Institutions, Incentives, and Consumer Bankruptcy Reform

Consumer bankruptcy filing rates have soared during the past 25 years. From 225,000 filings in 1979, consumer bankruptcies topped 1.5 million during 2004. This relentless upward trend is striking in light of the generally high prosperity, low interest rates, and low unemployment during that period. In response to this anomaly of ever-upward bankruptcy filing rates during a period of economic prosperity, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), which fundamentally rebalances the consumer bankruptcy system by creating new safeguards against fraudulent and abusive filings. Although BAPCPA drew broad bipartisan support on Capitol Hill, it is controversial within the academy. Critics have argued that these reforms are unnecessary and punitive, and that private market adjustments such as higher interest rates and more restrictive credit rationing are adequate policy responses to the problem of rising bankruptcy filings without the need for legislative reform. These criticisms are misplaced, and fail to appreciate the causes of the consumer bankruptcy crisis and the appropriate responses to it. Scholars have previously identified two models of the consumer bankruptcy process, the "traditional" or distress model and the economic incentives model. Neither model, however, can explain the observed bankruptcy filing patterns of recent decades. This article offers a new model of consumer bankruptcy rooted in New Institutional Economics that explains the rise in consumer bankruptcy filings as reflecting changes in the institutions, incentives, and constraints surrounding the consumer bankruptcy filing decision. It is argued that this new model of consumer bankruptcy is both theoretically and empirically superior to the traditional model. The demise of the traditional model, which has dominated bankruptcy scholarship for a century, has created a need for a new theory of consumer bankruptcy filings that can better explain the observed data. The model offered here fills that gap. This article identifies three institutional factors that can explain the observed rise in bankruptcy filings over the past several decades: (1) A change in the relative economic costs and benefits associated with filing bankruptcy; (2) A change in social norms regarding bankruptcy; and (3) Changes in the nature of consumer credit, toward more national and impersonal forms of consumer credit. All of these factors have tended to increase the incentives and opportunity for filing bankruptcy or reduce the constraints imposed on filing bankruptcy. In contrast to the traditional distress model, which purports to focus on changes in underlying household financial condition as the cause of rising bankruptcies, this model presented here examines the economic demand for bankruptcy itself, focusing on the incentives and institutions that condition consumer bankruptcy filings. The result of all of these changes has been to increase the equilibrium level of bankruptcy filings in America. In light of these changes, the article briefly discusses some policy implications of accepting this new model of consumer bankruptcy. In particular, the model described here explains the economic logic of BAPCPA, showing its key provisions to be consistent with the logic of the new model of consumer bankruptcy presented here. In addition, the article also addresses more far-reaching proposals, such efforts to reverse changes in social norms or proposals to allow contracting-around the mandatory discharge provision of current law.