The misconception of the consumer as a homo economicus: a behavioral-economic approach to consumer protection in the credit-reporting system.

• Author: Osovsky, Adi
• Position: IV. The Implications of Consumers' Irrationality in the Credit-Reporting System through VI. Conclusion, with footnotes, p. 908-933 - Symposium: Credit Reporting and Credit Scoring

4. THE IMPLICATIONS OF CONSUMERS' IRRATIONALITY IN THE CREDIT-REPORTING SYSTEM

   1. Unawareness of Rights Under the FCRA

      In 1979, the Credit Research Center at Purdue University conducted a survey of California bank cardholders to assess their understanding of the function of CRAs. Only 37% correctly identified CRAs as record-keeping agencies and the study concluded that consumers' knowledge of CRAs was quite limited. (185)

      Since then, consumers' literacy has only slightly improved. In a national survey in 2005, the United States Government Accountability Office (GAO) found that consumers understood the basics of credit reporting and the dispute process, but not much more. (186) For example, many consumers did not know how long items remained on their credit reports or the impact their credit history could have on insurance rates and potential employment. (187)

      In 2008, a survey commissioned by the Consumer Federation of America and Washington Mutual Bank found that consumers still have a poor understanding of credit scores, although their knowledge has slightly improved over the years. (188) For instance, "[l]ess than one-third of Americans (31%) ... understand that credit scores indicate risk of not repaying a loan, rather than factors like knowledge of, or attitude toward, consumer credit." (189) In addition, "[m]any Americans fail to understand that one's credit score reflects only how [he or she] use[s] credit, not factors such as income and age." (190)

      The problem of financial illiteracy is enhanced by consumers' unawareness of basic rights associated with the credit-reporting system, as discussed in more detail below.

      1. Unawareness of the Right To Receive a Free Credit Report

         According to the GAO survey, less than half of consumers (47%) know that the new law entitles all consumers to request one free credit report per year. (191) The survey also showed that only "58 percent of consumers had seen their credit reports at some point in time and that 45 percent of this group had viewed them within the last year." (192) Of the 58 percent who said they had viewed their reports, "the largest percentage [48 percent] said that they had seen their reports because they were making a large purchase, such as a car or home, or were refinancing." (193)

         Such data shows that most consumers do not fulfill the monitoring task that the law has entrusted to them. This should not come as a surprise in light of the fact that most consumers are not even aware of their right to receive a free credit report. Unawareness, however, is not the only cause for the lack of consumer inspection of credit reports; the status quo bias is an important contributor too. Thus, "[w]hile the majority of consumers (86 percent) [in the GAO survey] said that they should check their reports periodically, only 61 percent of this group reported actually having seen their credit reports." (194)

      2. Unawareness of the Right To Dispute Errors for Free

         The GAO survey found that consumers knew they had the right to dispute information on their credit reports, but only "about one-third of consumers correctly responded that CRAs would investigate disputed information for free." (195) In addition, the survey found that only a small percentage (18 percent) had actually disputed inaccuracies at some point. (196)

         Unawareness and procrastination--results of the status quo bias--may explain these results, but another factor is the dispute process itself. It has been argued that the current dispute process does not involve real investigation. (197) Rather, it is an automatic procedure that discourages consumers from disputing errors. (198) In this process, the consumer's written dispute and any accompanying documents are reduced into a two- or three-digit code that the assigned agency employee believes best describes the dispute. (199) This code alone is sent to the furnisher by a computer message; the consumer's documents are not forwarded to the furnisher, and there is no human contact between the CRA and the furnisher. (200) The consumer's complaint is then investigated by the furnisher, only on the basis of the received code. (201) In fact, the furnisher simply confirms that the limited information in the CRA's computer message matches its records, and then verifies the disputed information to the CRA. Needless to say, CRAs blindly accept the furnisher's response, and do not conduct any further investigation on the consumer's behalf. (202)

         As demonstrated above, financial illiteracy, unawareness, and procrastination play a significant role in consumers' failure to monitor their credit reports and improve their accuracy. The next section will show how these factors and other consumer biases are exploited by the credit-reporting system via marketing lists.

