Application of Behavioral Economics Principles

Introduction

Analogous to several corporates across other sectors, Financial Institutes (FIs) have inwards-looking business goals to meet. Retail banks constantly strive to acquire new consumers at low cost, retain existing customers, sell more from their portfolio, and drive bottom-line growth. FIs’ marketing and branding are targeted to accomplish these universal business objectives.

On the other hand, consumers need financial services that are suitable to their needs, solicit correct financial advice to manage their money, and sometimes also need help to perform a cost-benefit analysis on financial options available. In doing so consumers may get tricked with nudges and influences.

Nudges and influences are everywhere around us – some are planned while others could be unplanned. Some are designed to benefit the recipients while others are plotted for business motives. Sometimes you notice them straight in the face while many times nudges are very subtle, appearing insignificant at times. The people who design influences are called ‘choice architects’. They are the nudgers who plan, create, and decide the direction of outcomes.

Context

Many behavioral economists have spent decades together on research entailing human behaviors, irrationalities, nudges, and influences! Daniel Kahneman, Amos Tversky, Richard Thaler, Robert Cialdini, Dan Ariely are a few to mention. Richard Thaler popularized the term ‘Nudge’ with his 2008 book and Robert Cialdini did so with ‘Influence’, the book released in1984. Their enormous work is the primary foundation of this write-up.

Traditional economics assumes that all of us are Homo Economicus (Econs). Econ is a person who always acts rationally in her self-interest for any given condition, irrespective of external natural or artificial influences. Nevertheless, we surely are not! We all are Homo Sapiens (Humans). In this write-up, ‘people’ and ‘consumers’ implicitly refer to Homo Sapiens (Humans), who act and react irrationally to nudges.

Undoubtedly there is no magic wand to get 100 per cent consumer compliance by deploying influence tools. However, it is interesting to discuss the application of these principles in various industries. The write-up is an attempt to recognize the vital behavioral economics tools and their applications in the financial services sector.

Behavioral Economics Principles

1) Anchors: Anchors are the first set of numbers or information that people receive which influences their decision making

Pre-approved personal loans are a common site for most banking consumers. The pre-approved loan ‘amount’ is an anchor to push consumers towards the loan amount around that figure. Availing the ‘pre-approved’ amount loan could easily be against consumers’ best interest. They believe that the presented amount is correct for their needs (or wants, most of the time). Cost-benefit for such a decision is not done properly by the majority of the consumers getting anchored by the presented amount.

Credit card statements mentioning “Minimum Amount Due”, is another example of anchoring. It’s an optimal number for the bank. If consumers pay only the minimum due amount, banks maximize interest income. Failing to recognize this and thinking ‘anchor’ to be the correct amount to be paid, many consumers end up paying maximum interest charges. Credit card companies also show the ‘Available Cash Withdrawal’ limit in the statements but do not present the cost of cash withdrawals. Stated amounts are anchors to nudge consumers. This has become a grave issue in the USA, one of the biggest credit card markets in the world.

Consider one of the most subtle anchors. With evolved UI/UX principles and a focus on digital banking, banks now have Personal Finance Management (PFM) for consumers. When banks want to encourage more spending or credit, PFM would show financial information in a different way. For example, the default PFM dashboard would display something like ‘You have XXX credit left’, or “Your expenses are below planned limits”. This messaging encourages further spending. The credit amount or planned limits act as anchors, nudging consumers to adjust their spending around the anchor. Some PFMs can let consumers decide what goes on the dashboard, but in reality, not many people customize dashboards to suit their own best interests making the ‘default’ option sustain.

Consumers fail to realize or simply disregard the impact of such small steps on their financial well-being. People’s lack of knowledge or sheer ignorance may drive the success of such anchors.

2) Low-ball Technique: Give-it and take-it-later strategy to persuade people. Observed very often where the discounted offer is first thrown to get an agreement, and later sweeteners are removed

Flexible mortgage interest rates have become very popular in recent decades. It is the best example of low-balling consumers into a long term commitment. Lower interest rates offered for the first 1-3 years entice consumers to buy the mortgage product. After the initial 1-3 years, the benefit is removed and consumers are made to pay prevailing market interest rates. Consumers always have an option to switch to another bank, but transferring the loan may not get the same initial benefit one enjoyed till then. Such low-interest offers are chiefly for new applicants only.

