The economics of debt collection, with attention to the issue of salience of collections at the time credit is granted

Erik Durbin and Charles Romeo

Journal of Credit Risk

Abstract: This paper considers the role of policies that protect consumers from aggressive debt collection tactics. In general, rational consumers will select credit contracts based not only on price but also on the lender’s practices in the case of default and might prefer a contract that offers higher interest rates but more lenient collection tactics. We consider a model in which consumers can be optimistic in that they underestimate, at the time they borrow, the chance of a negative income shock that could cause them to default. This mindset induces consumers to perceive the welfare associated with borrowing to be greater than it is and to place less weight on the lender’s collection practices, which may cause them to prefer lower interest rate contracts even if they are accompanied by high collection effort in the event of default. We report supporting evidence that is consistent with consumers being optimistic when they borrow. We develop a two-period model of consumer borrowing that incorporates debt collection: consumers borrow in the first period, and repay, settle or default in the second. We show in both partial and general equilibrium settings that a restriction on debt collection effort can be welfare improving under some conditions. The restriction;operates by reducing the gap between perceived and actual consumer welfare for optimistic consumers.

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