Behavioral Economics and its Impact on Credit Decision Making

Behavioral economics is a field of economics that has changed the fundamentals of looking at human behavior. It makes use of insights from human psychology, judgment, decision making and economics to provide a more accurate way of understanding human behavior in terms of credit.

Though behavioral economics dates back to the 1950s it's relatively spoken a lot more now in the present times. A huge credit for the rise of Behavioral economics goes to Richard Thaler, an American economist who recently won the Nobel Prize in Economic Sciences. Also considered as the father of behavioral economics, Thaler has been highly influential in inspiring scholars from all over the world to research and understand how and why people behaved in a particular manner. His contributions alone have built a bridge between the psychological and economic analyses of individual decision-making. The empirical findings and theoretical insights of his research have been instrumental in the creation and rapid expansion in the field of behavioral economics.

One of his most famous and prize-winning concept in economics is 'Nudge theory'. The idea about nudge is that a relative policy shift done subtly encourages people to indulge in those decisions that are in their broad self-interest.

“By knowing how people think, we can make it easier for them to choose what is best for them, their families and society,” - Richard Thaler, from the book 'Nudge' written by Cass Sunstein and Richard Thaler in 2008.

Click here to view his award-winning research on 'Integrating Economics with Psychology' published by the Nobel Prize committee.

Difference between Traditional Economics and Behavioral Economics

The basic assumption made in traditional economics is that they consider people to be perfectly rational, patient and objective enough to know what makes them happy and take decisions in maximizing their happiness.

On the other hand, the aim of behavioral economists is to create models that account for the fact that people are impatient, they procrastinate in making decisions when they are hard and sometimes they even avoid in making those decisions altogether. They talk more about how the human psychology is imperfect and how these imperfections could make an impact on the economic decisions of people.

Impact of Behavior on Lending

Most often we see that the behavior of individual changes based on those factors that are not really finance related. The launch of the Goods and Services Tax (GST) in India is a fine example of this instance. Before the launch of GST, a lot of ecommerce businesses and brick & mortar owners held PreGST sale offers and they witnessed a huge rise in sales figures despite it being an offseason.

Similarly, people in Chennai would buy more ration during the flood emergency declaration based on the impact of the last few years that the flood had in the State. This behavior, in turn, impacts their overall savings.

Thus we can see that external factors are highly responsible for changing a person's behavior and in a lot of ways change the way people save. This impacts the overall finances of an individual and makes decisions harder.

Behaviour for Finance and its Impact

The activities we conduct on a day to day basis are primarily driven by behavioral patterns. The same patterns also guide our financial actions. Ever wondered why some people are good at saving money or how some traders/investors are always successful in predicting the stock market and on the other hand, some people are unable to break even or manage to save a penny for themselves.

For instance, any person can be classified as a Spender or a Saver. Typically Spenders are riskier in terms of finances because they don’t plan ahead. Another example is someone who is living with their parents. Traditionally we see that living with elders in India can have a positive impact on finances. However, in a lot of cultures, staying with parents after working age is often looked down upon which can create a negative outlook and behavior.

Behavioral finance is that field of economics that attempts to combine behavioral and cognitive psychological theory with traditional economics and finance to provide explanations for why people make such irrational financial decisions.

The way people think and feel has a huge impact in the way they behave while making financial decisions. These influences can be identified and categorized as behavioral biases. Behavioral biases can be further classified into two primary categories: Cognitive Biases and Emotional Biases.

Cognitive biases are the result of incomplete information or the inability of a person to analyze or synthesize information correctly. Gambler's fallacy is a common form of cognitive bias.

Emotional biases are the result of some spontaneous actions that affect the way an individual perceives information. These biases are deeply ingrained in the psychology of people and are harder to overcome in general. Some common forms of emotional biases include Loss Aversion, Overconfidence, Self-control, Status Quo, Endowment, Regret Aversion and Affinity.

Failure by Banks and Financial Institutions to Think about Behavior

Last month, HDFC Bank which is India's third-largest lender by assets, reported a whopping 52% surge in its toxic loan pile for the quarter ended September and a 68% jump in provisions towards them. In another instance, almost one-fifth of all public sector bank loans are stressed, and over one-tenth are non-performing i.e. the payments are not coming.

"If banks disclosed in their accounts the full extent of bad debts, the losses would wipe out their equity capital." - Times of India 

The failure of banks in looking at the behavioral patterns has a serious impact on credit lending. Even though they have started looking at alternate ways of analyzing data, it still is not enough to capture behavior.

InsigniQ's approach to Behavior

The behavioral aspect of a consumer is the core of InsigniQ calculations. We believe that the financial history only tells one part of the story and the consumer defaults are more about cash flow problems, financial naiveté or fraud.

We deal with all three of the above problems in different ways and understanding the behavior of the customer is very important for the second and third case. Thus, the models analyze the impact of different conditions on the financial behavior of the customer.

A good example of this is the recent Demonetization effect in India. During the period, a lot of consumers were tied for cash and saw an increase in the spending. This would not categorize the consumer as a good or a bad borrower, but if we don't look at their behavior in a particular instance of time, it is very hard to make a good financial assessment.

A lot of emphases has been given on the behavior of the consumer and studies in neuroeconomics highlight these issues as well. However, there are still no viable tools out there which take these theories and give a comprehensive tool-chain for analysis. This becomes even more important in countries like India where the concept of credit is still in its infancy.

It is really rewarding to see that Dr. Thaler's work has been recognized and we hope to see more people evaluating user behavior in terms of retail loans.