Consumers often use credit to manage their finances. Borrowing money allows them to meet extraordinary expenses, make important purchases, and endure temporary periods of lost income. Embracing credit can have downsides, however, particularly for borrowers who are unrealistic about how much debt they can carry. Such borrowers, who are too optimistic about their future incomes, may be unable to repay loans on time and may wait too long to take corrective action when their finances become overstretched. Their misguided sense of optimism and the financial mistakes it enables have stimulated a long debate about the need for regulations that limit the misuse of credit.

Philadelphia Fed economic advisor and economist Igor Livshits and his coauthors, Florian Exler, James MacGee, and Michèle Tertilt, look at several types of such regulations, exploring their effectiveness across two dimensions: 1) preventing overconfident consumers from borrowing more than they can repay, and 2) maintaining credit availability for rational consumers who are not at risk of misperceiving their financial risks.

In their paper, "Consumer Credit with Over-Optimistic Borrowers," these economists model a pool of borrowers that contains overoptimistic borrowers as well as more-realistic borrowers. Their simulations, in which households are subjected to income shocks (sudden disruptions of income, for example) and unforeseen expenses (such as medical bills or other big outlays), help explain how the two types of borrowers absorb unforeseen shocks. Their experiments show each type's propensity to overborrow (or not), and the effects of regulatory policies on the collective welfare of all borrowers.

Within the model, overoptimistic consumers — despite being confident about their future income streams — are more likely to suffer from bad luck in the form of income disruptions and therefore default on their loans more often than realists. The authors establish, early in their research, that this higher propensity to default does not mean that overoptimistic borrowers are being preyed upon or forced into loans they cannot afford to maintain. In fact, their model shows that overoptimists are actually subsidized by realists — an important interaction that emerges because lenders have no way to distinguish between the two types of borrowers at the time of loan origination. (This means that both types of borrowers are offered loans that bear the same interest rate, and as a result, overoptimistic borrowers are granted loans with lower rates than they would if their true risk type could be identified. By the same token, realistic borrowers are issued loans with higher rates than their risk type justifies — a circumstance that creates an interest-rate subsidy for overoptimistic borrowers.) 

Having modeled a credit market that accounts for overoptimistic borrowing, the economists explore the factors that contribute to the negative outcomes faced by overoptimistic borrowers. How do these borrowers behave when debt obligations become overwhelming? The answer includes this surprising insight: Overoptimistic borrowers tend to file for bankruptcy too late. By believing that their future incomes will keep pace with realists’ incomes, they delay filing for bankruptcy (or worse, they don’t file at all). Indeed, the experiment reveals that nearly half of their overborrowing is due to procrastination; by waiting too long to dissolve debt through bankruptcy, overoptimistic borrowers grow their indebtedness significantly more than if they had retired their loans sooner.

The authors point out that overborrowing and waiting too long to file for bankruptcy — two financial missteps that have harmful consequences — support the case for regulations that could help overoptimistic consumers. They therefore extend their model to simulate the effects of several policy ideas and find that these policies, despite making intuitive sense, are prone to fail. All of the considered options reduce overborrowing, the authors discover, but they tend to have negative ramifications, such as reducing the amount of affordable credit that borrowers can access. The lone option that does not crimp the credit supply is a financial literacy program for consumers. The authors make clear, however, that such programs are unlikely to be perfectly effective outside of their study. While they believe in the potential for financial literacy initiatives to improve welfare for both types of consumers, they caution that any gains observed in their small-scale experiment would not be easily scaled to a large real-world population.

This finding is arrived at by comparing results within a baseline economy (calibrated to match credit-market fundamentals reported in official U.S. economic data) to results within an experimental economy where (no longer) irrational consumers accurately perceive the potential for financial hardship and adjust their borrowing accordingly. Lenders in this experimental economy can identify each borrower’s risk type and price each loan with that factor in mind. Within this full-information economy, the model shows, welfare is higher for both types of borrowers than in the baseline economy. Realistic borrowers have access to lower interest rates (because they no longer subsidize overoptimistic consumers in the pool of borrowers), while overoptimistic borrowers benefit from the newfound, accurate perception of their financial risks — which helps them avoid overborrowing. For them, the resulting benefits more than offset the fact that their interest rates are no longer reduced through the subsidization effect noted above. (It is here, by documenting the direction of cross-subsidization, that the study makes one of its contributions to the existing body of research. Whereas most prior studies argue that behavioral borrowers tend to be taken advantage of by realists or by lenders, the authors provide a compelling argument for the possibility of cross-subsidization going from rational to less-rational consumers.) By comparing borrowers' outcomes within a benchmark economy to results in a full-information economy, Exler, Livshits, MacGee, and Tertilt show that overoptimistic consumers lower welfare for all borrowers.

As part of their assessment of the potential effectiveness of regulatory policies, the economists reiterate that desirable policy solutions should improve welfare on several fronts. Reducing overborrowing, while clearly beneficial, is not enough on its own. Ideally, as noted above, the broader availability of credit should not be constrained. "Our findings pose a cautionary tale for the effectiveness of consumer finance regulation," the authors write, pointing out that most of the policies they study don't appear to strike a desirable balance between reducing overborrowing and maintaining a supply of affordable credit. (Strict borrowing limits, which are among the policy options analyzed in the study, provide a case in point. While such limits might seem like effective tools for curbing overborrowing, the study suggests that they actually prohibit riskier households from borrowing exactly when they most need to — that is, when they are navigating transitory lapses in their incomes.) In short, despite their intended effects, the policies’ negative repercussions are shown to outweigh their benefits.

These research findings, as presented in "Consumer Credit with Over-Optimistic Borrowers," suggest that regulatory policies have the potential to improve outcomes for realistic and overoptimistic borrowers alike. However, the researchers acknowledge that policymakers will be hard-pressed to devise programs that promote financial well-being (ultimately reducing the number of defaults and bankruptcies) while maintaining a healthy supply of credit that consumers can readily access.