The credit card offers is another low-balling example. Consumers are lured into buying the card with initial offers and freebies. The advantage disappears after the first year for most of the cards.

3) Relativity: Consumers want to gain or save, relative to something or someone else

FIs declare a rate of interest on a savings account, deposits, mortgages, and other types of loans. Many times the interest rates are specified as a standalone number such as X per cent of Bank 1 v/s Y per cent of Bank 2, X being lower than Y. This relativity principle is deployed to influence consumers. People get swayed by the relative beneficial parameter (e.g. rate of interest). They fail to evaluate other important parameters such as minimum account balance requirements for the FI, processing time, processing costs, duration of discounted interest rate, and other hidden costs that can nullify the interest rate benefits (Y-X). So while comparing the options, consumers may easily get influenced by one or two parameters that the bank is projecting using the relativity principle.

Another classic example is the “NEW way” of banking relative to the older way. At present, the NEW ways include mobile banking, mobile wallets, NFC (Tap and Pay, Contactless Payments), etc. NEW gets marketed targeting millennials and Gen Z consumers as they form a majority of ‘Innovators’ and ‘Early Adopters’ in a diffusion of innovation model. Early Adopters followed by the Early Majority of consumer segments will get nudged one after other by the “NEW way”. After a certain time period, the NEW becomes “NEW NORMAL” but the relativity effect remains until the new “NEW” emerges. The New v/s Old relativity principle continues to influence. This is valid only when the NEW has a value for its target audience.

Sample Advert: NEW way of banking

4) Default Options: When one doesn’t know which option to choose, one tends to select the ‘recommended’ or ‘default’ option

In behavioral economics, it is widely known that default options become widely accepted for initial opt-ins and remain so – unchanged, almost for the entire lifetime of the product or service.

While choosing a pension scheme or multi-fund long term investment options, people frequently end up selecting the default investment plan and percentage fund distribution. Most of the consumers do not know any better than the default and don’t have enough guidance too. This does not mean that the default option could be bad, but it’s an example of a nudge and how default options work.

Remember opening your first ever bank account? For example, in India like many other countries, people open their first-ever bank account to receive a salary. Employers offer options (suggestions or tie-ups) but may nudge employees to choose one bank over the other. The reason could be as simple as many choose X bank over Y, or the person recommending has a bias towards bank X. At times there are no options and employers ask first-time employees to open an account in a specific bank only. Whichever bank people select, in high probability it becomes the ‘default’ choice of banking for a very long time or even one’s lifetime. A simple nudge and default option at the beginning of your career decide a primary bank for you.

Now, look at application forms that FIs have for account opening, investments, mortgages, or credit cards. In addition to lengthy terms and conditions that people don’t read, consumers also tend to ignore some other sections in the forms. Paper-based forms are commonly filled by agents barring a few key fields. So default options get selected in the process. One such example is given below in a mutual fund enrollment form. If certain options are not explicitly mentioned such as the ‘Growth or Dividend’ fund, the default to be considered would be the ‘Growth Fund’ investment. Spare a thought for consumers wanting to enjoy frequently paced dividend payouts, but getting locked into the Growth option because the agent forgot to tick the “Dividend” option. The same is the case with Dividend Payout v/s Dividend Reinvestment sub-options.

Sample Mutual Fund Form: Terms and Conditions Section

5) FREE: Free denotes without cost or any sort of payment

There are no FREE lunches, as they say. Someone, at some point, in some form bears the costs for the FREE. But it’s a well-tested psychological tool that marketers deploy. In financial services too, numerous organizations utilize FREE as a tool to influence. A few of the examples with associated tangible or intangible costs are listed below:

#‘FREE’ ToolPossible Costs
1FREE bank account!Are you getting interest on your FREE account? Do you have to maintain the minimum balance in your account? Are you getting same level of customer service as a no-frills account? That’s the cost!
2FREE credit card!Are you spending ‘more’ because you have a credit card now? Is your average monthly spend increasing on the credit card? Is FREE card offer for a limited duration before annual card fees kick in? That’s the cost!
3ZERO processing fees on mortgage!Did you notice the long-term flexible interest rate component of the mortgage? Did you spend more time behind the mortgage company for processing? Any pre-payment penalties? That’s the cost!
4No EMIs (Installments) for First 6 or 12 months on MortgageDid you check the mortgage period? It’s not even FREE, it’s a well-framed message to hide costs that are spread across the years to follow after the ‘No EMIs’ period.
5ZERO interest on installment paymentsDid you add all your installment payments and tally them with the cost of the product? Interest is embedded in installments and hidden, but that’s the cost anyway!

