Using Elasticities to Derive Optimal Bankruptcy Exemptions

Abstract

This article studies the optimal determination of bankruptcy exemptions for risk averse borrowers who use unsecured contracts but have the possibility of defaulting. In a large class of economies, knowledge of four variables is sufficient to determine whether a bankruptcy exemption level is optimal or should be increased or decreased. These variables are 1. the composition of households’ liabilities, 2. the sensitivity of the credit supply schedule to exemption changes, 3. the probability of filing for bankruptcy with non-exempt assets, and 4. the value given by households to a marginal dollar in different states, which can be mapped to changes in households’ consumption. I recover empirical estimates of the sufficient statistics using U.S. data over the period 2008–16 and find that increasing exemption levels improves overall welfare, although there is substantial variation in estimated welfare gains across U.S. states and income quintiles.

Essays on Consumer Credit Markets and Debtor Protections

“…He develops a sufficient statistic in a two-period model, then extends it to additional choice variables, multiple contracts, borrower heterogeneity, asymmetric information, and dynamics then calibrates the model to determine the optimal exemption level. My model differs from Dávila (2016) in two main ways. First, while Dávila (2016) focuses on bankruptcy filers, I use a broader measure of default and allow exemptions to affect borrowers who default without filing a formal bankruptcy.…”

“…This changes the population that benefits from raising exemptions and requires additional reduced form parameters to evaluate the welfare impact, in particular, the consumption drop among informal defaulters and the effect of exemptions on repayment in informal default. Second, while Dávila (2016) is based on the model of borrowing with default risk in Eaton and Gersovitz (1981), my model adapts Chetty (2006) and so produces a Baily-Chetty sufficient statistic formula that is analogous to those in the optimal social insurance literature. Since the purpose of my model is to guide the empirical analysis, I focus on a simple model that demonstrates the intuition.…”

“…The policy implications of my results differ from those of Dávila (2016). The calibration in Dávila (2016) generates an optimal exemption level of $100,000, which implies that most states should raise exemptions to improve welfare. My estimates, however, imply that exemptions are too high and even low-exemption states would benefit from reducing exemptions.…”

“…7 In the sufficient statistic approach that I adapt here, the welfare impact depends on only a few high-level statistics and holds in a general class of models. Dávila (2016) derives a sufficient statistic for the optimal level of asset exemptions in bankruptcy and shows that the formula holds in more realistic and general settings. This paper differs in two key ways.…”

“…This is critical, as most default and debt collection occur without a formal bankruptcy. 8 Second, I estimate the key determinants of the welfare impact, and some of these estimates differ dramatically from the calibrated values chosen in Dávila (2016). These differences are large enough to reverse the policy implications.…”