Borrowing Decisions and Repayment Capacity: Can Regulation alleviate Individual Behavioural Biases?

In recent years a significant stream of research has addressed the issue of overstretched consumers and “over-indebtedness”. Increases of personal debt and the impact of economic crises on families’ income have added to concern regarding individuals and households capacity to meet credit obligations, with severe implications on individual and social wellbeing. “Over-indebtedness” is caused either by unexpected/unlikely events that impede the pre-planned debt service (a “passive” source of risk), or by erroneous individual decision-making (an ”active” source of risk). It is clear that there is no way to avoid unexpected events, and thus to prevent “passive” “overindebtedness”. This means that these phenomena can be addressed only through ex-post solutions, such as personal redress schemes. Conversely, “active” behaviours certainly deserve attention and investigation, because there could be chances to inhibit unsound debt decisions. There are several explanations for the reckless behaviour of individuals borrowing more than what they can really afford. Some point to the predatory attitude of lenders. Indeed, lenders have powerful incentives to push borrowers to take out excessive loans, if they are allowed to price their risk freely (i.e. there are no rate ceilings), and/or to easily take out guarantees, and/or to transfer excessive risk to third parties. Bank regulation and supervision, as well as protective rules regarding repossession, foreclosures, accounting and usury, can certainly create disincentives to these behaviours. This is certainly the case in Italy (Cosma and Filotto, 2003). However, in this paper, we will not investigate this extreme and pathological side of lenders’ behaviour, but rather we focus on the demand-side of the market, and more precisely, the debt decision making of individuals, which is actually result of interaction between borrowers and lenders. In fact, a part of consumer finance literature suggests that “active” causes of excessive, and thus sub-optimal, borrowing are due to consumption and lifestyle behaviours. For example, irresponsibility or short-sightedness may lead an individual to non-optimal consumption or indebtedness choices (Banque de France, 1996; Frade, 2005; Haas, 2006). Specifically, a substantial stream of literature asserts that incorrect individual decision-making is motivated by individual behavioural biases induced by a distorted perception of “time”, by cognitive constraints, or also by impulsivity. This theory supports empirical findings, as in Dick and Jaroszek (2015) who analyse the German market and provide evidence that consumers with a lower tendency to reflect upon decisions are less rational when choosing among different types of loans, frequently opting for the easier, though more expensive, credit line. Similarly, Gathergood (2012) shows that consumers with weak self-control make greater use of quick-access but high-cost credit items and are more likely to have problems in repaying their consumer loans. Furthermore, from a different perspective, households might simply fail to understand the correct cost of borrowing or properly plan expenses and income, due to a lack of financial literacy and ability to manage their finances, as put forth by studies – such as Lusardi and Mitchell (2011) – or because of intrinsic cognitive limitations (Caratelli et al., 2015). Recently, research on financial literacy has extended its focus from investment decisions to credit-related issues, providing evidence that financially illiterate households take out loans with unfavourable debt conditions (e.g. Disney and Gathergood, 2013; Gathergood, 2012; Bajo and Barbi, 2015). As the soundness and sustainability of the personal and family financial situation is, and has been for a long time, considered a significant component part of social welfare, regulators in the US, in the European Union and consequently in Italy, have addressed the issue of borrowing choices, with pervasive and detailed provisions. In this paper, we assume that the quantity and quality of information used in consumer credit markets- both demand and supply side- are able to influence some behavioural biases that may interfere with sound debt decision making. The combined effort of borrowers and lenders in exploiting “value” of information is assumed to enhance individual and social wellbeing (in general terms, see Lucarelli and Brighetti, 2011). In this perspective, we apply a natural experiment, available in Italy, due to a reform of the consumer credit market. The Legislative Decree No. 141 of 13th August 2010 offers a cut-off date to test if enhanced information, requested by regulation as a key driver for the consumer credit market, is able to improve borrowing decision making. Therefore, we test if this change of regulation has had an impact on consumer credit borrowers behaviour, on the basis of two main waves of transformation, related to the enhancement of information: on the one hand, the strengthening of pre-contractual information, and on the other hand, the introduction of a mandatory creditworthiness evaluation. Based on the existing literature, we test if these regulatory changes have alleviated individual behavioural biases in favour of more widespread responsible borrowing. We believe that understanding the efficacy of regulation to alleviate individual behavioural biases should represent a priority, in order to formulate policy measures addressed at providing competencies and tools that can help individuals to manage their resources appropriately and to take sound borrowing decisions.