How to solve credit crunch

how to solve credit crunch


Mar 21st, 2011 @ 08:38 am › mitsloanexperts

The numbers are staggering: The average family debt in Canada has increased 78 percent over the last two decades, recently hitting $100,000 per family. In the third quarter of 2010, Canadians’ debt-to-disposable income ratio surpassed the US for the first time since the late 1990s. In my home country – I grew up just outside of Ottawa, Ontario – this is getting a lot of publicity (comparing ourselves to our American cousins is always a popular pastime).

As a behavioral economist – my field combines neuroscience, economics, and experimental psychology to understand human decision-making – I see the continued expansion of household debt as a potentially unavoidable consequence of current bank policies and human nature.

Take, for instance, the way that Canadian banks have changed their lending habits over the past 20 years, switching from promoting term loans with built-in repayment plans to lines of credit. The only payment requirement attached to a line of credit is a small monthly interest payment, called the “minimum payment.” Otherwise, lines of credit can be repaid at the borrower’s discretion. Based on what we know about human psychology, lines of credit – which today make up 60 percent of personal loans issued by chartered banks – do nothing whatsoever to help a consumer deal with his or her debt.

Let me explain: a key concept of behavioral economics is the human tendency to over-rely on “default options” when making a decision. Even when the consequences of our choices are great – such as how much and where we’re investing in a retirement plan, or how we elect to pay down debt – research

suggests that about 80 percent of consumers will simply stick with the “default option” advocated by the given financial institution.

This happens for several reasons. First, consumers are busy and choosing the default option is easy. Second, we see a phenomenon of “psychological myopia” where humans focus only on the present and what’s in front of them, and don’t necessarily think about the consequences of their actions. Third, humans tend to stick with the “status quo.” Once an option is chosen, we tend not to switch. This is the same reason students tend to sit in the same desk throughout the whole semester. Finally, consumers exaggerate the authority of the bank – they feel that if the bank is recommending it, it must be best. In Canada, banks are known as the “good gatekeeper” who are trying to do right by you.

Whether the banks are aware or not, their default repayment policies – which suggest only the “minimum payment” – have influenced Canadians to defer paying off their debt and I believe that banks could make a big impact on the debt loads of households with only a small change in the “default option” for repayments. Simply, banks could recommend higher monthly payments on lines of credit than the “minimum payment”. Consumers could still opt-out of this higher payment option and chose the minimum payment if they wished – we don’t want to limit consumer choice, but research shows that if banks were to recommend higher payments as the norm, most Canadians would pay down their loans faster and significantly reduce their debt loads.

Derek Dunfield is a Visiting Scholar at MIT Sloan and the MIT Neuroeconomics Research Center, Prelec Lab


Category: Credit

Similar articles: