial products does so only a couple of times during a lifetime. He has significantly less expert knowledge than sellers engaged with these products daily. This particular asymmetry of information and opportunity, in favor of the seller, makes it possible to beguile the inexperienced buyer into decisions that really only advantage the seller rather than the buyer.⁴ The miscellany of conflicts of interest and abuse of asymmetrical information includes excessive commissions and bonus payments for pushing clients into particular products regardless of the suitability.⁵ Such conflicts of interest were thrust into the limelight during the 1980s and 1990s, coinciding with the Thatcher and Reagan administrations of the 1980s and their later imitators. On both sides of the Atlantic, the government privatized state assets thus creating a new supply of private assets. It pulled back from state-sponsored social insurance which led to a new demand for these assets. Deregulated financial intermediaries were paid to bring the supply and demand sides together.⁶ In the process, a financial institution’s traditional fiduciary obligation to look after its client’s interests swirled in ever-increasing conflict with other interests.⁷ Asymmetrical information and conflicts of interest are the most common and often the worst instances of consumer abuse. But they did not first come ashore with the deregulating governments of the 1980s. While the scale may have increased, there is a long history of consumers being swindled by purveyors of financial products as far back as the Mississippi and South Sea bubbles of 1719–20⁸ and no doubt before.

The Elements of Modern Consumer Protection

The main elements of consumer protection have been constant for the last 30 years and approximate to a philosophy of individual responsibility. Consumers are free to make their own choices. However, especially for nonexperts in finance, choices should be free of undue pressure and made from an informed position. One critical element of this philosophy is the distinction between “vulnerable” consumers requiring extra advice, information, and protection and others who may be assumed to have the expertise and resources to look after themselves. This general approach could be characterized as “caveat emptor” rather than “caveat vendor.”⁹

A critical issue in practice is defining who constitutes a vulnerable consumer. They are deemed a broader group than those in a home for the bewildered. The term includes people who could lose their livelihoods by buying something they do not understand. In some jurisdictions it also includes those deemed politically vulnerable—such as minority consumers.¹⁰ Strict regulation exists regarding not so much what but how financial products are sold to vulnerable consumers. For instance, there are many jurisdictions that have regulations about the information that must be disclosed in a contract and understood by the purchaser. There are also often rules concerning which messages must be avoided in advertisements so as not to give a false impression of less risk or greater virtue ­inherent to a particular financial product. A popular approach taken by independent financial advisors is to ask ordinary consumers what their risk appetite is, and, based on the response, to steer them toward certain types of instruments and away from others.

Incidentally, most governments insure cash deposits at banks but only up to a level designed to cover the cash savings of the vulnerable and less well off. This limit tends to be raised in a crisis and languishes at forgotten levels during the good times.¹¹

Another key element of modern consumer protection concerns conflicts of interest between producers or sellers of financial products and those who advise buyers. Initially, only clear conflicts of interest, but later even potential conflicts, must now be disclosed. Increasingly, these conflicts, as well as certain types of referral fees, are being barred altogether. Financial education designed to make consumers less vulnerable and wiser to potential conflicts of interest is often seen as a critical element of the informed choice approach to consumer protection.

The final key element of current consumer protection is the prudential regulation of firms offering financial products to vulnerable consumers. This so-called “microprudential” regulation is designed to ensure that firms do not collapse leaving their customers in the lurch. Arguably, the microprudential regulation of banks began as the quid pro quo of deposit insurance, introduced by the Glass-Steagall Act (1933) in the United States and through similar legislation in several other countries around that time.¹² Since the state carried the risk from deposit insurance, and banks profited from this, microprudential regulation of banks happened the way a car insurer might place covenants on a driver’s age to improve the odds that the insurance would not be called.

Explicit state guarantee of insurance payouts is far less common than it is for bank deposits.¹³ However, as we have seen in the case of Equitable Life and Executive Life, states often feel compelled to provide a safety net when insurance firms fail, mainly because of the huge number of ordinary consumers involved. Today this is being used as a justification for more extensive ­regulation of insurance firms’ solvency.

The Historical Evolution of Modern Consumer Protection Regulation

Each failure to protect consumers has pushed the evolution of regulation in this area. I would argue that it is easier to appreciate this by looking at older crises rather than the GFC where the scale of bailouts¹⁴ shifted the focus of reform from consumer protection to taxpayer protection. Faced with the unpopularity of slashing government expenditure to finance bank bailouts, politicians have sought ways of involving the private sector next time around (see Chapter 4), including private sector funding of deposit insurance.¹⁵

The GFC also popularized the belief that certain financial instruments are inherently dangerous and should never be sold to vulnerable consumers.¹⁶ There is still a preference for regular warnings from regulators about the use of certain instruments—like financial spread bets in the UK—rather than the imposition of outright bans, but bans are becoming more frequent. On August 6, 2014, the UK’s new Financial Conduct Authority used its consumer protection powers for the first time in suspending the sale of “cocos” to retail investors on the grounds that the instruments were “highly complex” and “unlikely to be appropriate for the mass retail market.”¹⁷ Yet the distinction between what is appropriate or inappropriate is murky. It is hard to comprehend why, if cocos are too risky for retail investors, financial spread bets are also not too risky given their extreme volatility and the poor odds of beating the house.¹⁸

