Bankruptcy, Credit Constraints, and Insurance: Some Empirics

Bankruptcy acts as insurance if the decision to default is negatively correlated with income shocks. However, whether bankruptcy actually provides insurance is dependent on the punishment for default. Such rules can instead cause the consumer to become credit constrained. If debts are not fully enforceable then a rational lender may instead limit how much debt a borrower will be allowed to hold. This limit will be higher if the punishment for default is increased. The US provides a natural test of the theory since rules about what may be kept in consumer bankruptcy, the state exemptions, when filing for bankruptcy differs dramatically across the different states. This paper shows that increasing the level of these exemptions causes less debt to be held by consumers, and offers an explanation of the differing ability of consumers to smooth consumption.