Financial Mistakes and Credit Market Regulation

VoxEU column: Over-optimism and consumer credit regulation  (CEPR, February 2025)
        by Florian Exler, Igor Livshits, James MacGee, Michèle Tertilt

Some consumers are over-optimistic about their future income and underestimate the probability of experiencing negative income shocks, while others have more accurate (‘rational’) beliefs. This column introduces a framework that considers behavioural and rational borrowers to assess the effects of potential regulatory interventions. Over-optimists benefit from being partially pooled with (‘cross-subsidised’ by) rational borrowers. Small-scale financial literacy education leads to welfare gains for over-optimists, but broad-based education leads to a welfare loss for over-optimists. Policymakers need to evaluate the impact of regulation on cross-subsidisation, given its significant consequences on welfare.

Consumer Credit with Over-Optimistic Borrowers  in Journal of the European Economic Association (2025)
        by Florian Exler, Igor Livshits, James MacGee, Michèle Tertilt

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 little. In equilibrium, the welfare losses from mistakes are more than compensated by cross-subsidization. We calibrate the model to the United States 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 reducing default costs and financial literacy education improve welfare. However, financial literacy education benefits only rationals at the expense of over-optimists. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.

SYRI Study: Naïve Consumers and Financial Mistakes (SYRI Institute, July 2025)
        by Florian Exler and Alexander Hansak

The authors develop a novel quantitative framework to analyze the effects of naïve consumer behavior in the unsecured credit market and to evaluate the effectiveness of regulatory interventions aimed at reducing financial mistakes. The framework introduces new mechanisms into a standard macroeconomic model of consumer credit with equilibrium default and enables a quantitative analysis of financial mistakes and the welfare effects of different credit market regulations.

Naïve Consumers and Financial Mistakes (Draft:  Feb 2025)
        by Florian Exler and Alexander Hansak