Bankruptcy and Small Firms Access to Credit

Transcription

1 Bankruptcy and Small Firms Access to Credit Jeremy Berkowitz Federal Reserve Board and Michelle J. White University of Michigan June 2000 Contact Address: Prof. Michelle White Dept. of Economics Univ. of Michigan Ann Arbor, MI tel: 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 rises when non-corporate firms are located in states with higher bankruptcy exemptions. We test the model and find that small firms are 25% more likely to be denied credit if they are located in states with unlimited rather than low homestead exemptions. Acknowledgements: We are grateful to Emily Lin for research assistance and to John Wolken, Mitchell Petersen, Patrick Bolton, Ronald Mann, Katherine Samolyk, Mark Weinstein and the referee for very helpful comments. Earlier versions of this paper were presented at the N.B.E.R. Corporate Finance Meeting, the Federal Reserve System Conference on Small Business Access to Capital and Credit, Washington, D.C., March 1999, and the ASSA Meetings, Boston, January The Federal Reserve System and the N.S.F., under grant number NSF-SBR , provided financial support.

2 Small businesses are one of the primary sources of new jobs in the U.S. economy. From 1990 to 1995, small businesses (those with fewer than 500 employees) accounted for 90.1 percent of net new businesses and 76.5 percent of net new jobs. But businesses have a very high turnover rate: over 13 percent of 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 Despite the importance and the complexity of small business as a contributor to the U.S. economy, there has been surprisingly little academic research on the economic environment faced by small business owners or the effects of policy variables on small business success. In this paper, we investigate whether and how personal bankruptcy law affects small firms access to credit. It is well-known that the U.S. has separate bankruptcy procedures for individuals versus corporations. What is less well-known is that personal bankruptcy procedures also apply to small firms. 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 can file for bankruptcy and his/her business and unsecured personal debts will be discharged. When the firm is a corporation, limited liability implies that the firm s debts are legally distinct from the owner s. However, lenders to small corporations often require that the owner guarantee the firm s debts or give the lender a second mortgage on the owner s house. This wipes out the owner s limited liability for purposes of the particular loan and reduces the distinction between corporate and non-corporate small firms. It is also easy for owners of small corporate firms to transfer the firm s assets to themselves, so that lenders may not view the corporate/non-corporate distinction as meaningful. Thus personal bankruptcy law applies to noncorporate firms and may also apply to small corporate firms. 2 Suppose a small firm has made losses and its owner is considering filing for bankruptcy under Chapter 7. When individuals file for bankruptcy, their unsecured debts are discharged. Their future earnings are completely exempt from the obligation to repay, but they must give up all the assets they own in excess of an exemption level. While bankruptcy is a matter of Federal law and the procedure is uniform across the country, Congress gave the states the right to set 1 See U.S. Small Business Administration (1998). 2 Sullivan, Warren and Westbrook (1989) surveyed a sample of individuals who filed for bankruptcy during the 1980 s and estimated that around 20% had debts from a failed business. This is about double the proportion of all U.S. households that has self-employment income. 2

3 their own bankruptcy exemption levels and they vary widely. The higher the exemption level in a state, the more attractive it is for debtors who live in that state to file for bankruptcy, because they can keep more of their assets while obtaining discharge of their debts. Thus bankruptcy partially insures debtors wealth and the level of insurance rises when exemption levels are higher. As long as owners of small firms are risk averse, their demand for loans is likely to be higher in states with higher bankruptcy exemptions. But lenders find it less attractive to lend in states with higher bankruptcy exemptions, because borrowers are more likely to file for bankruptcy. Thus supply of credit to small firms is predicted to be lower in states that have higher bankruptcy exemptions. These predictions apply to non-corporate firms and also may apply to corporate firms. In this paper we present a theoretical model of bankruptcy and credit markets and test the model using the 1993 National Survey of Small Business Finance. We find evidence that variations across states in bankruptcy exemptions have important effects on small firms' access to credit. Small firms are 25% more likely to be denied credit if they are located in states with unlimited homestead exemptions rather than low homestead exemptions. We also find that lenders ignore the legal distinction between corporate and non-corporate small firms in making their lending decisions, so that the effect of bankruptcy on access to credit is approximately the same for both. I. Existing Literature We know of only one article which examines the effect of personal bankruptcy law on business credit markets. Scott and Smith (1986) examined the effect of the new U.S. Bankruptcy Code, adopted in 1978, on business credit markets. They argued that adoption of the Code caused the cost of business loans to increase and that lenders raised interest rates in response. They found support for this hypothesis in their empirical work. However their study examined only the net effect on interest rates of many changes adopted simultaneously as part of the 1978 Code, all of which applied uniformly over the U.S. Our study, in contrast, focuses on the effects of varying bankruptcy exemption levels across U.S. states on small business credit. As part of the Code, Congress allowed the states to adopt their own exemption levels, so that these vary across states. 3

