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Annu. Rev. Financ. Econ. 2009. 1:227–47 Key words
First published online as a Review in Advance on household finance, personal finance, consumer behavior, behavioral
August 28, 2009
economics, behavioral finance, retail financial institutions,
The Annual Review of Financial Economics is functional perspective
online at

This article’s doi: Abstract
Although consumer finance is a substantial element of the econo-
Copyright © 2009 by Annual Reviews. my, it has had a smaller footprint within financial economics. In
All rights reserved
this review, I suggest a functional definition of the subfield of
1941-1367/09/1205-0227$20.00 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 rela-
tive 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, finan-
cial 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


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 representa-
tion acknowledges the broad range of actors in the financial system, the boundaries of
financial economics research are somewhat narrower. Using Journal of Economic Litera-
JEL: Journal of ture (JEL) codes as markers (see, the field of
Economic Literature 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
Annu. Rev. Fin. Econ. 2009.1:227-247. Downloaded from

of the financial system (companies), and calls our attention to the importance of inter-
by Indian Institute of Technology - New Delhi on 08/22/10. For personal use only.

mediaries1, 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 econom-
ics.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 innova-
tion, 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
neglected—or more accurately, dispersed—subfield within financial economics. I echo
and elaborate on the theme laid out by John Campbell (2006) in his Presidential Address
AFA: American to the American Finance Association (AFA): “[H]ousehold finance. . . has attracted much
Finance Association 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 Campbell’s
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 Campbell’s article, as well as some of the other
survey pieces of related fields that I cite throughout the chapter.

What is consumer (or household) finance? Campbell (2006, p. 1553) argues that house-
hold finance “asks how households use financial instruments to attain their objectives.”

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.

228 Tufano

g..annualreviews.. banking overdraft protection. the payments by Indian Institute of Technology . debit cards (including prepaid). Rev. For personal use only. online funds transfer tools like PayPal. SCF: Survey of To understand the ubiquity of these functions. Fin.. nonbanks (e. and the infrastructure that supports all of these activities. online businesses. Downloaded from arjournals. including bank products (savings accounts and CDs).  Advancing funds from today until a later date. The investing or savings functions are embodied in a host of products and services.annualreviews. implicit borrowing is built into various derivative products. student loans. workplace retirement programs.g. mortgage loans. I adopt the functional approach of Crane et al. how consumers make financial decisions. From the perspective of businesses that serve consumers. tax treatment. check cashing stores).New Delhi on 08/22/10..g.. businesses. In addition to explicit borrowing. The definition is admittedly tautological as it refers to undefined financial functions. In the consumer sector. which holds that financial systems are best understood in terms of the functions they deliver. and how government action affects the provision of financial services. wire transfers. as well as by assembling a diversified portfolio or securing insur- ance against default. 2009. These products are delivered by a host of organizations. and regulators. banking organizations.g. including insurance (health. property and casualty. and other factors. and Social Security. This function is embodied in household credit. These products vary based on the intended time horizon. risks are managed through credit scoring models and credit risk practices.. payroll systems. I identify four primary and necessary functions of the consumer finance sector:  Moving funds. disability). auto loans. and government safety nets. which ranges from shorter-term unsecured borrowing (e. remittances. we can look at the adoption of various Consumer Finances financial products. checks. and through various hybrid organizations (e.g. life. mutual funds.g. even though they may be delivered by a wide variety of institutions and through a wide range of products. including options and forwards.. to secured borrowing (e. credit cards. function would include cash. person-to-person lending Web sites). postal and private money orders. The financial system must provide a mechanism for the transfers of Annu..g.g. However. social networks. including the government (e. Arguably. Econ. These functions are stable. person-to-person lending). money and post offices). To further clarify my proposed definition. level and type of risk borne by the investor. Recognizing the roles of money and payments for goods and services. to longer-term unsecured borrowing (e. the purchase of certain financial products (e. credit and charge cards. precautionary savings.g. The provision of credit can take place through the formal sector. Using data tabulated from the 2007 Survey of Consumer Finances (SCF) www. data processors. put options to protect one’s portfolio against declines). The risk-management function is satisfied through a variety of products and services. barter. a more expansive defini- tion 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.. and  Consumer Finance 229 .1:227-247. and payday loans).  Advancing funds from the future to today. The organizations that perform this function range from the family and local communi- ty to insurance companies and government disaster relief plans. as well as prepaid structures (e. Automated Clearing House (ACH) transactions. and margin loans).  Managing risk. most of the existing literature on consumer financial decisions is focused on the saving and investing functions. (1995) and Merton & Bodie (1995). variable annuities. friends and family). rent-to-own schemes). through the informal sector (e.

