Forgiving Features for Failed Entrepreneurs vs. Cost of Financing inBankruptcies

Anentrepreneur-friendly bankruptcy law lowers exit barriers by exposing failed entrepreneurs to comparatively less painful exit procedures. This in turn lowers the entry barriers and risks for entrepreneurs to launch new businesses. However, this reduced entry barrier may not come for free. From the standpoint of financial institutions a more lenient bankruptcy law means a higher risk of insolvency for their loans to entrepreneurs. In this study we examine the relationship between two forgiving features of a bankruptcy law (i.e., fresh start in personal bankruptcy law and automatic stay of assets in corporate bankruptcy law) and the rate of new firm entry, as well as the mediating effect of the cost of financing. We use a cross-country database of 28 countries spanning 15 years. While these two features share the same forgiving nature, we find that providing failed entrepreneurs with a “fresh start” encourages new firm entry but providing entrepreneurs an opportunity to recover from troubling situations with an “automatic stay of assets” does not. Most importantly, both “fresh start” and “automatic stay of assets” give financial institutions incentives to charge higher interest rate (i.e., lending rate) to entrepreneurs; this in turn lowers the rate of new firm entry.