Selling dreams: Entrepreneur optimism and collateral use in financial contracting

Abstract

Entrepreneurs seeking credit are prone to understating the risks they face and adopt too optimistic a view of their future prospects in order to reduce the anxiety involved with high-stakes, long-term ventures. This tendency exposes them to predatory lending practices that are detrimental in material terms, potentially justifying borrower protection policies on paternalistic grounds. We model borrowers overoptimism in credit markets where strategic profit-maximizing lenders design contracts that shape borrowers' incentives to appraise their projects. Borrowers are wishful thinkers and optimally bias their perceived probability of having a successful project in light of the anticipatory utility benefits of being overoptimistic and the cost of overoptimism that arises from impaired decision-making. In a monopolistic setting, we predict that loan terms are predatory and harm deluded borrowers in material terms when the borrower's risk is observable. When the risk is not observed, incorporating wishful thinking modifies the predictions of classical screening models: separating risks requires giving up a larger rent to high-risk borrowers and, consistent with empirical evidence, lenders may relinquish attempts to separate types and offer pooling contracts that feature positive collateral requirements and overoptimism. The case for paternalistic protection does not hold: the behavioral trait of borrowers increases their material payoff rather and does not expose them to predation. In competitive markets, the tendency towards optimism benefits high-risk borrowers and exacerbates cross-subsidization from low- to high-risks, and can also lead to pooling equilibria. In line with US lending market conditions before the financial crisis, competitive markets are more likely to give rise to overoptimism and collateralized loans to high-risk borrowers when credit is cheap and entrepreneurial profits are high.