NCPA - National Center for Policy Analysis

Generous Bankruptcy Laws Hurt Business Credit

November 12, 2002

Personal bankruptcy laws affect small firms' access to credit. When a firm is unincorporated, its debts are personal liabilities of the firm's owner, so 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, because the firm's debts will then 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.

Data from the 1993 National Survey of Small Business Finance (NSSBF) show that the supply of credit falls, and the demand for credit rises, when non-corporate firms are located in states with higher bankruptcy exemptions.

  • If small firms are located in states with unlimited rather than low homestead exemptions, for example, they are more likely to be denied credit, they receive smaller loans, and interest rates on those loans are higher.
  • Small corporations are also subject to credit restrictions, and lenders to small corporations often require that the owner guarantee the loan or give the lender a second mortgage on his house.
  • Lenders often disregard a small firm's organizational status in making loan decisions and primarily consider size.

The findings show that laws exempting assets from bankruptcy can harm the small businesses they are meant to help. Small businesses are the primary job engine in the U.S. economy despite their natural volatility. Over 13 percent of U.S. jobs in 1995 were in firms that did not exist before 1990 and over 12 percent of jobs in 1990 were in firms that had ceased to exist by 1995.

Source: Les Picker, "Generous Bankruptcy Rules Limit Small Firm Credit," NBER Digest, November 2002; based on Jeremy Berkowitz and Michelle, "White Bankruptcy and Small Firms' Access to Credit," NBER Working Paper No. 9010, June 2002, National Bureau of Economic Research.

For text

http://papers.nber.org/papers/w9010

 

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