A model of credit limits and bankruptcy with applications to welfare and indebtedness

Abstract

This paper presents a macroeconomic model of unsecured consumer debt and default where credit conditions consist of pre-approved interest rates and borrowing limits, a feature of actual credit cards. All loans, irrespective of their size and risk, take place against the same type of credit line, and some borrowers are credit constrained. This type of situation is shown to arise in a free-entry competitive equilibrium if there are fixed costs in banking and the banks' decisions on interest rates and on credit limits are made separately. Numerical experiments are conducted to study, on one hand, the macroeconomic and welfare effects of the consumer bankruptcy code, and on the other hand, the consequences of various factors for both indebtedness and bankruptcy. Restricting bankruptcy filings - be it through a stricter Chapter 7 means testing or a longer period of credit exclusion - leads to sizable welfare loses. The recent rise in filing rates and debt is best explained by a combination of lower intermediation costs and more severe non-discretionary expenditures shocks. The endogenous response ofthe credit limit proves to be crucial for these findings Keywords; bankruptcy, unsecured credit, general equilibrium, default risk, credit limits