Asset Exemption in Bankruptcy, Access to and Cost of Credit

Under the U.S. personal bankruptcy law, exempt assets are not liquidated following bankruptcy. Entrepreneurs can undo such a protection by posting collateral. We provide a complete characterization of the interplay between asset exemption from liquidation upon default and adverse selection in a competitive credit market. Severe adverse selection induces separation, with safer entrepreneurs choosing loan contracts characterized by high collateral requirements, lower cost of credit, and credit rationing for wealth-constraints applicants. Irrespective of adverse selection, poor safe entrepreneurs pool as they face too much rationing, otherwise. Higher exemption makes collateral more informative. Evidence from the Survey of Small Business Finances survey supports our theory.