   2. Exploiting Biases Through Marketing Lists

      In recent years, the utilization of credit history from CRAs' files has been very popular. Used by various retailers, prescreened solicitations have become an important source of new accounts for credit-card issuers. More than six billion solicitations were mailed in 2005 alone. (203)

      These solicitations, especially in the consumer-credit market, are considered a fertile ground for manipulation, as many firms seek to exploit consumers' biases. (204) Indeed, marketing lists from CRAs enable creditors to generate information and estimations about potential borrowers that even the borrowers do not necessarily know about themselves. Such information not only includes consumers' credit scores, but also their likely performance regarding a particular set of loan products, and whether they qualify for a better, cheaper loan. (205) As Duncan MacDonald, former general counsel of Citigroup Europe and North America, put it so well:

      No other industry in the world knows consumers and their transaction behavior better than the bank card industry. It has turned the analysis of consumers into a science rivaling the studies of DNA.... The mathematics of virtually everything consumers do is stored, updated, categorized, churned, scored, tested, valued, and compared from every possible angle in hundreds of the most powerful computers and by among the most creative minds anywhere. In the past 10 years alone, the transactions of 200 million Americans have been reviewed in trillions of different ways to minimize bank card risks. (206) Yet creditors are not required to reveal this information to the borrowers. (207) Nor are they required to offer the best and cheapest product that matches their borrowers' interests. This lack of information enhances consumers' biases, particularly overoptimism and self-control problems. Indeed, behavioral economists suggest that consumers underestimate how much they will borrow and overestimate their ability to pay bills in a timely manner. (208) As a result, many consumers are tempted by prescreened solicitations to pick a wrong product, a much more expensive product, or a product they do not really need.

      In light of these problems, the legislature has allowed consumers to opt out of marketing lists. However, a 2004 survey found that only about 20% of consumers were aware of their right to opt out of marketing lists. (209) In addition, only 20% of cardholders and 33% of noncardholders who were aware of such a right had placed their names on an opt-out list (meaning that approximately 4% to 6% of consumers had placed their names on an opt-out list). (210) This figure is similar to the "proportion of opt-outs indicated by a review of a large sample of [CRA] files at approximately the same time." (211) Interestingly, for consumers aware of their right to opt out, "a larger proportion of those with credit cards than those without (38 percent versus 14 percent) said that they had thought about placing their names on the opt-out list but had not yet done so." (212)

      Here too, overoptimism and the "other guy" effect have a major influence on consumers. Consumers may feel that their own finances are more adequately controlled than those of "other" consumers and that opting out is therefore unnecessary. (213) Indeed, evidence of such effect was found in the 2004 survey. "When asked ... whether they think that pre-approved offers of credit cards cause other people, in general, to use too much credit, about 85 percent [of respondents] said yes." (214) However, "[w]hen asked ... whether pre-approved offers have led them to use too much credit, only 15 percent" of respondents said yes. (215)

      As discussed in Part II.C, supra, these biases combined with CRAs' lack of incentives to protect consumers result in substantial economic harm to consumers. The next Part will explore possible solutions that may fit into the behavioral-economic model. Specifically, I will analyze two potential consumer-protection mechanisms: applying psychological tools for a better-designed system (libertarian paternalism) and enhancing consumer financial literacy. The behavioral-economic approach has yet to be applied to the credit-reporting system and will hopefully give new insights into problems that affect every consumer in the United States.

5. CONSUMER-PROTECTION MECHANISMS

   1. Consumer Protection Under the Policy of Libertarian Paternalism

      1. The Policy and Its Benefits

         Numerous economists and legal analysts are libertarians. They believe that people should be given as many choices as possible, enabling them to choose the one that suits them best. As a result, they oppose government intervention and are skeptical about nudging measures that they consider coercive and paternalistic. (216)

         Thaler and Sunstein argue that this antipaternalistic view is based on "a false assumption and at least two misconceptions. The false assumption is that people always ... make choices that are in their best interest." (217) As explained in Part III, supra, people sometimes fail to behave in their own best interests because of unawareness, incomplete information, self-control problems, or the...