Professional Documents
Culture Documents
Consumer Finance
Consumer Finance
REVIEWS
Further
Consumer Finance
Peter Tufano
Harvard Business School, National Bureau of Economic Research, and
Doorways to Dreams Fund, Inc. Boston, Massachusetts 02163;
email: ptufano@hbs.edu
Key words
Abstract
Although consumer finance is a substantial element of the economy, it has had a smaller footprint within financial economics. In
this review, I suggest a functional definition of the subfield of
consumer finance, focusing on four key functions: payments, risk
management, moving funds from today to tomorrow (saving/
investing), and from tomorrow to today (borrowing). I provide
data showing the economic importance of consumer finance in the
American economy. I propose a historical explanation for its relative lack of attention by financial economists and in business
school curricula based on historic geographic and gender splits
between business and consumer studies. I review the literature in
consumer finance, organized by its focus on the consumer, financial institutions, and the government. This work is spread out
between economics, marketing, psychology, sociology, technology,
and public policy. Finally, I suggest a number of open research
questions.
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INTRODUCTION
JEL: Journal of
Economic Literature
AFA: American
Finance Association
In teaching about financial intermediation, educators often draw two sets of circles on
either side of the blackboard, with a box between them. The circles represent a mix of
companies, governments, and households, either using or supplying funds. The central
box represents intermediaries through which funds flow. Although this generic representation acknowledges the broad range of actors in the financial system, the boundaries of
financial economics research are somewhat narrower. Using Journal of Economic Literature (JEL) codes as markers (see http://www.aeaweb.org/jel/guide/jel.php), the field of
financial economics (G) contains only three subspecialties: general financial markets
(G1), financial institutions and services (G2), and corporate finance and governance
(G3). Finance e-journals in the prolific Social Science Research Network (SSRN) are
similarly organized. In general, although financial economics focuses on one class of users
of the financial system (companies), and calls our attention to the importance of intermediaries1, our field largely fails to formally address one of our other major circles on the
board. The household sector is not explicitly a defined subfield within financial economics.2 The events of the past few years, however, should make it quite clear that the
financial products offered to households, the financial decisions they make, and their
relationship to financial markets have profound effects on the economy. Product innovation, new distribution channels, and other factors led to over-leverage in the consumer
sector, in turn giving rise to cataclysmic shifts in the financial world. This alone is a
testament that consumer finances cannot and should not be ignored.
In this chapter, I suggest that consumer finance is an important but somewhat
neglectedor more accurately, dispersedsubfield within financial economics. I echo
and elaborate on the theme laid out by John Campbell (2006) in his Presidential Address
to the American Finance Association (AFA): [H]ousehold finance. . . has attracted much
recent interest, but still lacks definition and status within our profession. To his point, I
propose a definition of the subfield; provide a provocative interpretation of the history,
which seems to have led to its apparent low status within financial economics; summarize
some of the key strands from the diverse literature; and suggest a series of research puzzles,
which seem particularly important in the current times. Complementing Campbells
address, which pointedly dealt with long-run investing decisions and mortgage decisions,
I focus on consumer credit, payment, risk, and savings decisions. All readers of this review
are advised to read it in conjunction with Campbells article, as well as some of the other
survey pieces of related fields that I cite throughout the chapter.
In his 2001 AFA Presidential Address, Franklin Allen lamented that financial institutions get little attention in
financial economics due to the neoclassical view that institutions do not matter (Allen 2001). As evidence of this
phenomenon, he noted that the millennial edition of the Journal of Finance had surveys on many parts of the field,
but not on financial intermediaries. I might add that it also did not include a discussion of consumer finance topics.
Public economics, although not part of financial economics, has its own category at the same rank in JEL codes
(H). The economics of households is only considered as a subtopic of microeconomics (D1: Household Behavior
and Family Economics). Furthermore, life cycle consumption and portfolio selection, which are part of household
finance, are categorized in E21 and G11.
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Recognizing the roles of households, businesses, and regulators, a more expansive definition of the field might be as follows: Consumer finance is the study of how institutions
provide goods and services to satisfy the financial functions of households, how consumers
make financial decisions, and how government action affects the provision of financial
services.
The definition is admittedly tautological as it refers to undefined financial functions.