4 On the personal bankruptcy side, Gropp, Scholz and White (1997) investigated how varying bankruptcy exemption levels across states affect markets for non-business loans. They found that in states with higher exemption levels, applicants were more likely to be turned down for credit, but demand for loans increased. Overall they found that higher bankruptcy exemption levels tend to shift credit from households with low assets to those with high assets, since lenders are willing to accommodate the increased demand of the latter but not the former. Berkowitz and Hynes (1999) and Lin and White (1999) re-examined this issue for mortgage loans. Peterson and Rajan (1994, 1996) examine small business credit markets using earlier versions of the NSSBF. They are mainly concerned with examining the effects of long term relationships between firms and banks and the effects of concentration in local banking markets on interest rates and availability of business credit. More recent research on banking relationships, using the same dataset, includes Cole (1998) and Cole, Goldberg, and L. White (1999). Cavalluzzo, Cavalluzzo, and Wolken (1999) examine patterns of race discrimination in banking relationships. There are a number of theoretical models which examine the effects of bankruptcy on credit markets. 3 II. A Stylized Model Suppose an owner of an unincorporated firm contemplates borrowing to invest in the firm. The amount to be borrowed, B, is assumed to be fixed. The loan will be due next period and, including interest, the borrower will then owe B > B. The owner also owns a house of value V, on which there is a mortgage of amount M. The mortgage is also due next period and, including interest, the owner will then owe M > M. The value of the house next period is assumed to be uncertain and its distribution is g(v). V may be uncertain either because housing values fluctuate or because the business lender can t predict how aggressively the owner will 3 Bester (1994) predicts that firms are less likely to default when loans are collateralized and Hart and Moore (1989) predict that firms are more likely to default when they have a single creditor rather than multiple creditors and when the liquidation value of the firm s assets is lower. Unfortunately our data do not allow these predictions to be tested, because default can occur anytime during the seven years prior to the survey while other firm characteristics are for the time of the survey only. Longhofer (1997) predicts that tighter rationing of small business credit will occur when bankruptcy exemptions are higher, but his model does not distinguish between the two types of exemptions. 4

5 attempt to protect his/her house from the lender s efforts to collect following default. 4 The owner s non-housing wealth next period, including the return on the investment in the firm, will be W. The distribution of W is denoted f(w). f(w) and g(v) are assumed to be independently and identically distributed and the two distributions are also assumed to be independent. The state in which the firm is located is assumed to have bankruptcy exemptions of X h for equity in the house (the homestead exemption) and X p for personal property. The mortgage lender is assumed to have a secured interest in the house, while the business lender is assumed to have an unsecured claim against all of the owner s assets. If the owner defaults on the mortgage, the mortgage lender forecloses on the house. If the owner defaults on the business loan, the business lender also has the right to foreclose on the house but may or may not choose to do so. When either lender forecloses on the house, the owner must relocate to another residence, which costs an amount R. Because the mortgage lender has the first lien, it always takes charge of selling the house in a foreclosure. The proceeds of selling the house are V-C f, where C f is the transactions cost of foreclosure. The proceeds are used, first, to pay off the mortgage balance, M ; second, to return an amount up to the homestead exemption, X h, to the owner; and, third, to repay the business lender up to the amount owed, B. The foreclosure procedure is the same regardless of whether the debtor files for bankruptcy. 5 If the owner decides to default on the business loan, then she is assumed to file for bankruptcy under Chapter 7. 6 The owner s cost of filing for bankruptcy is C b. In bankruptcy, the 4 Owners might, for example, transfer ownership of the house to their spouses or to a trust or have their lawyers use legal tactics to delay foreclosure proceedings by the lender. State rules also vary in how strongly they protect debtors in foreclosure proceedings. 5 In most states, the same exemptions apply regardless of whether the owner files for bankruptcy or not. However there is a uniform Federal bankruptcy exemption and about one-third of the states allow their residents to use it. If the state s exemption levels are lower than the Federal exemption levels, then the exemptions could rise when debtors in these states file for bankruptcy. 6 There are actually two personal bankruptcy procedures, Chapter 7 and Chapter 13, and debtors are allowed to choose between them. Under Chapter 7, debtors must give up all their non-exempt assets for repayment to creditors, but their future earnings are completely exempt from the obligation to repay. Under Chapter 13, debtors do not have to give up any of their assets, but they must propose a repayment plan under which they will use a fraction of their future earnings for three years to repay debt. Creditors must receive as much under Chapter 13 repayment plans as they would have received under Chapter 7. Most debtors choose to file for bankruptcy under Chapter 7 because they either have few non-exempt assets or they can rearrange their non-exempt assets to make them exempt. Chapter 7 is particularly favorable for business owners, since they are likely to have very high levels of unsecured business and personal debt, both of which will be discharged in bankruptcy under Chapter 7. But even if debtors have non-exempt assets and prefer to file under Chapter 13, their willingness to repay from future earnings depends on the amount they would be required to repay in Chapter 7. Because of this close connection between the obligation to repay under the two Chapters, we treat debtors decision to file for bankruptcy under Chapter 7 as a decision to file for bankruptcy generally. Also, debtors filing under Chapter 13 are only obliged to repay creditors 5

