56706 Country Studies Provide Powerful Lessons in Financial Consumer Protection Sue Rutledge1 the growth continues. Most new consumers are in developing countries where consumer protection and Key Messages financial literacy are still in their infancy. This is In countries that have moved from central particularly true in countries that have moved from central planning to market economies, protecting planning to market economies where protecting consumers consumers is necessary to create stable and is necessary to ensure stable and competitive financial competitive financial markets and give new markets and give new consumers confidence in the formal consumers confidence in the formal financial financial systems. systems. By 2008, household debt in the Europe and Household use of financial services has been rising rapidly Central Asia Region (ECA) had risen to levels in emerging countries, yet consumer protection and between 20% and 50 % of GDP. However, financial literacy remain weak. By 2008, household debt in many transactions still take place outside the ECA had risen to levels between 20% and 50% of GDP. formal financial sector, many people find However, many transactions still take place outside the financial service contracts difficult to formal financial sector in emerging markets. At the same understand, and consumer complaints are hard time, many people find financial service contracts difficult to redress. to understand and there are no agencies that are clearly The World Bank has conducted nine country identified as being responsible for addressing consumer studies in ECA to review consumer protection complaints; consumers have to take their disputes directly to and financial literacy frameworks in all court systems, a process that is often slow and expensive. financial segments - including banking, securities, insurance, private pensions, and non- The global financial crisis has highlighted the importance of bank credit institutions. consumer protection and financial literacy for the stability The World Bank recommends that ECA of the financial sector. In the US, the rapid growth of countries develop strong and specific complex residential mortgage products, combined with institutional frameworks for financial consumer securitized instruments which were sold to poorly informed protection, disclose financial information more parties, has caused much turmoil. Financial institutions clearly to consumers, improve business worldwide have been obliged to write off trillions of dollars practices in the financial sector, set up efficient of assets. In ECA too, damage to the financial sector was dispute resolution mechanisms, develop serious. financial education programs, and conduct financial literacy surveys. Why are Consumer Protection and Financial Literacy Important? Consumer Protection and Financial Literacy in ECA There are at least three reasons why consumer protection in financial services and financial literacy are essential for Until the financial crisis of 2007, the global economy was financial sector development in ECA countries. adding an estimated 150 million new consumers of financial services each year. Rates of increase have since slowed but First, they increase consumer confidence in the financial system and, in turn, contribute to reducing the risks to 1 The author would like to thank Caroline Cerruti for her valuable contribution in preparing this Knowledge financial stability. Both consumer protection and financial Brief, as well as all the members of the Consumer Protection and Financial Literacy team who prepared the literacy are needed to build trust in the financial system. In World Bank Policy Research Working Paper "Consumer Protection and Financial Literacy: Lessons from Nine Country Studies", June 2010. the banking sector, they typically broaden and diversify the ECA Knowledge Brief deposit base of banks, thus reducing liquidity risk. Well- literacy frameworks in all financial segments, including informed consumers also help foster financial stability by banking, securities, insurance, private pensions, and non- better protecting themselves from incurring large exposure bank credit institutions. Some reviews also looked at to market and other risks. Across the financial sector, microfinance lending and credit reporting. The reviews consumer protection and financial literacy promote access were conducted using Good Practices for Consumer to, and prudent use of, financial services. Protection and Financial Literacy in Europe and Central Asia: A Diagnostic Tool.2 Second, consumer protection in financial services and financial literacy address the imbalance of power, Five types of issues clearly stood out in the reviews of the information and resources between consumers and their nine countries: financial services providers. This imbalance is often a typical market failure. Financial institutions know their Inadequate institutional structure for financial consumer services well but individual consumers often find it difficult protection. In some countries, the financial supervisors view or costly to obtain information on the financial products consumer protection as part of their mandate for financial they purchase. In addition, complex financial products may stability. In others, the general consumer protection be difficult to assess even when all the information is disclosed. agencies deal with financial services but are mostly responsible for a limited number of retail financial services Third, consumer protection in financial services and such as consumer credits and payments. Consumer financial literacy promote efficiency and transparency in protection in insurance, securities and private pensions falls retail financial markets. Consumers who are empowered to the respective financial supervisors. The reviews showed with information and basic rights are an important source of that financial consumers generally have no clear idea about market discipline. This encourages financial institutions to which agencies to approach in case of complaints. compete by offering better products and services rather than by taking advantage of poorly-informed consumers. Insufficient or unclear disclosure on financial products. An