How large are the welfare losses associated with inefficient courts? Legal scholars and economists have long grappled with this important question because inefficiencies in the court system are jointly determined with other factors. For example, poorer countries often have more poorly designed laws, as well as fewer and less qualified court staff. This makes assessing the costs of inefficient courts a difficult task: to find plausible estimates, one would need variation in court efficiency that is unrelated to other local factors.

In a recent paper, ‘Busy Bankruptcy Courts and the Cost of Credit’, I address this challenge in a study of bankruptcy courts in the United States. I exploit the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which substantially changed the U.S. Bankruptcy Code – mainly by making it considerably harder for individuals to file for Chapter 7 bankruptcy. Following the implementation of BAPCPA, bankruptcy filings saw their largest drop during peace times since the start of court records in 1899. Because it almost exclusively changed consumer cases, the drop in the caseload of bankruptcy courts was most pronounced in bankruptcy districts with a higher pre-reform share of individual bankruptcies (as compared to firm cases). This led to a sizeable change in the caseload per judge in consumer-centric districts that was unrelated to economic fundamentals and largely unpredictable: around the passing of BAPCPA, commentators had widely varying opinions on what the potential effects of the reform might be.

I exploit this quasi-random drop in court caseload to study its effect on the loan terms of publicly-listed non-financial corporations. I find large indirect effects of BAPCPA on the interest rate spreads and loan maturities of firms: while the passing of the reform in the House in April 2005 had no effect, loan terms improved sharply and persistently in consumer-centric districts when the actual drop in caseload materialised in January 2006. Prior to the caseload drop, consumer-centric districts had not systematically differed in their loan terms compared to firm-centric districts. This result is also unchanged when excluding corporations that might have been directly affected by provisions in BAPCPA. Taken together, we can thus interpret the estimates as the causal effect of relieving overburdened courts. This is further supported by looking at the types of borrowers that were most affected: smaller, riskier, and more leveraged firms that face a higher risk of bankruptcy.

The causal estimate allows me to provide an estimate of the social costs of overburdened bankruptcy courts under an additional set up assumptions. At the heart of this exercise lies the idea that the estimated savings of lower interest rate spreads and longer maturities reduce the annual interest burden of non-financial corporations. Together with estimates on the costs of creating new judgeships in the United States, I can conduct a cost-benefit analysis for reducing the workload of courts. 

This back-of-the-envelope calculation implies large costs of inefficient legal enforcement and relatively low costs of resolving it. For example, I estimate that BAPCPA reduced the interest burden of U.S. non-financial corporations by around $8 to $15 billion per year. I also estimate the potential effects of the Bankruptcy Judgeship Act of 2017, which was signed into law on October 26, 2017 and added four new permanent bankruptcy judgeships. While the costs of these additional judgeships are in the range of $4 million, my estimates imply potential savings in the interest burden of up to $685 million. This approach also allows me to identify the bankruptcy districts with the highest social returns to hiring new judges, among others the Northern and Southern District of Texas and the Northern District of Illinois.

Taken together, my research suggests that the social costs of short-staffed courts are indeed enormous – a sentiment often voiced by the judges themselves. Policy makers should pay attention: the estimated benefits of creating new bankruptcy judgeships appear to dwarf the costs.

 

Karsten Müller is a Postdoctoral Research Associate at the Julis-Rabinowitz Center for Public Policy & Finance at Princeton University.