Income Loss and Bankruptcies over the Business Cycle

by David Fieldhouse, Igor Livshits and James MacGee

October 2012


Note: While abstracts are available in both English and French, some research papers are only available in their original language. This document is only available in English.

Abstract

This paper investigates the key factors that drive cyclical fluctuations in consumer insolvency filings, with a focus on the 2008-09 recession which witnessed an almost 50% jump in insolvency rate. We employ both an aggregate analysis using historical data at the national, provincial and city levels, and micro-level analysis which makes use of a unique dataset of Canadian filers over 2007-2011.

A natural explanation for the rise in insolvencies during recessions is an increased frequency of negative income shocks, manifested partly in the increased unemployment rate. Adverse income shocks place additional financial strain on debtors, which may make insolvency more likely.  Another important mechanism comes from the “supply side”, as lenders may tighten their lending standards during recessions due to higher perceived risk of lending or higher internal cost of funds. More limited access to credit could makes it harder for borrowers to roll-over existing loans or lead to higher interest rates for riskier borrowers, which could result in an increase in insolvencies.

We investigate the quantitative contribution of these two channels using aggregate data on insolvency filings, unemployment rates, debt levels, and key interest rates at the national, provincial and city levels. Our empirical analysis finds support for both mechanisms, as both the unemployment rate and the financial market variables are statistically significant in explaining the variation in bankruptcy filings. The results are broadly consistent whether we consider national level (annual or shorter quarterly series), provincial level or city level data. Interestingly, fluctuations in house prices at the city level seem to be related to fluctuations in the insolvency rates. Since home equity is the main asset of many households, changes in house prices could significantly impact the amount that households could borrow.

We use a unique dataset of insolvency filings in Canada that was provided by the OSB to investigate how (and if) the characteristics of filers vary over the business cycle. This data consists of all electronic filings from to , and contains data on both demographic characteristics of filers (age, gender, family size) and the nature of debts and income at the time that the debtors filed.

The data suggest that both adverse income and credit market conditions played a role in the rise in filings during the 2008-09 recession. We document that the fraction of unemployed among the filers does increase during the recession. A rough “back-of-the-envelope” analysis suggests that as much as a half of the rise in insolvencies may be due to increased unemployment. We also document an increase in the share of filers with “middle class” characteristics during the recession – a larger fraction of filers are homeowners, live with a spouse or a partner, have student loans, earn larger incomes, and are middle-aged. The average outstanding debts of filers are larger during the recession, supporting the hypothesis that rolling-over large debts became more difficult due either to tighter lending standards or to increased cost of funds.

These shifts in characteristics are broadly consistent with simple economic theory. As one would expect, unemployed filers became more prevalent during the recession. The increase in filers with “middle class” characteristics suggests that the high levels of unemployment during the recent recession impacted households with stronger labour force attachment, who would during more “usual” economic times have a low probability of extended periods of unemployment. Simple economic theory suggests that the filers most affected by a tightening of lending standards are those with higher debt levels. This reflects both the fact that higher debt levels makes these households more vulnerable to higher interest rates (i.e., larger risk premia on loans to riskier borrowers) or to a tightening of credit lines which makes it more difficult to roll-over their debt. This mechanism also leads to more filers in a recession with “middle class” characteristics (such as higher levels of education and home ownership), since these characteristics are often a prerequisite for initial access to large amounts of credit.

Thus, both macro- and micro-level empirical analysis supports the thesis that there are two important mechanisms driving the rise of insolvencies during recessions – the “direct” effect of adverse income shocks, and the “supply-side” effect coming from the tightening of the lending standards. Finally, we feel this work has motivated a need to better understand how these mechanisms interact and develop strategies to assess their individual impact.


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