Externalities among creditors and personal bankruptcy

Abstract

Purpose

The purpose of this paper is to explore the impact of creditors' undervaluing the total expected cost of a borrower's bankruptcy filing because a portion of the cost will be borne by other lenders. Creditors who bear a smaller portion of the total cost of a personal bankruptcy would be expected to take less care to avoid triggering one.

Design/methodology/approach

This paper presents a theoretical model of a creditor's decision of how aggressively to pursue collection. The model shows that because each lender's collection actions increase the probability of bankruptcy, each lender will collect more aggressively when a borrower has many loans. The paper tests the predictions of the model using a large dataset of credit card accounts.

Findings

The model highlights an important testable result: holding the level of debt constant, a borrower with many loans is more likely to choose formal bankruptcy and less likely to choose informal bankruptcy, i.e. chronic non-repayment absent a bankruptcy filing. This paper finds evidence that strongly supports the predictions of the model. Laws that limit creditor collection actions do not appear to mitigate the effects of increasing number of loans.

Originality/value

While a few papers have tested whether strategic interactions may impact business bankruptcy, no paper of which the author is aware has provided clear empirical evidence of the existence of common pool effects in the personal credit market. These effects point to an important and potentially underappreciated source of risk for borrowers and creditors in this market.

Citation

E. Dawsey, A. (2014), "Externalities among creditors and personal bankruptcy", Journal of Financial Economic Policy, Vol. 6 No. 1, pp. 2-24. https://doi.org/10.1108/JFEP-09-2013-0037