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Consumer bankruptcy has been on the rise in many countries, including the United Kingdom and America. This has happened against the background of specific prescriptions in the bankruptcy code and changes in the economic and social environment. The identification of the fundamental forces affecting bankruptcy decisions is important in order to understand the impact of the changes in the bankruptcy code. This study, by the University of Southampton, studies the macroeconomic effects of the bankruptcy code, household risk, the costs of intermediation and the stigma of bankruptcy when both the borrowing limits on credit lines and the risk of bankruptcy can respond jointly.

Key Findings

• Borrowing limits are one defining feature of the pre-approved credit lines that characterise credit-card unsecured consumer loans.
• These limits have an effect on consumer borrowing and there is an interaction between these credit limits and default risk.
• For each individual state there is a threshold level of debt above which household default occurs.
• The prevailing credit limit expresses a balance between the cost advantage of larger loans and their higher default risk. Credit is extended by the banks only as far as it does not exceed household debt threshold.
• Although loans of different size carry a different risk and there may be borrowing constrained households, potential entrant banks do not find it profitable to deviate by serving either riskier loans at a higher interest or safer loans at a lower interest.
• The optimal credit limit coincides with the level of debt above which sizable groups would start defaulting.
• In the benchmark model, bankruptcy occurs only for low-productivity bad-luck individuals with sufficiently high debts.
• A stricter means test and a tougher punishment of bankruptcy both imply an aggregate welfare loss. Much of this welfare impact is driven by the implications of the subsequent loosening of the credit limit. Utility declines most for bankrupt individuals and a looser credit limit shifts the distribution of agents towards the high-debt bankruptcy region. As for the recent rise in bankruptcy, a more severe expenditure shock is a prime candidate explanation, as opposed to the entrenched notion of a fall in the stigma cost. Only the former change can, in combination with the appropriate reduction in banking intermediation costs, be consistent with the observed increase in levels of personal debt and the rise in the average amount of debt discharged during bankruptcy, and the observed extension of credit limits.
• The recent rise in bankruptcy is due not to the reduced stigmatisation of bankruptcy but to more severe expenditure shock.  

About the Study

This research is carried out by Xavier Mateos-Planas and Giulio Seccia. The study formulates a model of unsecured consumer debt that accommodates the fact that a particular type of credit line is used to different degrees by different borrowers. Then it assesses quantitatively the practical significance of the response of the borrowing limits to the factors of interest. First, this research considers changes in the conditions for bankruptcy in the form of a stricter means test and a longer period of exclusion from credit after filing. Second, it explores the plausibility of different explanations for the rise in default and personal debt in the U.S. The model is calibrated to match features of the U.S. economy. It also contains simulations of the welfare effects of imposing a stricter means test on the households intending to declare bankruptcy. This is relevant to understand the impact of recent reforms, including the changes in the UK law.

Key words

Debt, bankruptcy, loans, banking, interest, stigma, expenditure, consumer, borrowing, credit, welfare

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