I. Introduction
The manner in which people react to behaviourally informed disclosures would typically
have some influence in the context of advised transactions, where a consumer meets an
advisor at some point in the chain of pre contractual and contractual events. In the light of
recent financial regulations, it is also of interest to examine how market interventions and/or
nudges change the economics of information disclosure. Prior research has shown that
disclosures have little impact on consumer behaviour and can backfire by leading advisors
giving even more biased advice. Policies requiring full disclosure have been portrayed as
ineffective or even counterproductive. Moreover, postponing disclosure was often viewed as
the preferred strategy since it attracted a legally straightforward (though morally
objectionable) wealth transfer. In addition, the 2008 financial crisis provides a good example
of how consumer naiveté can be exploited through inefficient contractual practices which
creates scope for better and more effective policy intervention.
This research seeks to develop systematic knowledge of how disclosure is linked to
efficiency and incentives of market participants. Development of a clear rationale for
efficient disclosure choices could have substantial implications in financial regulation since
the notion of reducing information asymmetry is consistent with regulatory views about
increasing investor confidence through more transparency. There is a need for a more refined
theoretical framework about how sellers disclose information and the potential role for
regulation in encouraging efficient disclosure. This would rest on findings related to how
rational buyers respond to information withheld by financial advisors. The starting point of
analysis would be the observation that information has economic value since it allows
individuals to make choices that yield higher expected payoffs than in the absence of that
information. Rather than focussing on whether disclosure is good or bad, (which is a question
to which there is no simple answer) it would be more productive to focus on exploring situations when the benefits of transparency outweigh the costs, testing interventions to
enhance disclosure effectiveness.
II. Theoretical Assertions
Professionals in the financial industry regularly face conflicts of interest which inform their
decisions regarding non-disclosure or disclosure of information constituting that conflict.
This research is aimed at demonstrating how this information asymmetry can be bridged
effectively without disclosure leading to unfavourable outcomes that backfire on either party
involved in a transaction.
The central argument is that although prior research indicates that disclosure is generally
ineffective in dealing with unavoidable conflicts of interest, it can be beneficial when
advisors have the ability to avoid conflicts. What consumers infer from a lack of information
is very important and their inference is subject to broad situational contexts which this
research aims to narrow down to advised financial transactions where consumers meet
advisors at some point in the chain of pre contractual and contractual agreements.
Even though recent findings stressing the importance of disclosure contradict prior research
with some conceptual strength and general reasoning, the case for transparency needs to be
strengthened by experimental research which is largely missing. There is a need for a
framework that distil the dynamics of disclosure in a practically applicable manner. While
this applicability can extend itself to various industries, this research narrows its focus to the
problem of informed disclosure in the rapidly growing global private banking and wealth
management industry, which is of tremendous economic importance.
III. Literature Review
Existing research questions the efficiency of disclosure as an answer to issues created by
unavoidable conflicts of interest. For instance, Madhavan (1996, p. 225) asserts that
transparency in securities markets leads to detrimental consequences such as increased price
volatility and lower market liquidity. Policy interventions were discouraged since it was
thought that they would backfire by stifling the beneficial roles played by advisors acting as
financial intermediaries. Sah et al. (2013b, p. 289) recognize the perverse effects of
disclosure in understanding that although disclosure can decrease advisee’s trust in the
advice, it can also increase pressure to comply with that advice if the advisees feel obliged to
satisfy their advisors’ personal interests. However, disclosure could have a positive impact if
it prompts advisees to think differently about their advisor. Evidently, patients have been
shown to take disclosure from their doctor as a sign of expertise or professional standing
(Pearson et al., 2006, p. 623). Analogously, within the finance industry, clients may conclude
that their financial advisor has expert knowledge about the fund he disclosed he invested in.
Sah et al. (2013b, p. 290) hold that advisees must be able to comprehend and correctly adjust
for biasing influence and be able to act on the information given to them for disclosure to
have the desired protective effect. That said, an important caveat is that striking this balance
requires a very high level of expertise and advisees could end up in a worse position (Sah et
al., 2013b).
