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