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Consumer Credit with Over-Optimistic Borrowers

Florian Exler, Igor Livshits, James (Jim) MacGee and Michele Tertilt ()

No 21-42, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: Do cognitive biases call for regulation to limit the use of credit? We incorporate over-optimistic and rational borrowers into an incomplete markets model with consumer bankruptcy. Over-optimists face worse income risk but incorrectly believe they are rational. Thus, both types behave identically. Lenders price loans forming beliefs—type scores—about borrower types. This gives rise to a tractable theory of type scoring. As lenders cannot screen types, borrowers are partially pooled. Over-optimists face cross subsidized interest rates but make financial mistakes: borrowing too much and defaulting too late. The induced welfare losses outweigh gains from cross subsidization. We calibrate the model to the U.S. and quantitatively evaluate policies to address these frictions: financial literacy education, reducing default cost, increasing borrowing costs, and debt limits. While some policies lower debt and filings, only financial literacy education eliminates over borrowing and improves welfare. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.

Keywords: Consumer Credit; Over-Optimism; Financial Mistakes; Bankruptcy; Default; Financial Literacy; Financial Regulation; Type Score; Cross-Subsidization (search for similar items in EconPapers)
JEL-codes: E21 E49 G18 K35 (search for similar items in EconPapers)
Pages: 58
Date: 2021-12-07
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fle, nep-law, nep-mac and nep-opm
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Related works:
Working Paper: Consumer Credit with Over-optimistic Borrowers (2020) Downloads
Working Paper: Consumer Credit With Over-Optimistic Borrowers (2020) Downloads
Working Paper: Consumer Credit with Over-Optimistic Borrowers (2020) Downloads
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DOI: 10.21799/frbp.wp.2021.42

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