Pooling is also exemplified through securitization. such as brokers.pdf]. Consumers gather infor- mation and make financial decisions with the help of formal and informal financial education.4 Seventy-seven percent of households report having debt (of any kind). or with inadequate levels of both. namely 3 For information on the shift from checks to electronic payments. or delegate these choices to others. more than 90% of Americans have a transaction (checking) account.annualreviews. but often three. parties contract with one another formally or informally. Government policies often attempt to improve the process of decision making by setting disclosure requirements. Econ. Mutual funds. policy concerns often focus on the fraction of Americans in the most precarious financial situations—particular- ly those without savings or health insurance. money orders).html). check cashers.. diversification bene- by Indian Institute of Technology . and advice delivered by a person’s social networks. giving them access to economies of scale. as well as through the structure of both explicit contracts and implicit arrangements in social disclosures mandated by government bodies. The insurance statistics come from industry sources [http://www. see Gerdes et al. and move funds backward and forward in time.1:227-247.htm and http://www. The current interest in behavioral finance deals primarily with the quality of household-level decision to buy shares in a pool. Consumers address con- flicts with others when selecting the firms and people with whom they do business. as well as by establishing guidelines for behavior embodied in the legal system. at least two. Fin. as well as those mechanisms that lead to better decisions.3 Approximately 94% report owning some sort of financial assets and more than 80% have two particular forms of risk protection: health and life insurance. such as the Truth in Lending Act (TILA) and associated Regulation Z that specify how annual percentage rates (APRs) must be calculated and reported so that consumers can make informed decisions.flexfs. 4 The SCF data represent weighted fractions of respondents with these products. Having multiple parties involved leads to potential conflicts of interest. the legal concept of fiduciary duty was established by society to preemptively address incentive conflicts.cbpp. For personal use only. which each party—as well as government—seeks to mitigate. Downloaded from arjournals. 230 Tufano . (http://www. A fiduciary’s duty of loyalty is intended to establish norms for behavior between certain providers of financial goods and services and their customers.  Providing financial information to facilitate decision making. Generally speaking. financial advisors. Govern- ments play a key role in incentive conflicts by regulating certain actions.New Delhi on 08/22/10. fits. The remainder presumably use some combination of cash or alternative payment systems (e.  Dealing with information asymmetries and incentive conflicts. To deliver payment services. news from the financial press. and is present in most borrowing and lending transactions (Sirri & Tufano 1995). 2009. Consumers can make decisions by themselves. Rev. Small transactions (assets or liabilities) can be combined to create portfolios that facilitate economies or diversification. Businesses use a similar set of tools. (2005). manage risk. allow investors Annu. a financial system must also deliver a set of ancillary functions:  Pooling. and professional management and administration.federalreserve. as well as through all intermediated businesses. both groups use the threat of litigation both to forestall incentive conflicts and to redress them. advice from brokers and advisors. In addition. or bank trust factsaboutlife2005complete%20(2). For example. for example. marketing activities of product vendors.g. In all consumer busi-

.2 trillion) of these funds held in tangible assets (mostly real estate) and $40. households7 held $ and even some risk-management products (i. a bank or credit union often will offer savings products. and provide employment.federalreserve.. not to suggest that consumer finance activities are less important elsewhere. primarily in credit cards).annualreviews. A functional approach best ensures that our analysis is not constrained by artificial boundaries imposed by traditional product categories. Rev. they will look across a variety of formal financial institutions.5 trillion.S. an by Indian Institute of Technology .g. with 37. In aggregate. Rather.5 trillion in assets. businesses produce goods and services. that the provider acts in the best interest of the customer. Although one can study banks or credit cards alone. Nonprofits account for 5-7% of assets and liabilities. taking a functional approach to understanding consumer finance serves researchers well. lending products. payment products. Corporations are central to financial economics. 6 Throughout the review. institution focus runs the risk of confusing or conflating the various functions and may miss relevant competitors and alternative providers. Yet in sheer size. Fin. These more traditional approaches must contend with the fact that a single product or institution delivers many different  Consumer Finance 231 .org delivering funds to merchants. and may also consider informal institutions. the classic book by Berle & Means (1991 [1932]) examines the implications of the separation between ownership and control. Using the United States as an example. such as the credit card. and a single function may be delivered by a host of seemingly unrelated institutions or products. According to the latest numbers available as of this writing (2009 Q1). or differences in institutional con- ventions across jurisdictions or over time. too.5 trillion) and consumer credit ($2. data to illustrate various points. mostly home mortgages ($10.e. A single product. but to use a consistent set of data. thus the figures largely reflect the household sector (see Teplin 2001). Econ. potential incentive conflicts exist in the delivery of nearly all financial functions. www. provides multiple functions as well—not only extending credit. it should be clear that consumer finance is a substantial element of the financial sector. Surely.g. Therefore.annualreviews. THE SCALE OF CONSUMER FINANCE With such an expansive definition.3 trillion in 5 Large strands of the financial economics literature are concerned with these conflicts. Another single institution may deliver a form of all of the financial functions. one can get a sense of the magnitude of the consumer finance sector as a driver of the economy. For personal use only. I use U. In short. loan insurance).6 The Federal Reserve’s Flow of Funds data are a commonly used source for aggregate statistics (http://www.New Delhi on 08/22/10. households held $14.. 7 Technically. such as their social networks. as the two are considered a single sector in the Flow of Fund calculations due to data limitations. as well as information (advice or marketing). They also provide pooling. nonfinancial) businesses held only $27. but also providing payment services by Annu. the household sector dominates the corporate sector. It has a second benefit. Downloaded from arjournals. People who want to borrow money do not necessarily begin with a single product (e.5% ($24. a credit card) or even a single institu- tion (e. For example. 2009. For example.1 trillion in liabilities. Corporate (nonfarm. this information refers to households and nonprofit organizations. in that it forces one to have a user-oriented focus on the financial system.3 trillion in financial assets.5 The functional approach to defining consumer finance can be contrasted with a prod- uct or institutional approach. and resolve informa- tion asymmetries and incentive conflicts.1:227-247. Bank of America).

