Consumer Finance - Peter Tufano

ANNUAL 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
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Annu. Rev. Financ. Econ. 2009. 1:22747 First published online as a Review in Advance on August 28, 2009 The Annual Review of Financial Economics is online at financial.annualreviews.org This articles doi: 10.1146/annurev.financial.050808.114457 Copyright 2009 by Annual Reviews. All rights reserved 1941-1367/09/1205-0227$20.00
Key words
household finance, personal finance, consumer behavior, behavioral economics, behavioral finance, retail financial institutions, functional perspective
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
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.
JEL: Journal of Economic Literature
AFA: American Finance Association
A FUNCTIONAL DEFINITION OF CONSUMER FINANCE

What is consumer (or household) finance? Campbell (2006, p. 1553) argues that household finance asks how households use financial instruments to attain their objectives.
1
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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SCF: Survey of Consumer Finances
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(http://www.federalreserve.gov/pubs/oss/oss2/2007/scf2007home.html), more than 90% of Americans have a transaction (checking) account. The remainder presumably use some combination of cash or alternative payment systems (e.g., check cashers, money orders).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.4 Seventy-seven percent of households report having debt (of any kind). Generally speaking, policy concerns often focus on the fraction of Americans in the most precarious financial situationsparticularly those without savings or health insurance, or with inadequate levels of both. To deliver payment services, manage risk, and move funds backward and forward in time, a financial system must also deliver a set of ancillary functions: Pooling. Small transactions (assets or liabilities) can be combined to create portfolios that facilitate economies or diversification. Mutual funds, for example, allow investors to buy shares in a pool, giving them access to economies of scale, diversification benefits, and professional management and administration. Pooling is also exemplified through securitization, as well as through all intermediated businesses, and is present in most borrowing and lending transactions (Sirri & Tufano 1995). Providing financial information to facilitate decision making. Consumers gather information and make financial decisions with the help of formal and informal financial education, marketing activities of product vendors, news from the financial press, advice from brokers and advisors, disclosures mandated by government bodies, and advice delivered by a persons social networks. The current interest in behavioral finance deals primarily with the quality of household-level decision making, as well as those mechanisms that lead to better decisions. Government policies often attempt to improve the process of decision making by setting disclosure requirements, 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. Consumers can make decisions by themselves, or delegate these choices to others, such as brokers, financial advisors, or bank trust departments. Dealing with information asymmetries and incentive conflicts. In all consumer businesses, at least two, but often three, parties contract with one another formally or informally. Having multiple parties involved leads to potential conflicts of interest, which each partyas well as governmentseeks to mitigate. Consumers address conflicts with others when selecting the firms and people with whom they do business, as well as through the structure of both explicit contracts and implicit arrangements in social networks. Businesses use a similar set of tools. In addition, both groups use the threat of litigation both to forestall incentive conflicts and to redress them. Governments play a key role in incentive conflicts by regulating certain actions, as well as by establishing guidelines for behavior embodied in the legal system. For example, the legal concept of fiduciary duty was established by society to preemptively address incentive conflicts. A fiduciarys duty of loyalty is intended to establish norms for behavior between certain providers of financial goods and services and their customers, namely
3 4
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.
THE SCALE OF CONSUMER FINANCE

With such an expansive definition, it should be clear that consumer finance is a substantial element of the financial sector. Using the United States as an example, one can get a sense of the magnitude of the consumer finance sector as a driver of the economy.6 The Federal Reserves Flow of Funds data are a commonly used source for aggregate statistics (http://www.federalreserve.gov/releases/z1/). According to the latest numbers available as of this writing (2009 Q1), households7 held $64.5 trillion in assets, with 37.5% ($24.2 trillion) of these funds held in tangible assets (mostly real estate) and $40.3 trillion in financial assets. In aggregate, households held $14.1 trillion in liabilities, mostly home mortgages ($10.5 trillion) and consumer credit ($2.5 trillion, primarily in credit cards). Corporations are central to financial economics. Surely, businesses produce goods and services, and provide employment. Yet in sheer size, the household sector dominates the corporate sector. Corporate (nonfarm, nonfinancial) businesses held only $27.3 trillion in
5 Large strands of the financial economics literature are concerned with these conflicts. For example, the classic book by Berle & Means (1991 [1932]) examines the implications of the separation between ownership and control. 6 Throughout the review, I use U.S. data to illustrate various points, not to suggest that consumer finance activities are less important elsewhere, but to use a consistent set of data. 7 Technically, this information refers to households and nonprofit organizations, as the two are considered a single sector in the Flow of Fund calculations due to data limitations. Nonprofits account for 5-7% of assets and liabilities, thus the figures largely reflect the household sector (see Teplin 2001).
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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?
A SPECULATIVE HISTORY OF SCIENCE: THE SPLIT OF CONSUMER STUDIES FROM BUSINESS STUDIES
Every one of the top 20 U.S. MBA programs offers at least one course on corporate finance; however, as of 2008 only two MBA programs offer explicit courses on consumer or household finance.10 When addressed, consumer finance typically is an ancillary component of related offerings. For example, courses on banking and financial institutions are offered by 14 schools, 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.corporate.visa.com/av/pdf/Visa_Corporate_Overview.pdf (data as of September 2008) and http://investorrelations.mastercardintl.com/phoenix.zhtml?c=148835&p=irol-reportsannual (data as of December 2008). Figures represent all card transactions worldwide. 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. 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. 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.
14
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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.
A BRIEF TAXONOMY OF RESEARCH IN CONSUMER FINANCE

