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Consumer Credit With Over-Optimistic Borrowers

Author

Listed:
  • Florian Exler
  • Igor Livshits
  • James MacGee
  • Michèle Tertilt

Abstract

There is active debate over whether borrowers’ cognitive biases create a need for regulation to limit the misuse of credit. To tackle this question, we incorporate overoptimistic borrowers into an incomplete markets model with consumer bankruptcy. Lenders price loans, forming beliefs—type scores—about borrowers’ types. Since over-optimistic borrowers face worse income risk but incorrectly believe they are rational, both types behave identically. This gives rise to a tractable theory of type scoring as lenders cannot screen borrower types. Since rationals default less often, the partial pooling of borrowers generates cross-subsidization whereby overoptimists face lower than actuarially fair interest rates. Over-optimists make financial mistakes: they borrow too much and default too late. We calibrate the model to the US and quantitatively evaluate several policies to address these frictions: reducing the cost of default, increasing borrowing costs, imposing debt limits, and providing financial literacy education. While some policies lower debt and filings, they do not reduce overborrowing. Financial literacy education can eliminate financial mistakes, but it also reduces behavioral borrowers’ welfare by ending crosssubsidization. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.

Suggested Citation

  • Florian Exler & Igor Livshits & James MacGee & Michèle Tertilt, 2020. "Consumer Credit With Over-Optimistic Borrowers," CRC TR 224 Discussion Paper Series crctr224_2020_245, University of Bonn and University of Mannheim, Germany.
  • Handle: RePEc:bon:boncrc:crctr224_2020_245
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    File URL: https://www.crctr224.de/research/discussion-papers/archive/dp245
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    References listed on IDEAS

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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Consumer Credit With Over-Optimistic Borrowers
      by Christian Zimmermann in NEP-DGE blog on 2020-12-21 19:08:44

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    Cited by:

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    2. Emily G. Moschini & Gajendran Raveendranathan & Ming Xu, 2022. "Over-optimism About Graduation and College Financial Aid," Department of Economics Working Papers 2022-09, McMaster University.
    3. Almut Balleer & Georg Duernecker & Susanne K. Forstner & Johannes Goensch, 2021. "The Effects of Biased Labor Market Expectations on Consumption, Wealth Inequality, and Welfare," CESifo Working Paper Series 9326, CESifo.
    4. Jonathan J Adams & Eugenio Rojas, 2023. "Household Consumption and Dispersed Information," Working Papers 001009, University of Florida, Department of Economics.
    5. Marta Cota & Ante Sterc, 2024. "Financial Skills and Search in the Mortgage Market," CERGE-EI Working Papers wp780, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    6. Gajendran Raveendranathan & Georgios Stefanidis, 2022. "Designing “Win-Win” Rate Caps," Department of Economics Working Papers 2022-03, McMaster University.
    7. Exler, Florian & Hansak, Alexander, 2021. "Naïve Consumers and Financial Mistakes," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242359, Verein für Socialpolitik / German Economic Association.

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    More about this item

    Keywords

    Consumer Credit; Over-Optimism; Financial Mistakes; Bankruptcy; Financial Literacy; Financial Regulation; Type Score; Cross-Subsidization;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E49 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Other
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • K35 - Law and Economics - - Other Substantive Areas of Law - - - Personal Bankruptcy Law

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