Caveat Emptor in the retail market for financial services

The discussion of caveat emptor usually begins badly, gets worse in the middle and ends in stalemate - at best! The language of the debate is adversarial and legalistic - and fails to recognise an industry and wider societal issue.

In a single generation we seem to have leapt from being a nation of savers to a nation of borrowers. After all, why save for tomorrow, when you can apparently have it today? This seemingly insatiable appetite for consumer goods has been fuelled by easy credit on flexible terms. Meanwhile, anyone owning property has been reassured by the inexorable rise in values that, on paper at least, has given people the healthy equity, and also the confidence, to continue spending.

Unfortunately, this obsession with today seems to have led to society falling out of love with savings, because pensions are about tomorrow. The credit pit has deepened and the savings ratio has fallen.1

Firms' perspective

Ask any firm in retail financial services whether the principle of caveat emptor exists in today's highly regulated market and it is likely to provoke an emotional debate. Many commentators will express the view that the degree of consumer protection offered by regulation is right, but it has to go hand in glove with consumers accepting more responsibility, such as reading the literature and documentation provided to them, asking questions about anything they are unclear of, and, if unsure, not proceeding.

If we examine the statutory position, the inclusion of the principle of caveat emptor in the Financial Services and Markets Act (FSMA) 2000 was debated at length during the drafting stages of the Act and its progress through Parliament. Indeed, major financial institutions and trade associations, including the IFA Association (the body representing independent financial advisers (IFAs) at the time), submitted evidence to the Joint Committee examining the draft Financial Services and Market Bill. The Industry argued that if the Financial Services Authority (FSA) purported to give consumers complete protection, it would inevitably fail, disappointing the consumer and discrediting the system. It was also felt that the term 'caveat emptor' generated anti-consumer sentiment and should be avoided. A preferred approach was to refer to the principle as consumer responsibility.

The outcome of the debate was that Financial Services and Market Act establishes the protection of consumers as one of the FSA's statutory objectives, but it does not provide protection that is 'absolute or 'all-encompassing'. FSA must have regard for the general principle that consumers should take responsibility for their decisions. Sir Callum McCarthy, Chairman of the FSA, described the position very succinctly in a notable speech back in February 2006: 'Consumer responsibility in financial services tends to focus on decisions made regarding the purchase of a financial product. But whilst this is an important aspect, there are wider issues that need to be debated.'2

One of the advantages of living in a liberal democracy is that the state provides a 'safety net' for those who are unable to provide for themselves. It is generally agreed that consumers have a duty to take some personal responsibility for their financial well-being. In a recent Yougov survey 91 per cent of people believed that they were ultimately responsible for their personal financial affairs and only two per cent thought that the Government should be responsible. However, it is questionable as to whether this transpires in consumer behaviour today; the savings-ratio is at a 47-year low and personal indebtedness stands at £1.3 trillion.3 Is this evidence of consumers taking responsibility for their financial wellbeing, and if not, what are the barriers?

'Mis-confident' consumers?

We live in changing times. It has been said that change is now at such a pace that it is unlike anything our ancestors have had to cope with. On a macro-political level, we live with the effects of a globalised world and what that means for the UK economy. The ability of capital to move around the world has never been greater - but nor has the ability of economic problems in one part of the world to impact on others. The ripples from the US sub-prime mortgage market crisis have been felt in Japan, Germany, and of course, in the UK. This has raised interesting questions for how consumers view their financial wellbeing. The last decade has been characterised by a boom in 'easy-terms' credit and a fall in the savings ratio. These events are clearly linked.

At a time when the UK life and pensions industry was suffering from the problems of past mis-selling, the banks recognised the opportunities for enhanced profit by looser credit standards. Rising house prices encouraged consumers to jump onto the house price train, and more people decided to buy their own homes. The rise in owner-occupier households has been a key-driver to the £1.3 trillion personal debt levels the UK now labours under. Homeowners have seen the value of their properties steadily increase and feel all the wealthier for it.

The buy-to-let sector has experienced tremendous growth over the last decade, fuelled by new homeowners who have seen property as the only sure-thing investment. More tangible than pensions, more interesting than long-term savings, more lucrative than stock market investments, the savings ratio has suffered as consumers have opted to do other things with their cash.

