Alumni Newsletter September 2015
Cause for Concern? The Rise in Consumer Credit and Bankruptcy
Consumer credit, which includes automobile loans, credit card debt, and lines of credit — especially home equity lines of credit — has risen by more than a factor of five since the late 1970s and, at 44 percent of disposable personal income, is more than double its level of 20 years ago (see Figure 1). This rise has left Canadian debt levels above the comparable U.S. measure (U.S. + Home equity in Figure 1). Not surprisingly, this coincides with a rising number of Canadian households with stressed finances, as evidenced by the roughly 4-fold rise in the filing rate between the early 1980s and mid 2000s and the spike in personal bankruptcy filings during the 2008-09 crisis (see Figure 2).
What are the main factors driving the dramatic rise in bankruptcies and unsecured borrowing? My research with Igor Livshits and Michele Tertilt suggests that financial market innovations have been a key factor reshaping the consumer credit market. Driven by improvements in risk assessment (such as the spread of credit scoring), lenders now offer credit to borrowers previously deemed too risky, while offering higher borrowing limits and better terms to lower-risk borrowers. Although much of the rise in consumer credit is due to more borrowing by (relatively) higher income households (reflected in the fact that home equity lines of credit accounts for much of the rise in consumer credit), increased access to credit plays a large role in the rise in bankruptcies.
One might suspect that the rise in bankruptcy filings is due to a relaxation of bankruptcy law. If anything, however, legislative reforms in Canada (and the U.S.) since the 1980s have gradually tightened bankruptcy laws. The objective of these reforms has been to encourage borrowers with sufficiently high income to repay part of their debt as a condition for discharging their remaining debt. The fact that U.S. filings have not risen above their level of the early 2000s despite the severe 2008 recession suggests that reform has discouraged some households from filing. The Canadian experience in the 1990s paints a similar picture, as the legislative reforms were followed by nearly a decade of relatively constant filing rates as filings rose in the U.S.
These bankruptcy reforms impact consumer credit markets. By increasing the recovery rate for middle- and upper-income households, the tightening of bankruptcy makes default less attractive. To the extent that lenders internalize this in their pricing, these legal reforms support products, such as lines of credit, offered to middle income borrowers. In turn, increased access to lower cost credit makes borrowing more attractive, and may play a role in higher consumer debt levels down the road.
So what are the implications of high consumer debt for the vulnerability of Canadians to higher interest rates or a sudden increase in unemployment if global economic uncertainty pushes the economy into a recession? This question motivates ongoing research (joint with Western alumn David Fieldhouse and Igor Livshits) that looks at how consumer bankruptcy and consumer borrowing varies with business cycle driven fluctuations in unemployment. Central to this work is the question of how lenders decisions on how to price and manage credit risk in response to labour and credit market conditions impacts households’ access to credit. Answering this question will help provide policy makers with an improved perspective on how to manage the risks of an era of high consumer debt levels.
References
Fieldhouse, David, Livshits, Igor and MacGee, James (2012). “Income Loss and Bankruptcies over the Business Cycle,” report written for OSB Contract # 5024680 for project PSN11-006, available at http://www.ic.gc.ca/eic/site/bsf-osb.nsf/eng/br03117.html
Livshits, Igor, James MacGee, and Michele Tertilt, “Consumer Bankruptcy: A Fresh Start,” American Economic Review, March 2007, 402-418.
Livshits, Igor, James MacGee, and Michele Tertilt, “Accounting for the Rise in Consumer Bankruptcies,” American Economic Journal: Macroeconomics, April 2010, 165-193.
“The Democratization of Credit and the Rise in Consumer Bankruptcies,” joint with Igor Livshits and Michele Tertilt, forthcoming, Review of Economic Studies.
MacGee, James, The Rise in Consumer Bankruptcy and Consumer Credit: Cause for Concern? (Commentary No. 356) Toronto: C.D. Howe Institute, April 2012.
Jim MacGee
September 2015
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