However, I adopt the functional approach of Crane et al. (1995) and Merton & Bodie
(1995), which holds that financial systems are best understood in terms of the functions
they deliver. These functions are stable, even though they may be delivered by a wide
variety of institutions and through a wide range of products. To further clarify my proposed
definition, I identify four primary and necessary functions of the consumer finance sector:
Moving funds. The financial system must provide a mechanism for the transfers of
money and payments for goods and services. In the consumer sector, the payments
function would include cash, checks, debit cards (including prepaid), credit cards, postal
and private money orders, wire transfers, remittances, barter, online funds transfer tools
like PayPal, Automated Clearing House (ACH) transactions, payroll systems, and the
infrastructure that supports all of these activities. These products are delivered by a host
of organizations, including the government (e.g., money and post offices), banking
organizations, nonbanks (e.g., check cashing stores), data processors, online businesses,
and others.
Managing risk. The risk-management function is satisfied through a variety of products
and services, including insurance (health, life, property and casualty, disability), the
purchase of certain financial products (e.g., put options to protect ones portfolio
against declines), precautionary savings, social networks, and government safety nets.
The organizations that perform this function range from the family and local community to insurance companies and government disaster relief plans. From the perspective of
businesses that serve consumers, risks are managed through credit scoring models and
credit risk practices, as well as by assembling a diversified portfolio or securing insurance against default.
Advancing funds from the future to today. This function is embodied in household credit,
which ranges from shorter-term unsecured borrowing (e.g., credit and charge cards,
banking overdraft protection, and payday loans), to longer-term unsecured borrowing
(e.g., student loans, person-to-person lending), to secured borrowing (e.g., auto loans,
mortgage loans, and margin loans). The provision of credit can take place through the
formal sector, through the informal sector (e.g., friends and family), and through various
hybrid organizations (e.g., person-to-person lending Web sites). In addition to explicit
borrowing, implicit borrowing is built into various derivative products, including
options and forwards, as well as prepaid structures (e.g., rent-to-own schemes).
Advancing funds from today until a later date. The investing or savings functions are
embodied in a host of products and services, including bank products (savings accounts
and CDs), mutual funds, variable annuities, workplace retirement programs, and Social
Security. These products vary based on the intended time horizon, level and type of risk
borne by the investor, tax treatment, and other factors. Arguably, most of the existing
literature on consumer financial decisions is focused on the saving and investing functions.
To understand the ubiquity of these functions, we can look at the adoption of various
financial products. Using data tabulated from the 2007 Survey of Consumer Finances (SCF)
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Consumer Finance
SCF: Survey of
Consumer Finances
229
For information on the shift from checks to electronic payments, see Gerdes et al. (2005).
The SCF data represent weighted fractions of respondents with these products. The insurance statistics
come from industry sources [http://www.cbpp.org/8-29-06health.htm and http://www.flexfs.com/pdf/LIMRAfactsaboutlife2005complete%20(2).pdf].
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that the provider acts in the best interest of the customer. In short, potential incentive
conflicts exist in the delivery of nearly all financial functions.5
The functional approach to defining consumer finance can be contrasted with a product or institutional approach. These more traditional approaches must contend with the
fact that a single product or institution delivers many different functions, and a single
function may be delivered by a host of seemingly unrelated institutions or products. For
example, a bank or credit union often will offer savings products, lending products,
payment products, and even some risk-management products (i.e., loan insurance). They
also provide pooling, as well as information (advice or marketing), and resolve information asymmetries and incentive conflicts. Another single institution may deliver a form of
all of the financial functions. A single product, such as the credit card, provides multiple
functions as wellnot only extending credit, but also providing payment services by
delivering funds to merchants. Although one can study banks or credit cards alone, an
institution focus runs the risk of confusing or conflating the various functions and may
miss relevant competitors and alternative providers.
A functional approach best ensures that our analysis is not constrained by artificial
boundaries imposed by traditional product categories, or differences in institutional conventions across jurisdictions or over time. It has a second benefit, too, in that it forces one
to have a user-oriented focus on the financial system. People who want to borrow money
do not necessarily begin with a single product (e.g., a credit card) or even a single institution (e.g., Bank of America). Rather, they will look across a variety of formal financial
institutions, and may also consider informal institutions, such as their social networks.