Without a central home in business schools or economics departments, research on consumer finance is disbursed among economics, finance, psychology, sociology, consumer sciences, and the law. Although the different groups are interested in similar phenomena, they approach them with different languages and tools. Given the breadth of the field and related disciplines, this review is insufficient. Wherever possible, I cite survey pieces that cover portions of the field. With these risks in mind, I divide the studies by the primary decision maker considered by the work: the consumer, the financial institution, the government, or a combination of these players.
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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NPV: net present value
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,
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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).
The Role of Government

Although government plays an important role in regulating many parts of the economy, consumer finance receives extra attention. Beyond ensuring the systems safety and soundness, federal and state banking regulation is designed to protect consumer interests. Similarly, the U.S. Securities and Exchange Commission (SEC) mission, in part, is investor protection. In intent, but perhaps not in practice, some consumer financial businesses are more closely overseen than other businesses.16 For example, some financial institutions that are entrusted with the money of others sometimes owe fiduciary duties of loyalty and care. Loyalty refers to putting the clients interests ahead of those of the fiduciary, and care refers to the requirement to use reasonable standards of diligence (for an extensive treatment of this topic, see Frankel 1998, 2006, 2008). Legal scholars and economists have opined about the reasons for these duties and other rules, as well as how market forces may make them irrelevant. These debates revolve around circumstances in which caveat emptorcombined with disclosure and competitionis appropriate, and when stronger rules and regulation are required. For a
SEC: U.S. Securities and Exchange Commission
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.
Multi-Party Field Interventions

The taxonomy above categorizes research based on the relevant decision maker, but any study of consumer finance tends to involve multiple parties (consumers, businesses, and the government). The taxonomy also does not differentiate by research method. 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. This testing can be structured in standard control-treatment fashion or as randomized field experiments, 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). Within consumer finance, these studies apply behavioral economics to induce behavior changes, so-called nudges in Thaler & Sunsteins (2008) language. In a series of influential papers, coauthors Choi, Laibson, Madrian, Metrick, and others (Beshears et al. 2008, 2009; Carroll et al. 2009; Choi et al. 2003, 2004a,b, 2009a,b; Laibson et al. 1998) intervene in employment settings to demonstrate that automatic enrollment features can dramatically increase participation in workplace savings plans. This work led to changes in the pension law to facilitate auto-enrollment programs. Thaler & Benartzis (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, and contributed to the IRSs adoption of Form 8888 to simplify saving part of a refund. Tufano (2008) studies the offer of a simple savings product at tax time, and implications for savings bond policy. Duflo and colleagues (2005) work on the incentive impacts of match funding measured the effect of increasing match rates on tax-advantaged savings. Ashraf and colleagues (2006) work on commitment savings demonstrates that making savings less liquid can increase the level of household savings. Karlan, Zinman, and others field experiments in South Africa disentangle moral hazard and adverse selection effects by borrowers and the implications of marketing (Bertrand et al. 2008, Karlan & Zinman 2008). Consumer finance is amenable to action research, offering laboratories that can generate meaningful samples to inform business practice and public policy.
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THE STATE OF CONSUMER FINANCE

