The Myth of the Rational Borrower:
Rationality, Behavioralism and the
Misguided “Reform” of Consumer
Bankruptcy Law
Susan Block-Lieb
Fordham University Law School
Ted Janger
Brooklyn Law School
U.S. Bankruptcy Policy Debate
Lender
R,R
R,I
Borrower
I,R
I,I
• Policy prescriptions turns
on why people break their
promises:
– whether the lender or
borrower are viewed as
opportunistic or
unfortunate?
• Paradigmatic
Borrower/Bankrupt
– Rational/irrational?
• Paradigmatic Lender
– Rational/irrational?
Worldview Motivating “Bankruptcy
Reform” – Rational/Rational
• Assumptions:
– Rational Consumers
• Rational and/or strategic actors
• Bankruptcy discharge gives consumers a “free walk” on their
consumer debt
• Consumers who don’t file for bankruptcy will repay their debts in full
– Rational (but impaired) Lenders
• Cannot price discriminate
– Cannot determine borrower’s type (honest/dishonest)
– Increases in the cost of credit lead to adverse selection
» High risk borrowers are price inelastic
» Low risk borrowers are price elastic
• Even in a competitive market, credit will be rationed
– All consumers will pay a higher interest rate and borrow less than is
“efficient.”
– Deadweight loss results
Policy Prescription – Eliminate
Bankruptcy Discharge
• Limiting access to bankruptcy discharge
will result in greater supply and lower cost
of credit.
Some data supports the “rational
borrower/rational lender” view:
Non-Business Bankruptcy Filings: 1970-2003
1,800,000
1,600,000
1,400,000
1,200,000
1,000,000
NBusBank
800,000
600,000
400,000
200,000
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
0
Household Debt Has Increased In
Absolute terms
Debt per Household in 1975 Dollars
25,000
20,000
15,000
Series1
10,000
5,000
0
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
19
01
20
03
20
And In Relation to Disposable
Income
But other data suggest that lenders do not
think that borrowers are opportunistic
Interest Rates Have Gone Down in
Absolute Terms
Commercial Bank Consumer Installment Credit Finance Rates: 1975-2003
20
18
16
14
12
New Car
10
OtherCG
CCPlans
8
6
4
2
0
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Moreover, the relation between
market interest rates and credit
card interest rates has remained
roughly constant.
Credit Card-TBill Spread 1983-2003
16
14
10
CCMarkUp
Linear (CCMarkUp)
8
6
4
2
Year
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
0
19
83
Interest Rate Spread
12
Paradox
• Even though bankruptcy filings have
increased considerably over time
– And in good times as well as bad
• The supply of consumer credit has
increased unabated.
• The interest rate paid on consumer debt
has declined while the markup (risk
premium) has remained constant.
And credit card lending remains
very profitable
Theory predicts credit rationing and
increasing interest rate
• Data raise questions
– Why would lenders ever agree to lend to
opportunistic borrowers??
• Data fit better with a different story, which
takes into account developments in the
consumer credit market and in consumer
lending technology . . .
U.S. Credit Markets in 1978
• Usury limits
• Inability to price risk
– Limited access to credit information
– Local transactions/local reputation
U.S. Market changes beginning in
1978 – Usury
• Marquette
• Usury limits eliminated in national lending
transactions
– National lending suddenly became more
profitable than local lending
– But only if you could get over the information
asymmetry.
U.S. Changes in the mid-1980s –
Information Asymmetry
• National credit reporting
– Credit scoring
– Risk based pricing
• National lending technologies
– Securitization
– National clearinghouses (Visa/Mastercard)
Worldview Motivating “Bankruptcy
Reform” – Redux
• Assumptions:
– Consumers
• Rational and/or strategic actors
• Bankruptcy discharge gives consumers a “free walk” on their
consumer debt
• Consumers who don’t file for bankruptcy will repay their debts in full
– Lenders
• Cannot price discriminate
Yes they can
– Cannot determine borrower’s type (honest/dishonest)
– Increases in the cost of credit lead to adverse selection
» High risk borrowers are price inelastic
» Low risk borrowers are price elastic
• Even in a competitive market, credit will be rationed
Not
necessarily
– All consumers will pay a higher interest rate and borrow less than is
“efficient.”
