02 December 2021

SUERF's Roldan: Caveat Emptor

The new equilibrium will entail lower volumes of products, less diversity of products being offered, and a higher price and lower volume of financial services being offered to clients with a less sophisticated financial education: rules to protect the weakest segment of the consumer pool may end up damaging them.

The principle of Caveat Emptor (buyer´s due diligence) enshrined in Roman Law has been incorporated to many legal systems, including common law ones. Nevertheless, in the first decades of the XXI century, the concept has been eroded in financial markets, where a zero-tolerance consumer rights approach that is prone to litigation and sanctioning has been introduced. This impacts markets: the price (the quantity of payment or compensation given by one party to another in return for one unit of goods or services) is not well defined.

1. Introduction

I must confess I have a soft spot for Romans. Yes, as an empire they did terrible things, crushing opposition from Judea to Hispania, from England to Germania. But they did things, from windows with glasses to the Porta Nigra in Trier, that have endured the passage of time, like no other civilisation in Europe has achieved.
One of those everlasting inventions was in the field of law. Roman law, the ancient legal system, is still studied today. Considering it is 2000 years old this is by no means a minor feat. The reason for this is not just the adequate architecture of the rules, that form the base of all civil law legal systems, but also the strong underpinning of the principles underlying it. In fact, even common law countries have adopted many principles derived from Roman law.

2. The principle of personal responsibility and consumer protection

One of the principles that pertain to the Roman legal system is that of caveat emptor, that can be translated as buyer´s beware, or the obligation of the buyer to ensure, up to a reasonable limit, that the good or service that she/he is purchasing does not contain any hidden defects (be it physical or in the form of underlying risks). Unavoidably, the seller of any good or service has more information about its nature than the buyer, and this is precisely the reason why the buyer must be diligent in understanding the characteristics of the purchased good or service. In the presence of asymmetrical information, a buyer´s due diligence is considered essential to ensure a sound daily business life.

That principle was nevertheless abandoned in the late XX 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, there was a need for a regulation that would protect them from unfair practices when buying goods or services. The issue of asymmetric information was sorted out by declaring the obligation by the seller to compensate the buyer from hidden defects.

Of course, the principles above must have some limits in order to maintain a smooth functioning of market-based economies. In particular, the protection was extended only to unsophisticated consumers, and even for this group the basic bona fide principles were still being enforced.

In practice a smooth business life was preserved by offering sellers a safe harbour: if some basic principles were respected (right to return the goods shortly after the purchase, guarantee for hidden effects offered, etc.), the seller knew that the transaction would not be subject to controversy and revision by authorities. Or, in other words, by safe harbour we mean a situation whereby the strict compliance with a set of rules put in place by authorities protects financial firms from litigation and supervisory actions. This safe harbour preserved a smooth business life for financial firms: potential compliance costs derived from consumer protection could be identified ex-ante and were kept under control.

Anyway, the actions of courts of justice, as the ultimate gatekeepers of maintaining a fair marketplace for financial products, guaranteed the prevalence of consumer rights, always under the principle of caveat emptor. Particularly, in the US the punitive justice system and class actions (whereby a group of people´s rights are defended in a lawsuit by a subset of them) were the ultimate discipline devices. In Europe, the existence of a very detailed set of obligations, allowed for a tick the box approach by courts on the fulfilment of the conditions attached to the safe harbour.

3. The emergence of a zero-tolerance culture and the unbounding of consumer rights

During the first decades of the XXI century, we are witnessing an additional push on the front of consumer rights and a further weakening of the principle of buyer´s beware. A zero-tolerance philosophy means that any failure of a single transaction in terms of consumer protection, among millions of transactions of the same kind, leads to ever tougher rules that weaken the caveat emptor principle.

This movement is also reversing the burden of proof, to the extent that for financial firms the concept of a safe harbour is increasingly an elusive one. If a single failure among millions of transactions provokes a backlash that creates a wave of judicial rulings and redresses, financial firms are not able to deal in advance with this uncertainty. Transactions that were deemed safe suddenly are seen as unacceptable.

Why this change of social attitudes matters? In the short run, it impacts the profitability of financial operators. In short, shareholders bear the impact. But if we consider ROE an endogenous variable that must be equal or superior to the cost of capital (the remuneration shareholders demand to stay in the capital of a financial institution) for the company to survive in the long run, the medium-term consequences will come as financial firms readjust to the new environment.

The first result is the lowering supply. Firms that do not react will be driven out of business, the ROE not matching the required cost of capital. And firms that react will try to avoid potential 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 those contentious clients. And we should not ignore that the worst problem for any consumer, the greatest attack to his/her rights, is not being able to access financial products.

Another reaction will probably be a simplification of the supply of products. Simpler products, with solid business margins, are a rational response to the ever-increasing consumer rights. A plain vanilla financial product will be less prone to potential changes in society´s mood. Over protection may well lead to lower number of products being offered.

And finally, another obvious reaction will be to become more digital. If the conversation of a customer and an employee of a financial firm is key to determine the chances of a future setback in terms of redress, then a way to reduce risks is to eliminate that human interaction....

moe at SUERF

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