Available at SSRN: https://ssrn.com/abstract=7594618
Abstract:
This thesis presents three essays on the field of personal bankruptcy. The research carried out is mostly, but not fully, theoretical in nature. The first chapter develops a model of general equilibrium with default and asks, among other things, how the level of default penalties can affect the welfare of different agents in an economy, when do agents face binding borrowing limits, and why some agents are denied credit upon application. In answer to these questions, it shows that there exists an intermediate range of Pareto optimal punishment levels where changes in the punishment level benefit one type of agent but harm another; outside this range, punishment levels can be changed to benefit all agents. It also proves that the existence of default is a sufficient condition for the emergence of borrowing limits which are binding; asymmetric information is not necessary for this to occur. Finally, is shows that some agents can be denied credit if default penalties are too low or too high. In these instances, it shows that even though these agents would like to borrow at the market interest rates, they are unable to do so. The chapter then also asks whether a competitive market will select the socially optimal punishment level, and shows that this is not, in general, the case - welfare can be improved if default penalties are set by a social planner. Finally, a numerical experiment is performed to evaluate the welfare effects of a change in the law which allows only low-income households to file for default on their debts. The result shows the welfare effects of this will depend on the degree of agent heterogeneity; if the gap between rich agents and poor agents is not large, then this policy benefits all agents. If however the gap between the rich and the poor is substantially large, then this policy will benefit those who save and rich agents who borrow, while harming poor agents who borrow. This illustrates the importance of agent heterogeneity when evaluating different policies in bankruptcy legislation under a general equilibrium setting. Following this, we argue that the welfare evaluations from various studies of bankruptcy may be biased upwards if they do not allow for enough heterogeneity among agents.
The second chapter extends this model to a world consisting of many open economies from between which funds can be transferred without cost, and examines how default penalties are set endogenously by the governments of each region. It then explores the implications of such endogenous punishment formation. From a normative perspective, it asks whether the resulting non-cooperative Nash equilibrium is welfare-maximising. We find that this is not in general the case, and that welfare can increase if governments set their punishment levels cooperatively. From a positive point of view, it compares the effect of an exogenous shock in income distributions to the equilibrium allocations in the case of fixed punishment levels and in the case of variable punishment levels (i.e. the case when governments are able to react to a change in the economic environment by altering bankruptcy legislation). The analysis shows that allowing for endogenous punishment levels can reverse the results of such exogenous shocks. For example, one of the puzzles in the literature is that default rates have been increasing, despite rising incomes. We show that, keeping punishments fixed, higher incomes result in more borrowing but less default. However, when we allow punishments to vary endogenously, these fall in response to higher incomes and the result is more borrowing and more default.
Finally, the third chapter develops the model to include bankruptcy exemptions which resemble legislation in the US and examines how these should be set optimally in a partial equilibrium environment. It then studies how optimal exemption levels depend on various economic variables. It derives a simple rule in a completely general environment which states that any exogenous shock which increases the level of borrowing implies a higher optimal exemption level. For example, all else equal, higher (future) incomes imply higher levels of borrowing. Therefore, economies with higher incomes should have higher exemption levels. It then tests this empirically using data from the US, where exemption levels vary between states. The main innovation from the empirical part with respect to similar studies is that the analysis controls for neighbourhood effects in the sense that states may take into account the exemption levels in neighbouring states when setting their own exemption level.
Summary:
In Three Essays on Personal Bankruptcy, Ioannis Kingdom examines how bankruptcy laws affect borrowing, credit availability, economic welfare, and the appropriate level of bankruptcy exemptions. Although primarily theoretical, the thesis offers several conclusions with continuing relevance to consumer bankruptcy policy.
1. Harsher Bankruptcy Laws Do Not Necessarily Improve Credit Markets
The first essay examines how penalties for default affect borrowers and lenders. Kingdom finds that excessively harsh or excessively lenient bankruptcy penalties can both result in consumers being denied credit.
Importantly, the optimal level of bankruptcy punishment is not necessarily what creditors or competitive financial markets would select. Government intervention may improve overall economic welfare.
The research also suggests that restricting bankruptcy relief to lower-income households does not necessarily benefit those households. Depending on the degree of income inequality, such restrictions may actually harm poorer borrowers while benefiting wealthier households.
2. Bankruptcy Policy Has Broader Economic Consequences
The second essay examines how governments establish bankruptcy penalties when capital moves between different economies.
Kingdom concludes that governments acting independently may adopt bankruptcy policies that are economically inferior to those developed cooperatively.
He also demonstrates that increasing incomes can produce both greater borrowing and higher default rates when governments respond by relaxing bankruptcy penalties. Thus, increasing bankruptcy filings do not necessarily indicate worsening household finances.
3. Higher Borrowing Levels Justify Higher Bankruptcy Exemptions
The third essay is particularly relevant to American bankruptcy practitioners.
Kingdom develops an economic model suggesting that circumstances encouraging greater borrowing generally justify higher bankruptcy exemption levels.
For example, higher anticipated incomes tend to support more borrowing, which in turn supports greater exemptions.
The essay also considers differences between American states and how neighboring states may influence one another when establishing exemption levels.
Commentary:
Although written twenty years ago, Kingdom's thesis challenges several assumptions underlying American consumer bankruptcy policy, particularly those reflected in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
First, making bankruptcy more punitive does not necessarily improve either lending markets or economic outcomes. The premise that restricting bankruptcy relief will automatically increase responsible borrowing or credit availability is simply not supported by these models. Indeed, harsher penalties can exclude borrowers from credit markets altogether.
This also calls into question the assumption that creditors, left to their own devices, will necessarily produce an economically efficient system of lending and debt collection.
Second, bankruptcy exemptions should not remain frozen while household borrowing and asset values increase.
North Carolina provides an obvious example. Its $35,000 homestead exemption under N.C. Gen. Stat. § 1C-1601(a)(1), subject to certain exceptions and enhancements, has not kept pace with the enormous increases in housing prices or household debt.
Kingdom's analysis provides an additional economic argument for increasing exemptions beyond the traditional justification of protecting a debtor's fresh start. Adequate exemptions may also improve the functioning of credit markets and the economy more broadly.
Indeed, the findings suggest that legislatures should regularly revisit exemption amounts, perhaps through automatic indexing, rather than treating exemptions as permanent figures requiring occasional political negotiations.
Third, bankruptcy policy cannot be evaluated solely by examining its effect on creditors or even an imaginary average debtor. Kingdom emphasizes that policies affect different income groups differently, sometimes producing particularly unfavorable results for those with the fewest resources.
That is an important caution regarding means testing, limitations on discharge, and other provisions ostensibly intended to protect poorer households.
Finally, the research suggests that competition between states in setting exemption levels does not necessarily produce optimal results. That is particularly relevant when considering whether states should continue to opt out of federal bankruptcy exemptions or whether more uniform, periodically adjusted federal protections would better serve debtors and creditors alike.
The larger lesson is that bankruptcy protections are not simply concessions made to financially distressed borrowers at the expense of creditors. They are integral parts of a functioning credit economy, and making bankruptcy relief more difficult, punitive, or inadequate may ultimately leave everyone worse off.
That is a lesson worth remembering whenever bankruptcy reform is presented as a choice between protecting consumers and protecting credit markets. The two objectives are not necessarily in conflict.
To read a copy of the transcript, please see:
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