Optimal Bankruptcy in a Nonoptimal World

Consumer bankruptcy insures individuals against misfortune.Like other forms of insurance, bankruptcy reduces an individual's incentive to guard against misfortune and provides her with an incentive to overstate her need for relief. The "first-best," or optimal, bankruptcy system, like the first-best tax or public assistance system, solves these moral hazards without any loss of efficiency. In bankruptcy, this first-best approach would deny relief to debtors responsible for their own distress and reduce the deserving debtors' obligations to an amount commensurate with their ability to pay. While the Bankruptcy Code tries (in part) to follow this first-best approach, such a utopian system requires omniscient judges who can perfectly determine which debtors deserve relief and how much a deserving debtor can pay. Real bankruptcy judges have interpreted the Bankruptcy Code to implement a second-best, or feasible, bankruptcy system that accounts for the limited information that they possess.