3 trillion in liabilities. such as payables. our hopes for the recovery in part hinge on the rate of consumer borrowing and spending. some of which are changing very rapidly.pdf (data as of September 2008) and http://investorrelations. Rev.8 trillion. Increasing debt was associated with high levels of consumer spending and low levels of saving. low interest by Indian Institute of Technology . report more than 75 billion transactions a year. using different leverage with combined transaction volume of $6.2 trillion. News and World Report) was gathered online in September of 2008. Information on the course offerings at the top 20 MBA programs (as ranked by Business Week and U. Downloaded from arjournals.zhtml?c=148835&p=irol-reportsannual (data as of December 2008). 10 These two courses were both introduced in 2008–2009. commercial paper. Visa and MasterCard. as of 2008 only two MBA programs offer explicit courses on consumer or household finance.8 Recent economic events have demonstrated the importance of the consumer sector to the economy. which is also shown in the figure. using program Web sites and online catalogs. the two largest card associa- tions.annualreviews. Rising home values. Figures represent all card transactions worldwide. Even by this narrow definition. federal policies to encourage homeownership.mastercardintl.S. one was undoubtedly the subprime mortgage market. Econ. new mortgage products. and mortgages) accounting for $7. Corporations hold $13.New Delhi on 08/22/10. Why? A SPECULATIVE HISTORY OF SCIENCE: THE SPLIT OF CONSUMER STUDIES FROM BUSINESS STUDIES Every one of the top 20 U. The payments systems used by consumers move trillions of dollars through the economy. Figure 1 (see color insert) represents time series trends for consumer leverage in the United States over the past five decades. courses on banking and financial institutions are offered by 14 schools. Just one part of that payments function—credit and debit cards—represents trillions of dollars of annual activity. and as Campbell notes. assets. suffers from lack of status. corporate bonds. Subsequent softening in housing prices exposed the over-leverage. consumer finance typically is an ancillary com- ponent of related offerings. Balance sheet numbers alone do not capture the magnitude of the consumer finance sector. economic crisis. Curiously. For personal use only. 232 Tufano . poor business practices. readers are referred to Shiller (2008) for a concise and poor consumer decision making all combined to produce over-leverage in the consumer sector. For example. with credit market instruments (including bank debt. so their financial asset holdings are approximately one-third that of households. Their debt is approximately one-half that of households. Fin. Now.10 When addressed. roughly equally split between tangible and financial assets. Some finance academics argue that the field of finance is defined by whether the activity affects asset prices. it has a remarkably small footprint in both. consumer finance deserves a prominent place in the field of financial economics and in business schools. 9 Although there are many explanations of the phenomena. with the rest being short- term liabilities.1:227-247.corporate. leading to foreclosures that rippled from the subprime space through CDOs and insurers to contribute to the demise of financial institutions. but a review of their course descriptions and the leading textbooks suggests that consumer-facing businesses and households account for relatively little of the 8 See http://www. Although there are many precipitating events that contributed to the current Annu. securitization. MBA programs offers at least one course on corporate finance. however.

rural land-grant universities studied households and prepared women to lead them. Industrialization and urbanization were changing the American way of life and causing many to fear the demise of the traditional moral fabric (Brown 1985). For personal use only. what has held us back from addressing these limitations while plowing for- ward 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. but these courses tend to examine the consumer in isolation from business or regulation. As this review makes clear. the study of consumers’ financial needs was subsumed under the field of home economics or consumer science. which was. but most focus solely on investing decisions. such as microfinance. The top 20 economics graduate programs all offer courses on microeconomics that deal with the decisions of representative consumers. This emerging philosophy 11 The top 20 graduate programs in economics were identified based on the U. and residential real estate. News and World Report 2008 ranking ( In response. First. Why does consumer finance receive so little attention in business schools and main- stream economics departments? One possibility is that consumer finance is so inherently Annu. Campbell’s diagnosis is correct. divorced from mainstream eco- nomics and business.1:227-247. Elite urban universities emphasized businesses and prepared men to lead them. Econ.S. Economics departments likewise spend relatively little class time on consumer finance issues. 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.annualreviews. 12 I thank Andrea Ryan for bringing her sociological perspective to this section. Focusing primarily on the finance and economics communities.  Consumer Finance 233 . and surveys are inherently suspect. and to consider the decision-making process primarily in the context of investing decisions. personal taxation. www. and the management of the institutions. 28). Fin. Campbell suggests that the problem may lie in two difficulties encountered by would-be researchers.11 Nine graduate programs offer be- havioral economics courses. 1558). multidisciplinary that it falls between the cracks. it is hard to observe and measure household activity.12 This intellectual divide can be traced to the 1800s. sociology.rankingsandreviews. In essence. there is another hypothesis for this inattention and the low status granted to consumer finance. Details were gathered online in December of 2008 using program web sites and online catalogs. then describes the various institutions. There are few data on transactions. thought to be “not merely demeaning. content. but possibly corrupting” (Daniel 1998. and the law. Second. not the full range of consumer financial decisions. and the Byzantine nature of personal taxation. These complications include the complex math of intertemporal models.New Delhi on 08/22/10. (The traditional sequence discusses money and interest rates. data are restricted by privacy considerations.) Behavioral fi- nance courses are offered at seven programs. The question is. regulation. Other related courses have six or fewer offerings. 2009. the need to model nontradable human capital and illiquid housing. he argues that “household decision problems involve many complications that are neglected by standard textbooks” (Campbell 2006.annualreviews. The blame for these changes often was placed on by Indian Institute of Technology . p. yet it also applies to many other parts of academia. there became an increasing urgency to recast the status of the busi- nessman from profit-seeker to professional (Khurana 2007). However. Rev.usnews. consumer finance requires an understanding of not only finance and economics but also psychology. industrial organization. and still is. Downloaded from arjournals.