Looking back before the GFC, conflicts of interest were seen to have played a major role in both the 1907 and 1929 stock market crashes. The 1933 Glass-Steagall Act tried to deal with the interweaving of commercial lending, stock trading, and underwriting viewed as a root cause of the boom and bust that brought considerable losses to ordinary consumers. It sought to resolve the conflicts of interest that the connection of activities within the same institutions created—such as the corporate finance division raising money for corporate clients by helping them to issue securities and then selling those same securities to clients of the brokerage or asset management divisions. Glass-Steagall divorced commercial banking from securities underwriting. Commercial banks were not allowed to issue, underwrite, sell, or distribute any type of security with the exception of US-government and government-agency securities and certain municipal bonds.¹⁹

Hindsight suggests that this enforced, legal separation provided important protection to consumers. However, it became increasingly leaky. The division was eroded over time and was constantly attacked by industry lobbyists, suggesting that US competitiveness was being undermined relative to the many jurisdictions without similar separation. Samuel Johnson’s oft-quoted remark, “Patriotism is the last refuge of the scoundrel”, comes to mind. In 1999, the Gramm-Leach-Bliley Act formally removed laws separating commercial banking, investment banking, and insurance activities, though by then the divisions had long since been undermined.

In the run up to the 1999 change in the law and shortly afterward, conflicts of interest returned with a vengeance, helping to propel the dotcom boom to great heights. The revelation of these conflicts in the inevitable bust spawned a series of laws and legal settlements worldwide. Once again they were designed to lessen conflicts of interest or at least require disclosures of potential conflicts. The most recognized law was the Sarbanes-Oxley Act of 2002²⁰ in the United States. It mandated greater disclosures of conflicts by securities analysts. Other rules sought to reduce conflicts by unbundling investment banking services. Trading commissions, for instance, could no longer include an unquantified payment for research or for giving trading clients access to investment banking clients.²¹

In the UK the government’s attempt from the late 1980s onward to reduce state provision of pensions, by incentivizing and facilitating greater private provision, was a precursor to a spate of misselling scandals. Lloyds TSB was considered the worst offender, with 44 percent of the 22,500 policies sold between 2000 and 2001 being deemed inappropriate for the investor. Rules on how financial products are sold to retail investors were subsequently strengthened.

Around the same time as the pension misselling scandal in the UK, the Enron and WorldCom scandals were unraveling across the Atlantic. They involved conflicts of interest between auditors and the managers and shareholders of companies. One of the main achievements of Sarbanes-Oxley was the establishment of US standards for external auditor independence. This restricted, for instance, audit firms from offering non-audit services—like management consulting for audit clients. Several countries have followed suit with similar legislation.²²

Microprudential regulation of financial firms has evolved substantially with each wave of bailouts. The capital that banks must set aside has become a highly complex affair of estimating a bank’s risks. Minimum capital levels to be set aside against risk-weighted assets has increased though what constitutes risk and what is deemed capital swings back and forth.

Is the Current Approach Working?

The liberal consumer protection philosophy described earlier has prevailed for the last 30 years. The approach that existed before was more rigid, bounded as it was by the 1929 stock market crash and ensuing global depression and at the other end by the 1980s liberalization of finance.²³ Deposits were guaranteed up to strict limits to avoid bank runs, and, as described previously, a separation of retail and commercial banking from investment banking was legally enforced to avoid conflicts of interest. While the regulatory narrative is of course highly politicized, it is arguable that consumer protection made strong gains between 1929 and 1979. Subsequently, there was less progress on defending consumers from abuse and more on enhancing consumer choice. Whatever the narrative, the abuse of consumers in relation to financial products has not noticeably trended lower with time and legislation over the past 30-odd years. I do not believe the current approach is delivering better protection. This is so despite the explicit recognition that consumers need extra legal protection coupled with the acute public and political awareness of consumer hardship resulting from faulty financial products.

Measuring consumer protection, however, raises a plethora of issues. What should the reference point be? Is it the number of actual victims of financial fraud versus the past figure or even the number of potential victims that matters? How do we compare different frauds inflicted upon consumers? Can we take into account consumer losses that do not go through the legal system?

In August 2012, the American SEC brought a civil enforcement action accusing ZeekRewards of perpetrating a massive Ponzi scheme in which a penny-bid auction site promised 1.5 percent daily returns to members who paid to place bids on goods where the lowest unique bid “won.” The court-appointed receiver estimated that some 2 million people were defrauded the tune of $600 million.²⁴ Was it a financial-fraud or garden-variety consumer fraud? Was the sub-prime scandal worse because half a million families who took out a subprime mortgage had their home in foreclosure?

On the subject of subprime—another highly politicized issue—there is a question as to whether all subprime borrowers were truly victims since many would not have had a home but for a subprime mortgage. The numbers game brings interesting comparisons. It would suggest that “subprime” had fifty-times-worse consequences than the fate of a mere ten thousand elderly and retired people persuaded by Lloyds TSB and others in the UK to replace reasonable state pensions with dud private ones. It is difficult to compare and contrast consumer protection over time. However, even drilling down to similar types of consumer protection failings does not reveal a recent downward trend.

