The Myth of the Rational Borrower: Rationality, Behaviorism, and the Misguided 'Reform' of Bankruptcy Law

Current economic analyses of bankruptcy law emphasize the ex ante incentives created by bankruptcy rules. Commentators argue that consumer friendly changes to the Bankruptcy Code, implemented in 1978, explain the increase in non-business filings over the last twenty-five years. These reforms, they argue, created incentives for rational borrowers to opportunistically leverage up and then file for bankruptcy. These commentators advocate limiting the availability of the bankruptcy discharge, limiting exemptions, and loosening federal restrictions on reaffirmation agreements. These ideas form the basis for recently enacted bankruptcy legislation. This article examines empirical data on the market for consumer credit and studies of consumer behavior, including studies of consumers who have filed for bankruptcy. Rather than corroborate rational actor and strategic incentive models of the market for consumer finance, the data lead to puzzling questions: During the twenty-five year period since the Bankruptcy Code was amended, the market for consumer credit has grown exponentially. Fear of strategic borrowers has not prevented the consumer credit market from expanding substantially, even into the subprime market, where the risk of strategic behavior is the greatest. Consistently wide spreads between banks' cost of borrowing and the rates charged by banks for consumer credit have made consumer finance transactions quite profitable for lenders, particularly where the borrowers' creditworthiness is questionable. In our view, these profits and changes in the technical infrastructure and legal regime in which consumer finance is imbedded help explain lenders' increasing willingness to lend to consumers, even in the face of increases in both the default and the non-business bankruptcy filing rates. What then explains consumers' increasing willingness to demand consumer credit? Although lenders' cost of funds has diminished substantially in the past twenty-five years, until recently little of this decrease has translated into reduced credit costs for consumer borrowers. Moreover, statistics show that U.S. households substantially increased their debt obligations during this period despite a failure of income or wealth to grow at corresponding rates. Increased willingness to lend, without a corresponding reduction in interest rates, should not significantly influence rational borrowers' preference for debt. Why are consumers willing to pay such high rates? The answer proffered by incentive analysts is that consumer borrowers are strategic, and hence don't care about higher rates or spreads. Behavioral decision research offers a counterstory that may better explain the behavior of both borrowers and lenders. This article outlines some of the implications that behavioral decision research holds for existing models of consumer borrowing and post-default behavior. Cognitive experiments suggest that, in order to compensate for bounded rationality, consumers adopt decisionmaking heuristics that both assist individuals in making purchasing and borrowing decisions and introduce systematic biases into consumers' decisionmaking. These biases lead consumers to buy and borrow more than a rational credit-using purchaser would. Overleverage results more from biases in consumer borrowers' decisionmaking than from efforts to realize on strategic advantages imbedded in consumer finance and consumer bankruptcy laws. Moreover, rational lenders can profit from these biases, even in the face of higher default rates. The increased risk is simply built into the lender's business model. The policy implications of behavioral decision research are, thus, considerable. On this view, limiting access to the bankruptcy discharge will do little to reduce consumer leverage and little to reduce the level of consumer default (even if those defaulting consumers find themselves unable to file for bankruptcy). It will simply increase the profit earned by consumer lenders and the harm suffered by consumers.