Prior research has failed to acknowledge that in many contexts, advisors have the ability to
eschew COIs. Sah and Loewenstein (2010) illustrate this in suggesting that doctors can
decide whether to meet with, and accept gifts from pharmaceutical company representatives.
In fact, it has been shown that disclosure can have beneficial effects by deterring advisors
from accepting COIs so they have nothing to disclose except the absence of any conflict of
interest. Previous research has indicated situations in which advisors subject to unavoidable
COIs (say in the case of mandatory disclosure) feel morally licensed to give more biased
advice when their conflict is disclosed (Cain et al., 2005). In case of mandatory disclosures,
governing dynamics change due to other motives arising out of the lack of choice. Broadly speaking, there are two ways forward. The first involves eschewing conflicts leading to disclosure becoming a vehicle of indicating honesty (see Mazar et al. (2008, p. 634)), bearing the monetary risk of the strategy backfiring. The second option involves the disclosure of the absence of COI increasing the likelihood of advice being followed (Sah and Loewenstein, 2014). While Fung et al. (2007) reported some field data on advisor behaviour, there is inadequate experimental research (Sah and Loewenstein, 2014, p. 4) addressing whether advisors are more or less likely to accept COIs in the presence of mandatory or voluntary disclosure.
There is a vast literature on the financial dynamics of increased disclosure, the most recent
findings pointing towards the benefits of increased transparency in light of the 2008 financial
crisis. Leuz and Verrecchia (2000) show how increased levels of disclosure are likely to be
valued by investors, leading to significant reductions in bid-ask spreads and increases in daily
turnover from voluntary adoptions. They logically conclude that such changes should
eventually lead to a reduction in a company’s cost of capital. This appears to be the optimum outcome given that consumers get value due to a reduction in information asymmetry and
investors gain monetary benefit in the long run due to client retention.
A report produced by Oxera in 2012 for the FSA (now known as the FCA1) found practical
tests of the benefits of disclosure indicating the effectiveness of disclosure in making
financial markets work well for consumers. An important and previously under researched
aspect of disclosure was the inherent complexity of information disclosed, which customers
are not always in a positions to process. This applies to pre-2008 mortgage lending
agreements, payday lending and insurance products. If underlying products are complex, then
disclosure of even simple information may either lead to unintended consequences or be
ignored (see Oxera (2012)). There are many examples of apparently simple information that
is not easily understood by typical consumers. This can be attributed to biases where which
lead most customers to act a certain way which is inconsistent with traditional economic
theory. Behavioural finance can support the nature of disclosure in explaining such biases,
however the literature fails to point towards a specific approach due to lack of experimental
evidence.
A preliminary evaluation of existing scholarship in the context of proposed arguments shows
that some of the errors made by consumers are persistent and predictable. Behavioural
finance accommodates for such deviations from standard analytical models and enables
regulators to intervene in markets more effectively. With the establishment of the Nudge unit,
or the Behavioural insights team, there have been numerous tests and over 150 randomised
controlled trials over a huge range of policy interventions for more effective public services
in the UK. The Nudge Unit has shown in its 2013-15 update report how behavioural insights
have delivered (BIT, 2015, p. 53) valuable results in health, tax collection and consumer
markets (among other areas). Most policy concerns human behaviour which is why it can
immensely benefit from a more empirical and behavioural focus.
