Rebel A Cole, Jason Damm, John Hackney, Masim Suleymanov
Review of Finance, Volume 29, Issue 1, January 2025, Pages 275–313, https://doi.org/10.1093/rof/rfae037
In the U.S., state-level exemption laws determine the amount of property that individuals can protect from creditor liquidation during the debt settlement process of bankruptcy proceedings. We exploit discontinuities in personal bankruptcy exemptions created by state borders to identify the spillover effects of these laws on business credit extended to small firms. While exemption limits pertain to personal bankruptcy filings, entrepreneurs often provide personal guarantees and/or personal collateral in order to obtain business credit. We demonstrate that greater asset protection for individuals negatively impacts the amount of credit available to small businesses, as creditors can expect individuals to file for bankruptcy more often and to recover less ex post. Small business owners are often liable for company debts because of business structure or personal guarantees. Despite the intuitive linkages between business and personal balance sheets, evidence suggests that policymakers are unaware of the consequences of these laws for small businesses.
We collect time-varying data on home equity (homestead) bankruptcy exemption limits across all U.S. states from 2006 – 2018 to estimate the effect of changes in the level of debtor protection on small business credit extended by banks. We document 70 exemption increases over the sample period. Subsequent to these law changes, we find a reduction of 1–2% in originations of business credit, for a rough estimate of –$4.2 to –$7.1 billion over the sample period. The effect is strongest for the smallest firms, which are more financially constrained.
We then provide household-level evidence that both business debt and personal debt decline for borrowers whose home equity becomes covered by the exemption change, indicating that overall credit availability declines for small business owners. We also rule out other potential credit substitutes such as those from FinTech lenders or the Small Business Administration.
Finally, we examine the real economic consequences of this reduction in business credit. We find that exemption changes contribute to a decline in the number of local establishments and employment, but only for the smallest firms. Meanwhile, there is no corresponding impact on medium-size or large-size firms. These results reveal that changes in the level of personal bankruptcy protection have particularly harmful consequences for the smallest firms, which are generally the most financially constrained. We also demonstrate that this impact is particularly prevalent in industries that are most dependent on external finance, suggesting that negative real economic effects occur via a credit market channel.