Informal Bankruptcy

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Abstract
In the economic literature on bankruptcy, the standard methodology is to model the individual's bankruptcy decision as a binary choice between "bankruptcy" and "no bankruptcy." We define an additional choice - non-repayment without seeking the formal protection of the bankruptcy - as informal bankruptcy. Using data from a large credit card issuer, we find evidence that while both lenient exemption laws and garnishment laws increase bankruptcies in the standard model, loose garnishment discourages default in our expanded model, while at the same time more pronouncedly shifting individuals from informal to formal bankruptcy. This result suggests that previous research may substantially understate the degree to which garnishment laws drive defaulting individuals to choose bankruptcy. Moreover, lenient exemption laws increase both formal and informal bankruptcy. We also find that borrowers living in majority black neighborhoods are more likely to choose informal bankruptcy, and less likely to choose formal bankruptcy, than other borrowers.

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