Personal Bankruptcy Law, Debt Portfolios, and Entrepreneurship

Abstract

Every year 400,000 entrepreneurs fail and 60,000 file for personal bankruptcy. The option to declare bankruptcy provides entrepreneurs with insurance against the financial consequences of business failures. However, it comes at the cost of worsened credit market conditions. In this paper, we construct a quantitative general equilibrium model of entrepreneurship to show that the presence of secured credit in addition to unsecured credit substantially alters the trade-off between insurance and credit conditions. A lenient bankruptcy law always worsens credit conditions, in particular for poor entrepreneurs. If secured credit is not available, their credit conditions are so bad that many prefer to become workers. In that case, we show that the optimal bankruptcy law is very harsh because the benefits from better credit conditions dominate the worsened insurance. However, if secured credit is available, entrepreneurs who might be rationed out of the unsecured credit market can still obtain secured credit. Therefore, they can run larger firms, which makes entrepreneurship more attractive. Since the presence of secured credit lowers the cost of a generous bankruptcy law, we find that the optimal law is lenient in this case: moving to the optimal bankruptcy law would increase entrepreneurship by more than four per cent.

Debt renegotiation under reputation concerns and tolerance for failure

“…Our results find empirical support in Fan and White (2003) and Armour and Cumming (2008) who show that more lenient bankruptcy laws encourage entrepreneurship. 4 Mankart and Rodano (2015) provides similar conclusion on the relationship between bankruptcy exemptions and entrepreneurship. Consistent with tighter monitoring and intolerance towards failure leads to more manipulation, Laux and Stocken (2012) find that more stringent enforcement laws may induce more misreporting.…”

“…Hence, at Date 2, the difference between the cost of capital that prevails for entrepreneurs who continue the initial project, r, and the one charged for those who renegotiate, r′, allows to capture the creditor's attitude towards distress. Indeed, the renegotiation terms underlying the decision to continue financing an underperforming project should reflect a creditor's tolerance for failure (see, e.g., Corbett & Mitchell, 2000;Landier, 2005;Mankart & Rodano, 2015;Rodano et al, 2016;White, 2011). A tolerant creditor would choose a debtor-friendly renegotiation conditional on the entrepreneur's early revelation of cash flow problems.…”

The (Un-) Importance of Chapter 7 Wealth Exemption Levels

“…17 However, as shown in Figure 6 there is no positive relationship between the exemption level and the occurrence of default. Previous models, for example Athreya (2008), Pavan (2008) and Lopes (2008) for consumers and Mankart and Rodano (2012) for entrepreneurs, find a strong positive relationship between the exemption level and default rates. The reason my model predicts only modest increases in the default rate when the exemption is very low and almost no increase once it exceeds $20,000 is that almost no household is affected by such high exemption levels.…”

“…4 Both exemption levels are measured in 1993 Dollars. The higher one corresponds to the population weighted median as shown byMankart and Rodano (2012).5 The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 has strengthened these requirements to $750 and 90 days.6 The data pertain to the period before 2005 when the bankruptcy law was reformed (BAPCPA 2005) and this period was increased to 8 years and some form of means testing was introduced.…”

An Anatomy of U.S. Personal Bankruptcy Under Chapter 13

“…It is well understood that personal bankruptcy laws affect credit markets and therefore the supply and demand for credit (Gropp et al., ; Lin and White, ), the ability of households to insure against labor income risk (Athreya et al., ), their consumption behavior (Grant, ; Filer and Fisher, ), labor supply (Han and Li, ), mobility (Elul and Subramanian, ), and entrepreneurial activity (Meh and Terajima, ; Mankart and Rodano, ).…”