Econ. The careful understanding of households—including their finances—was embraced by and grew as a result of rural land-grant colleges. this discipline applies “principles of finance. and contributing to the larger community and society (Apple & Coleman 2003). Their conferences are distinct. not in business schools or economics departments. having come about under the 1862 Morrill Act and its call for practical education in “agriculture and the mechanic arts” (Stage & Vincenti 1997). which opened in 1888. 7). was embodied in the missions of the first university-based business school. women dominate. then. Financial Services Review. develop. Nearly a century later. In essence. consumer education. comprising 62% of faculty in 13 The list—unfamiliar to most financial economists—includes the Journal of Consumer Affairs. and allocate monetary resources to meet their current and future financial needs” (Schuchardt et al. Scholars from these two worlds rarely interact. the Wharton School. Male faculty members comprise between 83% and 89% of finance departments at the top 20 business schools. 2007. the ratio of men to women faculty members in these respective programs. International Journal of Consumer Studies. as measured by their professional associations. Home economics emphasized not only nutrition and sanitation but also financial management. For personal use only. The 89% represents the proportion of men given all “known” faculty genders.. comprised nearly exclusively of men. faculty gender was not readily discernable by forename.e.New Delhi on 08/22/10.14 In consumer science programs.annualreviews. What we call consumer finance is most often studied in consumer science programs. continues to reflect their history. women were beginning to shed their role as strictly homemakers and to secure advanced education and develop professional careers. Concerns about the decline of social order also highlighted the importance of main- taining order in the home. and the sociology and psychology of decision making to the study of the ways that individuals. the consumer). the other. Just as the men were to be both businessmen and civic stewards. this schism still largely persists. A perusal of a recent consumer science research compendi- um (Xiao 2007) shows that the topics of interest are similar to those approaching the field from backgrounds in financial economics. and Journal of Family and Consumer Sciences. the study of businesses and the institutions that financed them were more typically found in urban business schools (Khurana 2007). each woman’s civic duty was to ensure that her home was well cared for. Downloaded from arjournals. and their journals are quite separate. Rev.1:227-247. on businesses as part of the broader society (i. p. Journal of Financial Planning.13 Furthermore. focused on household economics and management as part of the broader community (i. Family and Consumer Sciences Research Journal. soon named home economics. This application of science to domestic life took root in universities nationwide (Stage & Vincenti 1997).e. 2009. At the same time. homemaker was a manager of one portion of the economy—the place where everyone. to this day. as measured by membership in the AFA. By the early twentieth centu- ry. The 83% figure counts all individuals identified as “gender unknown” as women. and households acquire. laid their heads and wallets each night. In contrast. resource by Indian Institute of Technology . Often called personal finance. 14 A Web search was conducted in December 2008 using the AFA’s online directory. families. one academic profession. Fin.” while they did their “social and municipal housekeeping” (Apple & Coleman 2003). commerce). homemakers were charged with managing much of the “private economy. In some cases.. running smooth- ly. The Annu. These social conventions were soon reflected in academia. The tension between the increasing importance of managing the home and the opportunity to have a professional career gave rise to a new discipline. and especially men. comprised nearly exclusively of women. Financial Counseling and Planning. which launched in 1908. and the first graduate business program at Harvard. 234 Tufano .

org  Consumer Finance 235 . For example. how to evaluate insurance. but is linked to actual products and services. Merton’s (1971. how to manage credit card debt. Although the different groups are interested in similar phenomena. One positive sign is that. 2009. In most consumer science programs.annualreviews. the financial institution. Wherever possible. 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. sociology. in the recent revamping of the curriculum at the Yale School of Management.1:227-247. the gov- ernment. although financial planners advise risk-adverse or older households to hold bonds. and the law. they approach them with different languages and tools. Given the breadth of the field and related disciplines. Fin. I cite survey pieces that cover portions of the field. Rev. With these risks in mind. Another positive sign is the 2009 formation of a consumer finance working group at the National Bureau of Economic Research. research on con- sumer finance is disbursed among economics. etc. Other normative work. For example. consumer sciences. personal financial management is a standard offering. only faculty teaching consumer science courses in their division were counted. the consumer was explicitly acknowledged as one of the core topics of study. Downloaded from arjournals. with wealth also held in the form of nontradable human capital and housing (see Campbell 2006 for an overview). and there are many textbooks in this field. it provides high-level guidance for representative households. typically called personal finance or financial planning. Econ. until relatively recently academic models largely ignored bond holdings. Annu. I divide the studies by the primary decision maker considered by the work: the consumer. Beyond data limitations and modeling difficulties. The Consumer There is substantial normative and positive work on consumer financial decision making. calculating an optimal portfolio given time-varying investment opportunities. Only five of the 10 departments were represented in the association’s higher education unit. or a combination of these players. this review is insufficient. finance. www. 1973) seminal work exemplifies normative research in this area.15 Land-grant universities continue to be a dominant force in this field. psychology. and consumers more generally. and concluding that investors should hedge shocks to their wealth as well as to expected returns on that A BRIEF TAXONOMY OF RESEARCH IN CONSUMER FINANCE by Indian Institute of Technology . the absence of the consumer from consideration by top business schools—and top universities—may reflect historic divides of gender and geography. study- ing the impact of shocks to real interest rates and the equity premium. Subsequent models have examined the implications of richer sets of portfolio choices. Financial economists have built upon this solid foundation.New Delhi on 08/22/10. For personal use only. Al- though based on simplified assumptions. and 84% of the American Association of Family and Consumer Science’s Higher Education Unit. perhaps this divide will be closed. Wherever possible.annualreviews. These books cover topics such as how to set up a household budget. With new interest in consumer finance. There is often a considerable gap between scholarly work and this advice. the top 10 most active departments. Without a central home in business schools or economics departments. provides less elegant advice.

