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Formal vs. Informal Default in Consumer Credit

  • Xavier Mateos-Planas

    (Queen Mary University of London)

  • David Benjamin

    (SUNY Buffalo)

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.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 144.

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Date of creation: 2012
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Handle: RePEc:red:sed012:144
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  1. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
  2. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
  3. Hintermaier, Thomas & Koeniger, Winfried, 2011. "Debt Portfolios," CEPR Discussion Papers 8359, C.E.P.R. Discussion Papers.
  4. Xavier Mateos-Planas, 2011. "Credit Lines," 2011 Meeting Papers 1293, Society for Economic Dynamics.
  5. Athreya, Kartik & Tam, Xuan S. & Young, Eric R., 2009. "Unsecured credit markets are not insurance markets," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 83-103, January.
  6. Pavan, Marina, 2008. "Consumer durables and risky borrowing: The effects of bankruptcy protection," Journal of Monetary Economics, Elsevier, vol. 55(8), pages 1441-1456, November.
  7. Kartik Athreya, 2004. "Fresh start or head start? Uniform bankruptcy exemptions and welfare," Working Paper 03-03, Federal Reserve Bank of Richmond.
  8. Mateos-Planas, Xavier, 2009. "A model of credit limits and bankruptcy with applications to welfare and indebtedness," Discussion Paper Series In Economics And Econometrics 0910, Economics Division, School of Social Sciences, University of Southampton.
  9. Satyajit Chatterjee, 2010. "An Equilibrium Model of the Timing of Bankruptcy Filings," 2010 Meeting Papers 1282, Society for Economic Dynamics.
  10. Javier Díaz-Giménez & Andrew Glover & José-Víctor Ríos-Rull, 2011. "Facts on the distributions of earnings, income, and wealth in the United States: 2007 update," Quarterly Review, Federal Reserve Bank of Minneapolis.
  11. Greg Kaplan & Giovanni L. Violante, 2010. "How Much Consumption Insurance beyond Self-Insurance?," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(4), pages 53-87, October.
  12. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  13. repec:acb:camaaa:2009-15 is not listed on IDEAS
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