Working Paper

Assessing bankruptcy reform in a model with temptation and equilibrium default

Abstract: A life-cycle model with equilibrium default in which consumers with and without temptation coexist is constructed to evaluate the 2005 bankruptcy law reform and other counterfactual reforms. The calibrated model indicates that the 2005 bankruptcy reform achieves its goal of reducing the number of bankruptcy filings, as seen in the data, but at the cost of loss in social welfare. The creditor-friendly reform provides borrowers with a stronger commitment to repay and thus yields lower default premia and better consumption smoothing. However, those who borrow and default due to temptation or unavoidable large expenditures suffer more under the reform due to higher costs or means-testing requirement. Moreover, those who borrow due to temptation suffer from overborrowing when the borrowing cost declines. The model indicates that the negative welfare effects dominate.

Keywords: Consumer bankruptcy; Debt; Default; Borrowing constraint; Temptation and self-control; Hyperbolic discounting; Heterogeneous agents; Incomplete markets;

JEL Classification: D91; E21; E44; G18; K35;

Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2015-03-09

Number: 15-12

Pages: 47 pages