Bounded Rationality and Use of Alternative Financial Services

Abstract

The increasing pervasiveness of high‐cost alternative financial services ( AFS ) has captured the attention of policymakers, consumer educators, and financial counselors. Using data from the 2009 to 2012 waves of the National Financial Capability Study ( NFCS ), this article investigates AFS borrowing behaviors through the lens of a boundedly rational choice framework, with an emphasis on overconfidence. Through repeated testing of isolated samples of individuals with characteristics that make them less likely to objectively need such products, the roles of actual (objective) and perceived (subjective) financial knowledge in the decision‐making process are explored. Consistent results indicate that individuals with lower objective financial knowledge and those that are overconfident in their self‐assessed knowledge level are significantly more likely to utilize AFS instruments. These results suggest that a significant portion of AFS users may select these products without conducting adequate search, resulting in less than optimal financial decisions holding all else equal.