Black Swans and Risk in Retail Financial Services

In a recent speech, the EU Commissioner for Consumer Affairs, Meglena Kuneva, signaled 5 current priorities in relation to retail financial services:

1. Address the way investment products are designed, described and marketed to consumers; and ensure that new proposals in relation to the sale of credit and mortgages "meet the high standards of modern consumer policy".
   


2. Strengthen the strict rules and enforcement on the misselling of retail investment products, in the light of "clear indications that the laws that are meant to protect consumers were insufficient and may have been repeatedly violated."
   


3. Complete by the end of the summer an in-depth study of banking fees and charges to consumers which appear to be unfairly hitting consumers.
   


4. "Start with regulators a new debate on the correct balance of risk and reward on Main Street. It seems that in recent years, risk has been significantly outsourced to unwary consumers. The question is what amount of risk and toxic products are we willing to tolerate in the retail financial market?"


5. Start a serious discussion on the regulatory oversight structure that is needed to generate accountability to consumers and to ensure consumer protection principles are consistently implemented across retail markets.

The nub of all these priorities lies in the highlighted question. I'm equally fascinated by it, even though the answer to it must surely be "nobody knows." It's part of the process of democratising the financial markets. However, as a starting point for the discussion, I'd be more comfortable with the statement that risk has simply landed on unwary consumers (and taxpayers, more importantly), rather than that it was somehow "outsourced" to them, implying intent and activity on the part of someone else. Otherwise we risk focusing on who outsourced the risk, and how, which is necessarily facing the past, not the future. Nailing those who broke the law should not be part of this debate. The fact is, the law failed to protect consumers and taxpayers from risk in the financial markets.

To put it another way, it was a mistake for us ever to have believed that we had successfully outsourced our own personal financial risk to banks, employers and governments.

The credit crunch is a Black Swan event - a surprise event that has a major impact and is [being] rationalised by hindsight, as if it had been expected. Inquiry into the why's and how's is therefore largely academic, albeit tantalizingly so. To take a counterfactual approach, one might ask whether it would have occurred if the CDO had been strangled at birth in 1987. The CDS also played a role, so we might consider the implications of it's death on a whiteboard in 1997. And we might ask the same in relation to Gordon Brown's rhetorical adoption of the so-called Golden Rule - that the government would only borrow to invest rather than to fund current spending, and in doing so it was "prudent" to maintain debt levels below 40% of GDP (implying it was also prudent to borrow up to that limit).

But we will never really know the cause of the credit crunch. And nothing we do will necessarily prevent another one.

Yet it seems likely and perfectly natural that we consumers and taxpayers will continue to rein in our expenditure, and take steps that we believe will maximise the sustainability of our income, for as long as it takes for us to feel we are able to survive another major financial disaster. As markets seem to "recover" in parallel, it will become harder and harder not to become lulled into thinking that our self-discipline is working, and that, at some ominous peak, we are finally safe...

So the real challenge is: how can we ensure that we consumers and taxpayers always understand that each of us personally bears the risk of financial disaster?

You are on your own. Pay less. Diversify more. Be contrarian!