Therefore, taking a functional approach to understanding consumer finance serves
researchers well.
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assets, roughly equally split between tangible and financial assets, so their financial asset
holdings are approximately one-third that of households. Corporations hold $13.3 trillion
in liabilities, with credit market instruments (including bank debt, commercial paper,
corporate bonds, and mortgages) accounting for $7.2 trillion, with the rest being shortterm liabilities, such as payables. Their debt is approximately one-half that of households.
Balance sheet numbers alone do not capture the magnitude of the consumer finance
sector. The payments systems used by consumers move trillions of dollars through the
economy. Just one part of that payments functioncredit and debit cardsrepresents
trillions of dollars of annual activity. Visa and MasterCard, the two largest card associations, report more than 75 billion transactions a year, with combined transaction volume
of $6.8 trillion.8
Recent economic events have demonstrated the importance of the consumer sector to
the economy. Although there are many precipitating events that contributed to the current
economic crisis, one was undoubtedly the subprime mortgage market. Rising home values,
new mortgage products, securitization, federal policies to encourage homeownership, low
interest rates, poor business practices, and poor consumer decision making all combined
to produce over-leverage in the consumer sector. Figure 1 (see color insert) represents time
series trends for consumer leverage in the United States over the past five decades, using
different leverage measures. Increasing debt was associated with high levels of consumer
spending and low levels of saving, which is also shown in the figure. Subsequent softening
in housing prices exposed the over-leverage, leading to foreclosures that rippled from the
subprime space through CDOs and insurers to contribute to the demise of financial
institutions.9 Now, our hopes for the recovery in part hinge on the rate of consumer
borrowing and spending, some of which are changing very rapidly.
Some finance academics argue that the field of finance is defined by whether the
activity affects asset prices. Even by this narrow definition, consumer finance deserves a
prominent place in the field of financial economics and in business schools. Curiously, it
has a remarkably small footprint in both, and as Campbell notes, suffers from lack of
status. Why?
Although there are many explanations of the phenomena, readers are referred to Shiller (2008) for a concise
summary.
10
These two courses were both introduced in 20082009. Information on the course offerings at the top 20 MBA
programs (as ranked by Business Week and U.S. News and World Report) was gathered online in September of
2008, using program Web sites and online catalogs.
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content. (The traditional sequence discusses money and interest rates, then describes the
various institutions, regulation, and the management of the institutions.) Behavioral finance courses are offered at seven programs, but most focus solely on investing decisions,
not the full range of consumer financial decisions. Other related courses have six or fewer
offerings, such as microfinance, personal taxation, and residential real estate.
Economics departments likewise spend relatively little class time on consumer finance
issues. The top 20 economics graduate programs all offer courses on microeconomics that
deal with the decisions of representative consumers.11 Nine graduate programs offer behavioral economics courses, but these courses tend to examine the consumer in isolation
from business or regulation, and to consider the decision-making process primarily in the
context of investing decisions.
Why does consumer finance receive so little attention in business schools and mainstream economics departments? One possibility is that consumer finance is so inherently
multidisciplinary that it falls between the cracks. As this review makes clear, consumer
finance requires an understanding of not only finance and economics but also psychology,
sociology, industrial organization, and the law. Focusing primarily on the finance and
economics communities, Campbell suggests that the problem may lie in two difficulties
encountered by would-be researchers. First, it is hard to observe and measure household
activity. There are few data on transactions, data are restricted by privacy considerations,
and surveys are inherently suspect. Second, he argues that household decision problems
involve many complications that are neglected by standard textbooks (Campbell 2006,
p. 1558). These complications include the complex math of intertemporal models, the
need to model nontradable human capital and illiquid housing, and the Byzantine nature
of personal taxation.