rules of thumb). Behavioral considerations have been incorporated into corporate finance only recently (see Baker 2009 in this volume). However. (see Campbell’s 2006 discussion). and Thaler & Sunstein (2008). For surveys of this field and for an extended discussion of the implications for practice. Likewise. There are a number of key insights from behavioral economics. framing (i. misestimation and overconfidence). 2005).. which marries insights from psychology and economics.. hedges against time-variation in interest rates. In consumer finance. personal finance advice is often less driven by research than by rules of thumb. Subrahmanyam (2007). Because financial economics has not fully embraced consumer finance topics. Framed in NPV-like terms. the parameters for the function. Although this logic does not carry over neatly to consum- er finance. whereby people evaluate gains and losses asymmetrically. One of the earliest and most critical contributions to behavioral economics is Kahneman & Tversky’s (1979) and Tverskey & Kahneman’s (1991) concept of loss aversion. there is an extensive literature on the impact of personal taxation on household portfolio investment decisions (for a review. see DeBondt & Thaler (1995). utility maximization and utility functions serve comparable purposes. nor perhaps even usually true. Fin. Invoking free disposal. Downloaded from arjournals. and the Merton portfolio model has been extended to include considerations of bankruptcy (for a review. and even the existence of a rational time-consistent decision maker are long studied but still unresolved research questions Annu.g. 2009. Continuing the analogy to corporate finance. and cognitive biases (e. Mullainathan & Thaler (2001). There is a large and growing field of behavioral economics or behavioral by Indian Institute of Technology . behavioral considerations make evaluation of utility more complicated. but are central to any consideration of retail financial services.1:227-247. 236 Tufano . The awarding of the Nobel Prize in Economics to Daniel Kahneman in 2002 reflects the acceptance of this approach by mainstream economics. Translating a stream of consumption into utility is an extraordinarily subjective endeavor and even simple economic concepts are challenged. see Sethi 1996).New Delhi on 08/22/10. and for real-world concerns to be incorporated into models.e. it would require different discount rates for gains and losses. Modigliani & Miller’s (1958) and Miller & Modigliani’s (1961) seminal works demonstrated that many corporate finance decisions (e. Shefrin (2002). as the wealthiest individuals are no happier than others (Ben-Sharar 2007).annualreviews. For personal use only. In corporate finance. which spans positive and normative work. This stark conclusion set the stage for research into the relevant imperfections and their impacts.e. Econ. Rev. economists would assume that more is generally preferable to less. including the notions that decisions relate to heuristics (i. Taxes and bankruptcy are critical factors that explain corpo- rate finance choices. how information is presented or organized). The JEL codes’ placement of household economics under microeconomics reflects the interest in understanding utility and consumer demand. psychologists have documented that this maxim is not always. Whereas calculation of NPV is fairly straightforward. financing and dividend policy) neither create nor destroy value in the absence of various imperfections. Thaler (1993. 1994. A second element of consumer-facing research. see Poterba 2002). but modeling household preferences is considerably more complicated than calculating NPVs. value maximization is employed as a standard objective function and NPV: net present value the net present value (NPV) rule used to implement this rule.. models consumer preferences.g. This gap suggests an opportunity to apply scientific methods to provide better advice. the types of imperfections that make corporations’ decisions value-relevant also apply to household choices. The form of the utility function.

the middle class (thirtieth and fortieth percentiles) showing a pronounced propensity to hold real estate. financial knowledge. Continuing to incorporate lessons from psy- chology and sociology will illuminate consumer financial decisions. Building on this. Most of this positive literature seeks to relate these household choices to factors that include relative risks and prices of alternatives. A sociolog- ical approach to utility posits preferences in terms of levels relative to others. 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. One of the key questions is how behavioral biases affect markets. identifying strong appreciation of house values.annualreviews. 2002) work on investing documents loss aversion and gender differences. in which forward rates for discounting vary wildly depending on the horizon. 2009) and many still unpublished (see Lehnert & Maki 2007.annualreviews. behavioral decision-making biases. community  Consumer Finance 237 . Sirri & Tufano 1998). www. Telyukova 2008. and also identifies the role that money and finances have in defining social groups (see Zelizer 1995 for an extended discussion of this subject). research identifies apparent anomalies. A positive strand of consumer-facing research studies the actual financial decisions taken by consumers. Rev. Researchers explain this phenomenon as a strategic behavior related to imminent bankruptcy. Many of these studies report levels of financial market participation. and the highest quintile holding portfolios of public equities. Campbell’s (2006) survey begins with cross-sectional distributions of participation rates that illustrate how ownership of financial assets increases with wealth. Berk & Green (2004) conclude that return chasing can be socially optimal. time-inconsistent discount rates. and Zinman 2007). Bucks et al. Research on financial decision making often addresses how closely behavior reflects rational homo economicus versus a more behaviorally-challenged decision maker. with the SCF providing much of the raw data. Still others argue that there is no puzzle because the two are not substitutes and have different liquidity characteristics. real estate. 2009. An excellent example can be found in Browning & Lusardi’s (1996) comprehensive survey of consumer savings behavior. or the need for cash to pay for items that cannot be charged.1:227-247. Barber & Odean’s (2001. Downloaded from arjournals. For personal use only. Calvert et al. (2007) assess the welfare costs of household investing mistakes. a response to spousal self-control. Ippolito 1989. (2008) relate basic financial decisions to personal traits. (2003) and Campbell et al. and might require these rates to be path dependent. In the mutual fund context. This literature is still evolving with some new publications (see Bertaut et by Indian Institute of Technology . with less wealthy people largely holding safe assets and vehicles. a marked increase Annu. Hilgert et al. Econ. They review the various theories for consumer saving and the empirical support for each. Fin. household discount rates are likely nonconstant. and banking practices. and a rising fraction of families with delinquent payments. Quasi-hyperbolic discounting. has been shown to explain various consumer time preferences (Laibson 1997).New Delhi on 08/22/10. Gross & Souleles (2002) were among the first to document this latter fact. 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. (2006) provides a comprehen- sive summary of SCF findings as well as a comparison with the prior survey. and shares in private businesses in rough- ly equal proportions. in debts relative to assets. Often. Whereas most NPV models use constant discount rates. A small but interesting subvein of this participation litera- ture looks at the adoption of innovative retail financial products by consumers (see Frame & White 2004 for a review). Campbell (2006) discusses and references the literature on home mortgage choices. Their 2004 findings were prescient.

