Consumer Behavior in Financial Markets:

The Role of PolicySumit Agarwal

Federal Reserve Bank of Chicago and Indian School of Business

How Can Behavioral Economics Improve Policies Affecting Consumers?

European Union Conference28th November 2008

*The views are not necessarily those of the Federal Reserve Bank of Chicago

2

Introduction

Do consumers make mistakes in choosing a credit card contract?

Do they learn from their mistake? Do financial mistakes vary by age? Does a homeowner’s under/over-estimation of his

house value impact credit utilization? Do consumers optimally refinance their mortgage? Does direct marketing influence the choice

between a home equity loan and line of credit?

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Do consumers make mistakes in choosing a credit card?

Unique experiment: a large bank offers consumers 2 choices

- Can switch at any time!

Optimal choice: consumers expecting to borrow should choose Card (1)

consumers expecting not to borrow should choose Card (2)

Credit Card 2:

15% Interest Rate

No Annual Fee

Credit Card 1:

12% Interest Rate

$20 Annual Fee

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Do consumers make mistakes in choosing a credit card?

Percent of consumers with wrong credit card

2.9%0.4%

43.4%

20.5%

0%5%

10%15%20%25%30%35%40%45%50%

Cost per year: > $0

Cost per year:$50-$100

Cost per year:$101-$200

Cost per year:$201+

5

Do consumers learn from their credit card choice mistake?

Percent of consumers switching credit card

3.8% 3.6%

0.2%0%

1%

2%

3%

4%

5%

Total switched Switched tooptimal credit

card

Switched tosub-optimalcredit card

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Do they learn from their credit card fee payment mistake?

Total fee payment declines 66% over 5 years

$53

$157

$120

$89$67

$-$20$40$60$80

$100$120$140$160$180

1 2 3 4 5

Years

To

tal

Fe

es

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Do financial mistakes vary by age?

Younger and older consumers pay higher interest

5.0

5.5

6.0

6.5

7.0

7.5

18 28 38 48 58 68 78 88

Borrower Age

Inte

res

t R

ate

(P

erc

en

t)

Home Equity Loans Home Equity Credit Lines

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Do financial mistakes vary by age?

Similar U-shaped pattern of mistakes also exist in

− Small Business Interest Rates

− Mortgage Interest Rates

− Auto Loan Interest Rates

− Credit Card Interest Rates

− Credit Card Fees (Late, Over Limit, Cash

Advance)

Do Consumer Optimally Refinance Their Mortgage? Most consumers either refinance too early or too late.

Leaving significant money on the table. Optimal refinancing decision is quite difficult – solving a

system of differential equations is not trivial. Cannot be done on a hand help calculator.

Hence, financial advisors tend to simplify the solution and subscribe to the NPV rule to refinancing - Surveyed top websites (using google.com) and books at B&N and Borders.

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Does direct marketing impact the choice between a home equity loan and line of credit?

Who spends the most? Automotive (1): $20.9 billion Retail (2): $18.6 billion Telecom (3): $ 9.9 billion Financial Services (4) : $ 8.5 billion Medicine (5): $ 8.4 billion

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Consumption Motive Borrower Simulation

DM Line Offer

Walk-in Line CustomerDM Loan Offer

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Does Advertisement Impact Mortgage Choice?

Mortgage choice is sensitive to the economic environment.

Borrowers who received solicitations did not select product in manner consistent with theory.

Advertising campaign had persuasive effect.

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Summary of the Findings

Answers to the questions I posed earlier Small fraction of consumers make costly financial

mistakes. The bigger the mistake, the more likely they learn.

Consumer learn to pay 66% lower fee over a five years period.

The young and the old tend to make more mistakes.

About 40% of the consumers are persuaded by the advertisement and choose the wrong contract

About 40% of consumers refinance their mortgages too quickly.

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Policy Implications

Effective Solutions Financial Education and Advisors Simplification Defaults Disclosure

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Policy Implications – Financial Education

Require consumers to go through financial counseling before they could take a mortgage.

Examples: Cook country, Illinois required subprime borrowers to

go through financial counseling before taking a mortgage.

Marian country, Indiana has a program for the low-income borrowers to go through months of financial education program before they are eligible for a mortgage.

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Policy Implications – Financial Advisors

Financial advisors can be helpful: Provide suggestion on the optimal timing for

refinancing, choice between an ARM and FRM, and optimal credit card contracts based.

But they are costly And time-consuming And rely on consumer input

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Policy Implications – Simplification

Mistakes are small when contracts are simple. Choice between two credit cards.

Large mistakes in decisions to refinance, choose between ARM/FRM. Provide a web based calculator that can optimally

solve the mortgage refinancing problem. www.nber.org/mortgage-refinance-calculator

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Policy Implications – Defaults

To avoid paying fees (late, over-limit, cash advance) Default option to make a minimum payment fee from the direct checking account.

Default option to not allow purchases over the limit.

Consent to receive email marketing. Other examples include: Car insurance and Car purchase options

Defaults may not work because: Investors are not financially literate Investors display an endorsement effect Investors respond adversely to complexity Investors are prone to procrastinate

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Policy Implications - Disclosure

Disclosures in financial transactions Truth-In-Lending Good Faith Estimate Privacy disclosures

Benefits: Educate consumers and prevent deception Reduce search costs and facilitate Comparison shopping

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Policy Implications - Disclosure

Will the disclosure work as intended? How will consumers interpret and understand

disclosure? How will it affect consumer decisions? Will it help some consumers but harm others? Can the intent of the disclosure be circumvented?

Pitfalls of Disclosure Irrelevant information Too much information Confusing information Misleading information

References “The Impact of Homeowners’ Housing Wealth Misestimation on

Consumption and Saving Decisions”, Real Estate Economics, Vol. 35, Pp. 135-154.

“Do Consumers Choose the Right Credit Contracts?” (with Chomsisengphet, S., C. Liu, and N. Souleles), SSRN WPS

“Two Steps Forward, One Step Back: The Dynamics of Learning and Backsliding” (with Driscoll, J., X. Gabaix, and D. Laibson), SSRN WPS

“Age of Reason: Financial Decisions over the Life Cycle” (with Driscoll, J., X. Gabaix, and D. Laibson), SSRN WPS

“Optimal Mortgage Refinancing? A Closed Form Solution” (with Driscoll, J., and D. Laibson), SSRN WPS

“Does it Pay to Read Your Junk Mail: Evidence on the Effect of Advertisement on Financial Decisions” (with Ambrose, B), SSRN WPS