Risk of Overindebtedness and Behavioural Factors

Luisa Anderloni University of Milan – DEAS, Daniela Vandone University of Milan, August 4, 2010

RISK TOLERANCE IN FINANCIAL DECISION MAKING, C. Lucarelli, G. Brighetti, eds., Palgrave Macmillan, 2010

Abstract:
The aim of this paper is to analyse the link between behaviour and overindebtedness and to shed light on the effectiveness of policy measures to tackle household financial fragility. Behaviour leading to overindebtedness is often put down to social and psychological factors that reduce an individual’s capacity to evaluate the consequences of his/her consumption and borrowing decisions. Such decisions may not be rational from a classic economic point of view. In fact individuals tend, on the one hand, to overestimate their capacity to manage domestic financial resources and, on the other hand, to underestimate the possibility of being affected by negative events. As a result, these individuals systematically underestimate the risk of not being able to meet their financial commitments. Furthermore, they overestimate the immediate benefits and undervalue the future costs; such behaviour leads to the decision to purchase, using debt if necessary, regardless of the effect this choice may have on the sustainability of future debt levels. The fact that overindebtedness may be caused by individuals’ irrational behaviour is relevant and has to be taken into account in order to devise appropriate measures to prevent or manage situations of financial difficulties and to evaluate their effectiveness. The empirical literature has shown how psychological factors have an impact on the effectiveness of policies adopted to prevent and manage financial difficulties arising from overindebtedness. Studies carried out within behavioural economics have also shown that individuals have little awareness of these psychological mechanisms. Indeed, individuals in financial difficulties tend to lay the blame on exogenous factors such as job or family difficulties, which reduce income level below expected. Rarely do individuals recognise that the causes for their difficulties lie principally – or at least also – with their inability to manage money and the decisions made regarding spending and indebtedness. Furthermore, many studies have shown how deviant behaviour patterns persist even when individuals are aware of the risks they face. Individuals’ incapacity to take corrective steps despite knowing the dangers of overindebtedness may have significant implication for designing effective policies to management situations of indebtedness that may become pathological.

Keywords: Households behavioural finance, Overindebtedness, Consumer credit

JEL Classifications: G21
Working Paper Series