Formal vs. Informal Default in Consumer Credit

This paper studies informal default in consumer credit as the start of a process of negotiation with the lender. We consider an economy with uninsurable individual risk where households in debt have also the option of declaring formal bankruptcy. In a calibrated version of the model, informal defaulters are notably wealthier, have lower income, and hold more debt than formal defaulters, an implication consistent with the evidence. Quick settlements are achieved often, with limited discounts. Protracted negotiations feature individuals disaving before they reach agreement or declare bankruptcy. Allowing for negotiations raises default rates but substantially improves welfare as it provides greater insurance opportunities. Thus lowering the cost of informal default, as opposed to that of formal default, raises welfare and dampens consumption volatility. A tighter exemption improves welfare as the bargaining option mitigates the adverse effect on insurance via formal bankruptcy. Attempts at limiting collection outside bankruptcy reduce the incidence of bankruptcy but lower overall welfare.