Prior to 2007, it might have been arguable that enhanced microprudential regulation of banks had delivered a downward trend in bank failures. Post-2007 this is revealed to have been an illusion.²⁵ There were just 4 bank failures in the United States in 2004 and none in either 2005 or 2006. However, this quiet period was followed by 297 failures between 2009 and 2010 alone. Foreclosures of mortgages followed a similar trajectory.

Increased consumer information, education, disclosure and greater protection of vulnerable consumers have not protected consumers from being lured into the most traditional of investment frauds—the Ponzi, or pyramid, scheme. Although the term is often used too liberally, a real Ponzi scheme, named after Charles Ponzi’s 1920 scheme in Boston, is one where existing investors are paid returns from the cash of new investors. This unsustainable strategy works so long as the amount of new money flowing in is greater than the money owed to existing investors. With an attractive-enough rate of return being promised, and initially delivered, these schemes can last for a long, long time.²⁶

The demise of Bernard L. Madoff Investment Securities was an unpleasant Christmas gift to thousands of investors in December 2008. In terms of the loss of investor principal, it was the largest Ponzi scheme in history (at circa $17.3 billion). The trial and subsequent human tragedies means that few are unaware of Bernie Madoff. Yet despite this scandal, and despite the visible tell-tale signs of any Ponzi scheme in the form of unrealistically high and steady investment returns, consumers still queued up to join later schemes or failed to exit them. Post-Madoff, investors in Stanford Investment Bank’s certificates of deposit lost between $4.5 and $6 billion. Lenders to Petters Group Worldwide lost $3.7 billion. Investors in Nevin Shapiro’s Capitol Investments USA lost over $150 million. More than five years after closing down Madoff, the SEC closed Edwin Fujinaga’s Ponzi scheme where investors lost $800 million.²⁷ It seems that consumer choice and consumer protection are as much substitutes as they are compliments.

This book has already dealt extensively with the failure to save banks using risk-sensitive approaches to bank regulation.²⁸ So here we will focus on protecting consumers other than by ensuring the vendor doesn’t collapse. There are a handful of reasons why the existing efforts to protect consumers fall short of their goal. Let us examine these in greater detail before contemplating possible solutions. It is important to focus on the actual problem we are trying to solve rather than getting waylaid by the myriad of potentially good ideas.

What Is the Problem We Need to Solve?

At the core of this issue is the reality that most consumers are liquidity constrained. Regulators in developed countries imagine that the rest of society is like themselves. They are employed, work hard and become more senior over time. Each new pay grade allows them to put aside interest on the mortgage, payoff the car loan, and perhaps add to a pension and life insurance. They also spend time dealing with the new robber barons running hedge or private equity funds from the comfort of their mega yachts. What regulators sometimes forget is that those on median incomes lead a very different existence. The average consumer behaves as if cash-strapped with few assets and would consume more today if she could borrow on the basis of future earnings—a definition of being liquidity constrained.

This behaviour may be a reflection of social pressures to increase consumption as well as the realities of income inequality. In the UK, while the vocal economic and political elite earns multiples of £100,000, the average income of a working person is £27,820. But even this average is not representative. The median income, which 50 percent of the population earn less than, is £22,880 with 25 percent earning less than £14,300. Compare that with the average cost of renting a two-bedroom flat in London at £19,260. London is the most expensive part of the UK and incomes are often higher. However, rents are still as much as £6,558 or 29% of national median incomes for a one-bedroom flat in County Antrim and North Lancashire—the cheapest part of the country, with attendant lower incomes, higher unemployment, and prevalent underemployment.²⁹ Many countries have a more even income distribution than the UK or the United States. Yet the harsh truth is that in most of the world, ordinary consumers do not have much spare cash and want more. They exhibit a strong liquidity preference.³⁰

Some suggest that liquidity concerns are merely part of today’s fashion and are often fashionable following a major crisis. But evolutionary psychologists argue that strong liquidity preferences in humans are ancient. What psychologists call a “positive time preference” is hardwired into our genes and not merely a feature of the less fortunate. Our genetic design has evolved over several hundred thousand years in an environment where survival was a minute-by-minute affair. It made sense to opt for existing gains or pleasures rather than a hypothetical benefit in an uncertain future.³¹

No matter how many brochures or investment warnings are thrust in front of them, liquidity-constrained people favor riskier bets where they put aside less and hope to receive more.³² Liquidity-constrained people spend a greater proportion of their income on lottery tickets than others.³³ Most people who participate in lotteries understand that they are bad bets. The expected outcome is negative—the ticket price less the probability of winning, times the outcome if you do win is a loss. Yet they continue to buy lottery tickets weekly because doing so offers a miniscule chance of escaping their current predicament. When a financial advisor opens a box of chocolates, reads out the different ingredients, and asks which one they have an appetite for, liquidity-constrained individuals willingly take riskier choices.

Unintended consequences are a major issue with attempts to protect consumers. For example when single careers limited to one or two employers over a lifetime of continuous work were common, pension plans, life insurance and medical plans were usually linked to the employer—the so-called occupational pension and health schemes. Employers used these schemes to incentivize loyalty where the longer an employee stayed, the greater the benefits. In return, loyal employees received the benefits of risk spreading, pooling, and professional management of their pensions and often also received a subsidy (effectively paid for by those who only stayed with the employer for a short while). Overall this proved a mutually satisfactory bargain. However, there were alarming instances of troubled firms dipping into the pension plan, underfunding it, or closing it down without adequate provision for previous pension commitments.

