The Consequences of Bankruptcy Law for Firm Financing and Investment

Bankruptcy procedures have been an integral part of capital markets since inception, representing an important mechanism to balance the rights of creditors and debtors. Bankruptcy law, although aims at preserving borrower payments, can have significant consequences for firm financing and investment, as it ultimately needs to ensure that viable businesses continue. In this respect, primary bankruptcy procedures such as reorganization and firm liquidation can have different effects. The increase in the cost of bank financing after the 2005 reorganization reform in Italy implied that potentially viable projects do not receive funding, exacerbating opportunistic behavior among entrepreneurs. On the other hand, the 2006 liquidation reform slightly decreased, on average, opportunistic reporting behaviors by easing firms' access to credit. This is likely the most important result of Bankruptcy Law and Bank Financing, an article by Nicolas Serrano-Velarde (Department of Finance), Giacomo Rodano (Bank of Italy) and Emanuele Tarantino (University of Mannheim), accepted for publication in the Journal of Financial Economics.

Interestingly, the impact of different primary bankruptcy procedures has received little attention by empirical economic research. However, anecdotal evidence suggests that the distinction between different forms such as reorganization and firm liquidation can have important effects on firms' continuation values. As a matter of fact, a reform of reorganization procedures likely strengthens borrower rights to renegotiate outstanding financial contracts, increasing therefore the cost of bank financing. On the other hand, a reform of the liquidation procedures that strengthens creditor rights and reduces the cost of bank financing. As such, to effectively understand the impact of bankruptcy law is crucial to isolate the effects of these two procedures.

In their article, the authors disentangle the impacts of reorganization and liquidation on firm credit conditions and investment using data from the 2005-2006 Italian bankruptcy reform law for small- and medium-sized enterprises (SMEs). The Italian reform consisted of two distinct and consecutive laws. The first introduced legal outlets that made the renegotiation of credit contracts easier. Subsequently, the second law significantly speeded up firms' liquidation procedures. This two-step timeline allows the authors to effectively test the distinct effect of reorganization and liquidation on bank financing conditions and firm investment.

The authors find that, indeed, while increasing interest rates after the reorganization reform in 2005 led to tighter credit conditions, incentivizing firms' opportunistic behaviors, the liquidation reform in 2006 eased firms' access to bank financing, which in turn led to both a reduction in the likelihood of report a credit constraint and increased spurs investments. These results point decisively to the role of major instruments in bankruptcy in designing financial contracts and investment.