Personal bankruptcy and post-bankruptcy liquidity constraint

Abstract

Once a debtor files for bankruptcy under Chapter 7, all or some of the unsecured debts are discharged and the debtor is endowed with a financial fresh start. However, a post-bankruptcy consumer faces restrictions on borrowing against future income and is likely to be liquidity constrained. This paper intends to provide a quantitative analysis regarding the effects of limits for borrowing against future income imposed on a post-bankruptcy consumer. We obtain explicit expressions for the optimal consumption, investment in the risky asset, and discretionary bankruptcy decision through a duality approach when there exists a liquidity constraint after bankruptcy. The quantitative results show that a post-bankruptcy constraint has significant impacts on a debtor’s consumption, investment, and bankruptcy wealth level. The effects of an opportunity to file for bankruptcy compete with those of post-bankruptcy liquidity constraints. We find the criterion for the latter to dominate the former. We also provide implications on the expected time to bankruptcy.