Regulating Small Dollar Loans: The Role of Delinquency (Job Market Paper)
This paper analyzes whether and how to regulate small dollar lending in the United States. To that end, I develop a structural model of unsecured lending where heterogeneous households can not only file for bankruptcy but also become delinquent. Adding fixed cost of loan creation endogenously produces realistic interest rates of up to 300% for small loans. In the face of income and expenditure risk, households can partially insure through bankruptcy that provides legally mandated debt relief. However, lump sum court fees and lawyer costs prevent low income households from filing for bankruptcy protection. Without access to bankruptcy, these households become delinquent and pay late fees to avoid collection efforts from their banks. My quantitative results show that delinquency offers insufficient insurance against adverse events, granting room for welfare-improving policy interventions. In one such intervention, low income households are allowed to repay bankruptcy filing costs after debt relief, making bankruptcy more affordable. I show that bankruptcy filings increase and delinquency decreases. Low income households enjoy a 1% welfare increase, while aggregate welfare increases by 0.1%. The repayment plan proposed by the Consumer Financial Protection Bureau, that allows households to spread repayment over three periods, does not yield any welfare gains.
Bankruptcy legislation exhibits important welfare effects on the aggregate economy through effects on prices of and access to credit. In designing bankruptcy law, policy makers face a trade-off between insuring individuals against adverse shocks and providing incentives to repay debt. While the U.S. regime has a strong insurance component, many European systems are stricter in that they force delinquent households to repay (parts of) the outstanding debt through wage garnishment. Taking into account labor supply effects, this paper examines the optimal garnishment regime for the German economy and the resulting impact on credit prices. The optimal garnishment regime reduces garnishment rates by more than 15% while increasing the duration of garnishment from six to nine years. This results in an aggregate welfare increase of around 0.5%. Low income households gain up to 1.5% since they have significantly better access to cheaper credit. Cheaper credit allows them to better smooth consumption over the life-cycle. High income households already face favorable credit conditions and hence gain very little. Fully removing wage garnishment and moving to a “Fresh Start” regime similar to the U.S. raises the price of credit, since lenders internalize the possibility of not being paid back. Young households suffer from restricted access to credit and the welfare of newborns decreases by as much as one percent.