Human
beings are less rational than we assume. Nowadays, abundant laboratory and
field experiments show that we systematically fail to behave, decide or act
rationally, i.e., to act as maximizers of our own utility; the so-called “homo oeconomicus” does not actually
exist. These assumptions have led to the emergence of Behavioral Economics. When
the findings of Behavioral Economics are used in the field of Law, we then enter
the field of Behavioral Law & Economics (BLE). This is an interdisciplinary
meeting point for Law, Economics and Psychology (see recently in Greek legal
literature: Karampatzos, Private Autonomy
and Consumer Protection – A Contribution to Behavioral Economic Analysis of Law,
2016). BLE flourished in the US especially in the aftermath of the subprime
lending crisis. Various public policy instruments have been explored since then
with the intent to enhance consumer protection in bank loan agreements. In my
presentation I focus on some major BLE findings in relation to the problem of
private bank lending, and more specifically of the “Non-Performing-Loans”
(NPLs). Inter alia, I discuss the
following issues related to a BLE approach: (a)
Why resort to excessive borrowing, especially in case you are not in bad need
of financing? (→ mainly because of overconfidence bias, present-bias and
hyperbolic discounting). (b) Do Borrowers
Really Need Protection? What about the So-called “Learning-Effect”? (c) Free-Riders, Strategic Default and Moral
Hazard in combination with the twin phenomena of “herding/herd behavior” and “social
mimetism”. (d) Possible Proactive Measures for Borrowers’ Protection Pursuant
to BLE findings (→ light-touch state interventions, such as properly
designed default rules, informational duties and short cooling-off periods
after the conclusion of a bank loan agreement). My presentation ends with the
following two main conclusions: (a) The BLE approach may offer some valuable
insights into the borrower’s behavior at the time they enter into excessive
borrowing or they decide to go down the path of “strategic default”. (b) The
Greek banks experience great difficulties offloading their
NPLs; probably, there is
here a need for more active involvement of institutional actors, such
as the ECB or the Bank of Greece as well as of debiasing tools offered by the research done in the field of BLE.
I. Introductory
Remarks
a. The
Shift from Rational Choice Theory to Bounded Rationality Theory and the
Emergence of Behavioral Economics
Human
beings are less rational than we assume, or than the economists predict. Their
behavior is affected by all sorts of cognitive biases or, in more general terms,
systematic errors. The so-called “homo
oeconomicus” does not actually exist.
This is
the reason why the Rational Choice Theory has been set aside by the Theory of
Bounded Rationality (Simon, et al.),
which seeks to provide a more realistic approach on human behavior, to bring
forward the difference between Econs (who might exist only in the economist’s
mind) and Humans (who are much closer to real life and the dangers it poses to
all of us).
The
aforesaid assumptions led to the emergence of Behavioral Economics. Nowadays, abundant
laboratory and field experiments show that we systematically fail to behave,
decide or act rationally, that is, to act as maximizers of our own utility.
However, an
eventual misunderstanding must be cleared up here right from the outset: The
following paragraphs also refer to purely economic findings or theories; this
is no coincidence at all, since the starting point still remains the model of ‘rational
man’. What Behavioral Economics have successfully shown to us is that there are
significant systematic failures of said model, which should be taken into
consideration if we want to more accurately predict human behavior.
b.
Transition to the Field of Law: The Emergence of Behavioral Law & Economics
(BLE)
When the
findings of Behavioral Economics are used in the field of Law, mostly on a
prescriptive-normative level (: why a certain legislative provision should
be enacted), we then enter the field of Behavioral Law & Economics (BLE).
This is an interdisciplinary meeting point for Law, Economics and Psychology
(see very recently in Greek legal literature: Karampatzos, Private Autonomy and Consumer Protection – A Contribution to Behavioral
Economic Analysis of Law, 2016).
BLE
flourished in the US especially in the aftermath of the subprime lending crisis.
Various public policy instruments have been explored since then with the intent
to enhance consumer protection in bank loan agreements. The principle of ‘responsible lending’ was
reinforced: as a result, more informational duties were imposed to the banks.
The
application of BLE findings goes well beyond consumer protection and embraces a
series of significant public policy issues, such as environment protection,
organ donation, taxation, regulation of financial markets, etc. The aim is here
to help draft more efficient legal rules that promote individual and social welfare.