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. 2003) to retirement savings behavior (Lusardi & Mitchell 2007a. 2009. mutual funds. and notes the inconsistency between corporate finance.. Some research on retail financial institutions deals with their organization and econom- ics. a large and reasonably well-developed literature addresses the fundamental economics of retail investment man- agement. financial knowledge. economists have begun to appreciate biology: Neuroeconomics attempts to explain decisions. payday lenders. 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. Carhart 1997). the structure of financial products. Downloaded from arjournals. and the neoclassical view of financial institutions. Hilgert et al. Economists have begun to venture beyond psychology to understand consumer finan- cial decision making. 238 Tufano .. affect and emotions. by Indian Institute of Technology . manifesting a new-found interest in sociology and social networks.New Delhi on 08/22/10. Rev. and networks of firms (e. or real estate. and choices of retail financial institutions and the implications for consumer well-being and social wel- fare. brokerage firms. and pawn shops. Econ. Using this mutual fund work as a springboard. Camerer and colleagues’ (2005) accessible survey is a good introduction to this emergent field. credit card associations). At a more fundamental level. as well as governments that sell money orders and social networks where members lend to one another. Institutions include depositories. which acknowledges these conflicts. Christoffersen & Musto (2002) and Gil-Bazo & Ruiz-Verdú (2006) find evidence of strategic price setting by mutual funds. long understood in consumer sciences. there is a growing body of work linking financial behaviors with financial skills and education (see Lusardi’s 2009 volume for a summary). management. For personal use only. check cashers. For a survey of the costs that investors bear searching for positive performance. see French (2007). rent-to-own stores. insurance.1:227-247. Although these approaches to understanding the consumer-facing perspective are varied. economically sustainable? For an example of this type of work. preferences. and a host of other factors. Institutional work often is pigeonholed within academic departments or journals specializing in banking. social and community norms. such as financial risk taking. Because household finance typically reflects decisions of multiple people together. which ignores institutions and the conflicts. this perspective. Annu. For example. However. This line of work highlights the broader issue of how retail financial institutions deal with their customers.g. institutions also include peer-to-peer lenders.annualreviews.b) and to over-indebtedness (Lusardi & Tufano 2008). where managers set fees to profit at the expense of less-alert customers. Allen’s (2001) AFA presidential address focuses on agency conflicts inherent in institutions’ relations with customers. Studies have attempted to link this knowledge to savings behavior and financial participation (Bernheim 1998. studying whether certain mutual funds reliably deliver positive risk-adjusted returns (e.g. to underlying biological factors. is explicable. such as microfinance. insurance firms. 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 sharehold- er performance or customer outcomes? Is a certain business model.

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 else’s property. the Consumer Product Safety Commission oversees more than 15. Morse 2008. Fin. Alternative financial institutions are gaining more attention as well. as well as consumer protection issues raised by other studies naturally leads one to ponder the role of government.1:227-247. is investor SEC: and when stronger rules and regulation are  Consumer Finance 239 .pdf#sec1). Securities and Exchange Commission (SEC) mission. lensee 2005). A recent (still mostly unpublished) stream of work studies payday lenders. Morgan & Strain 2007. even before accounting for any distribution charges. as well as how market forces may make them irrelevant. consumer finance receives extra attention. and care refers to the requirement to use reason- able standards of diligence (for an extensive treatment of this topic. The Role of Government Although government plays an important role in regulating many parts of the economy.S. and question whether brokers’ incentives are aligned with those of their customers. researchers look at the relationship between the existence of payday lending and outcomes such as ability to withstand financial shocks. For example. For personal use federal. often looking for evidence of misaligned incentives between principals and agents in consumer finance Building off Caskey’s (1996) pioneering work on fringe banking. has more than 3500 full-time staff (http://www. Antitrust questions of this sort.16 Commission For example. etc. Legal scholars and economists have opined about the reasons for these duties and other rules. 2008). In intent. many businesses have relatively lighter and shared oversight. see Frankel 1998.sec. but perhaps not in practice. Rev. The extensive body of industrial organization research on credit cards asks whether prices are set competitively and whether some parties are systematical- ly benefited or harmed by the structure of the current two-sided market (Evans & Schma- Annu. questions about the relationship between firms and their customers relate to industry competitiveness.000 different products with a staff of 420 people (http://www. Simi- larly. Often. 2006. Melzer 2008. federal and state banking regulation is designed to protect consumer interests. the alternatives against which they compete. Bergstresser et al. Jackson (2009) discusses the general problem of conflicts of interest in consumer finance distribution channels. and Skiba & Tobacman 2008).S. the U. some consumer financial businesses are and Exchange more closely overseen than other businesses. www. closure of bank accounts for mis- management. Downloaded from arjournals. sometimes thought to be understaffed. Loyalty refers to putting the client’s interests ahead of those of the fiduciary.html). Beyond ensuring the system’s safety and sound- by Indian Institute of Technology . (2009) examine broker-sold mutual funds and find that funds sold by brokers underperform those sold directly to the consumer. These debates revolve around circumstances in which caveat emptor—combined with disclosure and competition—is appropriate. The SEC.annualreviews. Econ. Securities protection. and whether the service they provide helps or harms their customers. incidence of bankruptcy. in part. Scholars studying financial institutions have focused on these conflicts. For a 16 Rather than having specialized regulators.annualreviews.html#his). 2008. some financial institutions that are entrusted with the money of others sometimes owe fiduciary duties of loyalty and care.New Delhi on 08/22/10. Other industries with specialized regulators charged with consumer protection include foods and drugs and transportation (http://www. 2009. (see working papers by Campbell et al.