Robert Maxwell’s sudden death in 1991 revealed that the Mirror Group boss had, it appears, stolen £400 million from the 32,000 member-strong company pension scheme. Another classic example was the sale in 2000 of the last British mass-market car manufacturer, MG Rover, to a group that was advised by the firm’s auditors and included its former CEO. The price tag? £10. The government supported the takeover on the grounds that it would keep Rover in British hands and jobs local. The so-called “Phoenix Four” took the firm private, apparently pocketed £42 million from the pension fund before the firm collapsed in 2005 with no payouts or pensions for current and past workers.

Inquiries into these affairs called for widespread reforms to make their repetition impossible. Enacted reforms in the UK and elsewhere included requiring employers to fully account and provide for their future pension liabilities. However, the present value of these liabilities and funding gaps swing markedly with the rise and fall of long-term interest rates and stock markets. This was a particular problem for old or downsized companies like national coal, rail or post-offices. These were companies whose pension funds and commitments were huge relative to current company size. The value of the pension fund fluctuated immensely with changes in the business’ earnings. This scenario was further complicated by steadily rising life expectancies that in turn increased pension liabilities. Longevity risk—having to pay a pension for a longer period than anticipated as life expectancies rose—played a role in the demise of the Equitable Life Assurance Society. The management at companies with large pension funds were frustrated as attempts to rectify challenges at the operating company level were swamped by shifts outside of their control, such as the general direction of stock prices, shifts in interest rate levels, and increased longevity risk. Securities analysts came to view such companies as really pension funds or, in the United States, as retiree medical plans, with a small operating business attached. This disincentivised firms from continuing their pension and similar commitments.

Over time, firms began switching from defined-benefit or final-salary pension schemes to defined-contribution schemes. In a defined-contribution scheme, the final pension is determined by whatever size of annuity could be bought with the value of the pension pot. Pensions became variable, dependent on investment performance, (largely stocks), rather than fixed in proportion to final salary or length of service. This meant that the liability was no different than the asset—a positive development from the perspective of the operating company. There would be no more wild swings in earnings as a result of the performance of things the company could not influence. In short the employer ceased to act as insurer of the employees’ pension, merely the manager.

This was sold to pensioners on the basis that there was less chance of a company failure ruining their pension à la Maxwell and it made pensions as portable as employment and careers had become. But it also meant that the risk of the final pension being inadequate had effectively shifted from the firm to the employee. Employees are far less able to manage these additional risks. In the name of protecting consumers from pension fraud, regulators shifted much of the pension risk to those least able to manage it. Trying to protect consumers from pension fraud risk through accounting standards had unintended and significantly adverse consequences.

Traditionally, economic theory held that greater choice was always to be preferred. Up until the GFC that was also the credo followed by regulators.³⁴ Over the past twenty years, economics has begun to embrace and incorporate new psychological research that offers a more critical evaluation of choice. It is now suggested that while some choice is desirable too much can be debilitating. Nobel Laureate Daniel McFadden argues that excessive consumer choice creates the perception that there is a significant risk of getting it wrong—a problem augmented by the fear of getting life-impactful financial decisions wrong.³⁵ Arguably this explains why rising incomes in many countries and the associated pension, health, and welfare reforms have actually led to increased anxiety and unhappiness. There is an increase in uncertainty and risk attached to the benefits that were previously considered—rightly or wrongly—as an entitlement. Prolific choice has become a double-edged sword.³⁶

Conflicts of interest remain a major cause of consumer grief. They continue to exist because they are imbedded in the actual business model of financial advice. Advisors get paid by telling consumers to do something that either directly or indirectly generates a commission. Today these commissions must be disclosed, are increasingly unbundled, and some are simply banned. The obvious answer is to extend the scope of these bans. However the reality is that consumers do not want to pay directly for advice, especially if that advice, however correct, involves telling them to do nothing, or is something they could have done themselves. More bans have not meant more independent advice. There is merely less advice now. Once more, regulation has shifted greater responsibility onto consumers.

Another challenge we face with consumer protection relates to the interplay between past norms and new risks. Regulators find it difficult to ignore the baggage of their history. They could easily ban new-fangled products like bail-in securities on the grounds of being too risky. However, almost all the cutting-edge products are merely new combinations of preexisting products. The risks they carry can be recreated using old, common instruments. Yet stating that consumers can no longer be trusted to buy what they, their parents and grandparents, have always been able to buy is politically untenable.

Several products our parents bought, such as unlisted penny stocks, time-shares and cash-value life insurance were also likely to lose them money. Consider for a moment the buying of ordinary shares. The annual volatility of the S&P 500 Index—a diversified portfolio of five hundred stocks—is around 20 percent. The volatility of various individual stocks within that portfolio is much higher and the median investor holds possibly one, maybe two, stocks but not five hundred. These stocks are often not chosen for their diversification. More than likely they were inherited through employment or a connection to a family business. Regulators stop institutional investors with their expert, professional investment managers from buying too many equities but dare not ban retail investors from doing the same. History can get in the way of trying to make regulation coherent.

Despite all the financial education, independent advice, and mandated disclosures, the best predictor of consumers’ investment decisions is often tax policy. The average consumer’s principal savings are tied up in property. Not only can consumers leverage up to own a property investment, if they categorize it as their main home, the returns are often free of capital gains tax. In several countries, most notably the United States, mortgage interest is also tax deductible.

