By Ariel Cecchi, Ph.D.
Personal current accounts (or checking accounts in the US) are essential products that banks provide to individuals to manage their personal finances. An estimate shows that 94% of adults have a personal account in the UK. Despite their major role in people’s lives, the complexity and low transparency of overdraft prices have been responsible for consumers incurring unexpected debts. Concerned by consumers’ financial well-being, the Financial Conduct Authority has begun to address the issue through the application of nudges. (1)
Nudges are changes in choice architecture intended to influence behaviour positively. They act as reinforcements designed to overcome psychological inclinations and trigger propitious decisions. Nudges involve the application of rules and principles, such as Simplification, Defaults, Reminders, and Disclosure, among many others.
For instance, the simplification of complex pension scheme information allows us to make better decisions. The automatic enrolment in a company’s pension programme ensures a significant financial stability at retirement. Reminders on overdue bills from the energy company help us to avoid extra charges. Energy labels on appliances give us the opportunity to choose more energy-efficient products.
In recent years, the Financial Conduct Authority (FCA), the UK regulator responsible for protecting consumers and ensuring market integrity and fair competition, has done a great deal of work in the field of behavioural economics. Some of this work has focused on the application of nudges in the disclosure of current account overdraft costs.
Arranged and unarranged overdrafts
Overdrafts are deficits in a bank account when the balance falls below zero. “Arranged overdraft” and “unarranged overdraft” are the labels of two products banks offer to their customers to pay outstanding balances or declined payments. They function as a short-term credit; i.e., a form of debt the account holder contracts with the bank. Arranged and unarranged overdraft products help consumers avoid potential negative financial outcomes (e.g., arrears) and psychological consequences (e.g., anxiety). (2)
UK personal current account (PCA) holders can apply for arranged overdrafts for a low fee. In general, the estimate of such a monthly pre-agreed borrowing in UK accounts is about £250 per month. Unarranged overdrafts have the same function – to help customers cover unexpected payments – but at much higher charges and fees. Unfortunately, although unarranged overdrafts play a central role in allowing people to settle unexpected outstanding balances or overdue bills, consumers have the tendency to use this product too often while underestimating their financial impact. (3)
The FCA estimates that out of 52 million people in the UK holding a PCA, 19 million (37%) use an arranged overdraft and 13 million (25%) use an unarranged overdraft each year. Furthermore, there is a significant difference in prices across types of overdrafts. Firms made around 25p for every £1 lent out through arranged overdrafts and around £2.50 for every £1 loaned through unarranged overdrafts over a year. The total revenue from overdrafts made by firms in 2016 was about £2.3 billion, where 30% corresponded to unarranged overdrafts. (2)
The data also reveal that unarranged overdraft costs are heavily concentrated; the majority of fees and charges are paid by only 1.5% of consumers, who can spend around £450 per year. Moreover, consumers incurring the higher costs are either young or people with lower income who live in deprived areas. (2, 3)
Clear disclosure of price information is essential to make informed financial decisions. The complexity and lack of clarity of financial services’ costs are often responsible for causing investors to underestimate taxes in portfolio and retirement investments or for making households fail to remortgage.
The disclosure of overdraft costs has been carried out by implementing nudges. For instance, reminders have the purpose to help recipients understand the use of overdrafts, reduce charges and give them control over their borrowing. However, the FCA and the Competition and Markets Authority (CMA) observed that the application of reminders has not mitigated damaging financial decisions. Despite receiving annual summaries on overdraft costs over the years, consumers neither avoid nor reduce unarranged overdraft charges. (4) Similarly, although text and mobile banking apps alerts have been used since 2012, they have had a moderate impact on reducing these costs. (2)
Three main challenges have been identified as responsible for the mitigated result obtained with reminders (2):
Complexity: The overdraft price structure involves a combination of interest rates, fixed rates, cumulative daily and monthly fees, as well as other charges. The intricacy of this information makes overdraft prices difficult to compare between types of accounts and periods (see e.g., Nationwide), between types of overdraft and other available credits (e.g., personal loans), and between PCA providers (e.g., Santander, HSBC).
