Ronald Mann is a Professor of Law at Columbia Law School
The idea that the regularity of behavioral departures from full rationality justifies regulatory intervention has rarely gained more credence than in the context of consumer finance. The Credit CARD Act of 2009 rests on nothing so much as the supposition that cardholder decisions about spending and repayment reflect systematic misapprehension of the likely patterns of future behavior. And given Elizabeth Warren’s prior writings with Oren Bar-Gill, we can expect the new CFPB to rely heavily on such regulation.
This symposium seems an apt time to consider the difficulty of designing regulatory regimes that aptly take advantage of perceived behavioral regularities. My doubt comes not from skepticism about departures from rationality – I have no doubt that consumer use of financial products falls far short of the perfection of the rational actor. Rather, my point is a typical “second best” critique: the departures from rationality are so unpredictable and contextually specific that intervention designed to remedy one departure without accounting for the others has little chance of a salutary result.
I can make the example most simply by considering the decisional terrain that confronts a stereotypical potential payday loan customer. From the perspective of the regulatory activist, the behavioral weakness is obvious: the transaction seems attractive only because the customer, suffering from an optimistic bias, falsely believes that it will repay the loan after two weeks. In fact, this regulator knows, the customer is likely to roll the loan over several cycles before finally repaying it in full. To remedy that bias, a regulator of an earlier generation might have banned the transactions entirely, on the paternalistic premise that no rational borrower would use the product. A gentler modern regulator might establish a limit on rollovers, forcing borrowers to repay after a few cycles rather than continue to borrow or requiring some strong affirmative action to overcome a “nudge” against further borrowing. In either case, the result of the regulation (if the nudge is strong enough to have any effect at all, which is doubtful if individuals do not behave in social or market settings as they might in laboratory settings) will be some constraint on the payday lending market.
But how clear is it that the regulator has acted sensibly? Let me suggest three complications of the behavioral story that suggest hesitation might be the better course here. The first is the simplest: what is the empirical evidence to support the supposition of undue optimism? To be sure, there is considerable experimental evidence to support the general idea of an optimistic bias, but little of that evidence involves actual market transactions. And to the extent we know anything about the actual expectations of potential payday borrowers, the work of Bertrand and Morse suggests that on average they have a pretty accurate assessment of the likely rollover cycle.
The second and third points relate directly to the likely complexity of behavioral deficits. On that front, let’s consider why a borrower might be coming to a payday lender in the first place. One possibility (suggested by Agarwal, Skiba & Tobacman) is that payday borrowers use the product even when they have available liquidity on credit cards because they have an internal precommitment against additional credit-card borrowing. Such a precommitment might rest on a concern about the future costs of excessive credit card use. Although in some sense it is irrational to take out a high-cost payday loan with existing credit-card liquidity, it makes a great deal of sense to a borrower operating with such a precommitment. And so my basic point – if the regulator pushes that borrower out of the payday market, it well might be pushing the borrower into borrowing in a more open-ended (and potentially riskier) credit card transaction.
On the other hand, what do we think about the outcome if the effect of the regulation is to deter the customer from borrowing at all? If we consider the likely problem of debt aversion, we might take the point (made recently by Ian Ayres among others) that borrowing by the young (the dominant demographic segment for payday customers) is substantially below the level that rational actor theory suggests. So if regulation has the purpose of lowering the overall amount of borrowing by the young, it will exacerbate an existing general tendency to borrow at an infra-rational level.
My portrait of a stereotypical payday loan customer is of course just that – a stereotype that will not describe all, or even most of, the market. But my narrative differs from reality primarily because it is too simple, not because it is too complex. And if this brief sketch were enough to give pause to a quick nudge to overturn the optimistic bias, how dubious would such regulation be if we took the time to develop a full understanding of the decisional terrain of consumer finance?