Bank of England
The Bank of England is the central bank of the United Kingdom. The Bank was founded in 1694, nationalized on 1 March 1946, and in 1997 gained operational independence to set monetary policy. The Financial Services Act 2012 established an independent Financial Policy Committee (FPC), a new prudential regulator as a subsidiary of the Bank, and created new responsibilities for the supervision of financial market infrastructure providers.
The Financial Policy Committee (FPC) acts to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system and to support the economic policy of the Government.
The new Prudential Regulation Authority (PRA) supervises around 1,700 banks, building societies and credit unions, insurers and major investment firms. The PRA’s role is to promote the safety and soundness of these firms and – specifically for insurers – to contribute to the securing of an appropriate degree of protection for policyholders.
The PRA focuses on the harm that firms can cause to the stability of the UK financial system. A stable financial system is one in which firms continue to provide critical financial services – a precondition for a healthy and successful economy.
The financial crisis demonstrated the need for a new approach to financial regulation and as importantly, new ways of effectively communicating policy and its rationale to the public. Oxford Risk was already known to the Bank for its work in financial services and its consumer investor risk profilers, based on its understanding of how people consider and make judgements about risk. The bank approached Oxford Risk for advice on communicating risk. Preliminary discussions suggested several questions characterised the issues including:
- How should the regulators ensure that risk is appropriately managed both by institutions and individuals?
- How is risk best communicated to individual investors and businesses?
In order to gain a better understanding of the answers to these and other questions, Oxford Risk, in collaboration with the Oxford University Institute for New Economic Thinking (INET), held a one-day international workshop at Nuffield College Oxford in July 2013.
Leading thinkers in the fields of economics, psychology, biology, mathematics explored how the latest research can inform regulators and businesses. The two UK regulators, the Bank of England and the Financial Conduct Authority took part in the workshop. How should the regulators ensure that risk is appropriately managed both by institutions and individuals?
Regulators and financial advisors should take into account the difference between risk and uncertainty. Risky decisions are about choices between probabilities, in contrast, decisions about uncertainty are ones in which the range of outcomes are unknown.
Many decisions made by individual consumers and institutions involve uncertainty rather than risk. How individuals and institutions do or should deal with uncertainty is not well understood, but generally people construct a story to justify their choice, whether or not it is a good decision.
Economists, psychologists and biologists have all built related theories to predict how people ought to respond to risky choices in order to find the right balance between increased gains and avoidance of excessive risk. However, individuals and organisations often do not behave as predicted by the theories. Instead they follow simple psychological rules that lead to predictable biases, such as choosing a familiar option or copying the choices of others.
Choices made by consumers, including consumers of financial services, are affected by the way in which alternatives are presented. This is referred to as ‘choice architecture’, or more colloquially, ‘nudging’. Nudging could be used to favour the interests of either consumers or retailers of financial products and services, and regulators should aim to ensure that consumers are guided towards outcomes that are ‘best’ for them. Setting the default for pension enrolment as ‘opt-in’ rather than ‘opt-out’ is a well-known example. The nudge approach could also be useful for regulators to ensure that institutions do not take inappropriate levels of risk.
The Science of Risk
Claire El Mouden of the Department of Zoology at the University of Oxford has produced a paper that brings together different insights gained from the study of risk in a range of scientific disciplines. It provides the essential background reading to start a discussion about how insights from these diverse empirical and theoretical approached may be applied to major outstanding policy issues, such as those raised at the workshop. You can read the full version of the paper here.
Oxford Risk and Oxford University INET will work with the regulatory authorities and academic researchers to close gaps in our understanding of financial risk and uncertainty in order to inform future business practice and regulation in financial services.