Summary
The principle of Caveat Emptor (buyer’s due diligence) enshrined in Roman Law has been incorporated into many legal systems, including those of common law. However, in the first decades of the 21st century, the concept has been eroded in financial markets, where a zero-tolerance consumer rights approach, prone to litigation and penalties, is being introduced. This impacts markets, as the price (the compensation one party gives to another in exchange for a unit of goods or services) is not well defined. The new equilibrium, among other consequences, will lead to a lower volume of products, a reduced diversity of products offered, a higher price, and a lower volume of financial services offered to clients with less sophisticated financial literacy. In this way, the protection rules created to protect the weakest segment of consumers may end up harming them.
Introduction
I must confess that I have a soft spot for Roman culture. Yes, it is true that as an empire they did terrible things, crushing every opposition they encountered from Hispania to Judea, from Britannia to Germania. But they created things, from glass windows to the Porta Nigra in Trier, that have endured over time, as no other civilization in Europe has managed to do.
One of those lasting inventions took place in the field of law. Roman law, the ancient legal system, is still studied today. Considering it is 2,000 years old, this is by no means a minor feat. The reason is not only the adequate architecture of the rules, which forms the basis of all civil law systems, but also the robustness of the principles that underpin it. In fact, many principles derived from Roman law have even been adopted by common law countries.
The Principle of Personal Responsibility and Consumer Protection
One of the principles of the Roman legal system that has endured to this day is caveat emptor, which can be translated as the buyer’s obligation to ensure, to a reasonable extent, that the good or service acquired does not contain any hidden defects (either physical or in the form of underlying risks). Inevitably, the seller of any good or service has more information about its nature than the buyer, and this is precisely why the buyer must be diligent in assessing the characteristics of the good or service purchased. In the presence of asymmetric information, buyer’s due diligence is considered an essential factor in ensuring a sound business environment.
That principle was abandoned at the end of the 20th century, with the emergence of a consumer rights philosophy. Instead of the application of personal responsibility, it was considered, and rightly so, that for unsophisticated buyers, regulation was necessary to protect them from unfair practices when purchasing goods or services. The issue of asymmetric information was resolved by obliging the seller to compensate the buyer for hidden defects in the good or service offered.
Of course, the aforementioned principles must contain some limits to maintain the proper functioning of market-based economies. In particular, protection only extended to unsophisticated consumers, and even for this group, the principle of good faith on the part of the seller remained in force.
In practice, commercial life was preserved by offering merchants a safe harbor: if some basic principles were respected (right to return goods shortly after purchase, warranty for hidden damages, etc.), the merchant knew that the transaction would not be subject to control and review by the authorities. Or, in other words, a safe harbor refers to a situation where strict compliance with a set of rules established by authorities protects financial firms from litigation and supervisory actions. This safe harbor allowed for a calm business life for financial firms: compliance costs could be identified ex-ante and kept under control.
In any case, the actions of the courts, as ultimate guarantors of maintaining a fair market for financial products, ensure the protection of consumer rights, always under the principle of “caveat emptor.” In particular, in the U.S., the punitive justice system and class actions (in which a group of consumers defends their rights in a lawsuit filed by a subset of the plaintiffs) represent a very powerful additional disciplinary element to prevent abuses. In Europe, the existence of a detailed set of obligations allows for a simple comparison by the courts regarding compliance with the conditions linked to the safe harbor.
The Rise of a Zero-Tolerance Culture and the Expansion of Consumer Rights
Since the first decades of the 21st century, we have been witnessing an additional impetus on the consumer rights front and a review of the principle of buyer’s due diligence. A zero-tolerance philosophy means that any failure (in terms of consumer protection) in a single transaction, among millions of transactions of the same type, leads to increasingly strict rules that weaken the principle of caveat emptor.
This movement is also reversing the burden of proof, to the point where for financial firms, the “safe harbor” is becoming increasingly unattainable. If an isolated failure among millions of transactions induces a reaction that causes a wave of court rulings and reparations, this represents a situation of uncertainty that financial firms are unable to face in advance. Transactions that were considered safe until that moment suddenly become unacceptable.
