Protection for Whom? Creditor Conflict and Bankruptcy

In the absence of a bankruptcy law, private debt collection remedies generally result in an ad hoc disposal of the debtor's assets, which reduces the aggregate value of creditors' claims. We show that creditors will often choose not to write private contracts that would prevent this inefficient behavior, even though these contracts would be to the mutual benefit of all creditors. Our analysis therefore provides an economic rationale for the existence of a bankruptcy law that makes a collective resolution compulsory for all creditors. We argue that such a mandate is a requisite part of any effective bankruptcy system, including proposals for market-based resolutions of insolvency.