6 owner is obliged to give up all her non-housing wealth in excess of the personal property exemption for repayment to creditors. Depending on the values of V and W in period 2, there are three cases to be considered. Case (1). No foreclosure by the business lender (V <= M X h C f ) Suppose the net value of the house in period 2, V-C f, turns out to be less than M' X h. This means that if the owner defaults on the business loan, the business lender will not foreclose on the house, because sale of the house would not cover higher ranking claims and the lender would therefore receive nothing. Because the business lender never forecloses, the owner decides separately whether to default on the business loan or on the mortgage, i.e., she may default on either loan without defaulting on the other. Consider first the owner s decision to default on the mortgage. If V - M < -R, then the owner's equity in the house is more negative than the cost of relocating and she has an incentive to default on the mortgage. 7 She relocates and the mortgage lender sells the house V - C f. 8 The housing portion of the owner's wealth is -R. Now suppose M - R<V< M X h C f. The owner's equity in the house may be either positive or negative, but it is great enough that she does not default on the mortgage. The housing portion of her wealth is therefore V - M. Now consider the owner's decision whether to default on the business loan. If she defaults on the business loan, then she is assumed to file for bankruptcy. W ~ denotes the critical level of wealth, W, such that the owner is indifferent between defaulting versus not defaulting on the business loan/filing for bankruptcy. Suppose first that the owner does not default on the mortgage. If W W ~, then the owner repays the business loan in full. After repayment, her total net housing plus non-housing wealth is W-B V - M. If X p W < W ~, then the owner defaults on the business loan and files for bankruptcy. In this case, she repays W-X p to the business lender and her total net wealth is X p -C b V - M. This implies that W ~ = B X p - C b. Now suppose the owner defaults on the mortgage. If the owner repays the business loan in full, then her total net wealth is W-B -R. If she defaults on the loan and files for bankruptcy, then she repays W-X p to the amount they would have received under Chapter 7, so that lenders expected return is unaffected by whether debtors file under one Chapter or the other. See White (1998) for further discussion of the choice between Chapters 7 versus 13 and of ways that debtors can rearrange their assets to make filing for bankruptcy more favorable. 7 This implicitly assumes that the owner does not expect the value of the house to increase in the future. If the owner did expect the value of the house to increase, then she might prefer to delay defaulting on the mortgage. 8 Assuming that the mortgage loan is non-recourse, the mortgage lender has no additional claim against the owner s non-housing assets for the remaining amount owed on the mortgage, which is M - (V-C f ). 6

7 the business lender (assuming that her period 2 wealth exceeds X p ), and keeps total net wealth of X p -C b -R. This implies that the critical level of wealth at which she is indifferent between filing versus not filing for bankruptcy is again W ~ = B X p - C b. Thus the critical level of wealth W ~ is invariant to whether the owner defaults on the mortgage. Figure 1 shows W on the horizontal axis and net total wealth after repaying both debts and/or filing for bankruptcy on the vertical axis. Two lines in figure 1 are labeled case (1), of which the higher and lower lines correspond to the owner not defaulting and defaulting on the mortgage, respectively. The segments of both lines to the right of W ~ correspond to the region of full debt repayment, while the segments to the left of W ~ correspond to default on one or both loans. In the two flat segments, the owner keeps non-housing wealth of X p plus home equity, so that net total wealth is independent of W. Case (2). Foreclosure by the business lender (M X h C f < V < M X h C f B ) Now suppose the value of the house exceeds the mortgage plus the homestead exemption. If the owner defaults on the business loan, the business lender will foreclose on the house, because foreclosure yields partial repayment of V-C f -M'-X h. Since foreclosure on the house by either lender forces the owner to incur the expense of relocating, the owner either defaults on both loans or repays both loans in full. If she defaults, then she also files for bankruptcy. The level of wealth at which the owner is indifferent between defaulting or not defaulting on both debts is now denoted W ~ '. If W W ~ ', then the owner repays both debts in full and keeps W-B' V - M'. If X p W < W ~ ', then the owner defaults on both debts. In this case the mortgage lender forecloses and receives full repayment of M' from the sale of the house. The business lender receives W-X p from the owner s financial assets plus V-C f - M' - X h from the sale of the house. The level of wealth W ~ ' at which the owner is indifferent between filing versus not filing for bankruptcy is therefore W ~ '= W ~ -VM'-RX h. Figure 1 shows the owner s total net wealth in case (2). Because W ~ must be less than W ~, owners are less likely to file for bankruptcy in case (2) than case (1). 9 9 W ~ - W ~ = M -VX h -R. By the conditions for being in case (2), this expression must be negative. 7

8 8 Case (3). The business owner always repays both loans (V > M X h C f B') In this case, the value of the house is sufficient to repay both loans in full, even if nonhousing wealth W turns out to be low. The owner s total net housing plus non-housing wealth is always W - B' V - M'. See figure 1. Seven U.S. states had unlimited homestead exemptions in 1993 (see table 1). Note that if the homestead exemption is unlimited, then debtors must be in case (1). If the personal property exemption is unlimited, then debtors can be in any of the three cases, but they are always in the left-most portions of the curves in figure Now turn to the supply side. Lenders expected return from making loans at interest rate r is: 11 dv V g B dv V g dw W f B dw W f X W dw W f X M C V dv V g dw W f B dw W f X W ER h f p h f h f p h f f X B M C W p W X W h f B X M C X M C W W X p X M C C ) ( ] [ ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ~ ~ ~ 0 ~ ~ = (3.1) The three terms in square brackets on the right hand side of (3.1) correspond to repayment in cases (1), (2) and (3), respectively. Consider how increases in the two exemption levels affect the interest rate r and whether lenders ration credit. From (3.1), it is straightforward to show that p ER X / < 0. If the personal property exemption rose but lenders did not change the interest rate on loans, their expected return would fall because debtors are more likely to 10 None of the states have unlimited exemptions for personal property in general, but several have unlimited exemptions for particular types of personal property, such as retirement accounts or equity in a single vehicle. 11 Here we assume that the minimum value of V is C f and the minimum value of W is zero.

