Central banks need to apply behavior economics

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.

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