A Quantitative Theory of Unsecured Consumer Credit with Risk of Default

TLDR

The default option resembles a bankruptcy filing under Chapter 7 of the U.S. Bankruptcy Code. The study models an economy where households smooth consumption with riskless assets and defaultable unsecured loans, and applies this model to evaluate a new means‑testing policy for Chapter 7 bankruptcy. The model assumes competitive intermediaries offering a zero‑profit menu of loan sizes and rates, and analyzes the resulting general‑equilibrium consumption smoothing with riskless assets and defaultable unsecured loans.

Abstract

We study, theoretically and quantitatively, the general equilibrium of an economy in which households smooth consumption by means of both a riskless asset and unsecured loans with the option to default. The default option resembles a bankruptcy filing under Chapter 7 of the U.S. Bankruptcy Code. Competitive financial intermediaries offer a menu of loan sizes and interest rates wherein each loan makes zero profits. We prove the existence of a steady-state equilibrium and characterize the circumstances under which a household defaults on its loans. We show that our model accounts for the main statistics regarding bankruptcy and unsecured credit while matching key macroeconomic aggregates, and the earnings and wealth distributions. We use this model to address the implications of a recent policy change that introduces a form of "means testing" for households contemplating a Chapter 7 bankruptcy filing. We find that this policy change yields large welfare gains.