effective financial consumer protection framework Where the EU Directive on Consumer Credit has been should provide consumers with: implemented, clear disclosure of effective rates for consumer credits is provided. However, many of the other Transparency - by providing full, plain, adequate, terms and conditions require a careful reading of the and comparable information about the prices, terms financial contracts. In Romania, some borrowers receive and conditions, and inherent risks of financial mortgage contracts printed in a 6-point font size that is too products and services; Choice - by ensuring fair, non-coercive and small to read. In none of the nine countries are consumers reasonable practices in the selling of financial informed of the risks involved in taking long-term loans in products and collection of payments; foreign currency and at variable interest rates. Redress - by providing inexpensive and speedy mechanisms to resolve complaints and disputes; and Unfair or abusive business practices. The worst abuses Privacy - by ensuring control over access to against financial consumers are often committed by personal information. unlicensed financial service providers. In Slovakia, some non-bank credit institutions (which, at the time of the In addition, consumers should have access to programs of review, were not registered with the National Bank) charged financial education that enable them to develop the financial capability required to understand financial products and consumers interest rates of 120% to 225% per annum while services, and to exercise their rights (and responsibilities) as banks were lending at less than 14%. Another common financial consumers. problem relates to debt collectors. In Russia, when the financial crisis hit household lending, some banks increased the use of third-party debt collection agencies to improve Lessons from Nine Country Studies loan performance. However, these agencies remain unlicensed and their methods of operation are not subject to Starting in 2005, the World Bank initiated a pilot program that has conducted country reviews in Azerbaijan, Bulgaria, strict controls. Croatia, the Czech Republic, Latvia, Lithuania, Romania, 2 World Bank, Finance and Private Sector Department of the Europe and Central Asia Region, Good Russia, and Slovakia. Each country review provided a Practices for Consumer Protection and Financial Literacy in Europe and Central Asia: A Diagnostic Tool, detailed analysis of consumer protection and financial December 2009 (available at http://www.worldbank.org/eca/consumerprotection) ECA Knowledge Brief Deficiencies in the customer complaint/dispute resolution Clear information disclosure. One option is the use of "key framework. Complaints are not systematically analyzed and facts statements" that provide all key terms and conditions answered. Large financial institutions have generally set up in simple and plain language for all retail financial products specialized complaint departments and banking supervisors and services. Standard contracts for retail financial services, review banks' complaint files while conducting on-site or at least standard basic contract provisions, would also supervision. Nonetheless, the process of collecting help consumers understand their legal obligations. complaints is inefficient: there are neither central agencies for, nor aggregated statistics on, consumer complaints. The Prohibition of abusive business practices. All financial reviews found that at least 50% of the complaints are institutions that deal with the public should be registered inquiries which can be addressed by financial education.3 with a financial supervisory agency. All entities that solicit As for complaints leading to disputes, only three countries funds from the public for investment (or speculative) have some mediation mechanisms to help the parties resolve purposes should be licensed and those who attempt to issues amicably. The other countries either have no out-of- engage in pyramid schemes4 and financial fraud should be court mediation services or have services that focus on prosecuted by experts in financial services. All sellers of specific financial services only. Yet, going to court is not a retail financial services should be qualified and certified to viable alternative for most financial consumers. ensure that they understand the products and services that they sell to the public. Ex-ante reviews by regulators of all Low level of financial literacy and lack of awareness of financial products sold to the public may be required. Unfair customer rights in financial services. A 2008 financial or deceptive practices should be explicitly prohibited and literacy survey conducted in Russia showed that half the personal data carefully protected so that consumers are respondents considered their level of financial literacy as aware when their personal data has been shared. unsatisfactory. Over 80% were unable to correctly answer five out of six basic financial questions. None of the nine Efficient customer complaint/dispute resolution countries studied had a financial education strategy in place. mechanisms. Each financial institution should have a customer complaint department. Complaints about financial Recommendation for Consumer Protection and services should be consolidated in one location and statistics Financial Literary published about the number and types of complaints. Drawing lessons from the nine country studies, the World Complaints should be differentiated from inquiries (for Bank recommends: which consumers should receive financial education) and Strong and specific institutional frameworks. As one option, disputes (for which a court process, mediation or arbitration financial supervisory agencies may adopt consumer is needed to resolve the issue at hand). A fast and protection as part of their mandate. However, they need to inexpensive out-of-court mechanism - such as a financial address the inevitable conflicts of interest that arise between ombudsman - is recommended. prudential and business conduct supervision, and ensure that Development of financial education programs. Financial consumer protection receives sufficient focus. As a second education is