Sample Advert: EMIs (Installment) Waiver Offer

Recently an Indian bank had launched a campaign where lucky winners spending maximum on a given day with their debit cards would get a FREE iPhone (or something of equivalent value). Here costs to consumers are more collective than just to an individual. The FREE tool is influencing consumers to spend more (more costs). It’s equivalent to playing a costly lottery.

At times the main product or service may not be tagged as FREE, but completely unwanted and unrelated FREEbies are presented to nudge consumers into buying. For e.g. a bank may offer a premium credit card and combine it with say FREE USD 100 worth of gift vouchers. Many of us would have experienced that such coupons come with their own terms and conditions, making them almost worthless (or with more costs from our pockets)!

FIs go on listing benefits such as FREE unlimited withdrawals at ATMs, FREE checkbook, FREE debit cards, FREE financial consulting, etc. First-timers and relatively naïve consumers can easily get influenced with FREE, even though offerings are very basic or even worthless like USD 100 vouchers occupying our drawer’s space!

6) Hot State v/s Cold State: If there were magic potions, better choose the one to control emotions!

Emotions fly high all the time in the everyday life of an average consumer. Imagine that you are buying a car and never thought of a car loan. Now you really enamored a more expensive model. That’s when you see a car loan offer that entices you to go for the car model you liked. You end up spending more and getting the car you wanted. At that moment you don’t bother yourself with the thought of paying the extra interest on a car loan. When people are in the middle of a purchasing decision and the decision is already made (at least in their subconscious mind), people go into a ‘hot state’, and the decisions they make are easily driven by influences. They may not make the same decision in a more rational ‘cold state’.

There are a lot of banks and FOREX kiosks in international airports for currency exchange. As a typical traveler arrives in a new country, she would be in a ‘hot state’ (with real need) looking to get her hands on local currency for basic expenses like a taxi. It is quite self-explanatory and straightforward how this ‘hot state’ is leveraged by the FIs at the airport, charging a premium for currency exchange.

Investment decisions people make to save personal tax is another familiar example of ‘host state’ behavior. Towards the end of the financial year, people are in a ‘hot state’, looking for investment options to save tax. This is a ‘hot’ period for financial institutes to nudge potential consumers and sell more. Money is on the table and banks just have to deploy tactics to get the maximum share.

Another example is spending with credit cards. Banks know average spends on various types of cards they offer and come up with ‘promotional’ campaigns with merchant partners such as spend INR 5000 and get a cabin bag free, or spend INR 15,000 and get gift vouchers worth INR 1,000. When shoppers are close to those magic figures (say already shopped for INR 4000 or INR 13,000), they are in a ‘hot state’ and will not mind spending a little more to get the ‘benefit’ of the offer. More than benefits, they don’t want to ‘lose the chance’ when they are so close.

Sample Advert: Credit Card Offers

7) Loss Aversion: It is a tendency to prioritize and prevent ‘losses’ compared to making equivalent ‘gains’

In earlier sections, we referred to this point briefly. Consumers would avoid possible ‘loss’ of the gift vouchers and spend more to be in the respective promotional campaign categories of INR 5,000 or INR 15,000. It is proved by behavioral psychologists that people care more about the ‘loss’ than the equivalent ‘gain’ and would strive to prevent such a ‘loss’.

People also overvalue what they have (status-quo bias). Combine that with loss aversion, and we observe a very few consumers switching primary bank accounts. As per U.S. Retail banking satisfaction study conducted by JD Power in 2019, 4% of account holders had changed their primary bank accounts in 2018. The number is 1.4% of the total bank consumer base in the U.K. Consumers are averse to losing their existing comfort factor, service they enjoy, and relations (in case of private and branch banking). They end up opening multiple bank accounts rather than closing and shifting their account from one to another.

“Don’t miss this chance or festive season limited time loan offer” type of messaging uses loss aversion technique to induce urgency. FIs may combine it with the scarcity principle and make consumers complete for ‘the limited number of slots’. Messaging such as “Available only for first 100 applicants” or “First come first serve basis offer” practices scarcity rule as people don’t want to lose out on scarce things to their peers.

To promote a particular channel or service, FIs are seen to launch campaigns like “Mobile App ONLY offers” or “Discount ONLY on the specific payment method”. As consumers tend to avoid the “loss” that may incur by not using the specific channel or payment method, they get nudged to download the App or try the new payment method.

