Presentation of the paper

Economics of bankruptcy exemption: Signaling value of collateral, cost of credit and access to credit

Speaker

Luca Deidda

Università di Sassari

Abstract

We analyze a model of competitive credit market in which according to the bankruptcy law, some assets can be exempted from liquidation following the event of default. We assess  the role of such exemption under two alternative asymmetric information settings:   one characterized by moral hazard (MH); and one by adverse selection (AS). In particular, we study how the level of exemption affects the   role   of   collateral   depending   on   the   dominant   source   of   asymmetric information. We find that, under MH, the cost of credit is higher for borrowers who are requested to post collateral, more so the higher is the exemption level. 

Differently, in the case of AS, the decision to post collateral results in a lower cost of credit, more so the higher is the exemption level.  Finally, under AS, a higher level of exemption is associated with a lower level of credit rationing. Similarly, credit rationing either stays unchanged or goes down with exemption in the case of MH. We exploit cross State variability in the level of asset exemption from liquidation, according to personal bankruptcy US State laws prior to 2005 federal reform, in order to identify the signaling role played by collateral in the credit market for small business in the US using SBFF data. The empirical results support the adverse selection hypothesis, showing that posting collateral results in a lower cost of credit, and this effect is stronger the higher is the value of exemption. From a different perspective, the empirical results corroborate the idea that, the lower is the exemption level the less powerful is the role of collateral as a signaling device, while the more important is the credit worthiness in determining the cost of credit.  

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