Using Elasticities to Derive Optimal Bankruptcy Exemptions

This paper characterizes the optimal bankruptcy exemption for risk averse borrowers who use unsecured contracts but have the possibility of defaulting. It provides a novel general formula — which holds in a wide variety of environments — for the optimal exemption as a function of a few observable sufficient statistics. Knowledge of borrowers’ leverage, the sensitivity of the interest rate schedule faced by borrowers with respect to the level of the bankruptcy exemption, the probability of bankruptcy and the change in consumption by bankrupt borrowers is sufficient to determine the optimal bankruptcy exemption. When calibrated to US data, the optimal bankruptcy exemption implied by the model ($100,000) is larger than the average exemption in the US ($70,000), but of the same order of magnitude. JEL numbers: K35, E21, D14