Ensuring customers receive fair value for financial services is a major regulatory concern at the moment. Issues of fairness in pricing are likely to become increasingly prevalent and complex in the future as firms’ use of new technologies and data becomes more sophisticated.
Fair pricing is directly relevant to FCA’s strategic objective to make the markets it regulates work for consumers and links to its work on vulnerable customers, culture, competition, innovation and consumer trust. In its 2020/21 business plan FCA explained that it is targeting three outcomes:
- Consumers can choose from products that meet their needs, at a suitable quality and price
- Digital innovation and competition supports greater value for consumers
- Vulnerable consumers are not exploited or targeted with poor valueproducts and services and access to key products and services is fair
FCA investigations into pricing practices in general insurance, cash savings and mortgages have shown that markets sometimes fail to achieve fair value for consumers.
To achieve its desired outcomes FCA intends to build on the thinking in its June 2018 research paper, “Price discrimination in financial services: how should we deal with questions of fairness?” (the “Research”). The Research set out a framework for thinking about economic and fairness aspects of price discrimination.
For the purpose of the Research, price discrimination was treated as the practice of charging different prices to different consumers that have the same costs to serve, but different willingness to pay. The critical element of this definition is the underlying demand-side feature – the different willingness to pay.
Practical examples of price discrimination exist everywhere (e.g. student discounts) and are widely accepted. However, in financial services price discrimination often takes more complicated forms. One reason for that is the complexity of financial products, which can make it difficult to identify when price discrimination is happening and to what degree. For example, if insurance premiums vary between two postcodes how can we know whether that is because of differences in risk (cost-based pricing) or because people have different levels of willingness to pay (price discrimination)?
The Research concluded that three conditions must be satisfied to make price discrimination possible.
First, consumers must have different levels of price sensitivity. This might be due to the way they value a product or because they have particular costs that others do not (e.g. switching costs) or it may simply be that they are more or less savvy or engaged in the process of seeking out alternative products and prices.
Second, firms need to be able to distinguish between the less and more-price sensitive consumers, so they can charge accordingly. Firms can, over time, learn consumers’ behaviour and set prices based on certain characteristics or demographics. More information through big data and advanced algorithms of artificial intelligence will potentially enhance the ability of firms to identify different types of consumer behaviour.
Third, firms must be able to adapt products to ensure different prices can be charged to different consumer groups. This is usually done by designing products that match to the demand profiles of the different groups.
If price discrimination is found to exist, when should FCA take action? FCA needs to strike the right balance between firm and consumer responsibilities. The Research identifies 6 questions which will help to guide FCA’s thinking. Several are unsurprising: who is harmed by the discrimination, how large is the pool, how significant is the harm and how essential is the product or service? The other two are less obvious: what is society’s view (would it consider the discrimination to be egregious and unfair) and how is the firm discriminating (in an open and transparent manner which a consumer can identify and respond to or more covertly)? FCA has subsequently stated that it considers the last of those questions to be of fundamental importance to the assessment of the fairness of a pricing practice.
If FCA decides that it is appropriate to intervene, there is a range of options:
- Interventions that remove the necessary conditions for price discrimination (which are discussed above). For example, interventions could be targeted at the firm’s ability to distinguish between the less and more-price sensitive consumers by imposing constraints on the way certain types of data are collected or used.
- Interventions that reduce commercial incentives for firms to price discriminate. For example, FCA may draw attention to discriminatory practices, highlighting the harm and identifying the worst offenders. The incremental gains made from price discrimination are off-set by potential damage to the brand caused by the controversial pricing practice.
- Interventions that put formal constraints on prices, for example price caps or uniform pricing requirements. Recent action in relation to overdraft rates and single easy access rates for bank accounts would be examples of similar action. This sort of remedy would, however, be difficult to design and enforce across a range of products, particularly where it is difficult to unpick price discrimination from cost-based pricing. It would also be important to consider the likely market response following such an intervention (e.g. 40% overdraft rates across many banks).
A key part of any product governance process is to ensure the proposed product or service, and the related distribution strategy, delivers value for money to the target market in a range of scenarios. The starting point is to obtain a thorough understanding of the needs of the target market so products can be designed and priced to meet those needs (with no unnecessary bells and whistles). If different prices are going to be charged to different consumers that needs to be objectively justifiable (for example, because of the different costs of distribution or servicing). Pricing strategy should be set and the delivery of value should be monitored regularly by the board.
Of course, FCA can take action against individual firms if it considers they are not acting in customers’ best interests or product governance processes are deficient. FCA expects firms to exercise extra care where consumers may be vulnerable and may be more likely to intervene if the pricing practice results in harm to vulnerable customers. FCA is shining a light on the culture within firms at the moment, expecting to find decision-making processes which are driven by what is right and fair for consumers, rather than what is permissible within the rules – all part of its move towards a more outcomes-focussed approach to regulation.
This article was first published in Thomson Reuters on 27 July 2020.