IV. Theoretical Framework
Most recent theories are focussed on showing how increased disclosure can bring a more
promising financial prospects. Prior research is clearly more aligned with the sentiment of the
1960s and 70s where the view of markets having self-correcting properties was widely
accepted. Alan Greenspan, the much celebrated former chairman of the Fed was convinced
that laissez faire capitalism was the way forward and that markets always get it right. He believed a lie not through a rational deduction but through his conviction of the accuracy and
applicability of Ayn Rand’s libertarian philosophy. This made him a tireless advocate of
deregulation until the crash happened and he finally made a confession that he made a
mistake in assuming that the self-interest of organisations, specifically banks and others, was
such that they were capable of protecting their own shareholders. While the confession might
have felt like a vindication for behavioural economists like Dan Ariely (especially after
publishing ‘Predictably Irrational’), it was also an important step ahead for behavioural
economics because we learnt that relying on standard economics theory alone as a guiding
principle for building markets and institutions might, in fact, be dangerous. It is not
increasingly clear that the mistakes we make are not entirely random but part of the human
condition. Moreover, the mistakes in our judgement can aggregate in the market, sparking a
scenario in which the accumulation of many small-scale mistakes spark a global financial
catastrophe. While western economies still haven’t recovered completely, the turnaround on
Greenspan’s part created new opportunities for behavioural economics, which are yet to be
availed.
While it is now known that the EMP was flawed and that those in favour of it were wrong, it
is now time to propagate the alternative view with required experimental evidence because
the need for it is so great. The research question that is framed out of it is simple. This
research proposal is about the financial dynamics of information disclosure. In recent
decades, there have been many studies about the advance of informational asymmetry and
their implication for contract theory and market failures as a possibility. In economics,
contract theory studies how economic actors can and do construct contractual arrangements
generally in the presence of asymmetric information. One of the most prominent applications
of it is the design of optimal schemes of managerial compensation. The first formal treatment
of this was by Kennith Arrow in the 1960s. A standard practice in the microeconomics of
contract theory is to represent behaviour of a decision maker under certain numerical utility
structures, and then apply an optimisation algorithm to identify optimal decisions. Such a
procedure has been used in the contract theory to represent the behaviour of a decision maker
under certain numerical utility structures, and then apply an optimisation algorithm to
identify optimal decisions. Such a procedure is applicable to several situations such as moral
hazard, adverse selection and signalling. The underlying spirit of these models lies in finding
theoretical agents to motivate agents to take appropriate actions, even under an insurance
contract. The main results achieved through this family of models involve mathematical properties of the utility structure of the principal and agent, relaxation of assumptions and variations of the time structure of the contract relationship, among others. Contact theory also utilizes the notion of a complete contract which is thought of as a contact that specifies the legal consequences of every possible state of the world. More recent developments known as the theory of incomplete contracts pioneered by Oliver Hart and his co-authors, study the incentive effects of parties’ inability to write complete contingent contracts, e.g. concerning relationship-specific investments.
My research is dependent on such framings because it aimed at understanding how informed
disclosures in the context of advised transactions can affect consumer behaviour bound by
contractual and pre-contractual agreements. Note that the assumption of irrationality is
appropriate but will be adapted to specific contexts and amended as required. In addition, the
theoretical framework will be linked to the methodology by choosing quantitatively robust
techniques but also undergirded by a qualitative foundation.
V. Methodology
Behavioural finance remains a discipline that is organised around standard failure of
economic principles. This study aims to begin with a demonstration of the failure of some
common economic assumptions through experiments, proceeding to provide a psychological
explanation for that failure. Through the prism of advised transactions in the financial
industry and data available on market comparison websites for insurance products and credit
cards, this study aims to test the effectiveness of policy tweaks related to informed
disclosures. Behaviourally informed policy design changes need to be experimentally tested.
The gold standard methodology of randomised controlled trials, often used in medical
research would be helpful since people are assigned at random to different treatments
including a control group that receives no treatment. While this approach is ideal, it may not
be practically feasible which is why some compromises might need to be made since
practical difficulties are bound to arise with both, government and private organisations.
There are multiple sources of data for the purpose of analysis. Some of the possibilities are as
follows: (i) Data on advised transactions pre/post disclosure obtained through bank
compliance officers (ii) Data on credit card statements before and after issuing mortgage
contracts and (iii) Data from credit card and insurance comparison websites (with a study on
extended warranties and add-on products). While obtaining data from bank compliance
officers might be difficult, it is possible to work with credit card data comparison websites, collaborating with them to change the way information is presented and record responses
thereafter. The second option gives rise to the possibility of undertaking the Difference in
difference approach, which involves mimicking an experimental research design using
observational data. One could calculate the effect of a treatment such as the manner in which
information is presented on websites on an outcome (turnover, client retention etc.) for the
treatment group to the average change over time for the control group. While this Difference
in differences approach may lead to certain biases, its intended purpose of eliminating
selection bias may also be realised.