9 default. Therefore lenders must raise the interest rate when X p rises in order to maintain the same expected return. Also, 2 2 / p ER X is negative as long as f(w) is increasing in the region between W=X p and W= W ~. Therefore if X p rises by a constant amount, the increase in the interest rate necessary to maintain the same expected return gets larger as the level of X p increases. This is because raising the interest rate only increases repayment when borrowers do not file for bankruptcy, and the probability of borrowers not filing for bankruptcy gets smaller as X p rises. At a certain X p level, the probability of bankruptcy becomes sufficiently high that no interest rate is high enough for lenders to maintain the same expected return when X p rises. At this point, lenders either must accept a lower expected return or cease lending completely. Thus in this model, credit rationing takes an extreme form: lenders either do not ration credit at all or, at a high enough level of X p, they cease lending completely. The story for increases in the homestead exemption is essentially the same. 12 It is straightforward to extend the model so that credit rationing occurs in a less abrupt way. For example, suppose some owners have previously filed for bankruptcy, but otherwise all owners are identical. Suppose lenders know which owners have filed for bankruptcy and they treat a past bankruptcy filing as a signal of higher default risk on a new loan. Then lenders would quit lending to previously bankrupt owners if either exemption rises to a particular level, but would only quit lending to owners with a clean credit history if the exemption rises to some higher level. We test for the effect of prior bankruptcy filings and also prior financial default on whether owners are credit rationed. 13 Another possible extension of the model is to introduce asymmetric information. In the Stiglitz-Weiss (1981) model, owners invest in two different projects---one safe, one risky---but lenders cannot observe owners types. In our context, raising the interest rate in response to an increase in the exemption level could cause adverse selection to occur, because owners who invest in the safe project might respond by deciding that the project is no longer worthwhile. Therefore increasing the interest rate makes lending unprofitable and lenders instead respond to an increase in the exemption level by rationing credit more tightly to all borrowers. 12 See Wang and White (2000) for further discussion and simulation results. 13 Longhofer (1997) analyzes a similar model in which borrowers differ according to how much they apply to borrow, but are otherwise identical. 9

10 Now turn to the demand for business loans and consider the effect of an increase in X p on owners demand for business loans. In figure 1, a rise in X p shifts X p, W ~, and W ~ rightward by the same amount. Therefore owners are more likely to file for bankruptcy. It also shifts the flat portions of the curves in cases (1) and (2) upward, so that owners keep more of their wealth when they file for bankruptcy. Lenders respond to the increased probability of default by raising the interest rate (assuming that they continue to lend), which lowers owners net wealth when they do not file for bankruptcy. Overall, the rise in the exemption level combined with a rise in the interest rate shifts resources from situations in which owners net wealth is relatively high to situations in which their net wealth is relatively low. Thus the personal property exemption provides wealth insurance for owners and, the higher is X p, the higher the level of insurance. On the other hand as X p rises, owners expected net wealth in period 2 falls, because they are more likely to incur the costs of filing for bankruptcy. Assuming that owners are risk averse, it is straightforward to show that there is an optimal personal property exemption X p *, which trades off the gain to owners from additional wealth insurance against the loss from higher bankruptcy costs. As long as X p is less than X p *, increases in the level of X p raise owners demand for loans. The same analysis applies to the homestead exemption. 14 Thus the model predicts that increases in either of the exemption levels X p and X h cause owners to increase their demand for business credit (as long as each exemption is below its optimal level) and cause lenders to reduce the supply of business credit. We test these predictions below. III. Empirical Tests Our primary data source is the 1993 National Survey of Small Business Finances (NSSBF). This survey covers a representative sample of U.S. non-financial, non-farm, for-profit businesses that have fewer than 500 employees. The dataset includes approximately 1,750 noncorporate firms and 2,800 corporate firms. 15 The NSSBF asks managers whether their firms have applied for credit within the last three years and also asks whether managers were discouraged from applying for loans at any 14 If the costs of bankruptcy and foreclosure are zero, then the optimal exemption levels are the highest levels at which loans are available. See Wang and White (2000) for further discussion. 10