Why is this shift in societal attitude so important? In the short term, it affects the profitability of financial operators. Ultimately, shareholders bear the impact. But if we consider that ROE is an endogenous variable that must be equal to or greater than the cost of capital (the remuneration that shareholders demand to remain in the capital of a financial institution) for the company to survive in the long term, the medium-term consequences will arrive as financial firms adapt to the new environment.
The first result is a decrease in supply. Companies that do not react will be forced to abandon their businesses, as their profitability will not match the cost of acquired capital. And companies that do react will try to avoid potentially weaker clients (weaker in terms of financial literacy, cultural level, age, employment prospects, etc.). The new equilibrium will be accompanied by a lower supply of financial services, especially for the weakest clients. And we must not ignore that the worst problem for any consumer, the biggest attack on their rights, lies in not being able to access financial products.
Another reaction will likely be a simplification of product offerings. Simpler products, with solid commercial margins, are a rational response to increasing consumer rights. A simple financial product will be less affected by potential changes in societal mood. Overprotection can lead to a more limited product offering.
And, finally, another obvious reaction will be increased digitalization. If the conversation between a client and an employee of a financial firm is key to determining the possibilities of a future setback in terms of compensation, then one way to reduce risks is to eliminate that human interaction.
The Failure of the Regulatory and Supervisory Architecture in the Field of Conduct Rules
The Design of Conduct Rules
Felix Hufeld, head of the German Supervisory Agency (BAFIN), has pointed out a difference between the architecture of conduct rules and solvency rules for financial firms. Both regulations are not immune to crises, and financial crises and scandals impact regulation. We saw this after the Global Financial Crisis (GFC), with the push to enact Basel III after Basel II was finalized (bad timing: Basel II was completed just before the GFC). And the same is observed in the field of conduct rules, whether as a result of financial scandals or court rulings.
Solvency regulation is reformed in a more structured and multi-year manner, with clear debates on the flaws of previous rules, the principles underlying the proposed new regulation, and with well-defined impact studies and consultation processes. Conduct rules also respond to a well-thought-out design, but the succession of small local financial scandals adds a gold plating or local over-regulation that makes them more complex, confusing, expensive for financial firms in terms of compliance costs, and indecipherable for the consumer.
This “layered” structure of conduct rules goes against the availability of affordable financial products for all consumers. The goal of conduct rule regulation should not be to restrict the supply of products to a limited set of options or to target them at a small group of consumers (the most prosperous). It should never be forgotten that the worst outcome for consumer rights is not having access to goods or services. The line between effective protection and regulation that does not stifle supply is both thin and indispensable.
The Digital Revolution and the Perimeter of Consumer Protection
The digital revolution will probably represent a positive development overall (once costs and benefits are netted out). Let’s consider aspects such as better and cheaper access to financial products, increased competition, an improved user experience, increased efficiency in the financial sector, etc. But we cannot be naive about the associated challenges: any revolution usually means that someone’s blood ends up splattering on the asphalt.
Some risks are already obvious: cyber risk and cybercriminals abound in this new world. But the challenges go further. The digital revolution is blurring the lines between countries, but also between sectors. And, even more revolutionary, it is making the regulation of digital service provision much more complicated. We cannot even agree on the architecture of regulation: should we continue to regulate based on who you are (entity-based) or based on what you do (activity-based)? Should we implement the mantra of “same activity and same risks imply same regulation and supervision”? Should we opt for a new combination of activity-based and entity-based regulations for bigtechs?
All these questions are important, as a consumer may encounter very different de facto protection depending on the type of company providing the services. And the problem is not only that of equivalent regulation: we must not forget that any regulation is only as good as the supervision that ensures its implementation and monitoring.
Or, in other words, what is the point of regulated financial firms being subject to strict rules if financial services can be provided by unregulated financial firms from remote locations (or without physical employees)? The mix of the digital revolution, the unbundling of financial services, and the disappearance of sectoral and national borders pose a great challenge for consumer protection.
