Asset exemption in entrepreneurs' bankruptcy and the informative role of collateral
|Title||Asset exemption in entrepreneurs' bankruptcy and the informative role of collateral|
|Publication Type||Working Paper|
|Year of Publication||2016|
|Authors||Arca, P, Atzeni, G, Deidda, LG|
|ISBN Number||978 88 9386 007 9|
|Keywords||collateral, Cost of credit, Credit rationing, Exemption, Pooling, screening, Separation|
If an entrepreneur files for bankruptcy under Chapter 7, (i) most of her debt is discharged, and (ii) only her non-exempt assets are liquidated. Entrepreneurs can undo this “insurance” by posting collateral. The opportunity cost of doing so is lower for safer entrepreneurs who face a lower probability of default. Accordingly, we show that under adverse selection, as exemption increases, collateral becomes a more effective sorting device. As a result, an entrepreneur’s decision to post collateral improves access to credit and reduces the cost of credit to a greater extent the larger the exemption is. Econometric tests using data from the US Survey of Small Business support our theory.