Life insurance policies enjoy favorable tax treatment. Often, after exhausting their tax-free investment accounts, consumers are persuaded to buy opaque investment instruments (cash life insurance policies) disguised as life insurance policies solely for the tax benefits. Financial regulators and the tax authorities are seen as distinctly separate plates, yet much of the financial industry lies along the active fault lines of the two. To ignore tax policy is to ignore a significant aspect of how consumer choice works in practice.

Increased consumer choice and increased disclosures to make those choices better informed, coupled with some additional safeguards, seems an almost-noble approach, nested in individual responsibility. Alas, it does not work in a world of liquidity-constrained individuals. This failure is further confounded by conflicted investment advice, accounting practices that discourage the choices customers really need and tax policies that encourage substitution of proper investment decision-making with tax planning. But to note these constraints is not to advocate an abandonment of the existing tools of consumer protection. Indeed, efforts to reduce conflicts of interest, rules on how something should be sold, and what disclosures are required are all exemplary and necessary. However, they are simply insufficient in a liquidity-constrained world. Preserving the distinction between vulnerable and regular consumers is correct—although in the section below I suggest drawing the line between them differently. Doing so would improve the functioning of the financial system and its capacity to provide financial protection to certain consumers. It has also been argued that the mere presence of hedge funds and private equity firms distorts markets, tilting them against vulnerable or even ordinary consumers. The popular solution advocated in Europe is that they are taxed out of ­existence. I will examine this solution before presenting my own.

Should We Clamp Down On Hedge Funds and the Like In the Name of Consumer Protection?

Financial markets need liquidity to operate properly. A well-functioning market is one where locating a buyer for every seller and vice versa does not require wild price swings. Liquidity requires diversity.³⁷ In a sense, it requires “losers”, namely investors prepared to bet that a falling market will soon turn around. While the crowd sells, they buy, providing liquidity and helping to stabilize markets. To be buyers when all others are sellers, they must be working with different valuations, objectives, or capacities. “Chasers”—those who sell markets that are going down in price or buy those going up—drain liquidity and cause instability. Regulators should observe the proportion of “losers” and “chasers” in their markets and consider ways, like those we will discuss in Chapter 12, of stopping their markets being overrun by chasers. Failure to do so risks a repeat of events like the May 6, 2010, “Flash Crash,” when the Dow Jones Industrial Average Index plunged over five hundred points, or 4 percent, in a matter of a minutes—the biggest intraday points swing in the Index’s history.³⁸

So to function well, financial markets need a section—albeit a relatively small proportion—of investors who are unconstrained. They must want to buy when all others are selling or are critically prepared, as we shall see further on, to sell insurance against future losses when everyone else wants to buy it. Who would want this role of “loser,” or financial insurer? Should it be Aunt Agatha, risking her life savings, or alternatively, a hedge fund with seriously wealthy investors who could afford to lose everything in the fund? In the interests of financial market liquidity, those investors who can prove that they have a level of assets where the risk of old-age penury is small should be unconstrained. This goes hand in hand with being unprotected by the state. Unconstrained does not mean above the law on insider-information or creating false markets. It is simply that they can afford to lose everything and should never be bailed out. The distinction we should draw, therefore, is not between financial experts and non-experts but between those with the capacity to absorb huge losses and those who cannot.³⁹

Individual Capacity for Risk and Loss

Following on from our earlier discussion, we should assume that ordinary consumers, no matter how much information, disclosure, and warnings they have, would behave in a liquidity-constrained manner by placing irrational bets.⁴⁰ How should they be protected? I suggest borrowing from the framework based on the concept of risk capacity developed in Chapter 5 for banks and Chapter 6 for insurers. This is a subtle but crucial shift from the current approach of using risk sensitivity and risk appetite. Liquidity-constrained individuals will go for the greatest potential return, within the boundaries of familiarity or social acceptability. Often these are bad bets. They do not even represent the best return per risk.⁴¹ Simultaneously, in asking consumers about their risk appetite, financial advisors are posing the misleading connection that higher returns are available only to the brave. Of course while higher returns come from taking greater risks, certain individuals have a greater ability to absorb particular risks than others. Extra returns are available to them without being bold and fearless. Others have less capacity to absorb the same risks so for them the return available requires a higher level of bravery. The game of good investment is not to be the bravest. The key is to first maximize the return available by taking risks that are less of a risk to you than for others given your specific capacity to absorb those risks.

Factors that influence this absorption rate include how the financial risk is being taken and funded and whether a consumer has a natural ability to hedge the risk. Also important is whether the consumer possesses a superior understanding and knowledge of the risk, which makes it smaller for him than others. Take the example I discussed in the previous chapter. If a consumer is saving to foot the expense of a medical emergency, he has little scope to earn extra returns from taking liquidity risks. Recall that liquidity risk is the risk that asset prices would be significantly lower if you were forced to sell tomorrow as opposed to having time to find a willing buyer. The consumer may have some modest scope to take liquid credit risks if he is able to diversify his investments. If, on the other hand, he is putting aside a monthly amount for a pension in twenty years’ time, he has the capacity to earn extra returns from taking liquidity and market risks. He doesn’t have the capacity to absorb inexpertly managed credit risks as credit risks rise over time allowing for a corporate bankruptcy or other adverse credit event to materialize. The “What is your risk appetite?” approach to consumer financial advice rides roughshod over the essential connection between risk taking and risk capacity.

