Is Bankruptcy Law Bankrupt?

Economic analysis discloses that bankruptcy law adversely distorts the cost and allocation of credit.

Bankruptcy (both corporate and non-​corporate) is a legal device by which the state legally and economically intervenes to absolve insolvent debtors from their full financial obligations once the debtors have paid their debts to the limited extent that their assets allow. By releasing debtors from their contractual obligations, bankruptcy gives the illusion of benefitting debtors at the expense of creditors. But at best, this benefit is for the very short run. In practice, creditors take the risk of bankruptcy into account as a cost of extending credit. Borrowers will ultimately bear these costs either in the form of higher interest rates or by less available credit. Because the anticipated losses to creditors from bankruptcy are reflected in higher interest rates and reduced availability of credit, bankruptcy statutes are only nominally “pro-​debtor” and actually transfer wealth from those who do repay their loans (and those who are denied loans) to those who get loans but do not repay.

Corporate bankruptcy reorganizations produce similar problems. Congress, the courts, and the federal SEC refuse to make stockholders merely “residual claimants.” That is to say, in many cases creditors need not be fully repaid before stockholders in the corporation get something of value. To the extent that this generous treatment of shareholders imposes costs on lenders, lenders will pass on these costs in the form of greater borrowing costs and reduced credit. Here again, instead of transferring wealth from creditors to debtors, bankruptcy law redistributes wealth and opportunities among debtors.

In large measure, current bankruptcy statutes and various proposed bankruptcy “reforms” (which claim to be more “lenient” with debtors) redistribute wealth in complex ways. Furthermore, often the supposed beneficiaries of such statutes actually prove to be their victims.