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This paper uses a principal/agent framework to analyze consumer bankruptcy. The bankruptcy discharge partly insures risk-averse borrowers against bad income realizations but also reduces the borrower’s incentive to avoid insolvency. Among our results are the following: ( a ) high bankruptcy exemptions increase bankruptcy insurance but at the cost of reducing the borrower’s incentives to stay solvent; ( b ) reaffirmations—renegotiations—have ambiguous efficiency effects in general, but the right to renegotiate is especially valuable for relatively poor persons; ( c ) giving consumers the ex post choice regarding which bankruptcy chapter to use also provides more insurance but, by making bankruptcy softer on debtors, has poor incentive effects; and ( d ) serious consideration should be given to expanding the scope of consumers’ ability to contract about bankruptcy because trade-offs between risk and incentives are context sensitive and, thus, are poorly made in statutes of general application.
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