Campbells diagnosis is correct, yet it also applies to many other parts of academia. The
question is, what has held us back from addressing these limitations while plowing forward on hard problems in other areas? The neglect of consumer finance in business
schools is particularly puzzling because of the substantial profit opportunities available in
this sector. However, there is another hypothesis for this inattention and the low status
granted to consumer finance. It may be that our current state of research and teaching
reflects a century-old split that left consumer and business topics separated by gender and
geography. Elite urban universities emphasized businesses and prepared men to lead them;
rural land-grant universities studied households and prepared women to lead them. In
essence, the study of consumers financial needs was subsumed under the field of home
economics or consumer science, which was, and still is, divorced from mainstream economics and business.12
This intellectual divide can be traced to the 1800s. Industrialization and urbanization
were changing the American way of life and causing many to fear the demise of the
traditional moral fabric (Brown 1985). The blame for these changes often was placed on
commerce, thought to be not merely demeaning, but possibly corrupting (Daniel 1998,
p. 28). In response, there became an increasing urgency to recast the status of the businessman from profit-seeker to professional (Khurana 2007). This emerging philosophy
11
The top 20 graduate programs in economics were identified based on the U.S. News and World Report 2008
ranking (http://grad-schools.usnews.rankingsandreviews.com/grad/eco/search). Details were gathered online in
December of 2008 using program web sites and online catalogs.
12
I thank Andrea Ryan for bringing her sociological perspective to this section.
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was embodied in the missions of the first university-based business school, the Wharton
School, which opened in 1888, and the first graduate business program at Harvard, which
launched in 1908.
Concerns about the decline of social order also highlighted the importance of maintaining order in the home. At the same time, women were beginning to shed their role as
strictly homemakers and to secure advanced education and develop professional careers.
The tension between the increasing importance of managing the home and the opportunity
to have a professional career gave rise to a new discipline, soon named home economics.
This application of science to domestic life took root in universities nationwide (Stage &
Vincenti 1997). Home economics emphasized not only nutrition and sanitation but also
financial management. Just as the men were to be both businessmen and civic stewards,
each womans civic duty was to ensure that her home was well cared for, running smoothly, and contributing to the larger community and society (Apple & Coleman 2003). The
homemaker was a manager of one portion of the economythe place where everyone,
and especially men, laid their heads and wallets each night. In essence, then, homemakers
were charged with managing much of the private economy, while they did their social
and municipal housekeeping (Apple & Coleman 2003).
These social conventions were soon reflected in academia. By the early twentieth century, one academic profession, comprised nearly exclusively of women, focused on household
economics and management as part of the broader community (i.e., the consumer), the
other, comprised nearly exclusively of men, on businesses as part of the broader society
(i.e., commerce). The careful understanding of householdsincluding their financeswas
embraced by and grew as a result of rural land-grant colleges, having come about under the
1862 Morrill Act and its call for practical education in agriculture and the mechanic arts
(Stage & Vincenti 1997). In contrast, the study of businesses and the institutions that
financed them were more typically found in urban business schools (Khurana 2007).
Nearly a century later, this schism still largely persists. What we call consumer finance
is most often studied in consumer science programs, not in business schools or economics
departments. Often called personal finance, this discipline applies principles of finance,
resource management, consumer education, and the sociology and psychology of decision
making to the study of the ways that individuals, families, and households acquire,
develop, and allocate monetary resources to meet their current and future financial needs
(Schuchardt et al. 2007, p. 7). A perusal of a recent consumer science research compendium (Xiao 2007) shows that the topics of interest are similar to those approaching the field
from backgrounds in financial economics.
Scholars from these two worlds rarely interact. Their conferences are distinct, and their
journals are quite separate.13 Furthermore, to this day, the ratio of men to women faculty
members in these respective programs, as measured by their professional associations,
continues to reflect their history. Male faculty members comprise between 83% and 89%
of finance departments at the top 20 business schools, as measured by membership in the
AFA.14 In consumer science programs, women dominate, comprising 62% of faculty in
13
The listunfamiliar to most financial economistsincludes the Journal of Consumer Affairs, International
Journal of Consumer Studies, Financial Counseling and Planning, Journal of Financial Planning, Financial Services
Review, Family and Consumer Sciences Research Journal, and Journal of Family and Consumer Sciences.
14
A Web search was conducted in December 2008 using the AFAs online directory. In some cases, faculty gender
was not readily discernable by forename. The 89% represents the proportion of men given all known faculty
genders. The 83% figure counts all individuals identified as gender unknown as women.
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the top 10 most active departments, and 84% of the American Association of Family and
Consumer Sciences Higher Education Unit.15 Land-grant universities continue to be a
dominant force in this field.
