Blame Financial Innovation, Not Income Shocks, for Rise in Bankruptcies

Between 1980 and 2004, personal bankruptcies skyrocketed by some 540 percent to 1.5 million filings per year. Meanwhile, a number of competing theories have been put forth to explain the near vertical trajectory of filings. Now, a new NBER working paper has sliced and diced these explanations to present some intriguing findings. (free version)

(On a related note, the WSJ's Grep Ip reports that NBER's president Martin Feldstein is stepping down next June.)

The researchers found that:

• Medical shocks explain less than 20 percent -- and probably under 10 percent -- of the rise in bankruptcies.
• In the same vain, income shocks have had a negligible impact on personal bankruptcy rates.
• The same goes for changes in the age structure of society and the increase in the number of unmarried and divorced people over the same time period.
• The bulk of the rise (close to 90 percent) of personal bankruptcies can be chalked up to a combination of credit market innovations that have lowered both transaction costs for financial institutions and the costs of bankruptcy.

Jim MacGee, an assistant professor of economics at The University of Western Ontario and one of the paper's coauthors, told me the results had come as a surprise to the researchers. "Originally we thought that income uncertainty would play a very big role, but our conclusion is that while uncertainty does seem to play a role, it's a rather small one."

The study only looked broadly at the possible explanations for the rise in bankruptcies, so the next step for researchers is to piece apart what kind of credit market advances accounted for the rise, MacGee said.

These likely include things like the increased use of credit scores as well as data-mining to price the risk of lending to people previously locked out of credit markets.

Another question worth considering is if the benefits of easier access to credit has offset the negative impact of bankruptcy. The answer is tied to how much a consumer knows about his own financial situation and the lending arrangement he's getting into. More on that tomorrow.

It's also worth noting that new bankruptcy laws passed in 2005 have dramatically increased the cost of filing for bankruptcy: through March of 2007 filings are down about 170 percent from the previous year.

Related:

• Shame As It Ever Was: Stigma and Personal Bankruptcy (pdf)
• Technology, Information and Bankruptcy (pdf)
• Personal Bankruptcy and Credit Market Competition (pdf)
• Financial Collapse and Class Status: Who Goes Bankrupt (pdf)