Transparency: The misunderstanding of the costs and purpose of overdrafts (i.e., short-term credits), the lack of transparency when consumers are effectively using an overdraft and their easy access over other suitable credits result in customers using unarranged overdrafts over long periods.
Engagement: Due to the complexity and the lack of transparency, overdraft alerts fail to engage consumers to adopt positive behaviours towards a reduction of unarranged overdraft costs.
Concerned by the modest results obtained from overdraft alerts, the FCA tested different rules and nudge principles. The findings reveal that in addition to notifying consumers on overdraft costs, nudges have to incorporate fundamental aspects like Timing, Channel, Defaults and Format in their design.
Timing: When alerts should be received
Given our predisposition to recall recent over past information, annual summaries, monthly or weekly alerts might not properly engage consumers to act accordingly. Whereas these notifications keep consumers informed, subjects can still fail to incorporate early information into the decision-making process. Text and mobile bank apps alerts reach their pick of affectivity when they are received at the moment when a remedial action is required (“just in time”), for example, when a payment is about to be declined. (2, 4, 5)
Channels: Where alerts should be sent from
Information can be sent by letters, emails, text messages, mobile banking apps or other methods. However, not all of these channels are equally successful. The FCA found that text alerts alone reduce unarranged overdraft charges by 5% to 8% while using both text alerts and mobile banking apps together result in a reduction of 24%. This difference seems to be attributed to the fact that mobile app alerts provide timely information (monitoring) and facilitate immediate action by using the app to adjust the account balance (managing). Text notifications allow monitoring but might fail to motivate consumers to log into online banking services to take action. (4)
Defaults: How to obtain alerts (self-enrolment or automatic enrolment)
Defaults are preselected options that aim to simplify consumer decisions by offering them the most advantageous choice. Whether alerts should be sent over self-enrolment (Santander, Barclays, Lloyds Banking Group) or automatic enrolment (Co-operative, Nationwide) depends on the impact of each option on consumers’ behaviour. Research shows that consumers who voluntarily register for mobile banking apps and text alerts significantly reduce overdraft costs and those who are automatically enrolled reduce charges by 25%. However, although UK PCA providers have been offering self-enrolment overdraft alerts for several years, only 3% to 8% of consumers have registered for them. Therefore, since February 2018, the CMA requires larger firms to automatically enrol consumers into both unarranged overdrafts and refused payment alerts. (2, 5, 6)
Format: What content alerts need to have
The format of the alerts plays a central role in the impact of the message. Receiving timely and automatic information from the right channels is fully effective only if the content of the alerts has the right format. Long and complex messages on overdraft costs will only increase confusion. Field studies show that the content will be effective when notifications are written in friendly and lay terms, briefly explain overdrawing and costs, specify how much time the customer has to act, and notify the action to take. (2)
Testing the effectiveness of nudges is of crucial importance to design relevant interventions that positively influence behaviour. The work by the FCA contributes to this goal. However, well-designed interventions will be fully effective only if firms also change their practices to ensure that consumers can manage their personal finance beyond nudges.
The FCA is currently putting forward some recommendations and consulting on mandatory rules to reform how banks operate and charge for overdrafts. These regulations are intended to simplify overdraft pricing structures, introduce online calculators, offer alternative credits to overdrafts and identify vulnerable customers. (3, 7)
Nudges are powerful interventions intended to trigger favourable decisions. However, as it is the case with overdrafts, their design needs to be carefully tested. Disclosure, Timing, Channel, Defaults and Format are principles that when appropriately applied can effectively mitigate detrimental financial decisions. Moreover, to be fully effective, the context of nudges has to be propitious to reinforce positive behaviour. Banks also have the responsibility to offer transparent and clear financial products and services.