Income Eligibility Requirements in Consumer Lending

Abstract

With moral hazard in consumer lending, competition among lenders could in principle lead to imprudent risk taking. The problem is not too much competition but rather too little prudential regulation. The Dodd-Frank Act (2010) adopted general income requirements for eligibility for a consumer loan, a tool of micro-prudential regulation that has hitherto been largely neglected in the economics literature. Whilst adopted under the rationale of ‘fairness’ towards consumers, this micro-prudential regulation induces prudent risk taking in the consumer credit market. “The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.” [Adam Smith 1759, in Ashraf et al. 2005, p. 134] “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such as they were best capable of protecting their own shareholders.” [Testimony of Dr. Alan Greenspan, October 23, 2008, Hearing before the House Committee on Oversight and Government Reform]