NCPA - National Center for Policy Analysis

DID BANKRUPTCY REFORM INCREASE FINANCIAL DISTRESS?

November 5, 2007

When Congress reformed bankruptcy laws two years ago, its aim was to crack down on those who were using bankruptcy as an easy way to escape their debts.  But the reforms had an unintended effect -- while bankruptcy filings dropped, financial distress increased, says Michelle J. White in a National Bureau of Economic Research Working Paper.

According to White:

  • The new bankruptcy law dramatically reduced lenders' losses from default and bankruptcy and they started lending more, even to consumers with bad credit.
  • In turn, many behaved shortsightedly and took advantage of the greater availability of credit to borrow more than they could easily handle --- ignoring the risk of financial distress
  • As a result, credit card debt increased more quickly during the past two years than at any time during the previous five years.

Further, the new bankruptcy law exacerbated the problem of shortsighted consumers borrowing too much, because it prevented many of them from using bankruptcy to limit their financial distress.  For instance:

  • Many consumers in financial distress were unable to file for bankruptcy under the new law, because they cannot afford the costs of filing, cannot meet the new paperwork requirements, or are ineligible.
  • This means that their debts will not be discharged and they will remain vulnerable to creditors' collection calls and to wage garnishment that may take funds they need for basic necessities.

White argues that lowering the costs of filing for bankruptcy would help debtors who are in the worst financial distress by making it easier for them to file.  But changes in bankruptcy law cannot solve the basic problem of shortsighted consumers borrowing too much.  Instead, White argues that changes in credit market and truth-in-lending regulation are more likely to work because they motivate lenders to lend less to the most vulnerable consumers.

Source: Laurent Belsie, "Did Bankruptcy Reform Increase Financial Distress?" NBER Digest, November 2007; based upon: Michelle J. White, "Bankruptcy Reform and Credit Cards," Working Paper No. 13265, National Bureau of Economic Research, July 2007.

For text:

http://www.nber.org/papers/w13265

 

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