Finally, the history of the financial sector reminds us that, along with financial innovation that promotes well-being, harmful financial innovation also often occurs. This time will be no different. Technology brings opportunities, but it will also bring headaches.
The Complexity of Rules
The basic rationality of conduct rule regulation (offering an adequate level of protection to consumers while providing financial firms with a safe harbor) is being challenged by the great complexity of financial regulation.
Two elements have blurred this principle. First, the retrospective bias by which past contractual relationships have been judged based on principles currently in force. If economic progress is accompanied (and rightly so) by ever-increasing levels of protection, there is a risk that supervisors or courts will apply new and higher protection standards to old contracts. For example, most of the litigation surrounding mortgages in Spain may correspond to this type of bias. Financial firms that did what was right (and not just what was acceptable) when the financial contract was signed, see their “safe harbor” disappear as principles and standards on financial consumer protection evolve.
The second factor affecting companies is the complexity of regulations. In general, regulators have tried to address the increasing complexity of the financial ecosystem by increasing the density of rules (something that can be observed, for example, in Basel III or the Resolution framework). In the case of financial consumer protection, the move towards more complex financial regulation is the result of two forces acting in the same direction. The first, already mentioned, is the impulse to codify all possible interactions between consumers and financial firms in an increasingly complex financial sector, where new intermediaries and novel financial products abound. The second, also cited, is the impact that financial scandals have on the formation of new protection rules in the form of additional layers. This mix of forces, normative (rules that respond to a well-thought-out design by the authorities) and positive (which react very quickly for political reasons to specific scandals), is exclusive to the field of conduct rules.
What does all this mean in practice? Financial firms are facing increasing complexity in financial regulations, which imply higher compliance costs, but which, due to their evolution (lack of stability) and increased demands, are not providing the “safe harbor” they need to operate. Selling financial products under these circumstances becomes an impossible-complex exercise: like driving on a road where traffic lights and rules change as you drive.
The Risks of Artificial Intelligence and Outcomes-Based Consumer Protection
Can a well-designed financial program engage in misselling? In principle, these improper practices are the result, on the one hand, of the interaction of two human beings (one is a financial sector worker and the other a consumer who wishes to purchase a financial product), on the other hand, of the confusion that can arise from that interaction, and finally, of the sale of an unsuitable product to the consumer. If the human factor is eliminated on the financial firm’s side, the possibility of confusion arising is also suppressed. Or, in other words, a well-constructed computer interface would ensure that the consumer, after having gone through all the procedures, with all the incorporated checks, would only buy a product that suited their needs.
Do supervisors agree with this approach? Not at all. They recognize the difficulties of demonstrating, for example, that artificial intelligence, with extensive use of big data and machine learning techniques, can engage in misselling or abusive sales practices. But they also point to the solution: if the outcome is unfair to the consumer, then it is possible to impose a sanction on the company. We are moving from a punitive system based on objective evidence to an outcomes-based sanction system.
What is the problem with this system? It is an open protection system that offers no “safe harbor” to companies.
Conclusion
Perhaps we wonder why all the above arguments are important. I believe they are, for several reasons. Any market transaction is defined by three elements: supply (someone willing to sell), demand (someone willing to buy), and a price (the amount of payment or compensation one party gives to another in exchange for a unit of goods or services). The problem with an open protection system that lends itself to litigation and penalties is that the third element, price, is not well defined.
What is the rational response to this situation? That the company will compensate for the lack of clarity in pricing by shifting the supply curve upwards: the new equilibrium will be characterized by a lower volume of products, a reduced diversity of product offerings, and higher prices. But given that the risk of litigation is not evenly distributed among clients, but is higher for less sophisticated clients, the new equilibrium will likely mean that lower volumes of financial services are offered to weaker clients, or to clients with less sophisticated financial literacy. In other words, the rules and practices being put in place to protect the weakest consumer group may end up severely harming this very group of clients.
The Romans knew it well: the proper functioning of commercial traffic requires a little diligence and care from everyone involved in any transaction. Let us hope that the concept of caveat emptor returns to legislation in the not-too-distant future.
José María Roldan, Chairman of the Spanish Banking Association (AEB)
