New research at the Bank of Israel: Individual bankruptcies: consumer credit, the business cycle, and the “Leniency Index”

New research at the Bank of Israel: Individual bankruptcies: consumer credit, the business cycle, and the "Leniency Index"

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Full research (Hebrew)

• The "Leniency Index" proposed in this new research reflects the widespread legal policy regarding the bankruptcy process and the economic rehabilitation of debtors; the higher the index, the more efficient the bankruptcy process is and the more worthwhile it is to open the processes by debtors who are in financial distress.
• The research found that the bankruptcy rate of individuals relative to the population in Israel is coordinated not only with macroeconomic variables but, even more so, with the "Leniency Index".
• The research examines the impact of the legal reform on the bankruptcy process in Israel that went into effect in September 2019, which focused on the debtors, with one of its main goals being the economic rehabilitation of debtors and their return to proper economic life.

The rise in the inflation rate accompanied by an increase in the interest rate is liable to increase the risk of a rise in cases of individuals' (households and "authorized businesses")[1]bankruptcies. The share of these cases relative to the population is an important economic variable both for economic activity and for pricing the risk facing credit providers. Moreover, individuals' bankruptcies impact on economic activity via numerous channels, particularly on the business cycle's depth and on labor productivity. Therefore, understanding the range of factors impacting on these cases is important for economic policy makers. The considerations impacting on the decision to open a bankruptcy proceeding do not depend only on the debtors' economic and financial condition, but also-and even more so-on the legal environment regulating the processes and the social and cultural variables related to the approach to the proceeding by society and the government.

According to the World Bank, an efficient rehabilitation process is one in which, at its conclusion, the debtor is rehabilitated and sets off on a new economic path. In addition, an efficient proceeding provides an incentive for the work effort of the debtors being rehabilitated, encourages business initiatives, and therefore even leads to increasing the productivity in the economy. In the past decade, many advanced economies implemented various reforms in bankruptcy proceedings, and in Israel the reform in this area went into effect in September 2019. All the countries have placed the focus on the economic rehabilitation efforts by debtors and their return to proper economic life. These reforms include a significant change in the legal framework regulating the goal of the proceedings and how they are implemented, and therefore impact on the range of considerations by debtors in opening a bankruptcy proceedings.

In their new research, Dr. Roy Stein and Yehonatan Berzani of the Bank of Israel Research Department, and Dr. Moran Ofir of the Harry Radziner Law School in Reichman University, calculated for the first time in Israel the "Leniency Index", reflecting the widespread policy regarding bankruptcy and the economic rehabilitation of debtors who need this process. The uniqueness of the index proposed in this research relies on the characteristics of the proceedings and the legal environment in actuality, as opposed to such indices around the world that are based on surveys and questionnaires. The index indicates a marked change in the legal environment regulating these proceedings due to the reform in bankruptcy laws, and it particularly reflects the system of incentives surrounding the decision to submit a request to open a proceeding. The reform, which benefited debtors, with one of its main goals being the economic rehabilitation of debtors and their return to proper economic life, increases the incentives to open proceedings and the number of requests for opening and managing them. In fact, a statistically significant effect of the "Leniency Index" on the scope of opening proceedings has been found. The adjustment of the index to the various legal environments proves its great importance, both for examining the effect of the legislative reforms and for determining appropriate social and economic policy. The "Leniency Index" indicated a decrease in the incentives to open bankruptcy proceedings after the approval of the reform in March 2018, which intensified toward its implementation in September 2019. This development, deriving from the expectations for the implementation of the reform, indicates that the individuals preferred to wait with submission of a request to open bankruptcy files until the implementation of the reform. In fact, the closer the reform's implementation date came, the sharper the decline in the scope of requests submitted. After the implementation of the reform, the "Leniency Index" increased sharply and served as the main explanation for an increase in the scope of requests submitted to open bankruptcy files of individual that occurred the end of 2019 and in the beginning of 2020, even before the COVID-19 crisis.

The COVID-19 period did not increase, to a statistically significant degree, the share of submissions of requests to open bankruptcy proceedings among individuals. Moreover, in April and May 2020, in which the first and severe lockdown, and the slow exit from it, occurred, the scope of requests to open bankruptcy proceedings declined markedly. These findings indicate that despite the sharp decline in economic activity, this period did not lead to a wave of bankruptcies by individuals as had been expected. It may be that the policy of the government and the Bank of Israel conducted at that time-which included payment grants, unpaid leave policy, extending loans with government guarantees, freezing mortgages and broad deferrals of payments-is what led to that.

We also found that consumer credit impacts, to a statistically significant degree, the number of individuals' bankruptcy cases. In contrast, credit for housing purposes, which includes real estate assets as security[2], does not impact on it to a statistically significant degree. It may be that this outcome was seen because over the period of the sample, home prices increased nearly consecutively, and therefore it is important to examine if these findings will remain in place even in a period in which real estate prices do not experience a prolonged increase. Moreover, we found a statistically significant correlation of the corporate bankruptcy rate as an estimate of the business environment in which individuals operate, on the number of bankruptcy cases of individuals. The tight connection between the scopes of corporate bankruptcies to the parallel rate among individuals indicates the potential connectivity forming, and that one sector will lead to a wave of bankruptcies in a different sector. A partial explanation of this correlation may be that with small and medium sized companies (SMEs), at times the owners tend to give personal guarantees for the company's liabilities, and thus combine their financial robustness with the financial resilience of the corporation they own.

The "Leniency Index", 2011-9/2021

The "Leniency Index" reflects the legal environment regulating the management of individual bankruptcy proceedings. The figure shows the effect on the scope of bankruptcy cases of Israel's reform, which mostly benefited the debtors facing extensive loans and increased the efficiency of the proceedings until granting the bankruptcy discharge. Moreover, the index reflects the expectations of these debtors (and of the creditors) for a future change in the legal situation. The figure can also indicate that the effect of the reform continued over the course of the sample. This work indicates an upward trend that has not yet reached its conclusion, even after two years have passed since it was implemented.

[1]"Authorized business"-one of main ways to register for self-employed and owners of small and medium sized businesses.

[2]This credit is defined from the beginning as less risky credit than is credit that is not for housing purposes.