A Model of Credit Card Delinquency

Limited commitment for the repayment of consumer debt comes from two places: formal laws granting a partial or complete discharge for debts under certain circumstances, or "bankruptcy," and informal default and renegotiation, or "delinquency." In the US, both channels are used routinely. The usefulness of each of these routes as a way out of debt depends on the costs and benefits available through the other: delinquency exposes a household to collections processes initiated by lenders, while formal bankruptcy appears to carry more visible consequences for future transactions, including restrictions to even secured forms of credit. This paper is the first, to our knowledge, to evaluate unsecured consumer credit markets in the presence of both bankruptcy and delinquency. We show that these two options indeed interact in important ways. Specifically, we show that stricter control of delinquency, as defined by a relatively high ability to garnish wages, leads to more bankruptcy and lower welfare. Similarly, we find that eliminating the bankruptcy option altogether leads to a modest increase in delinquency. Perhaps most interestingly, we show that interest-rate ceilings, even though they have the standard effects in terms of limiting credit access, improve ex-ante welfare for all. This occurs because the inability to reprice debt after delinquency allows a useful level of "state contingency" in debt that does not increase average borrowing costs substantially. In essence, households have to pay the costs of delinquency in order to get the benefits of a low interest rate.