Noncognitive Abilities and Financial Delinquency: The Role of Self‐Efficacy in Avoiding Financial Distress

• Author: CAMELIA M. KUHNEN,BRIAN T. MELZER
• Published date: 01 December 2018
• DOI: http://doi.org/10.1111/jofi.12724
• Date: 01 December 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 6 •DECEMBER 2018

Noncognitive Abilities and Financial

Delinquency: The Role of Self-Efficacy

in Avoiding Financial Distress

CAMELIA M. KUHNEN and BRIAN T. MELZER∗

ABSTRACT

We investigate a novel determinant of financial distress, namely, individuals’ self-

efficacy, or belief that their actions can influence the future. Individuals with high

self-efficacy are more likely to take precautions that mitigate adverse financial shocks.

They are subsequently less likely to default on their debt and bill payments, especially

after experiencing negative shocks such as job loss or illness. Thus, noncognitive abil-

ities are an important determinant of financial fragility and subjective expectations

are an important factor in household financial decisions.

FINANCIAL DECISIONS REQUIRE INDIVIDUALS to consider intertemporal trade-offs in

an uncertain environment. For example, a prospective saver evaluates whether

the expected benefits of precautionary savings outweigh the cost of reducing

consumption today. A borrower struggling to repay a loan compares the poten-

tial benefits of avoiding default to the costs of reducing spending or getting a

second job today to avoid default. Or a middle-aged couple evaluates whether

insuring their long-term care is worthwhile at the expense of the insurance

premium. In each of these choices, the agent considers a trade-off involving an

action that is costly today and has an uncertain effect on the distribution of

future outcomes. Therefore, individuals’ subjective perception of this trade-off

is likely to influence their decisions.

Building on this idea, we examine the effect of subjective beliefs on finan-

cial behavior. People vary in their self-efficacy, or belief that their actions or

effort can influence the future. A growing economics literature on noncognitive

skills shows that self-efficacy is important for educational attainment and la-

bor market success (e.g., Heckman, Sixrud, and Urzua (2006) and Lindqvist

∗Camelia Kuhnen is at the Kenan-Flagler Business School at the University of North Carolina

at Chapel Hill and NBER. Brian Melzer is at the TuckSchool of Business at Dartmouth College and

the Federal Reserve Bank of Chicago. We thank Wei Xiong (the Editor); two anonymous referees,

as well as Gadi Barlevy; TomDeLeire; Benjamin Keys; Lindsey Leininger; seminar participants at

UC Berkeley,the University of Virginia, NC State University,University of Colorado – Boulder, and

participants at the AEA 2014 meeting, the 2014 FDIC Consumer Research Symposium, and the

2015 University of Alberta Frontiers in Finance conference for helpful comments and discussion. All

remaining errors are ours. This paper represents the views of the authors and does not necessarily

reflect the opinions of the Federal Reserve Bank of Chicago or the Federal Reserve System. Wehave

read the disclosure policy of the Journal of Finance and have no conflicts of interest to disclose.

DOI: 10.1111/jofi.12724

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2838 The Journal of Finance R

and Vestman (2011)). In this paper, we investigate whether self-efficacy also

matters for financial choices, such as defaulting on debt, setting aside emer-

gency savings, and insuring against risks.

Why might self-efficacy matter for financial decisions? Self-efficacy influences

an individual’s perception of the benefits from acting. Consider a borrower at

risk of default. His efforts to avoid default are immediately costly and may be

ineffective. If he has low self-efficacy,he will perceive his sacrifices to have little

effect on his financial future and defaulting will appear optimal. By contrast,

an individual with high self-efficacy will believe his actions can reduce his

chance of default, and thus may choose to sacrifice consumption or work longer

hours today. A simple way to conceptualize the role of self-efficacy is within

an effort choice problem, where providing effort is costly but increases the

chance of avoiding a poor outcome in the future. People with lower self-efficacy

foresee less marginal benefit from exerting effort or making sacrifices today,

so they choose to spend less effort, which in turn increases the likelihood of a

bad outcome. Within this framework, we would expect individuals with lower

self-efficacy to have higher rates of financial distress, to spend less effort to

prepare for potential adverse shocks, and upon encountering such shocks, to

become delinquent at higher rates.