Consumers are borrowers as well as savers. Indeed, in the Anglo-Saxon world, they often borrow to purchase assets (homes) that eventually become their principal savings. However it may be easier to comprehend consumer protection issues from the perspective of a consumer buying a dud savings product. I will illustrate my suggested approach with the case of savings products, but similar principles can be applied to borrowing. In a sense, borrowing is merely savings in reverse. You receive the payout up-front and then repay through monthly contributions. The protection concerns are about whether the size or variability of those contributions are understood and appropriate to the circumstances of the consumer.

Ordinary consumers should only be able to invest in insured funds. A further set of consumers with more than a certain minimum level of assets would be allowed to invest in uninsured funds. The insurance could come from either insurance firms or financial providers purchasing financial insurance securities, like financial options. It is likely that part of the return of the less ordinary investors will come from selling financial insurance to ordinary consumers, helping to close the investment loop. There are some parallels here with the original Lloyds insurance market where syndicates of wealthy “names”, who were occasionally ruined by doing so, insured the rest of us.

There would be different tiers of maximum losses. The logic of this tiered arrangement is fourfold. The risks available to liquidity-constrained consumers need to be limited for the reasons previously cited in this chapter. Once a consumer has sufficient liquidity in safe assets to buffer life’s unanticipated events, she can afford to take proportionally greater credit and liquidity risks with savings and borrowing products. Those with more disposable income have a greater capacity to take credit and liquidity and market risks than others. Finally, to achieve the best allocation of their resources, mixing assets and liabilities, consumers need to be explicit about what capacity for risk their investments or borrowing requires. It might be the capacity to lock up funds for a lengthy time, or be able to manage a diversified pool of credit risks.

For example, a fund could be insured against a loss of principal in excess of 10 percent on a daily basis. This insurance sets the risk capacity of the fund. To reduce insurance premiums and boost net returns, this fund’s manager would end up taking credit rather than liquidity risks. He would also invest in a diversified portfolio of short-dated bonds of corporates with plenty of interest cover from their earnings. Another fund could be insured against any loss of principal, but only after a five-year period. The manager here has a wider capacity to invest in liquidity and market risks but not credit risks. This diversified portfolio would have a significant equity component as well as other investments whose risks can be spread over time.

Regulators would only have to set the broad parameters of the insured funds market that retail investors would be allowed to invest in freely. The market would then develop on its own. There would be funds that insured end-of-period returns up to one day, six months, two years, and beyond. Funds could also insure against a loss of principal greater than 0 percent, 5 percent, 10 percent, and 20 percent. Ordinary consumers would only have access to invest in a higher tier after reaching a minimum level of investment in the lower tier. A consumer wishing to invest in a fund that was insured against a loss of principal greater than 10 percent must show investments in funds with a loss of principal of less than 5 percent.

Minimum investment-per-tier levels would be informed by consumer surveys and set quite low. The purpose is to provide the most restraint to those with the least capacity to take risk. Others can be less constrained. In 2015, American households have, on average, $12,800 to save or spend on discretionary items and individuals less than that.⁴² We accept that the mean average hides a skewed distribution and the authorities may prefer to use the median rather than the mean level.⁴³ The minimum investment in the lowest risk tier before a consumer is allowed to proceed to higher tiers could be set at 50 percent of the average annual discretionary spending and savings available to individual consumers ($6,400). The minimum investment in the next tier could be set at 25 percent ($3,200), the next tier at 12.5 percent ($1,600), and so on.

Many will share my extreme unease at the extent of paternalism being presented here. They may prefer an alternative where disposable income is automatically placed in different accounts in accordance with the structure described, but which consumers can then opt to reallocate. A traditional economist might argue that this is a nuisance. People will end up where they would otherwise have chosen to be after the unnecessary costs of both time and expense. However, there is now a substantial amount of literature on how simple, gentle nudges can and do change behavior.⁴⁴

This alternative approach is probably best mated with a more muscular approach to ensuring independent financial advice. Instead of multiple disclosures and lengthy fine print, financial advisors should be banned from any relationship with financial services providers. They should be paid by an agency for independent financial advice. The service would be privately delivered but centrally funded through a small transaction fee like the Section 31 fees⁴⁵ that finance the US Securities and Exchange Commission. Central funding will allow for advice that sometimes recommends doing nothing.

Conclusion

Ferdinand Pecora, chief investigative counsel to what became known as the Pecora Commission, looking into the background of the 1929 Great Crash wrote, “Legal chicanery and pitch darkness were the banker’s stoutest allies.”⁴⁶ More than eighty-five years later, consumer protection in the financial industry remains a crucial and highly charged issue. Worldwide many a politician has built a hefty career on this single issue. In 2015, the “freshman” Massachusetts senator, Elizabeth Warren, was thrust into the democratic senate leadership mainly because of her relentless campaigning on this issue. Legislators have rapidly responded over the years with ever-tightening rules regarding conflicts of interest and disclosures. Yet each turn of the legislative screw appears to merely mark time before the next costly deception entangles us. The solutions I have described run the danger of paternalism. This must be weighed against the current approach of informed choice which has proved insufficient to the challenge that ordinary consumers, given the choice, eagerly and deliberately, make bad bets.