11 time during the past three years because they anticipated being turned down. We define a dummy variable, discouraged/denied, which equals one if managers either were discouraged from applying for credit or applied but were turned down within the past three years. We refer to firms that are discouraged/denied as credit rationed and we run separate regressions explaining whether corporate versus non-corporate firms are credit rationed. The main explanatory variables of interest are the homestead and personal property exemptions in the state where the firm is located. The personal property exemption is defined as the sum of the state's exemptions for cash and for equity in vehicles, plus the value of the wildcard exemption. Table 1 shows the two exemptions by state in We enter the homestead exemption as dollar value and dollar value squared. For states with unlimited homestead exemptions, we set the homestead exemption equal to the maximum dollar value across all states ($160,000). We also enter a separate dummy variable which equals one for states that have unlimited homestead exemptions. This means that the coefficient of the unlimited exemption dummy captures the marginal effect of the homestead exemption being unlimited rather than $160,000. We enter the personal property exemption as dollar value and dollar value squared. Since no states have unlimited personal property exemptions, there is no unlimited dummy. 16 An important issue is whether the bankruptcy exemption level can be treated as exogenous to lenders' decisions to ration credit. As part of the 1978 Bankruptcy Code, Congress adopted a uniform Federal bankruptcy exemption, but it gave the states the right to opt out of the Federal exemption by adopting their own exemptions. All states did so by 1983, although some states allow their residents to choose between the state s exemption and the Federal exemption. Between 1983 and 1993, only a few states changed their exemption levels each year (and the 15 The NSSBF is produced by the Federal Reserve Board and the Small Business Administration. See Cole and Wolken (1995) for discussion. We use the internal version of the dataset, which identifies the state in which the firm is located. 16 Sixteen states allowed their residents to choose between the state and the Federal exemption as of We substitute the Federal exemption for the state exemption if the firm is located in a state that allows its residents to choose and if the Federal exemption is higher. Some states have higher exemptions for married couples who file for bankruptcy and, if so, we use the exemptions applicable to married couples. In computing a dollar value for the personal property exemption, we ignore exemptions for goods such as clothing, furniture, cooking equipment, bibles, tools of the trade, farm implements, etc. We include only exemptions for cash, vehicles and near-cash assets such as jewelry that are specified as dollar values. Two states have unlimited exemptions for a single vehicle: Louisiana (for a non-luxury auto ) and Hawaii (for an otherwise unspecified vehicle). We code these at $20,000 and $40,000, respectively. 11

12 Federal exemption remained unchanged). Because all of the states changed their exemptions in the early 1980 s and there were few changes thereafter, we treat the exemption levels as exogenous. Other important variables are the owner s and the firm s previous financial difficulties. We enter separate dummy variables which equal one if the firm or its principle owner filed for bankruptcy within the past seven years, if the owner has been delinquent on personal financial obligations during the past 3 years, and if the owner has been delinquent on business obligations during the past 3 years. 17 To control for differences in perceived creditworthiness of firms, we include a number of firm demographic characteristics. These are the firm s age, the owner s age, a dummy variable for whether more than 50% of the firm s equity is owned by an African-American, a dummy variable for whether more than 50% is owned by another minority group (Hispanic or Asian), dummy variables for whether the firm is family-owned or female-owned, and the firm s total employment in log form. Financial variables include the firm s ratio of debts to assets, its ratio of profits to assets, the rate of growth of sales between 1990 and 1992, and a vector of dummy variables for the firm s sector (results for the latter are not shown). 18 We also include a dummy variable for a high Herfindahl index of bank deposit concentration in the market where the firm is located and the number of lenders that the firm borrows from. If the lender is a bank, we also include the number of years that the firm and the bank have had a relationship and whether the firm has a checking or saving account with the bank. 19 Finally, as a measure of local macroeconomic conditions, we include the unemployment rate in the state where the firm is located. 17 The personal financial delinquency variable equals one if the owner has been delinquent by 60 days or more on 1, 2 or 3 or more personal obligations. The business delinquency variable is similarly defined. 18 Gordon and Mackie-Mason (1994) argue that firms have tax incentives to choose corporate versus non-corporate form, which implies that the two types of firms may differ systematically. In particular, owners of money-losing firms have an incentive to choose non-corporate status so that the firm s losses can be deducted against other income of the owner; while owners of profitable firms have an incentive to choose corporate form in order to take advantage of corporate tax rates that tend to be lower than the top individual tax rate. Thus choice of organizational form may signal the firm s profit level. However because we control for individual firms profit levels (relative to assets), we do not expect the choice of organizational form to bias our results for the effects of bankruptcy exemption levels. 19 We generally follow Petersen and Rajan (1994) in our choice of financial variables. Following their lead, we truncate sales growth at the 95% level and define the cutoff for a high Herfindahl index at HHI