Drawing on these insights, we use data from the National Longitudinal Sur-

vey of Youth (NLSY) to test whether self-efficacy affects financial choices and

outcomes. Our main analysis uses the NLSY Child and Youth panel, which

follows survey participants from early childhood through adulthood. The sur-

vey tracks individuals’ cognitive and noncognitive abilities, including their

self-efficacy, from an early age. Once participants move into adulthood, they

also report their labor and financial market experiences. The survey’s finan-

cial variables include measures of borrowing, delinquency on loans and bills,

bankruptcy and asset repossession, precautionary saving, and health insur-

ance take-up. The sample includes roughly 6,000 younger adults (ages 21 to

41) between 2010 and 2014. We extend the analysis by using the NLSY 1979

panel (the parents of those in the Child and Youth panel) to study additional fi-

nancial choices—credit applications and denials, retirement preparations, and

purchases of long-term care insurance—among older adults (ages 47 to 56).

We document a strong negative correlation between self-efficacy and finan-

cial distress. Individuals with high self-efficacy, measured earlier in life, are

subsequently less likely to default on outstanding loans or fall behind on bill

payments than their peers with low self-efficacy. In turn, they are also less

likely to experience foreclosure, asset repossession, or personal bankruptcy. In-

dividuals with more self-efficacy also display greater use of traditional credit

products such as credit cards, automobile loans, and mortgages, and are less

likely to be rejected for credit and to turn to high-cost payday loans. The mag-

nitudes of these effects are meaningful in comparison to sample averages. A

one-standard-deviation increase in self-efficacy corresponds to a 1.9 percent-

age point decrease in the probability of loan default, a 0.5 percentage point

decrease in the probability of foreclosure, repossession, or bankruptcy, and a

0.7 percentage point decrease in the probability of borrowing through payday

Noncognitive Abilities and Financial Delinquency 2839

loans. In proportion to sample averages, these differences represent declines of

11% to 14% in the rates of default and payday borrowing.

We use the detailed data of the NLSY to explore why self-efficacy dis-

plays a negative correlation with financial distress. We first rule out poten-

tial differences—in ability, preferences, education, earnings, net worth, and

parental support—that may confound the effects of self-efficacy. We find that

self-efficacy remains negatively correlated with financial distress after condi-

tioning on measures of cognitive ability, risk tolerance, and time preference.

As documented in prior studies, both education and earnings rise with self-

efficacy.Nevertheless, self-efficacy remains strongly negatively correlated with

distress after controlling for educational attainment and income. We also ex-

amine sibling groups, for whom the NLSY collects data on each individual,

to test whether parental support accounts for differences in self-efficacy and

delinquency. In models with sibling group fixed effects, which limit the iden-

tifying variation in self-efficacy to differences across siblings, we continue to

find a strong negative correlation between self-efficacy and financial distress.

This finding implies that shared family support does not confound self-efficacy

in our main analysis. We also show that all of our findings for self-efficacy are

robust to controlling for further differences in noncognitive ability,as measured

by the “Big-Five” personality traits. Finally, we show that lower self-efficacy

individuals are not defaulting more because they are more indebted. As noted

earlier, these individuals are in fact less likely to borrow through traditional

credit market products.

Consistent with our theoretical motivation, we find that individuals with

high self-efficacy are more likely to take precautionary actions to avoid finan-

cial distress. They are more likely to set aside emergency savings, purchase

insurance, and plan for retirement. Roughly one-third of the respondents in

the NLSY Child and Youth panel maintain emergency savings sufficient to

cover three months of expenses. Our estimates indicate that a one-standard-

deviation increase in self-efficacy raises the likelihood of emergency savings by

2 percentage points, or 6%, relative to the sample average. This relationship

persists over the life-cycle, as the older adults in the NLSY 1979 panel also

set aside emergency savings at higher rates when they have high self-efficacy.

Individuals with high self-efficacy are also more likely to obtain insurance cov-

erage and plan for retirement. Among younger adults, the purchase of health

insurance increases with self-efficacy, even after controlling forincome and the

availability of employer-sponsored coverage. Among older adults, purchases of

long-term care insurance and preparation for retirement (e.g., visiting with a

financial planner) increase with self-efficacy, even after controlling for income

and net worth.

Individuals with high self-efficacy are not only more financially prepared, but

also more resilient when facing income and health shocks. Individuals with low

self-efficacy who experience a job loss or health problem default on their debt

and bill payments at very high rates—more than 50% higher than the rate

of those who remain employed and healthy. By contrast, individuals with the

highest self-efficacy experience little to no increase in default after an income