an effective form of consumer protection but option, economy-wide consumer protection agencies may cannot substitute for regulation. Building financial take on financial services. However, they need to find a way education is a long-term investment and its effectiveness to build the expertise and confidence to handle the complex should be carefully evaluated. Focus should be placed on technical issues related to financial services. A third "teachable moments" --such as, when a consumer takes a mortgage for the first time or starts to plan for his or her approach would be to create special purpose consumer retirement. Interactive stock market computer games are financial protection agencies, such as the one proposed in also effective in teaching high school students about the US and currently in place in Canada. The bottom line is financial investment. Middle - and high - income countries that there should be an institution identified to deal with should develop national strategies for financial education. consumer protection issues, with a clear mandate. 3 For instance, in Azerbaijan, the most common complaint consumers submitted to the Central Bank was that they did not understand why their commercial banks failed to grant loans to them. In Croatia, several 4 A "pyramid scheme" is a business model that involves the exchange of money for enrolling other people consumers complained to banking supervisors that "We don't understand what we signed". If they had co- into the scheme, often without delivering any service. New money (brought by new investors into the scheme) signed a loan, consumers did not realize that they might be obliged to pay the debt of their friend or family is the source of the payoff for existing participants. Pyramid schemes require an exponential increase in the member. number of participants to sustain them. ECA Knowledge Brief Conducting financial literacy surveys. The surveys should schooling. Updated surveys can later determine if the review the ability of consumers to evaluate financial financial education programs have been effective and if products, their spending/savings patterns, and their trust in additional consumer protection measures are needed. dispute resolution mechanisms with financial institutions. Globally, surveys of consumer protection and financial The surveys should be broken down by age, gender, literacy would be helpful, as would diagnostic reviews of geographic area, socio-economic levels, and years of formal countries in other regions like Latin America and Asia. Consumer Protection in Financial Services: How to Get it Right? Institutional Single agency is best. Structures If a consumer protection agency is responsible for financial services, create a specialized department for financial services with adequate expertise. If a consumer protection agency is responsible for basic financial services, enlarge its mandate to include ALL financial services. Alternative: create a specialized consumer financial protection agency (as in the US and Canada). Consumer Ensure simple and standard consumer disclosure. Disclosure Get professional associations to develop "key facts statements" that provide a simple summary of the terms and conditions of the financial contracts. Have standard contract provisions for high-volume core retail financial products. Business Register all financial institutions dealing with the public with financial supervisory agencies. Practices Explicitly prohibit and sanction unfair or deceptive practices. Require financial institutions to provide accurate information and hold them accountable for the information they provide to consumers. Establish a cooling-off period for complex, long-term savings products and those sold aggressively. Make provisions for annual audited financial statements, and fit and proper tests for credit institutions. Require regulatory licenses for entities that solicit funds from the public for the purpose of investment or speculation. Enhance the powers of securities supervisory agencies to investigate ponzi/pyramid schemes. Require consumers' signed approval if personal data is to be shared by financial institutions. Allow inexpensive ways for consumers to verify their personal information in the credit register. Enforce responsible practices (via codes of conduct, for example). Complaints Provide fast and inexpensive redress mechanisms. and Dispute Have clearly identified departments to handle customer complaints in all financial institutions. Resolution Advise customers in writing about where they should submit complaints when buying new financial services. Have financial supervisors review the complaint files of the supervised entities. Provide toll-free telephone lines at the central complaints offices. Complaints may be submitted by email, postal mail, or in person. Analyze and publish consumer complaints statistics. Provide alternatives to courts for disputes involving small amounts of money (for example, financial ombudsman). Financial Focus financial education on "teachable moments." Systematically evaluate programs. Education Elaborate national strategies/programs of financial education and financial literacy. Monitor consumer protection (for example, by using "mystery shoppers"). Financial Conduct national surveys of financial literacy and follow-on reviews. Literacy Promote global surveys of legal and regulatory frameworks for financial consumer protection, levels of financial literacy, and Surveys patterns of financial consumer behavior. What can the World Bank Group Do? for strengthening consumer protection and financial literacy. The World Bank can assist by preparing Diagnostic Reviews of Consumer Protection and Financial Literacy, About the Author conducting financial literacy surveys, and developing Sue Rutledge is a Senior Private Sector Development strategies or action plans to implement recommendations Specialist in the Finance & Private Sector Development Unit of the Europe and Central Asia Region of the World Bank. "ECA Knowledge Brief" is a regular series of notes highlighting recent analyses, good practices and lessons learned from the development work program of the World Bank's Europe and Central Asia Region http://www.worldbank.org/eca