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¹In the UK, there is a rich history of consumer advice bureaus. My mother never considers buying anything before consulting Which? consumer magazine. She would deliver an exasperated look if her children failed to follow this example.

²Lemon is a term used in the United States and elsewhere to refer to a faulty product.

³See Doug Galbraith, Chris Davis, and Phillips Fox, the HIH Royal Commission Report, (Canberra: Phillips Fox, 2003).

⁴This is explained further in one of the most powerful essays in economics: George Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84, no. 3 (1970), pp. 488–500.

⁵For many more juicy stories of an abuse of conflicts of interest in finance, see Avinash D. Persaud and John Plender, “Fiduciaries,” in All You Need to Know About Ethics and Finance: Finding a Moral Compass in Business Today (London: Longtail, 2007).

⁶It was never presented thus and there were plenty of other legitimate reasons for the privatization of state assets and the deregulation of finance.

⁷See Persaud and Plender, “Mis-selling & Investor Protection,” in Persaud and Plender, Ethics & Finance, 2007; and Philip Augar, The Death of Gentlemanly Capitalism: The Decline and Fall of UK Investment Banking (London: Penguin, 2000).

⁸See Gary S. Shea, Understanding Financial Derivatives During the South Sea Bubble: The Case of the South Sea Subscription of Shares (Oxford Economic Papers 59, supplement 1, Fife, UK: University of St. Andrews, 2007), pp. i73–i104.

⁹While the principle of caveat emptor, Latin for “buyer beware”, gives responsibility to buyers, it does not mean that sellers are beyond reproach. This concept is neatly encapsulated in the following extract from the Bank of England’s Fair and Effective Markets Review (London: Bank of England, 2014, p. 17):

“[Caveat emptor] . . . has always been subject to the general law on fraud and misrepresentation, which has long been relatively strict, embodying the principle that (in the words of a Victorian judge, Lord Macnaghten in Gluckstein vs. Barnes [1900] AC 240) ‘sometimes half a truth is no better than a downright falsehood’. And over the years the practical application of the caveat emptor principle has been further qualified by judicial and statutory intervention (for example on implied terms), by disclosure and other provisions of consumer law, and, in the context of investment transactions, by statutory and regulatory rules. For example, caveat emptor does not trump the regulatory obligation on a firm to act ‘honestly, fairly and professionally.’ Market manipulation cannot therefore be said to be consistent with caveat emptor, even where it takes place between two counterparties of broadly equal bargaining power and sophistication.”

¹⁰Vendors are required not to discriminate against vulnerable consumers, which can sometimes rub against the need to give this group additional care.

¹¹In October 2008, the limit of the Federal Deposit Insurance’s guarantee of bank deposits was raised from $100,000 to $250,000.

¹²Today, around 100 countries have some form of deposit insurance. Typically, not all depositors are insured. The insurance tends to only cover retail deposits—so not deposits of companies or counterparties. Even on retail deposits, there is a cap with the current EU cap set at €100,000. The argument for capping is that it limits the cost of the scheme, protecting those least able to protect themselves—the vulnerability distinction—while also eliminating the spectre of bank runs.

¹³This is because a key motivation of deposit insurance is to stop a bank run. Depositors recognize that the failure of one bank can trigger the failure of others. However, their precautionary attempt to pull out their deposit from a safe bank for fear of losing it during a collapse could itself cause a collapse. Runs on insurance firms are far less likely (except in the rare case of reinsurance, insurance firms do not lend to insurance firms) so there is no need to avoid them by insuring insurance payouts. There are schemes to help alleviate insurance losses. In the US, for instance, several individual states (but not the federal government) must place a proportion of insurance premiums into a fund that can be drawn on to compensate customers in case of an insurance firm’s failure.

¹⁴The headline-hitting pledges of Treasury support to banks came to over $7 trillion worldwide, with the UK government alone pledging £1.2 trillion. However, the final amount of direct support, and the ultimate cost once repayments are considered, was a small fraction of this, excluding the final costs of the support offered through the central bank, which has not yet been accounted for.

¹⁵In December 2013, EU member states agreed on reforms that would require governments to impose fees on banks equivalent to 1.0 percent of insured deposits, earmarked for disbursing the costs of resolving or rescuing banks.

¹⁶For an explanation of why this is generally a bad idea, see Chapter 8.

¹⁷Cocos (or contingent, convertible, notes) are bonds issued by banks that pay an attractive coupon in good times and in bad; contingent on the issuer’s capital falling below a stated threshold, they convert into equity that could be lost completely without any recourse. For the FCA press release on restriction of the sale of cocos, see www.fca.org.uk/news/fca-restricts-distribution-of-cocos-to-retail-investors.

¹⁸Further compounding the mixed messages, in the UK financial spread bets are also subject to the lowest level of betting tax—3.0 percent—but are banned outright in many other jurisdictions.

¹⁹Following the Glass-Steagall Act, the doyen of banking at the time, John Pierpont Morgan, chose to remain in commercial banking, but two of his partners, Harold Stanley and Henry Morgan, founded a new investment bank: Morgan Stanley.

