13th March 2012

Bode's Sensitivity Integral and the Waterbed effect

The Waterbed effect is a phenomenon that will increasingly cause concern to those who regulate the industry and those it regulates in regard to pricing, consumer detriment and delayed back office system upgrades.

It is in fact the natural but not necessarily intended potential to squeeze one part of a complicated and complex regulated business model and the attendant regulatory processes to cause a serious bulge elsewhere in the process.

The metaphor of the water-filled mattress seems to be a common sense albeit simplistic description but it is supported by a little known mathematical formula called Bode’s Sensitivity Integral.

The Waterbed effect is already well illustrated in the mobile phone industry where regulation fixes the prices of basic products and services only for consumers to see significant increases in the price of peripherals and additional services as a direct consequence.

So, the Waterbed effect theory in RDR dictates that in achieving:

• the elimination of bias in the market
• ensuring the adviser is the true agent of the consumer
• clarity over the costs of advice

and the various other factors, we will no doubt see the bulge appear somewhere else.

As Nic Ciccutti said in MM this week “One might have hoped that by now the FSA would have realised its’ RDR process will take affordable advice beyond the reach of millions of consumers and by further entrenching the need for subjective analysis, it is simply piling ever increasing costs on the consumer”.

Yes, costs in every conceivable way and not only for consumers. Cost is something that the FSA incurs for firms, often with little thought of logic or affordability and with little benefit analysis being done on the consumer impact it creates.

He goes on to say, “Clearly, the requirements of this latest FSA activity will place considerable burden on software suppliers O&M Systems, SelectaPension, Distribution Technology and others which supply software solutions to help advisers in this area. The consultation will almost certainly delay the launch of other new systems being developed in this area”. Further illustrations of the Water Bed Effect.

So how else will the Water Bed effect manifest itself?

• The elimination of bias in the market could see the banks being presented with a huge regulatory sponsored opportunity to no doubt miss-sell in ways nobody could dream possible.
• In ensuring the adviser is the true agent of the consumer, the result will be that mass market consumer will not want to pay for advice that has previously been seen as free- especially as the FSA still has no education plan in place to at least try and justify it.
• Clarity over the costs of advice, sadly the clarity will be that for the mass market, cost equals no advice sought if they have to pay for it.

Also consider this example of theWaterbed effect. When a consumer is able to obtain lower prices from an adviser, is it possible that other consumers will have to pay more for the same input from another adviser firm as a result?

Is this bad for consumers? The asymmetric exercise of consumer power can lead to consumer detriment through raising other consumers’ advice charges- the ‘Waterbed effect’.

While a large and powerful firm improves its own terms of advice supply by exercising its market power in getting cost reductions, the terms of its lesser resourced competitors can deteriorate sufficiently so as ultimately to increase the average price of advice. Such consumer detriment from the Waterbed effect is more likely if the adversely affected firms are already sufficiently squeezed, due to relatively higher regulatory and other operating costs and a lower market share.

So while we lay in our Waterbed, what should we wear to prevent a bulge getting the better of us?

Chanel No. 5, of course was Marylin Monroe's choice, what is yours?

RDR, FSA/FCA, Panacea Comment