Archive for December 14th, 2007

Central banks need to apply behavior economics

December 14, 2007

I was very glad to know the Boston Fed has a behavior economics/finance research centre and is doing pretty active research in the field.

I came across this speech by Ric Battellino, Deputy Governor of the Reserve Bank of Australia, where he raises questions which can be solved using BE/BF. The speech basically discusses the way Australian funds management industry has grown and challenges.

The Aussie funds industry is amongst the top 10 in the world in terms of size mainly on account of rise in superannuation funds (ageing population is an Aussie problem as well). I was also amazed by this bit of statistic:

It is also notable that in Australia there has been significant direct participation by retail investors in the markets for sophisticated financial products. For example, retail and high net worth investors account for about two-thirds of the assets of Australian-based hedge funds, compared with less than half globally. Over the past five years, retail investors are estimated to have purchased around 15 per cent of the CDOs issued in Australia.

The reason for this is: 

One of the reasons for this higher participation by Australian retail investors in these markets is that the regulatory regime in Australia does not restrict retail access to any financial products as long as the provider meets certain disclosure requirements.

Well, well! This is no small figure by any means. Because of high retail participation, there are usual challenges of full disclosure etc.

Here is the BF/BE bit:

A related challenge facing the industry is financial advice, and how this is paid for. There appears to be a general reluctance on the part of retail investors to pay for financial advice on a fee-for-service basis. Instead, there has been a preference for commission based advice, despite the conflicts of interest that can arise in this situation. This reluctance to pay for advice upfront appears to be a form of money illusion, whereby investors may feel that they are somehow paying less for financial advice if the cost is buried in reduced earnings in the future.

To understand what we mean by commission based advice and fee for service advice, see this. To put it simply, people often like to pay their costs upfront at one time (commissions) rather than pay based on the service of the advisor. It is a behavioral problem known as money illusion. The solution is – financial literacy. (However, even financially literate people are human beings and make the same mistakes!)

I always believe BE/BF can help us understand many a challenges in a better manner. It just needs better models and applications, which is being worked on by a few economists.


Assorted Links

December 14, 2007

1. So who would be the CEO who would be ousted next? MR helps. This is the website where bets are taking place.

2. MR pointsthat NBER charges $5 per download. I think it should be made free.

3. WSJ Blog points to Greenspan interview and Tim Geithner speech

4. New Economist points to a new paper on whether economic sanctions work or not.

5. Greg Mankiw points to effective tax rate in US.

6. EPSA Blog defends World bank.

7. Ajit Balakrishnan on the research dilemma at IIMs. I think the problem is huge. Apart from the suggestions he gives, IIMs need to put all their research together at one place and allow free download. Then, it should possibly also ask newspapers to cover their research in an informative manner (not like the way newspapers cover celebrate placements at IIMs)

8. AV Rajwade says: It seems market fundamentalists want freedom only so long as markets are favourable. I agree completely.

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