Consumer Credit with Over-optimistic Borrowers

Does the presence of borrowers with behavioural biases create a need for regulation to limit the misuse of credit? Proponents of consumer finance regulations often argue that some consumers overborrow because of behavioural biases, which leads them to become heavily indebted. In contrast, opponents maintain that regulations harm borrowers by increasing the cost of borrowing and limiting access to credit.

We use a model with both “rational” and “behavioural” consumers to examine what occurs when unsecured consumer credit (e.g., credit cards) is regulated. In the model, behavioural consumers are overly optimistic about their future income. This leads them to make financial mistakes: they borrow too much and default too late. Since these over-optimistic consumers incorrectly believe they are rational, both types of consumers behave identically. Lenders cannot discern between the two, so they use type scores—similar to credit scores—to track the likelihood of a borrower being behavioural or rational. This means that both types of borrowers with the same type score borrow at the same interest rates. Since rational borrowers default less often, they end up subsidizing the borrowing costs for behavioural borrowers. This results in over-optimistic borrowers facing lower interest rates than they normally would if they weren’t grouped with rational borrowers.

Our calibrated model allows us to evaluate several regulatory policies: reducing the cost of default, increasing borrowing costs, imposing debt limits and providing financial literacy education. While we find that some policies do lower debt and filings, they do not reduce overborrowing by behavioural consumers. Although financial literacy education eliminates financial mistakes, it also reduces behavioural borrowers' welfare because it removes the cross-subsidization of interest rates. These findings offer a cautionary tale for consumer financial regulations.