Warren (2008a. Karlan. 2009. Fin. the law ensures that consumers have information. As Hynes & Posner’s summary makes clear. 1998) intervene in employment settings to demonstrate that automatic enrollment features can dramatically increase participation in workplace savings plans. The taxonomy also does not differentiate by research method. In a series of influen- tial papers. the question is. 197)? Coates & Hubbard (2007) argue that the workings of financial markets—competition among mutual funds and active movement of money by investors—make portions of the 1940 Investment Company Act irrelevant or moot. Duflo and colleagues’ (2005) work on the incentive impacts of match funding measured the effect of increasing match rates on tax-advantaged savings. tration’s reforms of the financial system. Karlan & Zinman 2008).org by Indian Institute of Technology . Econ. and the government). Ashraf and colleagues’ (2006) work on commitment savings demonstrates that making savings less liquid can increase the level of household savings. why would the market not supply these benefits if consumers are willing to pay for them (Hynes & Posner 2002. Zinman. These issues engender strong debate.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. For personal use only. Laibson.b. in which a treatment is administered randomly to members of the population to increase the power of the tests (see Harrison & List 2004 and the reviews in this volume of the Annual Review of Financial Economics for details on these methods). 2008. For a summary of the current law. and others (Beshears et al. Multi-Party Field Interventions The taxonomy above categorizes research based on the relevant decision maker. businesses. and bans discrimination. For example. Downloaded from arjournals. Carroll et al. coauthors Choi. Choi et al. and contributed to the IRS’s adoption of Form 8888 to simplify saving part of a refund. 2008. Consumer finance is amenable to action research. Metrick. p. and implications for savings bond policy.1:227-247. Rev. see the volume by Lampe et al. A recent and important trend in consumer finance research is to use field experiments that not only engage multiple parties but also test the impact of interventions. (2008) including Hotchkiss & Parker (2008). However. these studies apply behavioral economics to induce behavior changes. This proposal is one of the key elements of the Obama Adminis- Annu. This work led to changes in the pension law to facilitate auto-enrollment programs. Thaler & Benartzi’s (2004) Save More TomorrowTM (SMarT) experiment gave workers the ability to commit today to save part of their future salary increases. and has been rolled out by Vanguard in the United States and by AXA in Europe. Beverly and colleagues’ (2006) work on tax refunds demonstrated the potential of paying yourself first using tax refunds.annualreviews. but any study of consumer finance tends to involve multiple parties (consumers. so-called “nudges” in Thaler & Sunstein’s (2008) language. This testing can be structured in standard control-treatment fashion or as randomized field experiments. Madrian. 240 Tufano . provides insurance against shocks. 2009. Within consumer finance. Laibson et al.New Delhi on 08/22/10. Tufano (2008) studies the offer of a simple savings product at tax time. and others’ field experiments in South Africa disentangle moral hazard and adverse selection effects by borrowers and the implications of marketing (Bertrand et al. 2009a. 2003. 2009. offering laboratories that can generate meaningful samples to inform business practice and public policy.b. review of this topic and the empirical work on consumer finance law. see Hynes & Posner (2002). 2004a.

