Beyond bankruptcy: Does the bankruptcy code provide a fresh start to entrepreneurs

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Abstract

This paper assesses the extent to which the U.S. bankruptcy system is effective in providing small businesses a “fresh start” after a bankruptcy filing. We use data from the 1993, 1998 and 2003 National Survey of Small Business Finances to explore how firms fare after a bankruptcy filing. Our results suggest some areas of concern though there are clearly promising aspects as well. On the positive side, previously bankrupt firms are not any more burdened than the average small firm by problems relating to profitability, cash flow, health insurance costs, or taxes—all considered to be major problems facing all small businesses. There is little to distinguish these firms in terms of firm size, as measured by employment. Further, the fact that these firms are surviving several years after the filing is itself a testament to the efficient functioning of the U.S. bankruptcy system. It suggests that the bankruptcy system goes a long way toward helping businesses recover and resume operations after a bankruptcy filing.

However, the one area of concern that persists after a filing is financing or credit access. A bankruptcy on a firm’s credit record negatively affects a firm’s ability to obtain loans, especially at reasonable interest rates, even controlling for credit scores. In general, these firms have a nearly 24 percentage point higher likelihood of being denied a loan and are charged interest rates that are more than 1 percentage point higher than those charged to other businesses. A bankruptcy affects all types of financing, even trade credit, which is a significant form of lending between businesses. In fact, it appears that firms with a bankruptcy record are rationed out of the market, with all types of loans being denied at significantly higher rates than other firms. This fits in with the predictions of the Stiglitz and Weiss (1981) credit rationing model. Further, our results show that bankruptcy leads to a class of discouraged borrowers who are significantly less likely to even apply for a loan.

Aparna Mathur is a resident scholar at AEI.

The full paper is available at The Journal of Banking & Finance's website.

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