Beyond data limitations and modeling difficulties, the absence of the consumer from
consideration by top business schoolsand top universitiesmay reflect historic divides
of gender and geography. With new interest in consumer finance, and consumers more
generally, perhaps this divide will be closed. One positive sign is that, in the recent
revamping of the curriculum at the Yale School of Management, the consumer was
explicitly acknowledged as one of the core topics of study. Another positive sign is the
2009 formation of a consumer finance working group at the National Bureau of Economic
Research.
The Consumer
There is substantial normative and positive work on consumer financial decision making.
Mertons (1971, 1973) seminal work exemplifies normative research in this area. Although based on simplified assumptions, it provides high-level guidance for representative
households, calculating an optimal portfolio given time-varying investment opportunities,
and concluding that investors should hedge shocks to their wealth as well as to expected
returns on that wealth. Financial economists have built upon this solid foundation, studying the impact of shocks to real interest rates and the equity premium. Subsequent models
have examined the implications of richer sets of portfolio choices, with wealth also held in
the form of nontradable human capital and housing (see Campbell 2006 for an overview).
Other normative work, typically called personal finance or financial planning, provides
less elegant advice, but is linked to actual products and services. In most consumer science
programs, personal financial management is a standard offering, and there are many
textbooks in this field. These books cover topics such as how to set up a household budget,
how to manage credit card debt, how to evaluate insurance, etc.
There is often a considerable gap between scholarly work and this advice. For example,
although financial planners advise risk-adverse or older households to hold bonds, until
relatively recently academic models largely ignored bond holdings. For example, academic
research by Campbell & Viceira (2001) only recently reconciled the holding of bonds as
15
The top 10 most active departments were defined as a result of online research in September 2008. Wherever
possible, only faculty teaching consumer science courses in their division were counted. Only five of the 10
departments were represented in the associations higher education unit.
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236
hedges against time-variation in interest rates. Because financial economics has not fully
embraced consumer finance topics, personal finance advice is often less driven by research
than by rules of thumb. This gap suggests an opportunity to apply scientific methods to
provide better advice, and for real-world concerns to be incorporated into models.
A second element of consumer-facing research, which spans positive and normative
work, models consumer preferences. The JEL codes placement of household economics
under microeconomics reflects the interest in understanding utility and consumer demand.
In corporate finance, value maximization is employed as a standard objective function and
the net present value (NPV) rule used to implement this rule. In consumer finance, utility
maximization and utility functions serve comparable purposes, but modeling household
preferences is considerably more complicated than calculating NPVs. The form of the
utility function, the parameters for the function, and even the existence of a rational
time-consistent decision maker are long studied but still unresolved research questions
(see Campbells 2006 discussion).
Continuing the analogy to corporate finance, Modigliani & Millers (1958) and Miller &
Modiglianis (1961) seminal works demonstrated that many corporate finance decisions
(e.g., financing and dividend policy) neither create nor destroy value in the absence of
various imperfections. This stark conclusion set the stage for research into the relevant
imperfections and their impacts. Although this logic does not carry over neatly to consumer finance, the types of imperfections that make corporations decisions value-relevant also
apply to household choices. Taxes and bankruptcy are critical factors that explain corporate finance choices. Likewise, there is an extensive literature on the impact of personal
taxation on household portfolio investment decisions (for a review, see Poterba 2002), and
the Merton portfolio model has been extended to include considerations of bankruptcy
(for a review, see Sethi 1996).
Behavioral considerations have been incorporated into corporate finance only recently
(see Baker 2009 in this volume), but are central to any consideration of retail financial
services. Translating a stream of consumption into utility is an extraordinarily subjective
endeavor and even simple economic concepts are challenged. Invoking free disposal,
economists would assume that more is generally preferable to less. However, psychologists
have documented that this maxim is not always, nor perhaps even usually true, as the
wealthiest individuals are no happier than others (Ben-Sharar 2007).
There is a large and growing field of behavioral economics or behavioral finance,
which marries insights from psychology and economics. The awarding of the Nobel Prize
in Economics to Daniel Kahneman in 2002 reflects the acceptance of this approach
by mainstream economics. For surveys of this field and for an extended discussion of
the implications for practice, see DeBondt & Thaler (1995), Mullainathan & Thaler
(2001), Shefrin (2002), Subrahmanyam (2007), Thaler (1993, 1994, 2005), and Thaler &
Sunstein (2008). There are a number of key insights from behavioral economics, including
the notions that decisions relate to heuristics (i.e., rules of thumb), framing (i.e., how
information is presented or organized), and cognitive biases (e.g., misestimation and
overconfidence).
