Insolvency institutions and efficiency

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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.
Bankruptcy, Foreclosure, Insolvency, Efficiency
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