Sunday, November 21, 2010

Interest rates get a rise: A Behavioural Economics perspective

It's been two weeks since Americain won the Melbourne Cup and the Reserve Bank of Australia (RBA) raised the cash rate by 25 basis points.  In both cases the result was unexpected.  The Commonwealth Bank (CBA) responded by lifting variable rates by 43 basis points with the other "big banks" following a week later with increases between 39 and 42%.  Public outrage was followed by political outrage as both major parties muttered about how to regulate the power wielded by the big banks. But what does Behavioural Economics tell us about the reaction to interest rate increases above the RBA rate?

1. Pricing irrationality
Have you moved your home loan as a result of the interest rate policy change? Let's take a minute to consider the scale of what CBA did.  On an average $300k loan the increase of 43 basis points (CBA) vs 25 (RBA) is a difference of 18 cents per dollar.  Over 30 years this is $54,000 or $34 or week.  $54,000 must be worth consideration, right?

Remember when petrol was less than $1 a litre?  Not that long ago, but now that the psychological barrier has been broken, we find ourselves paying $1.29 and beyond on a regular basis. Where's the outrage now?  Around the same time, Woolworths and Coles introduced their petrol docket savers where you can knock off $0.04 per litre.  On a 40L tank that's $1.60.  100L tank, $4.   For around the price of a coffee the petrol savers have been an outrageous success for the grocers because they have changed behaviour in their favour - people shopping in their outlets so they can save on petrol.

$54,000 vs 4c a litre.  I'd hazard a guess and say that more people have changed their grocery shopping than changed banks.  Why? We have different scales of pricing in our minds due to the effects of priming and consideration of one activity (petrol) does not means reconsideration of another (mortgage).

2. Revenge
I'll take my loan elsewhere!  I won't put up with this treatment! Revenge is a powerful emotional reaction and Behavioural Economics has illustrated it can cause irrational responses.  In the example of interest rates the revenge would be withdrawal of your business and it would be irrational because of the financial detriment through exit fees and the inevitability of rate changes across all loan providers.

3. Adaptation
Dan Ariely covers Adaptation in "The Upside of Irrationality".  Pretty simply, we underestimate how quickly we become desensitized to change.  And that's why two weeks after the interest rate shift it has faded to the background and I imagine very few people are still contemplating a change of bank. Of course this is exactly what the banks prey on - we get used to the higher rates, we get used to the standard of service and we adapt to paying more for our mortgages.

An interesting aside with adaptation- we are more likely to adapt when the change is less frequent.  In this case, an annual interest rate hike would in theory be less inflammatory than the monthly expectation-teasing RBA announcement.

4. Identifiable victim
The concept here is that we respond to individual suffering rather than the suffering of masses.  World Vision apply this principle when they ask that you sponsor a child rather than support a community. What do interest rates have to so with this?  Two things - from the bank's perspective they treat us as a mass and so do not see the suffering of individuals for whom a rate rise is devastating. And from our perspective, we would probably cope better with the behaviour of banks if they presented themselves as individuals who are making decisions in the best interests of their community ie shareholders.  And given many of us are bank shareholders (through Superannuation and managed funds), personalising the benefit may soften the blow.

5. Self herding
This is not the first time the banks have exceeded the RBA's official increase.  Can you remember the dates of other changes?  I can't. Although I can remember I was outraged. And I can remember I didn't switch banks. What that leads to is repeatable behaviour - in other words, I remembered I was annoyed but didn't do anything.  Therefore this time I am more likely to follow the same (inert) path.  Self-herding suggests that we recall our actions, apply them to a more general principle, and then follow the same path when a a similar situation happens.  Again, the banks rely on the pattern of inertia when they increase rates - much like insurance companies and utilities providers who increase prices.

6. Priming
Priming is where our pricing expectations are set in relation to a particular context. In this case, the RBA has primed our expectations of what is a "fair" increase at 25 basis points.  When the banks move in line with this, people get on with life because there is no one really to blame.  It is only when the banks "price gouge" by moving beyond the RBA rate that it becomes a story. 

Where does all this leave us when it comes to interest rate increases beyond the official cash rate?  It's an understandable reaction to get angry when the banks breach our sense of fair play, but I think a large part of the issue is that we get mad at ourselves for not acting the last time it happened.  It's our irrational selves at play - expending more energy looking for discounted groceries than the best loan.  So before the next rate change there are a couple of things you can do - check which banks you have shareholdings with because it may ease the pain if you ultimately profit, and of course, if you are not satisfied with your bank, take action in anticipation of another inevitable rate increase.

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