Whereas calculation of NPV is fairly straightforward, behavioral considerations make
evaluation of utility more complicated. One of the earliest and most critical contributions
to behavioral economics is Kahneman & Tverskys (1979) and Tverskey & Kahnemans
(1991) concept of loss aversion, whereby people evaluate gains and losses asymmetrically.
Framed in NPV-like terms, it would require different discount rates for gains and losses,
Tufano
and might require these rates to be path dependent. Whereas most NPV models use
constant discount rates, household discount rates are likely nonconstant. Quasi-hyperbolic
discounting, in which forward rates for discounting vary wildly depending on the horizon,
has been shown to explain various consumer time preferences (Laibson 1997). A sociological approach to utility posits preferences in terms of levels relative to others, and also
identifies the role that money and finances have in defining social groups (see Zelizer 1995
for an extended discussion of this subject). Continuing to incorporate lessons from psychology and sociology will illuminate consumer financial decisions.
A positive strand of consumer-facing research studies the actual financial decisions
taken by consumers. Many of these studies report levels of financial market participation,
with the SCF providing much of the raw data. Bucks et al. (2006) provides a comprehensive summary of SCF findings as well as a comparison with the prior survey. Their 2004
findings were prescient, identifying strong appreciation of house values, a marked increase
in debts relative to assets, and a rising fraction of families with delinquent payments.
Campbells (2006) survey begins with cross-sectional distributions of participation rates
that illustrate how ownership of financial assets increases with wealth, with less wealthy
people largely holding safe assets and vehicles; the middle class (thirtieth and fortieth
percentiles) showing a pronounced propensity to hold real estate; and the highest quintile
holding portfolios of public equities, real estate, and shares in private businesses in roughly equal proportions. Building on this, Calvert et al. (2007) assess the welfare costs of
household investing mistakes. A small but interesting subvein of this participation literature looks at the adoption of innovative retail financial products by consumers (see Frame &
White 2004 for a review).
Research on financial decision making often addresses how closely behavior reflects
rational homo economicus versus a more behaviorally-challenged decision maker. An
excellent example can be found in Browning & Lusardis (1996) comprehensive survey of
consumer savings behavior. They review the various theories for consumer saving and the
empirical support for each. Hilgert et al. (2003) and Campbell et al. (2008) relate basic
financial decisions to personal traits, financial knowledge, community traits, and banking
practices. Campbell (2006) discusses and references the literature on home mortgage
choices. Barber & Odeans (2001, 2002) work on investing documents loss aversion and
gender differences. A long stream of work on determinants of mutual fund flows examines
how investors respond to past performance as salient but are less sensitive to losses
(Chevalier & Ellison 1997, Ippolito 1989, Sirri & Tufano 1998). One of the key questions
is how behavioral biases affect markets. In the mutual fund context, Berk & Green (2004)
conclude that return chasing can be socially optimal.
Often, research identifies apparent anomalies, such as why households tend not to hold
equities or why they borrow from high-cost credit cards while maintaining balances in
low-yielding savings accounts. Gross & Souleles (2002) were among the first to document
this latter fact. Researchers explain this phenomenon as a strategic behavior related to
imminent bankruptcy, a response to spousal self-control, time-inconsistent discount rates,
or the need for cash to pay for items that cannot be charged. Still others argue that there is
no puzzle because the two are not substitutes and have different liquidity characteristics.
This literature is still evolving with some new publications (see Bertaut et al. 2009) and
many still unpublished (see Lehnert & Maki 2007, Telyukova 2008, and Zinman 2007).
Most of this positive literature seeks to relate these household choices to factors
that include relative risks and prices of alternatives, behavioral decision-making biases,
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financial knowledge, social and community norms, preferences, affect and emotions, the
structure of financial products, and a host of other factors. For example, there is a growing
body of work linking financial behaviors with financial skills and education (see Lusardis
2009 volume for a summary). Studies have attempted to link this knowledge to savings
behavior and financial participation (Bernheim 1998, Hilgert et al. 2003) to retirement savings
behavior (Lusardi & Mitchell 2007a,b) and to over-indebtedness (Lusardi & Tufano 2008).
