Bank of Israel: Lenient Bankruptcy Laws Harm the Credit Market

To ease the burden on bankrupts suffocating from debt – or to prevent the rise in loan costs for the general public? According to a new study published by the Research Division of the Bank of Israel, the answer to this question reveals an economic trap: when the law becomes too lenient toward debtors, banks immediately react by tightening the tap for everyone else.

The researchers found that the intensity of the banks' negative reaction and credit contraction is almost twice as strong (a decrease of about 0.33 standard deviations in the credit growth rate) compared to the increase in the number of insolvency applications (an increase of only 0.16) — a figure reflecting that the cross-sectional price paid by the credit market is much heavier than the point-based assistance granted to debtors.

The study, which analyzed data from 13 countries in Europe and Israel over two decades (2001–2020), presents an unequivocal bottom line: while the surge in the number of citizens rushing to exploit the lenient law and file for insolvency is only temporary, the reaction of banks and financing bodies is much longer and deeper.

The findings of the scientific analysis (by Yonatan Barzani, Roi Stein, and Georgi Walter) show that following debtor-friendly legislation, the number of insolvency filings peaks after 3–4 years, but gradually weakens until a full return to the original level after 6–7 years. In contrast, financial institutions did not even wait for the day the law actually came into effect: lenders began reducing credit supply as soon as the legislation was approved. This reduction peaked within two years and continued beyond the five-year horizon, continuously reducing the growth rate of consumer credit for households.

These data connect directly to findings examined in Israel following the Insolvency and Economic Rehabilitation Law that came into effect in 2019. The Israeli law was intended to help debtors rehabilitate, but in practice, it worsened the situation for creditors. An analysis of insolvency cases in Israel showed that the debt repayment rate of borrowers who fell into difficulty dropped from 31% before the reform to 25% after it, partly because the median time to receive a discharge from debts ("pater") was shortened from 75 months to 60 months. At the same time, the median debt of debtors climbed from 250,000 shekels to 320,000 shekels — a phenomenon indicating that the law's leniencies provided an incentive specifically for those with higher debts to enter the process.

To understand why lenders and debtors react differently, the researchers isolated the various legislative clauses. What drove citizens to apply for insolvency was mainly the reduction of social stigma and the simplification of bureaucracy. In contrast, what scared off banks and triggered red lights for them were the clauses concerning the conditions for receiving a discharge from obligations and debt restructuring mechanisms — the exact elements that increased the "haircut" absorbed by creditors and led credit providers to tighten underwriting conditions in advance.

The result is a structural policy dilemma where the broad and normative public pays the price for protecting debtors. When the government grants increased protection to the needy and shortens the path to debt erasure, it creates a side effect of credit rationing. Banks re-evaluate risk, raise interest rates, and reduce access to credit, especially for weaker populations.

The Bank of Israel warns that excessive leniencies for debtors take a heavy toll on the entire economy and recommends that policymakers not treat the law as a single block but rather perform targeted adjustments. The researchers recommend maintaining the simplification of bureaucracy and the reduction of stigma – clauses that help debtors rehabilitate without scaring banks – and simultaneously tightening back the conditions for debt erasure ("pater") and payment installment mechanisms, which are the main risk generators that scare off credit providers.