The payment system has evolved from barter. meaning “one who manages a household. saving. psychology. Rev.annualreviews. Payments. sociology.New Delhi on 08/22/10.. laws. and social networks that shape the decisions and how they are perceived. but rather that con- sumer decisions reflect behavioral biases. or depress. The study of household payments. but does the form of payment affect consumer behavior? The introduction of electronic www. and governments interact to deliver the financial functions required by consumers that enable Annu. and government policy. THE STATE OF CONSUMER FINANCE Researchers in economics and finance study the allocation of scarce resources. sociologists. and research should embrace neoclassical economics. New research on consumer decision making—such as the work on automatic enrollment—promises to dramatically change saving and spending behavior through better financial products and regulations. then laws and regulations play an important role. The broad benefits of deeper study of consumer finance may be substantial. law. and seashells to plastic cards and mobile banking (Evans & Schmalensee 2005). time. Econ. This openness acknowledges that utility maximization is not a mechanical exercise. at the core of the subfield. excess leverage.” Consumer finance studies these household managers and the financial choices they make. psychologists. Furthermore.g. policy analysts. and technology. information them to allocate money. The emerging interest in the field represents a deeper openness by financial economists to insights from other disciplines. and poorly designed mortgage  Consumer Finance 241 . or make good decisions. For some researchers. In his economics textbook. Conversely. business practice and public policy below in the Future Issues section. analyze it. however. If there are meaningful conflicts of interest between businesses and consumers. FUTURE ISSUES 1. For others. regulations. and managing risk functions is complicated. this sector is merely a convenient laboratory for studying other phenomena (e. political scientists. Finally. For personal use only. examin- ing corporate governance in the mutual fund industry). and legal scholars who seek to understand household decision making. oxen. and inform. I list some issues where future research might be able to learn from. The understanding of how consu- mers and businesses behave should inform policymakers. and nonfinancial elements. 2009. This review demonstrates the importance of consumer finance and the work of financial economists. and borrowing by consumers can fuel. The multidisciplinary nature of consumer finance problems makes them exciting. saving.annualreviews. whether it is acting in the best interests of consumers and whether it can be delivered in a better way.1:227-247. the primary research focus is to understand how households. as spending. borrowing. by Indian Institute of Technology . also requires considerations of industrial organization. or limitations in the capacities of consumers to search for information. The law of one price holds that two things with the same payoffs will have the same value. effort. an economy. businesses. and risk. the consumer’s decision is made in the context of a web of relationships with businesses. affect. the failure to carefully understand consumer financial decisions can lead to the problems of insufficient retirement savings. Downloaded from arjournals. To understand the economic efficiency of the consumer finance sector. but requires substantial boundary spanning. Mankiw (2009) notes that the word economy comes from the Greek word oikonomos. Consumer finance must understand how consumers should and do choose among their financial alternatives. industrial organization economists. macroeconomists must be concerned with the consumer sector. Fin.

Downloaded from arjournals. What skills. perhaps combined with geo-data. is among the least explored topics in consumer finance.g. and what impact might this have on decision making? 2. and consumption? What is an optimal level of leverage for a household? Is there a difference between leverage taken on for asset purchases versus current consumption? What is the optimal set of bank- ruptcy or loan modification rules to help current families in distress fairly and efficiently. Offering sensible defaults can dramatically change behavior. or alternatively fun or exciting. but also establish appropriate incentives for behavior? 4. apart from investment risk aversion. Research by Prelec & Simester (2001). by Indian Institute of Technology . Can households Annu. and mech- anisms to cope with risk? Risk products tend to be marketed individually.d2dfund. Agarwal et al. Financial decision making. one can separate asset allocation and security selection decisions. Defined contribution plans leave much of the decision about how much to save for retirement—and how to invest it—in the hands of individuals who may be unwilling or unable to make wise choices. or Cole et al. etc. 2008). determine an overall level of risk protection and separately consider how this bundle might be allocated among different products? Shiller (2004) has taken a leading role in advancing new risk-management contracts for housing.annualreviews. Rev.1:227-247. to support savings (Tufano & Schneider 2008)? 5. 2007. rather than as a portfolio related to households’ overall risk profiles. provide a better understanding of consumer decision making? Budgeting is tedious. but critical for healthy household functioning. What is the optimal amount of short-term savings for households? What instruments are appropriate for this type of savings? Can it be made automatic. Managing risk. Can we create a modern version of defined benefit plans? Short-run or rainy-day saving is the primary savings goal for the bottom quintiles of the U. a non- profit research and development firm that designs and tests financial innovations to serve 242 Tufano . Saving and investing. I am the co- founder and Chairman of Doorways to Dreams Fund (http://www. among others. Consumers need to make a bewildering array of financial decisions.New Delhi on 08/22/10. households have high levels of borrowing and low levels of savings. Econ. finds that easy access to credit affects spending behavior and willingness to pay. What is a useful measure of a household’s current level of risk—its ability to bear financial shocks. information. For personal use only. savings. payment systems (cards and mobile or m-banking) provides researchers with microtransaction data (e. How has the easy access to credit through credit cards and home equity products changed household leverage. Fin. In investing. population. Borrowing and credit. Can this information.S. 2009. Is it possible to create better risk-management products for families? 3. Can electronic payment systems facilitate real-time budgeting. or advice do consumers need to make better decisions? What is the best way to deliver these skills? What is the potential for delivery of financial education through new media and channels (financial entertainment)? DISCLOSURE STATEMENT I am the co-organizer of the NBER Working Group on Consumer Finance. Household risk. Where else can this technique be applied? Consumers will need to make some financial decisions in settings where automatic features may be infeasible.

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Data can be found at http://research. Fin.annualreviews. Mortgage Debt is the ratio of mortgage liability to household real estate values. Rev. For personal use only. Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) and represents the ratio of personal saving to DPI.stlouisfed.6).New Delhi on 08/22/10.5 1959Q1-2009Q1 (1959 = 1) by Indian Institute of Technology . 0. and savings rate (0. mortgage debt (2.2).1:227-247. 2009. The savings rate is based on the U.0 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 195 196 196 196 196 196 197 197 197 197 197 198 198 198 198 198 199 199 199 199 199 200 200 200 200 200 Liabilies/Assets Mortgage Debt Consumer Debt Savings Rate Figure 1 Consumer debt and savings rates.2).org  Consumer Finance C-1 . Downloaded from arjournals.5 0. 2. www.5 2.7).txt. Ratios as of 2009 Q1 were as follows: Liabilities/assets (2. consumer debt (1. Debt data are from the Federal Reserve’s Flow of Funds for households and non-profits. Econ.0 1. Consumer Debt is the ratio of consumer revolving and non-revolving debt to disposable personal income (DPI).0 Annu.

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