²⁰The official title is the Public Company Accounting and Investor Protection Act more commonly known as SOX. It was enacted on July 30, 2002 in the wake of a series of major corporate and accounting scandals, including WorldCom and Enron. Enron’s collapse brought down Arthur Andersen—at that time one of the “big 5” accounting practices. The company was found guilty of criminal charges relating to its auditing of Enron.

²¹This was a particular concern during the dotcom and later housing-finance bubbles when ordinary investors felt that banks were giving their more frequent trading clients, like hedge funds, priority access to information and opportunities regarding their investment banking clients.

²²SOX-like regulations on auditor independence and stricter corporate governance were enacted in Canada, Germany, and South Africa in 2002; France in 2003; Australia in 2004; India in 2005; and Japan and Italy in 2006.

²³In the UK, there was a raft of liberalization measures that were collectively referred to as the “Big Bang” of 1987. In the US, Glass-Steagall was watered down through the 1980s and effectively repealed by the Gramm-Leach-Bliley Act of 1999.

²⁴See the ZeekRewards Receivership Web site: http://www.zeekrewardsreceivership.com/.

²⁵For an explanation of how banks’ risks have been exported off balance sheet only to return when the crisis struck, see Avinash Persaud, “Where Have All the Risks Gone: Credit Derivatives, Insurance Companies and Liquidity Black Holes,” Geneva Papers on Risk and Insurance 29, no. 2 (April 2004), pp. 300–12.

²⁶For one of the best studies of modern Ponzi and pyramid schemes, see Ana Carvajal, Hunter Monroe, Catherine Patillo, and Brian Wynter, “Ponzi Schemes in the Caribbean” (WP/09/95, International Monetary Fund, April 2009).

²⁷See U.S. Securities and Exchange Commission, “SEC Freezes Assets in Ponzi Scheme Targeting Investors in Japan” (SEC Press Release 2013-201, Washington, DC, 2003), www.sec.gov/News/PressRelease/Detail/PressRelease/1370539844572#.VNDq5GR4oz.

²⁸See Chapter 5.

²⁹Based on £1.58 million postings on Gumtree, the UK’s site for classified ads: www.gumtree.com.

³⁰The idea of liquidity preference and its economic implications was developed by John Maynard Keynes in The General Theory of Employment, Interest and Money (New York: Harcourt Brace, 1936).

³¹See Rajendra Persaud, “Choose Long-Term Benefits over Constant Cravings, ” Times Educational Supplement, January 16, 2004.

³²See Milton Friedman, and L. J. Savage, “The Utility Analysis of Choices Involving Risk,” Journal of Political Economy 56, no. 4 (August 1948), pp. 279–304.

³³See Emily Haisley, “Loving a Bad Bet: Factors That Induce Low-Income Individuals to Purchase State Lottery Tickets” (Pittsburgh: Carnegie Mellon University, 2008).

³⁴I recall UK regulators, prior to the GFC, wondering aloud whether it was right to deny the less well off the choice and benefits of investing in hedge fund-leveraged and unconstrained investment firms.

³⁵See Daniel McFadden, “Free Markets and Fettered Consumers” (AEA Presidential Address, January 7, 2006). Professor McFadden shared the 2000 Nobel Prize in Economic Sciences with James Heckman for his work on the development of theory and methods for analyzing discrete choice.

³⁶Some, like Renata Salecl and Barry Schwartz citing experimental psychology and consumer studies, describe too much choice as debilitating, a tyranny, and a source of despair. See Renata Salecl, The Tyranny of Choice (London: Profile Books, 2011).

³⁷See Avinash Persaud, Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk (London: Risk Books, 2003).

³⁸I remember the Flash Crash well. I got up to give the after dinner talk at a conference in Geneva as the meteoric fall began. Only later did I understand why everyone was ignoring my carefully planned remarks and staring, nose down, open mouthed, at their BlackBerrys.

³⁹After the GFC, many well-remunerated financial experts in asset management companies objected to being termed experts. They stated that they could not have possibly known what they were buying when they placed credit default swaps in their portfolio to spice up returns and boost performance bonuses. It is best not to assume anyone is an expert. Focus should be directed at their capacity for loss.

⁴⁰See M. Friedman and L. Savage, “The Utility Analysis of Choices Involving Risk,” Journal of Political Economy, 1948, Vol 56.

⁴¹Which would be the preferred position of a risk and liquidity-neutral investor.

⁴²See Experian Discretionary Spend Report.

⁴³That number where 50 percent of observations are higher and 50 percent are lower.

⁴⁴See Daniel Kahneman, Thinking Fast and Slow (New York: Farrar, Straus and Giroux, 2013). Daniel Kahneman won the 2002 Nobel Prize in Economics for his work on the psychology of judgment and decision-making and its implications for the study of economic behavior. Also see Richard Thaler and Cass Sunstein, Nudge: Improving Decisions About Health, Wealth and Happiness (New Haven, CT: Yale University Press, 2008).

⁴⁵This refers to Section 31 of the US Securities Exchange Act of 1934. As of February 2014, it requires each exchange to pay the commission a rate of $18.40 per million transactions, which raises in excess of $1.5 billion to cover the costs of the SEC.

⁴⁶Ferdinand Pecora, Wall Street Under Oath: The Story of Our Modern Money Changers (New York: Simon and Schuster, 1936).