The growth of the consumerist society has also played its part. Easy-terms credit has fuelled a spending culture that, along with a buoyant mortgage market, helped the UK avoid the recession other countries experienced four to five years ago.

Those organisations that are charged with offering consumers access to pensions and long-term savings were also guilty of failing to help their customers. Product complexity, obscure terminology, inflexible products were all bound to look second best when compared with credit driven products and their high profile marketing.

Of course, this analysis extends only so far. Many consumers felt excluded from the financial services debate completely and turned their backs on the industry. They expected the government to help - or their employer to provide.

The last decade has seen the withdrawal of the state from some of the roles it played in care provision - and the value of state pensions have clearly reduced in real terms. Employers have sought to cap and minimise their pensions liabilities, close their final salary pension schemes, and generally encourage employees to take care of themselves.

Perhaps, just as clarity was most needed on who was responsible for an individual's long-term financial wellbeing, we have experienced an age of ambiguity. This has served the consumer, the industry, and the government ill.

Changing behaviour

Legislators and regulators often fail to recognise that most changes they make have very little, if any, immediate effect. Careers are relatively short term in these roles and both types of people want to achieve more than their predecessors, which means that we end up with a situation of perpetual change, often before the effects of the last set of changes become apparent. This is a problem because the changes often confuse non-law makers and are of huge cost to the economy, particularly the industry that has to administer them.

Legislative and regulatory changes that aim to influence individual behaviour generally have less of an immediate impact than other changes, for example, drink driving laws in the UK were introduced in 1967, but it took nearly three decades for drink driving to no longer be acceptable to society.

A key underlying premise for the FSA conducting the Retail Distribution Review (RDR) is that retail financial products appear not to be demand-led. It is the FSAs view that consumers do not act as a strong force in the industry and that the distribution model could work more effectively. Therefore, the FSA has decided the main aims of the review are to create a retail market where 'consumers are capable and confident', 'information for consumers is clear, simple and understandable' and 'firms are soundly managed, adequately capitalised and treat their consumers fairly'. In effect, similar to drink-driving laws, the RUR involves an exercise to change individual financial behaviour. However, the FSA has no power to force people to save, so unlike restricting the amount people can drink before driving, they are planning something comparable with changing the way beer is sold and how it is brewed.

Of course, like any market, retail financial services has two sides: supply (the firms that operate in the market, supplying goods and services to consumers) and demand (consumers who either do, or don't, demand the services offered). Changes in consumer behaviour are rarely 'fixed' by tinkering with the supply-side. The FSA is potentially on shaky ground if it believes that it can change consumer behaviour by just trying to 'fix' the retail financial distribution model. The record high personal debt level and record low savings ratio is partly because of the availability of cheap credit, but mainly because of consumer attitudes to savings and debt. The increasingly high levels of unsecured debt show consumers have moved from a savings culture to 'borrow now, worry about paying back later'; this has led to increasing bankruptcies and individual voluntary arrangements (IVAs).

Access to information

It is unfair to claim that the sole responsibility for personal finances lies only with the individual; without a properly regulated financial services market consumers would be ill-advised to take any responsibility Consumers need access to clear, simple and understandable information; consumers need regulatory protection; and consumers need competitive choice. Individuals will only choose to take responsibility for their personal finances if there is a financial market to cater for their needs and if they are aware of the options available. The default 'easy' option will always be to rely on the option that requires no action - the safety net. However, by trying to create a perfect financial services market, we must not confuse those that are already engaged with their personal finances.

The increase and constant change in consumer protection regulation can exacerbate the complexity of financial information. In the long-term, consistency is the most effective way to ensure information is clear and easily understandable. Constant legislative and regulatory changes, like some of the more radical proposals in the RDR, could potentially be counterproductive by increasing consumer confusion. The RDR proposes to create new types of advisers, redefine the word independent and it will mean that consumers that are used to the existing framework will have to learn how the proposed changes affect them.