13 Table 2 shows summary statistics. 20 Statistics are shown by type of firm and separately by whether firms are credit rationed (discouraged/denied). The overall probability of firms being credit rationed is.29 for non-corporates compared to.26 for corporations. Among the important differences between the two types of firms are that corporate firms are larger on average, less likely to be family owned, and less likely to be owned by African-Americans or other minorities. Only about 1% of non-credit-rationed firms/owners have previously filed for bankruptcy, compared to 6-8% of credit-rationed firms/owners. However, the probability of past financial delinquency business or personal is much higher. For non-corporate firms, the probability of a past business delinquency is.36 if firms are credit rationed and.11 otherwise. For corporate firms, the figures are.45 and.13, respectively. The figures for past personal delinquency are also high. Table 3 shows the results of logit regressions explaining whether firms are credit rationed. The first column shows the results for non-corporate firms and the second shows the results for corporations. Both types of firms are significantly more likely to be credit rationed as their debt/asset ratios increase and less likely to be credit rationed as the number of years of relationship with the lender increases. Corporate firms are significantly less likely to be credit rationed if they have a checking account with the (bank) lender and the relationship is negative although not significant for non-corporate firms. The fact that the debt/asset ratio is a significant determinant of whether both types of firms are credit rationed but the profit/asset ratio is not suggests that lenders find balance sheet information to be more reliable and verifiable than profit information for small firms, regardless of whether they are corporate or non-corporate. Both types of firms are significantly more likely to be credit rationed if their owners are African- American and non-corporate firms are significantly more likely to be credit rationed if their owners belong to other minority groups In all calculations, we use the NSSBF sampling weights, which make the sample representative of the target population of U.S. small businesses. 21 Our findings that variables such as the number of years that the firm has had a relationship with its lender and whether the firm has a checking account with its lender are similar to those found by Petersen and Rajan (1994) and Berger and Udell (1995), who used an earlier version of the NSSBF. See Cole (1998), Cole, Goldberg, and L. White (1999), and Cavalluzzo, Cavalluzzo, and Wolken (1999) for further discussion of the effects of lending relationships and owners race on whether firms receive credit. 13

14 Now turn to the bankruptcy exemption and past financial distress variables. All of the exemption variables have the predicted signs (positive for the dollar exemption variables and the unlimited homestead exemption variable and negative for the squared dollar exemption variables). The homestead exemption and squared homestead exemption variables are statistically significant for non-corporate firms and the squared and unlimited homestead exemption variables are statistically significant for corporate firms. However the personal property exemption variables are not significant for either type of firm. 22 The past bankruptcy filing and past personal and business delinquency variables are positive and significant for both types of firms. 23 Table 4, column 1, shows the effect of varying the bankruptcy exemption levels on the predicted probabilities of firms being credit rationed. The predictions are calculated assuming that both types of firms are family-owned, are not African-American- or other minority-owned, and have average values for the other right-hand-side variables. If a non-corporate firm is located in a state whose homestead and personal property exemptions are both at the 25th percentile of the relevant distributions and if neither the firm nor its owner has previously filed for bankruptcy or been delinquent, then the probability of the firm being credit rationed is.129. This figure rises to.145 if the homestead exemption in the firm s state is instead at the median level and to.181 if the homestead exemption is unlimited. Thus the probability of non-corporate firms being credit rationed rises by about 25% if they are located in states with unlimited rather than low homestead exemptions. Now suppose the homestead exemption remains at the 25 th percentile, but the personal property exemption is instead at the 75 th percentile. Then the firm s probability of being credit rationed is.137. For corporate firms, the predicted probability of being credit rationed is.198 if both exemptions are at the 25th percentile. It rises to.209 if the homestead exemption is at the median level and to.257, or by 23%, if the homestead exemption is unlimited. The predicted probability of corporate firms being credit rationed rises from.198 to.206 if the personal 22 An F-test shows that the three homestead exemption variables are jointly statistically significant at the.99 level in both the non-corporate and corporate samples. 23 In the results reported in table 3, we dropped 124 non-corporate and 52 corporate firms due to missing data, nearly all because the years of banking relationship variable was missing. To check whether omitting these observations made the sample unrepresentative, we reran the model without the relationship variable, so that most of the missing observations could be included. The results were virtually the same as those reported in table 3. 14

15 property exemption is instead at the 75 th percentile. Thus the effect of increased bankruptcy exemptions is similar for corporate versus non-corporate firms. These results are striking and suggest that the rules of personal bankruptcy have important effects on whether both noncorporate and corporate firms are credit rationed. The second through fourth columns of table 4 redo the calculations for firms/owners that have previously filed for bankruptcy or been financially delinquent. Holding the exemption levels fixed, the probability of firms being credit rationed approximately triples when their owners have previously filed for bankruptcy and approximately doubles when firms or their owners have previous personal or business delinquencies, regardless of whether firms are noncorporate or corporate. For example, the probability of a non-corporate firm being credit rationed when the homestead exemption is unlimited rises from.181 to.545 if the owner has previously filed for bankruptcy and from.181 to.352 and.430 if the firm or its owner has prior personal or business delinquencies, respectively. The increases for corporate firms are similar. Our results suggest that lenders ration credit both by tightening credit availability to all borrowers in states where bankruptcy exemptions are higher and by refusing to lend to owners having observably bad credit histories. Firms that are discouraged from applying for loans may differ from firms that apply, but are turned down. We therefore reran the models in table 3 with the dependent variable redefined to equal one for discouraged firms only, using the same sample. 24 We also ran a similar model explaining whether firms loan applications are denied, using as our sample only firms that applied for loans (i.e., discouraged firms are excluded). The results, shown in table 5, are similar to those in table 3. Again, the homestead and squared homestead exemption variables are significant for the samples of non-corporate firms and the squared and unlimited homestead exemption variables are significant for the samples of corporate firms. All of the past bankruptcy and financial distress variables are positive and statistically significant for both types of firms in the model explaining whether firms are discouraged, and the pattern is the same in the 24 For the sample of non-corporate firms, 27% (499/1829) were discouraged from applying for loans and 6% (114/1829) applied but were denied. However 5% (87 firms) were both discouraged and denied. This is possible because the discouraged question asks if the firm was discouraged from applying for a loan at any time during the past three years. For corporate firms, the figures are 24% discouraged (686/2808), 7% denied (198/2808) and 5% both (148/2808). 15

