This is a co-authored post by Iain Ramsay and Joseph Spooner. Both authors were members of the working group for the World Bank Report on the Treatment of the Insolvency of Natural Persons
Personal insolvencies are declining in England and Wales according to the most recent Insolvency Service statistics released on April 29, 2014. However the small overall decline since the same quarter last year masks significant changes in the use of different insolvency options. Bankruptcies have contracted by almost 15 percent, but there is an increase of 14 percent in Individual Voluntary Arrangements, where individuals attempt to repay a percentage of their debts, generally over five years. This trend may be viewed positively as an indication that individuals are working hard to repay their debts, and not sloughing off their obligations. But a high bankruptcy rate may not be a bad economic signal. The English per capita bankruptcy rate (approx 2.3 per 1000 capita) is about half that of Canada (4.4 per 1000 capita in 2012) a country held forth as a paragon of financial virtue—and one with a relatively straightforward and easily accessible personal bankruptcy system. The higher bankruptcy rate in Canada may point to the ability of over-indebted individuals to have a swift ‘fresh start’ and resume life as a productive member of society.
Why are more consumers in England not writing down their debts through bankruptcy? First, official statistics on personal insolvencies underestimate those who are over-indebted and trying to pay down their debts. The statistics do not report the many private debt management plans offered by the ‘over-indebtedness industry’ in the UK, which has grown exponentially during the past two decades. These informal plans outnumber formal solutions such as bankruptcy, IVAs and Debt Relief Orders. This industry with its ‘one-stop shops’ offers consumers a wide range of options, from debt consolidation through access to debt management plans that may last eight years or more, and the formal Individual Voluntary Arrangements that normally runs for five years.
A second reason is that bankruptcy is not cheap. An upfront fee in cash of £525 must be paid. This might deter many individuals, along with the significant bankruptcy stigma, which continues to exist in the UK. Filing for bankruptcy also meant until recently that banks would automatically close a bankrupt’s account, which hardly facilitated a process of financial rehabilitation. While the introduction of the low-cost Debt Relief Order procedure for “no-income, no-assets” cases in 2009 was a welcome development, very narrow entry conditions mean that this procedure cannot provide an alternative solution for all of those excluded from bankruptcy.
A fundamental question is whether England has struck the right balance between the wide variety of repayment plans, sometimes lasting many years, and the straight discharge of most debts in bankruptcy after one year. Individuals may find themselves shackled to long debt repayment plans that ultimately fail: almost one-third of Individual Voluntary Arrangements fail to complete. Many individuals may choose a repayment plan because they assume it will be better for their credit rating (and they may be able to retain their home) but credit reference agencies make little distinction between bankrupts and those who have been on repayment plans. The complexity of the English system with its many alternatives also creates difficulties for individuals choosing the best option, and increases the power of private and public intermediaries in the system, whose financial incentives may not align with public interest concerns.
Writing off debts after a recession may have important benefits by permitting individuals to make a fresh start, be more productive, and undertake new credit obligations. The IMF recognized these facts in chapter 3 of the 2012 World Economic Outlook suggesting that a long and slow deleveraging process for individuals after a household debt bubble may retard economic recovery. Freeing households to borrow and spend may be particularly important in an economy as dependent on consumer demand as that of the UK. Bankruptcy can reduce the externalities of over-indebtedness such as illness and family conflict and creditors are forced to account for the consequences of bad or irresponsible lending decisions. The fear of moral hazard—that individuals will run up debts in a risky manner knowing that they can discharge them in bankruptcy—is a concern but evidence suggests that this is a relatively modest problem and most modern bankruptcy systems have mechanisms to protect against moral hazard by consumers.
Politicians however are generally not interested in promoting bankruptcy for consumers. The political costs are high since there is little kudos in being associated with measures that may be interpreted as permitting individuals to walk away from their debts. Many studies indicate however that individuals in debt have primarily suffered from a change of circumstance such as reduced employment and rarely enter lightly into bankruptcy.
The government prefers to delegate much insolvency policy development to committees of expert bodies primarily composed of bankruptcy professionals and industry groups such as the British Bankers Association, with modest input from consumer groups. These groups have little interest in promoting bankruptcy as a relatively swift discharge of debts in return for giving up all non-essential assets. Informed policy making is further undermined by the absence of systematic empirical and theoretical analysis in the UK of the role of consumer bankruptcy. Cuts to the Insolvency Service’s policy funding in recent years will not improve this position. More attention should be devoted to this topic before the next recession.