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Bankruptcy and Delinquency in a Model of Unsecured Debt
Limited commitment for the repayment of unsecured consumer debt originates from two places: (i) formal bankruptcy laws granting a partial or complete legal removal of unsecured debts under certain circumstances, and (ii) informal default followed by renegotiation, "delinquency." In the US, both channels are used routinely. The usefulness of each form of debt relief depends on the costs and benefits available through the other. This paper introduces a model of unsecured consumer credit in the presence of both bankruptcy and delinquency. Our model suggests that, in practice, bankruptcy and delinquency serve different purposes, with each being used to insure a particular type of income shock. Our results also indicate that these two options likely interact in important ways. We show that stricter control of default via tougher treatment of delinquent debtors can be counterproductive by increasing the risk of bankruptcy by enough to lower credit use overall–something consistent with cross-state comparisons in the U.S–in a way that lowers welfare.