16 model explaining whether firms were denied loans, although some of the variables fall short of significance. The coefficients are all somewhat larger than those in table 3, except for the coefficients of the past delinquency variables in the regression explaining whether firms were denied loans. The results show that the bankruptcy exemption variables have similar effects on firms that are discouraged from applying for loans and on firms that apply for loans, but are turned down. Past bankruptcy and past financial delinquency by firms or their owners also affect firms that are discouraged and denied similarly. We ran three additional robustness checks. First, when firms answer the NSSBF s questions concerning their most recent loan applications, their answers may refer to loan applications that occurred prior to These early loan applications potentially present endogeneity problems because our bankruptcy exemption variables and the other control variables are for We therefore reran the models in table 3, but excluded firms whose most recent loan applications occurred prior to The results (not shown) are very similar to those in table 3. Second, we redefined our benchmark credit rationing variable (discouraged/denied) so that firms that were discouraged but nonetheless applied for and received credit were not treated as credit rationed. This situation may occur because the questions refer to the past three years and firms may be discouraged but apply for and receive credit during the period. 26 Lastly, we redefined our benchmark credit rationing variable so that firms were treated as credit rationed if they were denied credit on a prior loan application even though their most recent application was approved or if they were offered credit but on worse terms than they applied for. 27 Again the results (not shown) are very similar to those in table 3. Thus our results are not sensitive to whether we exclude loan applications earlier than 1993 or whether we include firms that were denied on a prior loan application. Now turn to loan size. For the most recent loan application, the NSSBF also asks the size of the loan that the lender offered. 28 To examine the effect of bankruptcy exemptions on loan non-corporate and 185 corporate firms fit this criterion non-corporate and 224 corporate firms fit this criterion non-corporate firms and 176 corporations were accepted on their most recent loan application but denied on a prior application and 46 non-corporate firms and 133 corporations were offered loans on worse terms than they applied for. 28 The NSSBF actually asks separately how much the firm applied for and how much the lender offered. In theory, these separate measures might allow us to separately estimate a demand curve from the former and a supply curve from the latter. However, in practice, the two variables are extremely closely related, with a correlation coefficient of.994. Presumably, firms apply for the amount of credit that they expect lenders are likely to grant and lenders may tell borrowers in advance how much they are willing to lend. 16

17 size, we ran a two stage Heckman model. The first stage is a probit regression explaining whether firms are credit rationed and the second stage is an OLS regression explaining the size of the loan, in logs, for firms that were offered credit. (The sample size at the second stage is smaller both because only firms offered credit are included and because several firms were dropped because the years of relationship variable was missing.) The second stage contains an additional variable, denoted λ, whose coefficient is the correlation between the error terms in the first and second stage regressions. We expect the coefficients of the second stage regression to reflect a combination of supply and demand considerations. The predicted effect of an increase in the bankruptcy exemption is both to increase loan demand and to reduce loan supply. If we observe positive coefficients on the exemption variables at the second stage, then we can conclude that the positive effect on demand of an exemption increase more than offsets the negative effect on supply, and vice versa. One problem is that identification is rather weak. We enter variables at the first stage regression which have a fixed effect on the profitability of making a loan, such as the Herfindahl index of deposit concentration, whether the lender is a bank, the characteristics of the firm, and the number of lenders that the firm borrows from. We enter variables at the second stage which affect the marginal profitability of making a larger or smaller loan, such as the firm s profit to asset ratio and the bankruptcy exemption variables. But nearly all of the variables arguably affect both. At the second stage, we also enter a dummy variable indicating whether the loan carries a floating interest rate. The results for the first stage are similar to the logit results already discussed and are not shown. The results for the second stage are shown in table 6, for noncorporate and corporate firms separately. None of the exemption variables and none of the financial distress variables are statistically significant for either type of firm. Thus the results suggest that lenders take the bankruptcy exemption level and evidence of past financial distress or bankruptcy into account in deciding whether to offer loans, but not in deciding on loan size. These results are consistent with the extreme form of credit rationing suggested by the symmetric information model (lend with no credit rationing or do not lend at all), rather than the less extreme form of credit rationing suggested by the asymmetric information models (limit the size of loans offered to all borrowers). 17

