DP15785 Lending to Overconfident Borrowers
We study how banks lend to overconfident borrowers. For identification, we exploit variation in pupils’ overconfidence across areas in Italy. We find that borrowers born in overconfident areas make larger forecast errors on future sales, pay higher loan rates and are more likely to be denied credit. Consistent with a credit market model where borrowers have biased beliefs, collateral-based banks are more likely to grant credit to overconfident borrowers, who then invest and default more than others. We estimate that bad loans in Italy would be €10 billion (8%) lower in 2017 if banks relied less on collateral when lending to overconfident borrowers.