Ebook Personal Bankruptcy and Credit Market Competition
The last quarter century saw a dramatic increase in the share of U.S. consumers filing for personal bankruptcy, thereby seeking a discharge of their unsecured debt. In 2005, this increase led to the most comprehensive change to U.S. bankruptcy law since 1978. Unsecured debt adjusted by income also increased throughout the period. While several causes for the rise in bankruptcies have been advanced, and it is the subject of ongoing research, two potentially significant changes occurred during this period: banking deregulation — the relaxation of bank entry restrictions in the 1980s and 1990s — and technological change in consumer lending. Banking deregulation, by removing barriers to entry, increases credit market competition and therefore affects the supply of credit; new screening technologies change the way loans are made, allowing for interest rates to better reflect underlying risk and, thus, facilitating lending to riskier borrowers. In this paper we examine whether banking deregulation and technological change played a role in the increase in consumer bankruptcy.
The empirical literature has mostly focused on cross sectional differences in personal bankruptcy. In particular, it has revolved around legal institutions as a way to answer whether consumers file due to adverse events, as part of a rational financial calculation, or as a consequence of unfair or deceptive lending practices. Usually, researchers have exploited the different asset exemptions across U.S. states (that is, the amount of personal assets protected from creditors when a person files) to determine how important financial incentives are in a person’s decision to file. In the time series, however, the real increases in bankruptcy exemptions are too small to explain the dramatic rise in filings.
This paper examines whether credit supply factors can explain the rise in bankruptcy rates. The only other paper that we know to ask a similar question is Gross and Souleles (2002). Using a panel of credit card accounts over 1995-1997, they study how much of the increase in bankruptcy rates can be explained by changes in the risk composition of borrowers as opposed to changes in unobserved factors, taken to be borrowers’ willingness to default. They find that only the increase in the latter has explanatory power.
We exploit the dramatic changes in the U.S. banking industry throughout the 1980s and early 1990s. Over the period, U.S. states gradually lifted restrictions on branching within the state as well as entry barriers to interstate banking. While determining the degree of market power is usually difficult, we use the state-level variation in deregulation dates as a way to measure the impact of changing credit conditions on consumer bankruptcy.
We find that bank deregulation increased competition among banks for borrowers, leading them to adopt more sophisticated technology for estimating borrower credit risk. In turn, this allowed previously excluded households to enter the credit market. In particular, we document four findings. First, we find that the removal of entry restrictions by out of-state banks into state markets was associated with a 10 to 16 percent rise in the rate of personal bankruptcy. This is a significant magnitude that contrasts with the results in Gross and Souleles (2002), where changes in the risk composition of borrowers has no explanatory power and the increase in borrowers’ willingness to default can explain less than one percent of the increase in the bankruptcy rate over a two-year period. Second, using bank financial data we find that deregulation was associated with increases in the growth rate of credit card loans. Third, we explore the mechanism behind these results. We use credit card loan productivity, defined as the average loan per bank employee, as a proxy for the use of information technology such as credit risk scoring software (Petersen and Rajan, 2002). We find that credit card loan productivity increases following interstate deregulation, suggesting that technology played a role in the expansion of credit and the resulting bankruptcies. Fourth, we find that credit risk, measured as the loss rate on loans, decreases following deregulation. Thus, while banks made more bad loans, which explains the increase in bankruptcies, they did not do so on average. This reduction in average credit risk along with the increase in the bankruptcy rate suggests that banks increased credit to both existing low risk customers as well as new, riskier ones, following banks’ enhanced ability to discriminate risk.
We conduct a number of robustness tests. One important issue is how exogenous banking deregulation is to credit market changes. Our results are robust to controlling for the state of development of banking markets. Importantly, because we might expect more competitive banks to offer less resistance to deregulation, we find there is no relationship between the deregulation date and the the level of credit card lending productivity at the beginning of the sample. Finally, we control for important factors that lead households to find bankruptcy attractive, i.e. bankruptcy “demand” factors, including unemployment rates, income growth and homestead exemptions. Our results are robust to all of these controls.
The current financial crisis appears to contradict our findings: lending expanded rapidly in the 2000s, accompanied by novel financial products, yet default rates among even prime borrowers have increased sharply and several large banks have failed or been acquired at low prices. We discuss how our results relate to the financial crisis in greater detail in Section 7. Mortgages are fundamentally different from the unsecured loans that we study because their credit risk is tied directly to the value of the underlying collateral and not especially dependent on the risks and decisions of families. Gerardi et al (forthcoming) present evidence that lenders expected house prices to continue to appreciate, allowing them to make loans to virtually any borrower. Given the popularity of the so-called “low doc” mortgage it appears that lenders did not invest heavily in screening and monitoring technologies during the recent credit boom. Thus, the credit expansion of the 2000s was not due to an exogenous change, such as the relaxation of regulations limiting competition. Instead, it appears to have been due to a miscalculation by lenders.
Our paper is part of the growing literature on household finance with a focus on how credit market competition affects consumer access to credit and default (Campbell 2006, provides a review of this literature). Our findings stand in apparent contrast to the banking literature crediting banking deregulation for a host of positive outcomes, including greater bank efficiency, lower prices and higher loan quality, as well as to higher rates of new business formation and faster economic growth [Jarayatne and Strahan, 1996, 1998; Black and Strahan, 2002]. Although consumer bankruptcy filings may be seen as a negative outcome per se, our results indicate that some of the rise is due to lending to previously excluded households, and thus a potentially positive development. One must exercise caution here, however, as these borrowers are likely to be poorer and less educated, and thus more likely to make borrowing mistakes (Campbell, 2006). One concern is predatory lending. While the effects of competition on such practices are not fully understood, Bond, Yilmaz and Musto (Forthcoming) argue that competition among lenders reduces or eliminates the welfare loss suffered by borrowers due to predatory lending. Along these lines, Gabaix and Laibson (2006) provide a model where firms exploit unsophisticated consumers by offering confusing financial products which generate a cross-subsidy from na?ve to sophisticated consumers.
Our results thus suggest that, while the legal environment in which lenders and borrowers operate is obviously important, further research into the consumer lending industry is required to fully assess the welfare implications of greater access to credit and consumer bankruptcy.
In addition, our results are consistent with Livshits, MacGee, and Tertilt (2007), who calibrate an equilibrium model of personal bankruptcy in a heterogeneous agent life cycle model with incomplete markets. They find (as have others) that increased income and expense uncertainty cannot quantitatively explain the rise in bankruptcies since the 1970s. However, they do find a role for credit market factors: decreased transactions costs of lending. In their paper, it is this technological improvement that leads to increased filings. Our paper provides the first empirical confirmation of such a link.
The paper is organized as follows. Section 2 provides some background on personal bankruptcy law in the U.S., and on recent trends. Section 3 reviews the literature on personal bankruptcy and on the theories relating credit market competition with borrower default. Section 4 introduces the data and the empirical model and strategy. Sections 5 present and discuss results on the relationship between credit supply and personal bankruptcy, and the mechanism by which deregulation affects credit risk, respectively. We discuss our results in light of the current mortgage crisis in Section 7. Section 8 concludes.
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