Consumer credit with over-optimistic borrowers

Exler, Florian ; Livshits, Igor ; MacGee, James ; Tertilt, Michèle

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URN: urn:nbn:de:bsz:180-madoc-638854
Document Type: Working paper
Year of publication: 2022
Place of publication: Wien ; Mannheim [u.a.]
Publication language: English
Institution: School of Law and Economics > Makro- u. Entwicklungsökonomie (Tertilt 2010-)
Subject: 330 Economics
Classification: JEL: E21 , E49 , G18 , K35,
Keywords (English): consumer credit , over-optimism , financial mistakes , bankruptcy , default , financial literacy , financial regulation , type score , cross-subsidization
Abstract: We quantitatively analyze consumer credit markets with behavioral consumersand default. Our model incorporates over-optimistic and rational borrower typesinto a standard incomplete markets with consumer bankruptcy framework. Lendersprice credit endogenously, forming beliefs – type scores – about borrowers’ types.Since over-optimistic borrowers incorrectly believe they have rational beliefs, lendersdo not need to take strategic behavior into account when updating type scores. Wefind that the partial pooling of over-optimistic with rational borrowers results inspill-overs across types via interest rates, with over-optimists being cross-subsidizedby rational consumers who have lower default rates. Higher interest rates lower theaverage debt level of realists compared to a world without over-optimists. Due tooverestimating their ability to repay, over-optimists borrow too much. We evaluatethree policies to address these frictions: reducing the cost of default, educating over-optimists about their true type, and increasing borrowing cost. Of the three, onlythe lower default costs improve the welfare of over-optimists. However, rationalconsumers are made worse off by that policy.

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