Generous Bankruptcy Rules Limit Small Firm Credit

The authors 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.

Small businesses are the primary job engine in the U.S. economy. From 1990 to 1995, businesses with fewer than 500 employees accounted for 76.5 percent of net new jobs. But small businesses are, by their nature, volatile. 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. This high turnover frequently results in personal bankruptcy for the small business owners and, in turn, affects small firms' access to credit.

In Bankruptcy and Small Firms' Access to Credit (NBER Working Paper No. 9010), authors Jeremy Berkowitz and Michelle White investigate how 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. That exemption level is regulated by individual states and may take the form of owner-occupied housing exemptions (homesteading exemption), equity in cars, cash holdings, and goods, such as furniture and tools. The higher the exemption level, the greater is the incentive to file for bankruptcy.

Using data from the 1993 National Survey of Small Business Finance (NSSBF), the authors 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. When a firm is incorporated, limited liability implies that the owner is not legally responsible for the firm's debts. However, lenders to small corporations often require that the owner guarantee the loan and also may require that the owner give the lender a second mortgage on his/her house. This wipes out the owner's limited liability for purposes of the particular loan and makes small corporate firms into corporate/non-corporate hybrids. Thus, personal bankruptcy law may apply both to non-corporate firms and to small corporate firms. The authors find that lenders, therefore, often disregard a small firm's organizational status in making loan decisions and primarily consider size.

-- Les Picker