Understanding the causes of financial exclusion and underprovision

There is already a considerable body of research available into the extent of financial exclusion and underprovision in the UK. The nature of the subject means we will never have a perfect picture of the scale of exclusion and who is most affected but we know enough to understand we face a major problem in the UK.

However, while we know there is a serious problem, there is a major gap in our understanding of the root causes of financial exclusion and underprovision, and what interventions actually work to overcome the underlying causes. Moreover, there are major gaps in our understanding of how exclusion affects specific groups of consumers or regions in the UK.

This is where the Centre focuses its research activities. If policymakers and stakeholders are going to promote greater financial inclusion and provision, and help consumers achieve financial security, then we need to:

·         gain a better understanding of the root causes of financial exclusion and why consumers don’ t engage with financial services; and

·         identify solutions that work, and promote best practice.  

We want to develop innovative policy solutions that work. All of our planned projects are designed around this practical policy framework.

For example, we are planning a major project investigating which financial capability interventions are actually effective at changing consumer behaviour.  Another example, is the project we undertook looking at the impact of the credit crunch on overindebted consumers which included market led solutions for protecting vulnerable consumers. We are also working on a project to develop a more effective regulatory system which strikes the right balance between protecting consumers and making markets work (see Current and future projects). 

We are also taking this a step further by working in partnership with the financial services industry and third sector to create alternative business models that change the economics of access, and make products more affordable.

The causes of financial exclusion and underprovision

Consumers are not homogenous and the causes of exclusion are complex and varied. Moreover, the number of consumers affected very much depends on the product sector. But the Centre will focus its efforts on two broad target groups. 

Financially excluded: a combination of low disposable incomes and the economics of access in retail financial services means that this group are not commercially viable for mainstream retail financial providers. Alternatively, consumers may face actual exclusion because of a disability. In this case, there may be limits to what the market can provide and innovative solutions and alternative business models may be needed to change the economics of access or remove the barriers to access and develop affordable, accessible products and services. 

Underprovided: these are consumers who could afford to provide for their core financial needs but aren’t doing so due to demand and supply side factors and barriers to access (see below).

The causes of exclusion and underprovision

It is important not to oversimplify why financial exclusion and underprovision happens. There are numerous and complex factors that interact with each other and affect individual consumers and groups of consumers differently.

However, to aid its research and innovation programme FIC categorises the underlying factors into several broad groups:

• External environmental/ societal factors;
• income related and person-specific factors;
• demand-side factors; and
• supply-side factors.

Environmental, market and societal factors

This group of factors includes the broader socio-economic and demographic trends such as the ageing population, changing labour market structures, and political trends such as the transfer of risk and responsibility from state and employers to individuals.

Consumers are increasingly becoming expected to use the financial services industry to provide for the future, or protect themselves against risk. These trends may increase the risk that the needs of vulnerable consumers are not met (if they are excluded from the market) or consumers fail to make sufficient provision for various reasons.

Similarly, government and regulatory policy can have unintended consequences on consumers inadvertently contributing to financial exclusion or making it harder for consumers to provide for themselves.

There are also market developments to consider – for example, financial services companies are adopting increasingly sophisticated techniques to segment consumers into different groups according to profitability or risk. This can lead to more consumers being priced out of the market or denied access to products and services altogether.

Financial services providers in this case are not acting unfairly as these market innovations can benefit many consumers. However, it is important to monitor the impact of these market developments.   

Individual factors

This group of factors includes income levels and other individual factors such as disability. It goes without saying that income levels and affordability are among the main contributory factors to the current levels of financial exclusion. Consumers on lower incomes may simply not be able to afford financial services or may be priced out of the market due to market practices such as risk-based pricing. Other examples include consumers with restricted mobility being denied access to banking services if branches close down.

Market factors

Even if consumers can afford to use the market to meet their financial needs, a range of factors act as barriers to consumers getting access to fair and affordable financial services and products.

Again, there are complex set of interacting factors each requiring detailed analysis. However, the Centre categorises these into two broad groups: ‘demand side’ consumer related factors; and ‘supply side’ or market-related factors.

Demand side or behavioural factors

There are a number of barriers to access which can undermine consumers’ willingness to engage with financial services and/ or affect capacity and ability to make effective, informed choices and decisions.

These barriers include:

• low levels of consumer awareness of the need to plan and provide for the future, or shop around for better deals;
• low levels of financial literacy and capability;
• consumer trust and confidence;
• inertia and behaviour, and impact of external factors such as the property market.

The net result of these barriers is that consumers can ‘self-exclude’ to a large degree. This can be detrimental to consumers’ own welfare but this has a double whammy effect as consumers have to be persuaded to save or invest through expensive advertising or incentives, or need the support of expensive advice and guidance – this has the effect of pushing up distribution and access costs which in turn makes it unprofitable for industry to serve larger numbers of less profitable consumers.

Not surprisingly the government, regulators, charities and industry are expending huge resources on improving consumers’ financial capability. If interventions are to be effective then they need to change consumer behaviour, and help them participate effectively in the market. It is interesting that given the size of the resources we actually know very little in the UK about which interventions are effective at changing behaviour.

The only true measure of the success of financial capability interventions is whether are to be effective. Therefore, our strand of work in this area focuses on undertaking innovative research that provides real insight into how consumers behave in financial markets and identifying the interventions that are actually effective at promoting positive consumer behaviours.

Supply side factors

On the other side of the equation, a number of factors relating to the way the financial services industry operates and is structured means that consumers can be excluded or don’t have access to fair and affordable products and services. The key barriers are:

• distribution inefficiencies and ineffective competition;
• oversupply in the market and diseconomies of scale;
• complex products;
• inefficient regulation;
• public policy interaction (eg. means testing);
• basic economics of access.

Although the UK’s financial services industry appears to be competitive with hundreds of providers and literally thousands of products on offer, this activity does not always work in the consumer interest. We estimate that there are around 30-40,000 retail financial products on offer to UK consumers.

For example, the sheer number of products on offer in the retail investment and pensions sector adds to distribution costs as product providers have to compete fiercely using expensive advertising and commission payments to make sure their products are sold by financial advisers and intermediaries. Often the net result is ‘churning’ of existing customers’ business rather than genuine sales to new customers. Overall, the inefficiencies in the distribution system make products more expensive so excluding more consumers on lower-medium incomes.

Having large numbers of products and providers also means that providers don’t benefit from economies of scale which again means costs to the consumer are higher than is necessary if the market was functioning.

Complex products increase the need for expensive advice and regulation. Providers are apprehensive about distributing products to vulnerable consumer groups. These factors combine to push up distribution costs.

Effective regulation is critical as it needs to strike the right balance between providing an appropriate degree of consumer protection to inspire confidence in markets, while allowing the industry to operate to meet consumers’ needs. Unnecessary regulation benefits no one as it adds to costs for industry which are passed onto consumers so creating even further exclusion. This applies to conduct of business regulation and prudential regulation. Just as weak regulation encouraged reckless lending or risk-taking behaviour by some parts of the financial services industry, we need to avoid overregulation compounding the behaviour of the industry becoming more risk averse.

Tackling those demand and supply side barriers to access should create a better environment for retail financial services providers to extend access to a wider range of consumers.

However, even if these policies were 100% successful, the basic economics of access means that large numbers of consumers will always be economically unviable for mainstream financial providers. Radical, sustainable and innovative solutions are needed to meet the needs of these consumers. For example, we are working on the concept of social investment bonds to increase the pool of sustainable loan capital for third sector organisations such as credit unions and charities.