Bankruptcy and Interest Rates

The U.S. is considering tightening its bankruptcy laws. The gist of the proposals is to make borrowers repay more loans and make it harder for them to declare bankruptcy. The long-run effect would be to make it easier for less credit-worthy borrowers to obtain credit.

Bill Sjostrom has a nice discussion of bankruptcy and interest rates here.

Bankruptcy is a cost of lending. Lenders can choose which markets to lend in, so each market has to pay its way. Mortgage rates are lower than credit card rates because the borrower has a house for collateral. Car loan rates are higher than mortgage rates, but lower than credit card rates, because the car is collateral, but does not last as long as a house, and the borrower can more easily depreciate it by reckless driving. So credit card borrowers, to compete for funds against house and car borrowers, have to offer an interest rate that makes credit card lending as profitable as the lenders' alternatives.

...Easy discharge of debts drives up interest rates. The gainers are the dishonest borrowers who plan to retreat into bankruptcy (why worry about the interest rate if you do not plan to pay off?). The losers are the more honest borrowers who face higher rates.

To the extent that the U.S. does, in the end, tighten up its bankruptcy laws, the effect should be to reverse the distribution effects (set out above) and to lower interest rates eventually, especially on credit card balances. Also see the discussions by Jane Galt, by The Emirates Economist, and his reference to Larry White's cogent criticism of Paul Krugman.