8) Halo Effect: The tendency to like (or dislike) something, including things one has not observed

If you are a naïve and first-time potential bank consumer, how would you select your bank when you have a plethora of options around? When in doubt and not able to address this difficult question, people generally replace the question with a few easier ones. Which bank is more visible around them? Who (celebrity) is endorsing which bank? Which bank their close family/friends are using? Such thinking that influences the decision is the ‘halo effect’.

Air-conditioned bank branches, hospitable sales executives, ATM network around, and brand marketing help boost such halo effect in a positive way. If asked explicitly, consumers may even deny that they got influenced by ‘halo’ things.

9) Availability Bias (WYSIATI – What You See Is All There Is): This bias comes into play when people do not go beyond the available information at hand, influencing their decisions

Ponder on a scenario where an unforeseen natural calamity has struck and received wide coverage in media. “Available” information says that everyone should be worried as calamities can strike anytime catching them off-guard. The post-calamity period observes bank executives pushing insurance products because they know the role of ‘available’ fear in people’s minds. Research papers have been published in support of this fact. WYSIATI often makes people misjudge low-probability events overestimating their occurrence.

Consider the present COVID-19 pandemic situation. Everyone was made to see the growing patient numbers, graphs, estimates, etc. all the time for many months together. Even if someone wanted there was no escape from these numbers, and fear associated with it. The ‘availability’ of such information created panic. Leveraging this available bias, certain initiatives in financial services have seen renewed focus. The push for digital banking channels compared to branch banking, contactless (NFC) payments v/s traditional methods involving touches, 100% digital loan application forms, etc. to name a few. Very logical and apt for social distancing norms, the initiatives have surely been benefited from availability bias.

Sample Advert: Leveraging COVID-19 Scenario

WYSIATI also implies that people do not spend too much time thinking about what information is NOT made available to them. ‘Hidden charges’ is one such WYSIATI tactic that bothers many banking consumers even today. Examples being flexible interest rates on mortgages, pre-payment penalties, ULIP (Unit Linked Insurance Plans) admin charges, credit card interest charges calculations, etc. Advertisements and bank executives highlight the benefits, making them ‘available’ to consumers, but would not share ‘other charges’. Consumers only realize ‘not stated’ charges later during consumption.

10) Similarity Principle: Belonging to the same group (similarity) would increase compliance as people would use social proof to make decisions

We encounter bank sales executives asking to refer their product/services to any of our family or friends. Does it really help beyond just another sales lead? Yes, it does! Consider AMEX sales executive calling you and stating that the reference was given by a close friend of yours. It is more likely that someone in a ‘similar’ position or income level as yours gave the reference. The reference is more relevant and from the same social group. So you invariably listen more carefully even if AMEX didn’t interest you before. You may buy a premium product like AMEX thinking that a ‘similar’ social group (your friend or family) have it, so you should also possess it. ‘Similarity principle’ is at work here increasing conversion.

People try to replicate the investment plans of their colleagues. They take mortgage or car loan because many similar people around didn’t mind taking them. They choose the same mutual funds as purchased by close friends. We see ample of such examples in everyday life around us, even if it involves one of the important things – money!

When the situation is not clear, people follow what others do. Everyone taking a cue from everyone else. Call it a social proof or pluralistic ignorance.

Helpful Nudges and Influences:

Plenty of clever nudges and influences benefit consumers as well as society. FIs utilize the above mentioned principles to help and make certain things more convenient for people.

  1. “Save Paper” campaign has resulted in “E-statements ONLY” as the default option for bank consumers. When the campaign started a few years back, banks used to offer “Paper + E-Statements” bundled together in a single option. As internet availability increased, the default option became “E-Statements” ONLY. It’s working well to reduce paper wastage and without consumers losing any important information.
  2. In the bank application and investment forms, there is a well-designed nudge. If there is more than one applicant, the default option for ‘Mode of Account Operation’ is “Any one or Survivor”. This is very convenient because it would save the consumers hassles later on.