Economists have begun to venture beyond psychology to understand consumer financial decision making, manifesting a new-found interest in sociology and social networks.
Because household finance typically reflects decisions of multiple people together, this
perspective, long understood in consumer sciences, is explicable. At a more fundamental
level, economists have begun to appreciate biology: Neuroeconomics attempts to explain
decisions, such as financial risk taking, to underlying biological factors. Camerer and
colleagues (2005) accessible survey is a good introduction to this emergent field.
Although these approaches to understanding the consumer-facing perspective are
varied, they are linked in that they all attempt to address two fundamental questions: What
decisions should and do consumers make? What should and can explain these choices?
Financial Institutions
Institution-facing work seeks to explain the organization, management, and choices of
retail financial institutions and the implications for consumer well-being and social welfare. Institutions include depositories, brokerage firms, mutual funds, insurance firms, and
networks of firms (e.g., credit card associations). Institutional work often is pigeonholed
within academic departments or journals specializing in banking, insurance, or real estate.
However, institutions also include peer-to-peer lenders, check cashers, payday lenders,
rent-to-own stores, and pawn shops, as well as governments that sell money orders and
social networks where members lend to one another.
Some research on retail financial institutions deals with their organization and economics. Are there economies of scale and scope such as in banking or mutual funds? Can
merging firms capture these gains? How does technological innovation change production
functions? Which governance structures and incentive schemes produce higher shareholder performance or customer outcomes? Is a certain business model, such as microfinance,
economically sustainable? For an example of this type of work, a large and reasonably
well-developed literature addresses the fundamental economics of retail investment management, studying whether certain mutual funds reliably deliver positive risk-adjusted
returns (e.g., Carhart 1997). For a survey of the costs that investors bear searching for
positive performance, see French (2007).
Using this mutual fund work as a springboard, one question posed by performance
studies was whether pre-fee over-performance (if any) was passed along to investors
through higher post-fee returns or captured by the management company in the form of
higher fees. Christoffersen & Musto (2002) and Gil-Bazo & Ruiz-Verdu (2006) find
evidence of strategic price setting by mutual funds, where managers set fees to profit at the
expense of less-alert customers. This line of work highlights the broader issue of how retail
financial institutions deal with their customers. Allens (2001) AFA presidential address
focuses on agency conflicts inherent in institutions relations with customers, and notes the
inconsistency between corporate finance, which acknowledges these conflicts, and the
neoclassical view of financial institutions, which ignores institutions and the conflicts.
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Scholars studying financial institutions have focused on these conflicts, often looking
for evidence of misaligned incentives between principals and agents in consumer finance
settings. Levitt & Syverson (2008) study the real estate brokerage industry and find that
brokers who sell their own property get higher prices than when they are selling someone
elses property. Bergstresser et al. (2009) examine broker-sold mutual funds and find that
funds sold by brokers underperform those sold directly to the consumer, even before
accounting for any distribution charges, and question whether brokers incentives are
aligned with those of their customers. Jackson (2009) discusses the general problem of
conflicts of interest in consumer finance distribution channels.
Often, questions about the relationship between firms and their customers relate to
industry competitiveness. The extensive body of industrial organization research on credit
cards asks whether prices are set competitively and whether some parties are systematically benefited or harmed by the structure of the current two-sided market (Evans & Schmalensee 2005). Antitrust questions of this sort, as well as consumer protection issues raised
by other studies naturally leads one to ponder the role of government.
Alternative financial institutions are gaining more attention as well. A recent (still
mostly unpublished) stream of work studies payday lenders, the alternatives against which
they compete, and whether the service they provide helps or harms their customers.
Building off Caskeys (1996) pioneering work on fringe banking, researchers look at the
relationship between the existence of payday lending and outcomes such as ability to
withstand financial shocks, incidence of bankruptcy, closure of bank accounts for mismanagement, etc. (see working papers by Campbell et al. 2008, Morgan & Strain 2007,
Melzer 2008, Morse 2008, and Skiba & Tobacman 2008).