One of the main problems is not a lack of information for financial products, but too much information a significant proportion of which is a regulatory requirement - that leads to confusion and to people not reading most of the information provided. This is similar to the average person walking past a notice board; if the board has hundreds of notices on it, they won't be able to focus on any of them, but if the board only has one notice, they will read it. Therefore, to simplify information for the consumer, it should always be kept to a minimum that consumers want and need. But it should also provide 'hooks'. While a single side of A4 is more likely to be read than a 20page disclosure dossier, brevity is not enough of a virtue to risk being too scant with important information. The 'trick' must be to present the information in a way which gets consumers to engage with the information they need to understand. Whether this can be done by a series of questions, a mixed oral and written disclosure process, or by a process that requires different stages delivered over time, is an open debate. However, one thing is sure, the current overload is more due to a lack of confidence in the regulatory system and protection of the provider of that information, than for the benefit of the consumer.

The lack of consumer understanding, and demand for financial products, is also due to the infrequent purchases of financial products; most people do not regularly buy financial products and are therefore less likely to learn about them. Statistically, it used to be the case that more people were more likely to get divorced than change bank accounts - and most people use a bank account every day. People are exposed to other financial products even less frequently, and some products are only bought once, such as an annuity.

However, those people who see financial products costing them more money in everyday life tend to seek the cheapest product. Under-performing investment products and poor service from current accounts are not perceived as a 'cost' to the consumer. The credit card industry has been successful in promoting competition, which has led to better informed consumers; and competition exists in the life and investment industry because of intermediaries.

We must address the fundamental issue of information asymmetry if we want consumers to take responsibility for their financial purchasing decisions. This will require a simplification of financial terminology. If consumers have learned to understand the pros and cons of credit cards, as some commentators believe, then it should be possible for them to engage with other financial products.

It is easy to assume that the reason that demand for financial products is low is because of a lack of information; I believe this is a false premise. Credit card terms and conditions are not clear, simple or understandable but people went out of their way to learn about them to find cheap credit - it was demand-led.

The Government has acknowledged that there is a general reluctance to save by consumers, particularly for retirement, which has led to the extensive proposals for pension reform. The introduction of Personal Accounts in 2012 will require all employers to autoenroll employees and both will have to make contributions to the national scheme, unless the employee decides to opt-out. This form of 'soft compulsion' is the Government's solution to many individuals lack of engagement and willingness to take responsibility to save for their retirement.

Creating confident consumers

Consumers will only be confident enough to take responsibility for their personal finances if the market operates in an environment that generates sufficient trust. It is not fair to blame consumers for not taking responsibility for their personal finances in a poorly managed market. The market has to operate with transparency and integrity, as well as simplifying some of the complexities. People also want to know their financial assets are secure and well managed.

Traditionally, banks have built large expensive buildings with columns and marble because, by demonstrating their physical presence and financial commitment to a town, they earned the trust of the town's residents. Modern banks no longer require an exaggerated physical presence for their reputation (some internet banks have no physical presence at all); better communication, with tools like the Internet and media, has meant that reputation is increasingly important for financial service firms, as they are now held to account by clients across the world.

Where are the limits?

There needs to be a balance between rights and responsibilities and a clear line on the limits of where the responsibility of the financial provider/adviser ends and the consumer's responsibility begins. In financial services, it is clearly the responsibility of both providers and advisers to offer to keep their clients informed about the products they have purchased. However, there is also a duty of care on the consumer to act on information provided. If they choose to ignore it, there has to be time when the provider of that information can no longer be responsible for the lack of action of the consumer. Limitations legislation exists for this very purpose.

The 15-year long-stop rule available in the courts should also apply to financial advice. The long-term nature of certain financial products should not automatically make them a 'special case'. In particular, after 15 years, the changes in economic and regulatory environments are extensive, personal memory and records are either unreliable or unavailable, making judgements regarding the suitability of the initial advice difficult to assess, and therefore subjective.

The RDR raises some important questions about demand for financial products, and we support the regulator's objective of raising standards and increasing consumer confidence. But all stakeholders must recognise the challenge of doing so in a way that allows our industry to prosper, rather than being entangled by regulatory change.

The problems that the RDR is trying to address cannot he easily fixed by regulatory changes, they are embedded in the way people behave; regulatory changes will not increase demand, but long-term societal changes could. We have always believed that our industry must continually strive to improve standards for consumers, and the best way to achieve this is by the regulator and industry working in partnership with the advice profession.