Saturday, December 10, 2005

The Unintended Consequence of Bankruptcy Laws

....is the perpetuation of poverty.
The conclusion may not sound intuitive. So let me explain.

Let us at the outset understand the rationale behind Bankruptcy Laws and the problem supposedly being addressed by this legislative fiat.
Finance, in most countries, is beyond the reach of aspiring first-generation entrepreneurs without the backing of collateral. If the debtor does not have sufficient means, he often resorts to mortgaging the house in which he resides, which could well be his sole tangible asset. In the event of failure to repay the loan, he faces the grim prospect of being deprived of the only thing that he could lay claim upon.

To alleviate the distress of people facing such a predicament, Bankruptcy Laws are framed, wherein a substantial portion of household assets are exempted from seizure by creditors. The intent of this fiat is to prevent the borrower from being rendered destitute in case of a financial disaster.

At first sight, the law is seemingly beneficial. But the result is disastrous. The law deprives the talented entrepreneur without means of his only chance of gaining access to credit. The Bankruptcy exemption ensures that he is left with no assets that can be used as collateral. The probability of banks turning him down goes up considerably. This is how an entrepreneurial career is nipped in the bud, and enterprising businessmen are doomed to a mediocre existence.

The main beneficiaries in this system are the well-to-do established businessmen who will have enough assets left even after the exemptions that can be used as collateral. Such laws also insulate them from competition as new players will find it well-nigh impossible to finance their ventures.
Hence, a law that was framed with the intent of levelling the playing field has the opposite effect of widening the gap between the haves and the have-nots. Sad.

Do read this wonderful book for more on this.


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