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Households’ use of long-term finance

Claudia Ruiz's picture

This post is part of a series highlighting the key findings of the Global Financial Development Report 2015 | 2016: Long-Term Finance. You can view the entire series at gfdr2015.

The second part of Chapter 2 of the 2015 Global Financial Development Report examines the use of long-term finance by households. The section first discusses the main reasons that households use long-term finance products, while highlighting the risks inherent to their use. Making use of recent data initiatives, it then shows how usage of long-term finance varies substantially both across and within countries, and then outlines a set of policy recommendations that can help develop and promote long-term finance markets.

Why would households use long-term finance? And what are the risks they can incur?

Long-term finance offers households various tools to achieve their changing objectives throughout their life-cycle. Products such as pensions, insurance, or annuities can help households prepare for retirement, smooth their life cycle income, and insure against various life cycle risks. Student loans or mortgages can make lumpy but potentially high-yield investments affordable to households. Long-term savings instruments can allow households to accumulate and reap term premiums.

Even though borrower and saver households can benefit from long-term finance products, their usage can also entail substantial risks. Lack of transparency and proper consumer protection can lead households to make costly mistakes. Consumers are often marketed financial instruments that they do not understand and may be unable to service. Financial providers may have incentives to exploit shortcomings in understanding that could lead to substantial errors in the financing choices of households.

Low levels of financial education and financial awareness may also restrain households from using financial products or from managing them correctly (Hastings and Tejeda-Ashton, 2008; Lara-Ibarra, 2011; Cull and others, 2014). This is especially true in the case of mortgage contracts, which are one of the most important financial contracts that households enter into. Several studies find that households, particularly those that are less-educated and lower-income, commonly misunderstand mortgage contracts.[1]

Recent literature on psychology and finance also highlights the role of behavioral biases in shaping households’ financial decisions. As the 2015 World Development Report discusses, understanding these behavioral biases and how they influence financial choices allows for better tailored and more effective policies, such as financial education interventions, automatic enrollment systems, or electronic reminders.

Recent years have shown us that government policies to promote greater participation of households in long-term finance may backfire, as in the case of the U.S. subprime mortgage crisis. As discussed in the previous GFDRs (2013, 2014), a key contributing factor in the subprime mortgage crisis in the U.S. was the overextension of credit to non-creditworthy borrowers and the relaxation in mortgage-underwriting standards. As a consequence, many homeowners in the U.S. took out mortgages exceeding their means.

How does usage of long-term finance vary across and within countries?

Long-term financial markets, such as mortgage and insurance markets, are severely limited in many countries. In the case of housing finance, mortgage depth is less than 10 percent of GDP for most countries and only a few countries—such as Denmark, Switzerland and the Netherlands—have mortgage debt higher than 80 percent (Badev and others, 2013). Similarly, in 50 percent of countries, less than 4 percent of adults have an outstanding loan to purchase a house (Figure 1).
 

Figure 1. Frequency of depth and penetration of mortgage markets


Cross-country studies find a strong association between stable macroeconomic conditions in a country, such as low inflation, and the development of mortgage and insurance markets. The institutional framework of a country is also related to these markets’ development. For instance in the insurance sector, private ownership is found to foster the sector’s growth, even though in many countries the state is a major player in the sector. A supportive legal framework and developed credit and bond markets also enhance the growth and development of the sector. Similarly, government-owned banks and regulatory restrictions on banks’ real estate activities are found to be negatively related to both the depth and penetration of mortgage markets (Badev and others 2013, Feyen and others 2011). Additionally, studies find a strong positive association between the development of housing finance and stronger creditor and legal rights for borrowers and lenders in the form of collateral and bankruptcy laws.

But even within a country, individuals with higher income and more education are more likely to use long-term financial instruments as either savers or borrowers. As discussed in Chapter 2, lack of financial education, product transparency, and consumer protection may hinder the use of financial products across the population.

What policies can governments implement to develop and promote long-term financial markets for households?

Government policies to promote long-term finance for households should focus on addressing market failures, removing policy distortions and maintaining a stable macroeconomic environment, promoting competitive and stable financial institutions and markets through introducing laws and policies for healthy entry, exit, and regulation as well as a strong institutional environment for contract enforcement.

In regards to financial education and awareness, evidence favors financial education interventions that exploit more innovative mechanisms to deliver information. New attempts to convey experiential, rather than conventional learning may provide useful delivery channels to reach larger audiences, such as the entertainment media interventions. Interventions that aim at covering too many topics in classroom settings tend to achieve little. Studies agree that financial concepts are best taught during what are known as teachable moments.
Regulators should also promote product transparency and consumer protection in the financial market. Financial products, particularly long-term ones, can be overwhelmingly complex instruments for users. This, together with incentives from financial providers to direct customers to products that are more profitable to them, could lead households to make costly financial mistakes. Product transparency can raise the quality of the information available to consumers.

Other interventions such as default enrollment and reminders could offer practical remedies to the incidence of financial mistakes. Insights from behavioral economics suggest that these instruments may help reduce behavioral problems such as over borrowing or under saving. Given the size of the effects that studies find with default enrollment, countries such as the U.S. have even facilitated the automatic enrollment of workers into pension plans.

References

Badev, Anton, Beck, Thorsten, Vado, Ligia and Simon Walley, 2013, “Housing Finance Across Countries: New Data and Analysis”, World Bank.

Bucks, Brian, and Karen M. Pence. Do Homeowners Know Their House Values and Mortgage Terms? Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2006.

Campbell, John Y. "Household finance." The Journal of Finance 61.4 (2006): 1553-1604.

Cull, Robert, Gan Li, Nan Gao and L. Colin Xu. 2014. “Household Access to and Costs of Finance: Evidence from a Representative Chinese Household Survey.” Mimeo, World Bank.

Feyen, Erik, Rodney Lester, and Roberto Rocha. "What Drives the Development of the Insurance Sector?" (2011).

Hastings, Justine S., and Lydia Tejeda-Ashton. Financial literacy, information, and demand elasticity: survey and experimental evidence from Mexico. No. w14538. National Bureau of Economic Research, 2008.

Lara-Ibarra, Gabriel. "Information Framing and Retirement Management Decisions: Evidence from a Field Study in Mexico." The 2011 Annual Meeting of the Academy of Behavioral Finance & Economics. 2011.

World Bank. 2014. Global Financial Development Report 2014: Financial Inclusion. Washington, DC: World Bank.

World Bank. 2013. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. Washington, DC: World Bank.

World Bank Group. 2015. World Development Report 2015: Mind, Society, and Behavior. Washington, DC: World Bank.

 
[1] By comparing lender-reported data with household-reported information, Bucks and Spence (2007) find that households that have adjustable rate mortgages, which tend to be more complex mortgage contracts, underestimate the amount by which their interest rates can change, and in general are not familiar with the terms of their contract. Campbell (2006) also shows that in the U.S., many households fail to refinance their mortgages during periods of declining interest rates.