18 Among the other variables, the floating interest rate indicator is positive and significant for both types of firms and it suggests that loans carrying floating interest rates are about one million dollars larger on average. Also, female-owned non-corporate firms receive significantly smaller loans and non-corporate firms that buy information-intensive services from their lenders receive significantly larger loans. The λ terms in both regressions are insignificant, suggesting no support for the hypothesis that the error terms across the loan denial and loan size decisions are correlated. Now turn to whether bankruptcy exemption levels affect interest rates. Table 7 gives the results of OLS regressions explaining the interest rate on the most recent loan, conditional on firms most recent loan application being approved. 29 Because we did not find significant values of λ in table 6, we did not attempt to correct for selection bias. The only exemption variable that is statistically significant is the unlimited homestead exemption dummy in the sample of corporate firms and its sign--surprisingly--is negative. Thus the results suggest that lenders take bankruptcy exemption levels into account in deciding whether or not to offer loans to potential borrowers. But once they decide to offer loans, they do not restrict the loan size or raise the interest rate in response to increases in the bankruptcy exemption level. For both types of firms, the interest rate is significantly lower if the loan carries a floating rate (the difference is 99 basis points for non-corporate firms and 55 basis points for corporate firms). For corporate firms, the past financial distress variables are all positive and statistically significant, so that a past bankruptcy filing raises the interest rate by 99 basis points and past personal and business delinquencies raise the interest rate by 66 and 30 basis points, respectively. IV. Conclusion The paper investigates how personal bankruptcy law affects small firms access to credit. We show that when firms are non-corporate, higher personal bankruptcy exemptions reduce the supply of business credit and may raise demand for business credit. This is because higher exemptions provide business owners with partial wealth insurance which makes them more willing to invest if they are risk averse, but also makes them more likely to default. Personal bankruptcy exemptions also may affect the market for credit to small corporate firms, because small business owners can easily transfer funds from the firm to themselves even if the firm is 18

19 corporate. Thus lenders may not view the corporate/non-corporate distinction as meaningful for small firms. We test the model using data from the National Survey of Small Business Finance. We find that when firms are located in states with unlimited homestead exemptions rather than homestead exemptions at the 25th percentile, the probability of being credit rationed rises by about 25% for both non-corporate and corporate firms. However, we do not find evidence that variations in bankruptcy exemption levels cause loans to be smaller or interest rates to rise when loans are offered. We also find that when owners of firms have previously filed for bankruptcy, the probability that firms are credit rationed triples and, when firms or their owners have previously been delinquent on personal or business obligations, the probability that firms are credit rationed approximately doubles. Thus our results suggest that lenders ration credit by refusing to lend at all to owners having observably bad credit histories, rather than by limiting loan size or raising interest rates for all borrowers. Because our results are similar for both corporate and non-corporate firms, they suggest that lenders ignore the legal distinction between the two types of firms. Each year for the past several years, the U.S. Congress has adopted legislation which would limit homestead exemptions to a maximum of $100,000. Although the intended effect of the change is to discourage wealthy consumers from taking advantage of bankruptcy to shield their assets from creditors, our results suggest that the change would increase small firms access to credit corporate firms and 9 non-corporates were omitted because the years of relationship variable was missing. 19

20 References Berger, A.N., and G.F. Udell (1995), Relationship Lending and Lines of Credit in Small Firm Finance, J. of Business, vol. 68, pp Berkowitz, J., and R. Hynes (1999), Bankruptcy Exemptions and the Market for Mortgage Loans, J. of Law and Economics, vol. 42, Bester, H. (1994), The Role of Collateral in a Model of Debt Renegotiation, J. of Money, Credit and Banking, vol. 26:1, Cavalluzzo, K., L. Cavalluzzo, and J. Wolken (1999), Competition, Small Business Financing, and Discrimination: Evidence from a New Survey, manuscript, Federal Reserve Board. Cole, R.A. (1998), The Importance of Relationships to the Availability of Credit,'' J. of Banking and Finance, 22, Cole, R.A., and J.D. Wolken (1995), Financial Services used by Small Businesses: Evidence from the 1993 National Survey of Small Business Finances, Federal Reserve Bulletin, July. Cole, R.A., L.G. Goldberg and L.J. White (1999), Cookie-Cutter versus Character: The Microstructure of Small Business Lending by Large and Small Banks, manuscript, University of Michigan. Elias, S., A. Renauer, and R. Leonard (1994). How to File for Bankruptcy, 4 th edition. Berkeley: Nolo Press. Gordon, R.H., and J.K. Mackie-Mason (1994), Tax Distortions to the Choice of Organizational Form, J. of Public Economics, vol. 55, pp Gropp, R., J. K. Scholz and M.J. White (1997), Personal Bankruptcy and Credit Supply and Demand, Quarterly Journal of Economics, vol. CXII, pp Hart, O., and J. Moore (1989), Default and Renegotiation: A Dynamic Model of Debt, working paper 520, M.I.T. Dept. of Economics. Leonard, Robin (1998). Chapter 13 Bankruptcy: Repay Your Debts, 3 rd edition. Berkeley, CA: Nolo Press. Lin, Emily Y., and Michelle J. White (1999), Bankruptcy and the Market for Mortgage and Home Improvement Loans. Working paper, Univ. of Michigan Dept. of Economics. Longhofer, S. (1997), Absolute Priority Rule Violations, Credit Rationing, and Efficiency, J. of Financial Intermediation, 6(3), July 1997, pp