The economics of debt collection, with attention to the issue of salience of collections at the time credit is granted

Erik Durbin; Charles Romeo

Save this article

Need to know

We consider the role of policies that restrict debt collection in a setting where borrowers may have an optimistic bias. We develop a two-period model of consumer borrowing with debt collection in which consumers are at risk of receiving a negative income shock that may make them unable to repay their loan. In this setting, optimists underestimate the probability of this shock which induces them to over-borrow in parameterizations we consider.

We consider a rule change that restricts debt collection practices and describe how this affects the welfare of rational and optimistic consumers. Rational consumers take the rule into account and their demand for borrowing increases. Pure optimists do not take collection rules into account in making borrowing decisions, so their demand for credit is unaffected by the rule change. Since optimists over-borrow, the effect of the rule change is to shift demand by rational consumers closer to that of optimists. This makes demand by the two types of consumers more similar. One can think of the rule as introducing a distortion into the market that reduces the welfare consequences of being optimistic.

In a partial equilibrium setting with the interest rate fixed, the welfare of both rational and optimistic consumers is increased by a rule that restricts debt collection practices as the rule decreases the utility cost of debt collection. In a general equilibrium setting, the sign of the welfare change depends on the sizes of the interest rate change and the changes to the utility cost of debt collection; the welfare change is less likely to be positive if the restrictions generate a large increase in the interest rate, and more likely to be positive if the restrictions substantially decrease the utility cost of debt collection.

Abstract

This paper considers the role of policies that protect consumers from aggressive debt collection tactics. In general, rational consumers will select credit contracts based not only on price but also on the lender’s practices in the case of default and might prefer a contract that offers higher interest rates but more lenient collection tactics. We consider a model in which consumers can be optimistic in that they underestimate, at the time they borrow, the chance of a negative income shock that could cause them to default. This mindset induces consumers to perceive the welfare associated with borrowing to be greater than it is and to place less weight on the lender’s collection practices, which may cause them to prefer lower interest rate contracts even if they are accompanied by high collection effort in the event of default. We report supporting evidence that is consistent with consumers being optimistic when they borrow. We develop a two-period model of consumer borrowing that incorporates debt collection: consumers borrow in the first period, and repay, settle or default in the second. We show in both partial and general equilibrium settings that a restriction on debt collection effort can be welfare improving under some conditions. The restriction operates by reducing the gap between perceived and actual consumer welfare for optimistic consumers.

As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.

If you would like to purchase additional rights please email info@risk.net

You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.

If you would like to purchase additional rights please email info@risk.net