Researchers in economics and finance study the allocation of scarce resources. In his economics textbook, Mankiw (2009) notes that the word economy comes from the Greek word oikonomos, meaning one who manages a household. Consumer finance studies these household managers and the financial choices they make. This review demonstrates the importance of consumer finance and the work of financial economists, psychologists, sociologists, policy analysts, industrial organization economists, political scientists, and legal scholars who seek to understand household decision making. For some researchers, this sector is merely a convenient laboratory for studying other phenomena (e.g., examining corporate governance in the mutual fund industry). For others, however, at the core of the subfield, the primary research focus is to understand how households, businesses, and governments interact to deliver the financial functions required by consumers that enable them to allocate money, time, effort, and risk. The study of household payments, borrowing, saving, and managing risk functions is complicated. Consumer finance must understand how consumers should and do choose among their financial alternatives, and research should embrace neoclassical economics, psychology, sociology, law, and government policy. To understand the economic efficiency of the consumer finance sector, whether it is acting in the best interests of consumers and whether it can be delivered in a better way, also requires considerations of industrial organization, information economics, and technology. The understanding of how consumers and businesses behave should inform policymakers. If there are meaningful conflicts of interest between businesses and consumers, or limitations in the capacities of consumers to search for information, analyze it, or make good decisions, then laws and regulations play an important role. Finally, macroeconomists must be concerned with the consumer sector, as spending, saving, and borrowing by consumers can fuel, or depress, an economy. The multidisciplinary nature of consumer finance problems makes them exciting, but requires substantial boundary spanning. The emerging interest in the field represents a deeper openness by financial economists to insights from other disciplines. This openness acknowledges that utility maximization is not a mechanical exercise, but rather that consumer decisions reflect behavioral biases, affect, and nonfinancial elements. Furthermore, the consumers decision is made in the context of a web of relationships with businesses, laws, regulations, and social networks that shape the decisions and how they are perceived. The broad benefits of deeper study of consumer finance may be substantial. New research on consumer decision makingsuch as the work on automatic enrollmentpromises to dramatically change saving and spending behavior through better financial products and regulations. Conversely, the failure to carefully understand consumer financial decisions can lead to the problems of insufficient retirement savings, excess leverage, and poorly designed mortgage products. I list some issues where future research might be able to learn from, and inform, business practice and public policy below in the Future Issues section.
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
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2.
3.
4.
5.
payment systems (cards and mobile or m-banking) provides researchers with microtransaction data (e.g., Agarwal et al. 2007, or Cole et al. 2008). Can this information, perhaps combined with geo-data, provide a better understanding of consumer decision making? Budgeting is tedious, but critical for healthy household functioning. Can electronic payment systems facilitate real-time budgeting, and what impact might this have on decision making? Managing risk. Household risk, apart from investment risk aversion, is among the least explored topics in consumer finance. What is a useful measure of a households current level of riskits ability to bear financial shocks, and mechanisms to cope with risk? Risk products tend to be marketed individually, rather than as a portfolio related to households overall risk profiles. In investing, one can separate asset allocation and security selection decisions. Can households 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, heating, etc. Is it possible to create better risk-management products for families? Borrowing and credit. U.S. households have high levels of borrowing and low levels of savings. Research by Prelec & Simester (2001), among others, finds that easy access to credit affects spending behavior and willingness to pay. How has the easy access to credit through credit cards and home equity products changed household leverage, savings, 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 bankruptcy or loan modification rules to help current families in distress fairly and efficiently, but also establish appropriate incentives for behavior? Saving and investing. Defined contribution plans leave much of the decision about how much to save for retirementand how to invest itin the hands of individuals who may be unwilling or unable to make wise choices. 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.S. population. 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, or alternatively fun or exciting, to support savings (Tufano & Schneider 2008)? Financial decision making. Consumers need to make a bewildering array of financial decisions. Offering sensible defaults can dramatically change behavior. Where else can this technique be applied? Consumers will need to make some financial decisions in settings where automatic features may be infeasible. What skills, information, 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. 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
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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
1.0
0.5
0.0
199 9 200 1 199 5 198 5 198 7 198 3 198 9 197 5 196 7 197 1 196 1 195 9 196 3 196 5 196 9 197 3 197 7 197 9 198 1 199 1 199 3 199 7 200 7 200 3 200 5 200 9
Liabili es/Assets
Figure 1
Mortgage Debt
Consumer Debt
Savings Rate
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
Preface to the Annual Review of Financial Economics Andrew W. Lo and Robert C. Merton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 An Enjoyable Life Puzzling Over Modern Finance Theory Paul A. Samuelson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Credit Risk Models Robert A. Jarrow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 The Term Structure of Interest Rates Robert A. Jarrow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Financial Crises: Theory and Evidence Franklin Allen, Ana Babus, and Elena Carletti . . . . . . . . . . . . . . . . . . . . . . 97 Modeling Financial Crises and Sovereign Risks Dale F. Gray. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Never Waste a Good Crisis: An Historical Perspective on Comparative Corporate Governance Randall Morck and Bernard Yeung . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 Capital Market-Driven Corporate Finance Malcolm Baker. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 Financial Contracting: A Survey of Empirical Research and Future Directions Michael R. Roberts and Amir Sufi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Consumer Finance Peter Tufano . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 Life-Cycle Finance and the Design of Pension Plans Zvi Bodie, Jerome Detemple, and Marcel Rindisbacher . . . . . . . . . . . . . . 249 Finance and Inequality: Theory and Evidence Asli Demirguc-Kunt and Ross Levine . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
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 What Decision Neuroscience Teaches Us About Financial Decision Making Peter Bossaerts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383 Errata An online log of corrections to Annual Review of Financial Economics articles may be found at http://financial.annualreviews.org
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ANNUAL REVIEWS

JEL: Journal of Economic Literature

AFA: American Finance Association

A FUNCTIONAL DEFINITION OF CONSUMER FINANCE

SCF: Survey of Consumer Finances

THE SCALE OF CONSUMER FINANCE

A BRIEF TAXONOMY OF RESEARCH IN CONSUMER FINANCE

NPV: net present value

The Role of Government

SEC: U.S. Securities and Exchange Commission

Multi-Party Field Interventions

THE STATE OF CONSUMER FINANCE

Annual Review of Financial Economics

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