16
Rather than having specialized regulators, many businesses have relatively lighter and shared oversight. For
example, the Consumer Product Safety Commission oversees more than 15,000 different products with a staff of
420 people (http://www.cpsc.gov/about/faq.html#his). The SEC, sometimes thought to be understaffed, has more
than 3500 full-time staff (http://www.sec.gov/about/secpar/secpar2008.pdf#sec1). Other industries with specialized
regulators charged with consumer protection include foods and drugs and transportation (http://www.cpsc.gov/
federal.html).
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review of this topic and the empirical work on consumer finance law, see Hynes & Posner
(2002). For a summary of the current law, see the volume by Lampe et al. (2008) including
Hotchkiss & Parker (2008).
As Hynes & Posners summary makes clear, the law ensures that consumers have
information, provides insurance against shocks, and bans discrimination. However, the
question is, why would the market not supply these benefits if consumers are willing to
pay for them (Hynes & Posner 2002, p. 197)? Coates & Hubbard (2007) argue that the
workings of financial marketscompetition among mutual funds and active movement of
money by investorsmake portions of the 1940 Investment Company Act irrelevant or
moot. These issues engender strong debate. For example, Warren (2008a,b) argues that
neither market forces nor existing regulation of retail financial transactions has been
adequate and proposes a Financial Products Safety Commission to protect consumers
against unsafe products. This proposal is one of the key elements of the Obama Administrations reforms of the financial system.
Tufano
FUTURE ISSUES
1. Payments. The payment system has evolved from barter, oxen, and seashells to
plastic cards and mobile banking (Evans & Schmalensee 2005). The law of one
price holds that two things with the same payoffs will have the same value, but
does the form of payment affect consumer behavior? The introduction of electronic
www.annualreviews.org
Consumer Finance
241
2.
3.
4.
5.
DISCLOSURE STATEMENT
I am the co-organizer of the NBER Working Group on Consumer Finance. I am the cofounder and Chairman of Doorways to Dreams Fund (http://www.d2dfund.org), a nonprofit research and development firm that designs and tests financial innovations to serve
242
Tufano
low to moderate income families. One of the research projects cited in this piece was
completed by D2D Fund. I also serve on the FDICs Advisory Committee on Economic
Inclusion, am a Research Fellow at the Filene Research Institute, and am on a Federal
Reserve Bank of Boston advisory group. All of these organizations have taken public
positions on some of the issues mentioned in this chapter.
ACKNOWLEDGMENTS
I thank Andrea Ryan for her outstanding research assistance on this project. I benefited
from many conversations on this topic over the years with Dennis Campbell, John Campbell, Shawn Cole, Howell Jackson, Annamaria Lusardi, Asis Martinez-Jerez, Robert
C. Merton, and Daniel Schneider; my students at HBS; and my colleagues at D2D Fund,
the FDIC, and the Filene Research Institute. I am grateful for funding by the HBS Division
of Research and Faculty Development.
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2.5
2.0
1.5
0.5
Liabilies/Assets
Mortgage Debt
Consumer Debt
200
9
200
7
200
5
200
3
200
1
199
9
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7
199
5
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3
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1
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Savings Rate
Figure 1
Consumer debt and savings rates, 1959Q1-2009Q1 (1959 = 1). Debt data are from the Federal Reserves Flow of Funds for
households and non-profits. Mortgage Debt is the ratio of mortgage liability to household real estate values. Consumer Debt
is the ratio of consumer revolving and non-revolving debt to disposable personal income (DPI). The savings rate is based on the
U.S. Bureau of Economic Analysis National Income and Product Accounts (NIPA) and represents the ratio of personal saving to
DPI. Data can be found at http://research.stlouisfed.org/fred2/data/PSAVERT.txt. Ratios as of 2009 Q1 were as follows:
Liabilities/assets (2.2), mortgage debt (2.2), consumer debt (1.6), and savings rate (0.7).
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C-1
Annual Review of
Financial Economics
Contents
Volume 1, 2009
Volatility Derivatives
Peter Carr and Roger Lee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Estimating and Testing Continuous-Time Models in Finance:
The Role of Transition Densities
Yacine At-Sahalia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Learning in Financial Markets
Lubos Pastor and Pietro Veronesi. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
vi
Contents