In my
presentation I focus on some major BLE findings in relation to the problem of
private bank lending. In fact, one of the main challenges that the Greek
economy nowadays faces is the proper legal treatment of the so-called “Non-Performing-Loans” (NPLs).
The
numbers are just staggering: NPLs have reached a volume of around 108 billion
euros; the overall NPL level corresponds to 50% of the banks’ total loan
portfolio; Greece’s GDP in 2015 reached 176 billion euros, thus NPLs accounted
for 56.8% of Greece’s annual GDP the past year.
II. Main
Issues Related to a BLE Approach
a. Why
resort to excessive borrowing, especially in case you are not in bad need of financing
Overconfidence bias: we overestimate our own abilities/capabilities or prospects about the future
and at the same time we underestimate future risks or the dangers we face from
a certain activity.
Additionally,
present-bias, hyperbolic discounting and
multiple-selves problem: We stick to the pleasures of the present and
suppress the future negative repercussions of present decisions, attributing to
their occurrence a much lower probability than the actual; we make decisions
that our future self would not make, would actually regret; in a nutshell, we discount heavily the future. So, for
instance, we enjoy the provisional increase in the bank account balance due to
a loan and we suppress the mid- and long-term effects of having to repay the
money borrowed, at a high interest rate at that.
But what
do we actually mean by “hyperbolic
discounting”: divergence between short-term preferences and long-term
preferences à For
instance: "Would you prefer a dollar
today or two dollars tomorrow?" or "Would you prefer a dollar in one
year or two dollars in one year and one day?" It has been claimed that a
significant fraction of subjects will take the lesser amount today, but will
gladly wait one extra day in a year in order to receive the higher amount
instead.
b. Do Borrowers
Really Need Protection? What about the So-called “Learning-Effect”? Why Not Let
Them Fail and Learn From Such Transactional Failures?
Some
proponents of the strict enforcement of the principle “pacta sunt servanda”
suggest that if the legislator or the judge intervenes in such cases, then the
so-called “learning-effect” is lost.
“Let persons exercise their freedom to
err (errarum humanum est), make their own mistakes; they will learn from them
and thus they are not going to repeat them in the future”, as the argument
goes.
This
libertarian argument has indeed some merits (see Posner, et al.). However, a significant twofold caveat must be entered in respect of the
problem under consideration:
First,
there is an obvious systemic dimension of the problem of NPLs which calls for
the need of some kind of state or judicial intervention, especially due to the
deep, prolonged and unprecedented recession that Greece undergoes in the last 7
years.
Second,
at least in the field of household lending it may be seriously doubted whether
such a learning-effect may indeed take place; for: (a) household loan
agreements are normally concluded once in a lifetime of an individual and thus
are not reiterated in order for the learning-effect to develop its force; and on
the top of that (b) it is difficult to see what are we really supposed to learn
from an excessive borrowing that has devastating financial consequences upon us;
the answer is rather self-evident.
c. Free-Riders,
Strategic Default and Moral Hazard
Approximately
20% of the total of NPLs is due to strategic
default (according to relevant assessments of the Bank of Greece).
It rather
goes without saying what may happen to the economy and the society as a whole if
we lose faith in the enforceability of contracts. Partly, we are currently
experiencing in Greece the consequences of the occurrence of such a moral
hazard. Apparently, some enterprise and household borrowers that effectively
faced no problem in paying their bills have made use of protective legal
provisions that were not meant to protect them but enterprises or individuals in real need; in other words, they
have jumped in such provisions as “free-riders”.
And there is a domino-effect at work here: Clever entrepreneurs, acting as ‘homines oeconomici’, had every
reasonable reason to do so, since otherwise their competitors, who had already
embarked upon said strategy, would gain a significant comparative advantage and
would kick them out of the relevant market.
In
addition, the accumulation of many free-riders in the relevant market is
possibly exacerbated by the twin phenomena of “herding/herd behavior” and “social
mimetism”, meaning in our case that we feel much better when we
collectively break the law or disregard social or trade norms.
The
end-result? Discredit & No Credit. In Greece, the free-riders have caused the very
problems that any accumulation of many free-riders causes: The borrower’s legal
protection has been discredited through its excessive use; thus, the people who are in real need risk of being deprived of this
protection. And more importantly, the access to bank credit is essentially
precluded not only due to the lack of general liquidity, but also due to the
fact that the requirements set to banks for responsible lending are so strict
that the very people who need to have
access to bank loans, i.e., low-income people, are refused to have such access.
