Are Harsh Penalties for Default Really Better?

FRB Richmond Working Paper No. 09-11

61 Pages Posted: 12 Dec 2012

See all articles by Kartik Athreya

Kartik Athreya

Federal Reserve Banks - Federal Reserve Bank of Richmond

Xuan S. Tam

City University of Hong Kong

Eric R. Young

University of Virginia

Date Written: August 6, 2009

Abstract

How might society ensure the allocation of credit to those who lack meaningful collateral? Two very different options that have each been pursued by a variety of societies through time and space are (i) relatively harsh penalties for default and, more recently, (ii) loan guarantee programs that allow borrowers to default subject to moderate consequences and use public funds to compensate lenders. The goal of this paper is to provide a quantitative statement about the relative desirability of these responses. Our findings are twofold. First, we show that under a wide array of circumstances, punishments harsh enough to ensure all debt is repaid improve welfare. With respect to loan guarantees, our findings suggest that such efforts are largely useless at best, and substantially harmful at worst. Generous loan guarantees virtually ensure substantially higher taxes — with transfers away from the non-defaulting poor to the defaulting middle-class — and greater deadweight loss from high equilibrium default rates. Taken as a whole, our findings suggest that current policy toward default is likely to be counterproductive, and that guarantees for consumption loans are not the answer.

Keywords: unsecured credit, penalties, bankruptcy

JEL Classification: D91, E21

Suggested Citation

Athreya, Kartik and Tam, Xuan S. and Young, Eric R., Are Harsh Penalties for Default Really Better? (August 6, 2009). FRB Richmond Working Paper No. 09-11, Available at SSRN: https://ssrn.com/abstract=2188503 or http://dx.doi.org/10.2139/ssrn.2188503

Kartik Athreya (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Xuan S. Tam

City University of Hong Kong ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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