Chapter 5 - Rationality in the consumer credit market: choosing between alternative and mainstream credit

Abstract

A significant share of the population continues to rely on alternative financial services (AFS) outside the mainstream banking system to satisfy their credit needs. For instance, the most recent FDIC national survey (2017) shows that one-quarter of US households have used AFS in the last year. Skiba and Tobacman (2009) document that payday lenders have more storefronts in the United States than McDonald's and Starbucks combined and pawnbrokers continue to serve the financial needs of low-income families as they have done for centuries (Bos et al. (2012). Academics and policymakers are concerned about the use of AFS products, as they charge very high fees, have very high interest rates, and are susceptible to deceptive and predatory lending practices (Bhutta et al. (2015); Campbell et al. (2011); Morse (2011); Melzer (2011); Bhutta et al. (2015)). In this chapter we study the choice between uncollateralized mainstream credit (credit cards, credit lines, and installment loans) and alternative credit (pawn loans). Our objective is to test the conjecture that alternative credit markets are exploiting creditworthy borrowers by charging them high fees and interest rates. We have a very simple thought experiment in mind that will allow us to test the above conjecture. If we can back out the true underwriting model for a bank that issues uncollateralized mainstream credit and then test whether a borrower who generally takes out alternative credit can be approved for mainstream credit using this underwriting model, it would provide empirical proof for the statements made by academics and policymakers that consumers are making irrational decisions by taking out expensive loans. Alternatively, if borrowers using alternative credit cannot be approved for these mainstream loans, then it would appear that they are making a rational choice to access alternative credit despite the higher cost.