Asset Exemption in Entrepreneurs’ Bankruptcy and the Informative Role of Collateral

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