General Equilibrium with Private Information: Nonexclusive Contracts and Optimal Bankruptcy Regulation

This paper introduces an explicit institution of bankruptcy into a general equilibrium model of endogenous ̄nancial markets with asymmetric information. The institution of bankruptcy is modelled as a set of rules that determine if an agent is eligible to have his debts discharged. Those rules are called a bankruptcy code. Given a bankruptcy code, we allow free entry of intermediaries o®ering all possible ̄nancial contracts to agents seeking insurance against a private endowment shock. If the competitive equilibrium that arises in the presence of a bankruptcy code is constrained optimal, we say that the code is optimal. We show that a simple wealth-based eligibility condition is a necessary and su±cient condition for a bankruptcy code to be optimal. The bankruptcy code that we ̄nd to be optimal bears a close resemblance to the U.S. Chapter 7 bankruptcy procedure. The model therefore provides an insight into the risk-sharing function of an existing bankruptcy arrangement, and hence identi ̄es the institution of bankruptcy as an alternative to other institutions that assume this function, e.g., government welfare programs and redistributive taxation. As a contribution to the theory of general equilibrium with private information, this paper obtains optimality of equilibrium without imposing incentive compatibility constraints into the de ̄nition of the consumption set.