Social justice and, in particular, social mobility are, thus, severely damaged.
d.
Possible Proactive Measures for Borrowers’ Protection Pursuant to BLE findings
Cass Sunstein and Richard Thaler are the founders
of the so-called “nudge theory”. By
means of light-touch/mild state
interventions, called nudges, said authors purport to promote individual
and social welfare, e.g., help people quit smoking, pay taxes on time, conserve
energy, and so forth. For instance, they propose to change the default rule for organ donation from “opt-in” (i.e., we become donors only
if we expressly declare our will to be donors) to “opt-out” (i.e., by default
we are all donors unless we explicitly object to that). Such a transition from
an “opt-in” to an “opt-out” system may have impressive results (in the case of
organ donation it may lead to a drastic increase in the number of organ
donors).
Our
stickiness to default rules may be attributed to various biases, mainly to
inertia or to the so-called “status-quo”
bias or “anchoring-effect”.
Apart from
the design of proper default rules, there are also two other nudge-like tools that may prove helpful
in the context of the present discussion regarding excessive borrowing:
(a) Informational duties/input that help us understand the consequences of present
decisions upon our future prosperity, thus mainly seeking to reduce the impact
of hyperbolic discounting. The provision of information is, in principle, to be
welcomed. Nevertheless, we must also be aware of the problem of “information overload” and of the marginal utility of (additional)
information: Too much information cannot be processed and may lead to
adverse results (e.g., we tend not to read lengthy medicine information
brochures) and therefore maximal
information should not be confused with optimal information.
(b) Short cooling-off periods after the conclusion of the bank loan agreement. Such
cooling-off periods (usually of two weeks) are, in general, part-and-parcel in the
law of consumer protection. They offer consumers, after a doorstep or distance
selling, the chance to once more reflect upon their transactional decision and,
if they think that the good or service obtained does not deserve its money
–i.e., in essence, that no efficient
transaction has taken place–, they have the option to withdraw from the
contract concluded “in the heat of the moment” (à doorstep selling) or under “information asymmetry” (à distance
selling).
The same
approach might also be applied to bank loan agreements, primarily to household
loans, which means that the borrowers might be granted the right to withdraw
from the agreement within a certain time period (e.g., two weeks or one month)
at no expense to them, i.e., by just returning the loan without any interest.
Nonetheless,
in our case it is not certain whether the biases or behavioral errors at work
here, such as the hyperbolic discounting, only have a temporary impact and thus
are likely to retreat or “cool” within two weeks or one month. If this is not
the case –that is, if the biases/errors are persistent–, then the right of
withdrawal is of no use to the borrowers.
III. Concluding
Remarks
The BLE
approach may offer some valuable insights into the borrower’s behavior at the
time they enter into excessive borrowing or they decide to go down the path of
“strategic default”. These insights might prove useful, that is, might help us
design proper state intervention tools, with the intent to curb, in the future,
irresponsible private lending or strategic default.
Αs regards
the present, it is self-evident that the NPLs pose a great threat to the Greek
economy. Admittedly, there is no easy way out of this messy situation.
The
bail-in-tools available under the Bank Resolution and Recovery Directive, which became
fully applicable at the beginning of this year, aim to prevent a new bank
recapitalisation using state funds, that is, taxpayers’ money.
Further,
in respect of the distressed asset market in Greece it is submitted that for
various reasons this market is rather non-existent, although the newly
introduced NPL legal framework allows Asset Management Companies (AMCs) to
initiate legal action and any other judicial action necessary to collect debts
which they manage. However, according to IMF, Greece still has one of the
longest foreclosure periods (five years) and lowest rates of return on NPLs in
Europe (see the report
of White & Case LLP “Breaking bad: Tackling European NPLs”, http://www.lexology.com/library/detail.aspx?g=6424e927-b3a0-4ada-bac3-bd04441ca9a4).
And not to mention that the execution of foreclosures nowadays in Greece is a
very sensitive socio-economic issue.
In all events, the Greek banks experience
great difficulties offloading their NPLs. Probably,
there is a need for more active involvement of institutional actors, such as
the ECB or the Bank of Greece –which may provide credible guarantees to the
purchasers of NPLs–, as well as of debiasing
tools offered by the research done in the field of BLE.
Antonis G. Karampatzos, Associate Professor of Private Law, Athens Law School
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