– Deadweight loss results
Implications for lenders
• Enables lenders to market credit to higher
risk borrowers without fear of adverse
selection
• Lending can be profitable even with higher
default rates
• And higher bankruptcy filing rates
Now profitability and high default
rates are not mutually contradictory
Is this a problem?
• That depends on your view of the
borrower?
– Rational
– Only “quasi-rational.”
What are the implications of a
behavioral model of the market
for consumer finance?
For rational lenders
and
quasi-rational consumer borrowers
Behavioral decision research
suggests that consumers will
purchase and borrow more than
rational actors.
It also suggests that consumer borrowers
will be slow to react to forestall default and
that rational lenders face market incentives
to exploit borrowers’ decisional biases.
Rational v. Quasi-Rational
Purchasing:
• Rational consumers
possess:
– Complete information
– Stable preferences
• Quasi-rational
consumers possess:
– Bounded rationality
– Preferences
influenced by biases in
decisionmaking such
as framing and
anchoring effects
Rational vs. Quasi-Rational
Borrowing:
• (i) What are the costs and benefits of filing for
bankruptcy?
• (ii) How much do I owe already?
• (iii) What is the cost of the new credit
transaction?
• (iv) What is the likelihood that my income will
either remain constant or increase in the next
period?
• (v) Which is stronger, my preference for current
consumption or my preference for consumption
in the future?
How much do I owe already?
• A rational borrower:
– Complete information
– Computational facility
• A quasi-rational borrower:
– Credit card users spend
more than those spending
cash or writing checks.
Why?
• Cognitive dissonance
• Underestimation of ability
to repay at months’ end
• Underestimation of total
purchases within past
month
• Decision framed by credit
limits as signal of future
earnings potential
What is the cost of the new credit
transaction?
• A rational borrower:
– Complete information
– Computational facility
• A quasi-rational borrower:
– Confusing array of financial
products offered at
complex terms
– Financial illiteracy; time
constrained
– Rule of thumb  what is
the cost of the monthly
payment?
– Does disclosure regulation
help?
What is the likelihood that my
income will either remain constant
or increase in the next period?
• A rational borrower:
– Complete information
– Computational facility
• A quasi-rational
borrower:
– Ambiguity in
decisionmaking
– Overconfidence bias
Which is stronger, my preference for
current consumption or my preference
for consumption in the future?
• A rational borrower:
– Complete information
– Stable preferences
– Ability to delay
gratification
– Applies a single
discount rate over time
• A quasi-rational
borrower:
– Framing and other
influences on
preferences
– Immediate gratification
– Hyperbolic discounting
What should I do in the event of
default?
• A rational borrower:
– Complete information
– Framing of events
irrelevant
– Willingness to walk
away from
investments, if
marginal costs exceed
marginal benefits
– Willingness to sell =
willingness to buy
• A quasi-rational borrower:
– Prospect theory
– Sunk investments
– Endowment effects
Research agenda:
• Behavioral decision research suggests
that:
– Consumers will borrow more than a rational
actor model predicts, but there has been no
testing of this hypothesis.
– Consumers will be slow to react to signs of
default, and more reluctant to liquidate
possessions than RAM predicts, but there
have been few studies.
– Rational lenders face market incentives to
exploit quasi-rational consumers’ decisional
biases.
Policy implications:
• Consumer bankruptcy law; consumer finance
regulations
• Because rational lenders face incentives to
exploit biases in decisionmaking, consumer
protection regulations should invalidate or
otherwise limit certain Ks or K terms
• Disclosure regulation may be insufficient
consumer protection, standing alone
– Framing affects disclosure
– Lenders’ incentives to craft terms to evade disclosure
requirements
• Financial literacy education; budget and credit
counseling