An Optimal Personal Bankruptcy Procedure and Proposed Reforms

We investigate a proposed reform of U.S. personal bankruptcy law which combines Chapters 7 and 13. The proposed reform obliges debtors in bankruptcy to use part of both their wealth and their future earnings to repay debt and therefore bases the obligation to repay in bankruptcy on debtors' ability-to-pay. An important function of personal bankruptcy is to provide partial wealth insurance for risk averse debtors by discharging some debt when debtors' ability to repay turns out to be low. However the current bankruptcy system encourages debtors to file for bankruptcy even when their ability to repay is high. The proposed reform maintains the insurance function of bankruptcy, but reduces debtors' incentive to take advantage of the system. Using simulation techniques, we show that the reform improves efficiency relative to the current system