VI. Limitations
While the basic idea for pursuing a PHD is in place, the methodology needs to be refined and
a practical way of moving forward and designing an experiment/blending with observational
data is yet to be found
VII. General Discussion and Closing Comments
This research is motivated by the applicant’s interest in behavioural finance and its industry
wide applications. Second, it is driven by the scope of behavioural finance in the near future.
By developing expertise in behavioural finance, I hope to develop systematic knowledge and
specific skill sets which are widely applicable to the finance industry and more specifically to
organisations such as the Financial Conduct Authority and the Behavioral Insights Team.
Having been in contact with Stephan Hunt, Head of Behavioural Economics and Data
Science at the FCA, I have learnt about under-researched areas in the field of behavioural
finance and their potential scope in the future. I envision myself as a participant contributing to the growing literature in this area.
VIII. Indicative Bibliography
1. (Cartwright, 2015)
2. (Klass, 1978)
3. (Shalvi et al., 2012)
4. (Sah et al., 2013a)
IX. References
BIT (2015) 'Behavioural Insights Team Update Report 2013–15', Cabinet Office: London, UK.
Cain, D. M., Loewenstein, G. and Moore, D. A. (2005) 'The dirt on coming clean: Perverse effects of disclosing conflicts of interest', The Journal of Legal Studies, 34(1), pp. 1-25.
Cartwright, A. C. (2015) 'Richard H. Thaler: Misbehaving: the making of behavioral economics', Public Choice, 164(1-2), pp. 185-188.
Fung, A., Graham, M. and Weil, D. (2007) Full disclosure: The perils and promise of transparency. Cambridge University Press.
Klass, E. T. (1978) 'Psychological effects of immoral actions: the experimental evidence', Psychological Bulletin, 85(4), pp. 756.
Leuz, C. and Verrecchia, R. E. (2000) 'The Economic Consequences of Increased Disclosure (Digest Summary)', Journal of accounting research, 38, pp. 91-124No.
Madhavan, A. (1996) 'Security prices and market transparency', Journal of Financial Intermediation, 5(3), pp. 255-283.
Mazar, N., Amir, O. and Ariely, D. (2008) 'The dishonesty of honest people: A theory of self-concept maintenance', Journal of marketing research, 45(6), pp. 633-644.
Oxera (2012) 'Review of literature on regulatory transparency: Prepared for the Financial Services Authority'.
Pearson, S. D., Kleinman, K., Rusinak, D. and Levinson, W. (2006) 'A trial of disclosing physicians' financial incentives to patients', Archives of Internal Medicine, 166(6), pp. 623-628.
Sah, S. and Loewenstein, G. (2010) 'Effect of reminders of personal sacrifice and suggested rationalizations on residents' self-reported willingness to accept gifts: a randomized trial', JAMA, 304(11), pp. 1204-1211.
Sah, S. and Loewenstein, G. (2014) 'Nothing to Declare: Mandatory and voluntary disclosure leads advisors to avoid conflicts of interest', Psychological Science, 25(2), pp. 575-584.
Sah, S., Loewenstein, G. and Cain, D. (2013a) 'Insinuation anxiety: increased pressure to follow less trusted advice after disclosure of a conflict of interest', Work. Pap., Carnegie Mellon Univ., Pittsburgh, PA.
Sah, S., Loewenstein, G. and Cain, D. M. (2013b) 'The burden of disclosure: increased compliance with distrusted advice', Journal of personality and social psychology, 104(2), pp. 289.
Shalvi, S., Eldar, O. and Bereby-Meyer, Y. (2012) 'Honesty requires time (and lack of justifications)', Psychological science, 23(10), pp. 1264-1270.
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