Bank of Israel Warns Lenient Bankruptcy Laws Lead Banks to Tighten Credit Access
A new study by the Bank of Israel's research division reveals a significant economic dilemma arising from overly lenient bankruptcy laws. While such laws aim to ease the burden on debtors, the research shows that banks respond by sharply restricting credit availability to the broader public. Analyzing data from 13 European countries and Israel over 2001-2020, the study found that banks' credit tightening is nearly twice as strong as the increase in bankruptcy filings, indicating that the wider credit market bears a heavier cost than the targeted relief given to debtors.
The researchers, including Yehonatan Barzani, Roy Stein, and Georgi Walter, observed that the surge in bankruptcy filings peaks 3-4 years after legislation but gradually returns to baseline within 6-7 years. In contrast, financial institutions begin reducing credit supply immediately upon legislative approval, with the tightening peaking within two years and persisting beyond five years, continuously slowing consumer credit growth.
The findings directly relate to Israel's 2019 Bankruptcy and Economic Rehabilitation Law, intended to help debtors recover but which has worsened creditors' conditions. Post-reform data show a drop in debt repayment rates from 31% to 25%, partly due to a shortened median discharge period from 75 to 60 months. Meanwhile, median debtor liabilities increased from 250,000 to 320,000 shekels, suggesting that the law incentivizes higher-debt individuals to file for bankruptcy.
The study distinguishes between debtor and lender motivations: debtors are driven by reduced social stigma and simplified procedures, while lenders react negatively to provisions easing debt discharge and payment plans, which increase creditor losses. This dynamic creates a structural policy dilemma where broader society pays the price for debtor protections through credit rationing, higher interest rates, and reduced loan accessibility, especially for vulnerable borrowers.
Globally, bankruptcy laws balance social safety nets with market discipline. While U.S. reforms in 2005 strengthened creditor rights and reduced filings, Europe and Israel have trended toward debtor-friendly laws, challenging credit markets long-term. The Bank of Israel cautions against broad leniency, recommending targeted legislative adjustments that maintain stigma reduction and procedural simplicity but tighten debt discharge conditions and payment mechanisms to mitigate lender risk. The report also warns that easing laws during credit contractions or prolonged legislative processes may prompt banks to restrict credit even before laws take effect.
