Working Paper: NBER ID: w14972
Authors: Bruce I. Carlin; Simon Gervais
Abstract: Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, what legal rules maximize social welfare in the market? We address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. We characterize the optimal law within our modeling context, and derive how the legal system splits the blame between parties to the transaction. We also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.
Keywords: consumer protection; financial markets; legal rules; economic welfare
JEL Codes: G18; K2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Legal penalties for firms and brokers (G18) | Increase in effort in providing quality products and advice (L15) |
| Higher penalties (K49) | Improve product quality (L15) |
| Higher penalties (K49) | Reduce advising efforts by brokers (G24) |
| Brokers face penalties for advising errors (G24) | Provide thorough advice (G53) |
| Advising errors by brokers (G24) | Higher legal penalties for firms (L49) |
| Sales commissions (L85) | Diminished quality of advice (D80) |
| Legal system adjustments (K40) | Mitigate conflicts of interest from sales commissions (G18) |