Back to Basics – A Carte Blanche by Pierre Francotte

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In the ten years since the start of the financial crisis much of the financial regulators’ focus has been on making it less likely that banks can fail and, if they do fail, that a bail-out by governments is needed. This will not only reduce risks in the markets but will also achieve one of the side objectives of policymakers after the crisis: to make the European banking sector smaller, with companies getting more of their financing directly from investors, such as large institutional investors and wealthy individuals – but also from small  nsophisticated
investors: those who are being criticised for leaving their cash in bank accounts at negative real interest rates, while there are supposedly such attractive opportunities for much better returns by buying shares, bonds or mutual funds.

There are indeed investments that can generate a higher return than 11 basis points in a bank’s savings account, even when discounted for risk. The question is to what extent small unsophisticated investors have been given the means to assess the risks associated with these investments.

How many are able to compare the risk/return profile of the shares of one company as opposed to the bonds of another? And if the answer is to diversify via a balanced portfolio of assets, how many realise the risk of loss of value (market risk) of even triple A government bonds in today’s market environment, especially if you hold them via a mutual fund where the fund manager may decide not to keep the bond until maturity if its market value drops, but instead take its losses (or more correctly take “your” losses) right away?
How good is our education system in secondary schools or even in universities (other than
in economics or financial programmes) at developing basic personal finance skills? This is what national financial regulators like the FSMA in Belgium and international organisations like the OECD have been seeking to understand.

The answer is sobering. In a 2015 OECD survey, a large sample of adults were asked questions like these:

– If you deposit €100 in your bank at 2% guaranteed annual interest rate, how much will
you have in your account at the end of one year (assuming no costs, taxes, etc)? The correct answer for those of you wondering is €102.
– And how much would you have after 5 years: more than €110, less than €110, precisely
€110, or can’t calculate based on the information you have? The correct answer is more
than €110, due to compound interest.

About one third of Belgian respondents couldn’t answer the first question correctly, 50% the second question and over 60% couldn’t answer both correctly (the figures in Belgium are slightly better than the OECD average). We shouldn’t be condescending about those who struggle with these questions. Instead we should acknowledge the need for more practical education to ensure that most potential investors in financial instruments are
given the means to properly assess their risks and possible returns.

The FSMA has been taking a number of steps to do this in Belgium, but does the solution lie only with our financial regulators or also with our basic education system, starting in secondary and possibly even primary school?

Pierre Francotte
Professor
SBS-EM

 

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