    Sample Account Application from a Bank

  3. People are definitely not known for mastery of self-control. When it comes to savings and investments for the future, people are not disciplined enough. Consistent returns on investments need a lot of patience and a long-term view. Systematic Investment Plans (SIPs) as a product has offered exactly the same where consumers can steadily invest smaller (or bigger) amounts for a longer duration with a lock-in period option. SIP is a well-designed product to help consumers overcome their own downsides.
  4. Similarly, the “Invest small and watch your money grow” message is an influence that leverages on word “small”. People comply more for taking “smaller” steps when they are not fully sure of something. So SIP plans nudging consumers by asking them to start “small” have a better probability of compliance than saying “Flexible investment in SIP as per your budget”.
  5. Personal Finance Manager (PFM) is another self-control tool from the banks. Consumers do well with their money when they maintain various mental accounts for different objectives, namely – education, health, investments, entertainment, etc. PFM software helps consumers maintain such accounts in their digital banking channels like a mobile banking app. Consumers can define goals, track expenses, and also highlight if they are lagging behind on certain savings goals. Banks are assisting consumers here to help themselves.
  6. PFM’s intuitive graphics can influence consumers if designed well. The way PFM presents financial information (Framing Effect) can either help or deceive consumers. For example, if banks want to help consumers and encourage them to save more, PFM’s default view can show how much money the consumer has spent over a period rather than showing account balance only. Having a savings plans calculator like the below serves even better where consumers can calculate savings and earnings rate.

    Sample Savings Calculator Source: nubank Brasil

  7. FIs sometimes let consumers know what could be good for them in the long run. Insurance companies try and guide younger adults to buy life insurance at an early age to take benefit from lower premium amounts. It is debatable whether they guide well enough on the insurance + investment hybrid products, but it helps people if they start early. “If you buy later, insurance will cost you XXX more given all other health parameters remain the same” message triggers “loss aversion” among consumers and increases compliance of buying life cover at an early age.

There are also many other nudges FIs can ‘possibly’ do for consumers’ financial well-being.

  • Credit card statements never mention how much consumer has to pay if they miss the due date or pay only the minimum due amount. E.g. If you delay the payment or pay the minimum amount, you will have to pay XYZ per day or per week. Framing a message to highlight the extra cost can potentially nudge consumers to averse this loss. Consumers are likely to take a cue, pay up the bills, and possibly control their spending.
  • For personal loan/mortgage, if consumers are told that they would pay extra money if they just stick to bank stipulated EMIs (Installments), it is highly likely that consumers may consider paying a ‘little’ extra on top of their EMI amount. This will save them a lot in the longer term.

In a Nutshell

Though the human brain supposedly has a tremendous ability to store and process data, practically it has its limitations. It is vulnerable to nudges and can be influenced quite often with a few well-tested principles.  It’s in consumers’ good interest to be aware of these principles and defend themselves, when necessary while consuming financial services.

These principles also underline the supremacy of messaging that FIs can leverage for business as well as for the greater good of consumers. In the present technology, era tools can be leveraged effectively. FIs investing in digital transformation programs, digital channels, and UI/UX can deploy technologies to create, launch, and track nudges digitally. In fact, they can also be planted in a hyper-personalized way to be more efficient. WHEN, WHAT, WHERE and WHOM TO communicate with are the vital capabilities of digitally managed hyper-personalized nudges. Use of these influence tools optimizes conversion rates – a key performance indicator (KPI) FIs track as part of digital programs.

Considering the massive depth of the topic, it surely neither ends here nor claims to have covered all the influence principles in the write-up. We hope to have described key principles in behavioral economics and their applications in the financial services industry.

Next time someone is making you budge, check out if it’s a nudge!

 

References:

  1. Thinking, Fast and Slow by Daniel Kahneman
  2. Nudge by Richard H. Thaler, Cass R. Sunstein
  3. Influence: The Psychology of Persuasion by Robert B. Cialdini
  4. Yes! 50 Scientifically Proven Ways to Be Persuasive by Noah J. Goldstein, Steve J. Martin and Robert B. Cialdini
  5. Predictably Irrational by Dan Ariely
  6. Why We Make Mistakes by Joseph T. Hallinan
  7. Websites and advertisements from various banks (for Adverts and Images in the write-up)
  8. Research paper on ‘Catastrophes and the Demand for Life Insurance’: https://www.fox.temple.edu/cms/wp-content/uploads/2012/06/Jim_Carson1.pdf
Yogesh Joshi

Yogesh Joshi

General Manager - Business Development, Digital Financial Solutions (DFS). Yogesh is an experienced professional in business development, consulting and business analysis with a demonstrated history in mobile payments and digital banking. He has worked...