Bankruptcy and Small Firms' Access to Credit

Abstract

In this paper, we investigate how personal bankruptcy law affects small firms' access to credit. When a firm is unincorporated, its debts are personal liabilities of the firm's owner, so that lending to the firm is legally equivalent to lending to its owner. If the firm fails, the owner has an incentive to file for personal bankruptcy, since the firm's debts will be discharged and the owner is only obliged to use assets above an exemption level to repay creditors. The higher the exemption level, the greater is the incentive to file for bankruptcy. We show that supply of credit falls and demand for credit rises when non-corporate firms are located in states with higher bankruptcy exemptions. We test the model and find that, if small firms are located in states with unlimited rather than low homestead exemptions, they are more likely to be denied credit, they receive smaller loans and interest rates are higher. Results for non-corporate versus corporate firms suggest that lenders often disregard small firms' organizational status in making loan decisions.

Does Bankruptcy Law Affect Business Turnover? Evidence From New and Existing Business

“…Berkowitz and White (2004), and Fan and White (2003) argue that changes in the homestead exemption are exogenous because each state essentially determined its exemption in 1983 and most changes after that reflected inflation adjustments. Berkowitz and White (2004), and Fan and White (2003) argue that changes in the homestead exemption are exogenous because each state essentially determined its exemption in 1983 and most changes after that reflected inflation adjustments.…”

“…While there has been an extensive literature examining the impact of bankruptcy law on entrepreneurs (Armour and Cumming 2008;Berkowitz and White 2004;Fan and White 2003;Mathur 2005;Paik 2013), one aspect of these laws that warrants further investigation is whether or not bankruptcy law has created more businesses on net. The goal of the wealth protection is to allow individuals to protect some assets if the business fails.…”

“…First, bankruptcy discharges unsecured debt, creating wealth insurance if the enterprise fails (supply side effect). This mechanism will drive financial institutions to charge higher interest rates on small business loans, which will discourage individuals from starting a small business (Berkowitz and White 2004;Scott and Smith 1986). However, bankruptcy law also affects the cost of capital through higher interest rates (demand-side effect).…”

The Bankruptcy Reform Act of 2005 and Entrepreneurial Activity

“…Lenders know that the firm does not possess adequate assets to back the debt and that the firm's assets can be diverted to the owner. In effect, lenders do not view small businesses as separate corporations or entities (Berkowitz and White, ). That approximately 20% of all personal bankruptcy filings in the U.S. include some business debt indicates the importance of personal bankruptcy policy for small businesses (Sullivan et al, ; Lawless and Warren, ).…”

“…Consistent with the competitive market prediction, the study reveals that borrowers bear these increased costs in the form of higher interest rates. Berkowitz and White () also demonstrate that small firms are more likely to be turned down for loans if they are located in states with higher bankruptcy exemptions, implying that more forgiving bankruptcy law is negatively correlated with access to external credit . Therefore, in theory, we expect lower interest rates and an increase in the availability of credit, which encourage entrepreneurship, when bankruptcy law becomes more pro‐creditor.…”