Publication: Insolvency institutions and efficiency
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2015-06-19
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Abstract
While there is a vast literature on optimal bankruptcy laws and, specifically, on the optimal
allocation of control rights between debtors and creditors in corporate bankruptcy, little has been
said about the role that alternative insolvency institutions may play in the design of the optimal
insolvency framework. This paper attempts to fill this gap by modelling two insolvency institutions
-a bankruptcy system and a foreclosure system- that firms and their creditors may use when dealing
with financial distress. Firms choose between one or the other based on lenders’ willingness to
provide credit and the trade-off between two inefficiency costs, those from inefficient liquidations
and those from productive inefficiencies caused by overinvestment in capital assets. The model’s
key result is that welfare is a non-monotonic function of creditor control rights in bankruptcy,
implying that a perfectly “creditor-friendly” bankruptcy code (a code that always grants control
of the distressed firms to creditors) is very inefficient. A second result is that welfare is higher
when the bankruptcy system is too “creditor-friendly” (i.e., it ensures the provision of credit, but
generates too many inefficient liquidations) than when it is too “debtor-friendly”. Hence, if the
optimal level of creditor control rights in bankruptcy cannot be ascertained in practice, it may be
better to grant too much control of the bankruptcy process to creditors than too little, as the loss
from undershooting that level is larger than that from overshooting it.
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Keywords
Bankruptcy, Foreclosure, Insolvency, Efficiency