College of Humanities and Social Sciences
College of Humanities and Social Sciences

The Micro and Macro Economics of Bad Bankruptcy

Rutger Van Bergem

Major Professor: Donald J Boudreaux, PhD, Department of Economics

Committee Members: Tyler Cowen, Todd Zywicki

Carow Hall, Conference Room
April 19, 2016, 02:00 PM to 11:00 AM


This dissertation is meant as an example of a broader research agenda. The agenda focuses on the role that Legal and Regulatory institutions play in determining economic failure as well as on their role in the subsequent (re)-allocation of productive resources. The broad goal is to investigate how institutions that underlie reallocation and adjustment processes in the economy can hamper or facilitate the flow of resources to their highest productive use. The research effort can be distinguished into two interconnected parts of inquiry: (1) the micro-economic study of institutions involved in determining economic failure and reallocation of productive resources, and (2) the study of the macro-economic impact of the functioning of these institutions. The dissertation specifically investigates how corporate bankruptcy functions in this light.

The first chapter, entitled “The Effects of Legal Limbo on the Bankrupt Firm” argues that bankruptcy’s institutional environment creates inertia and steers firm governance during bankruptcy away from profit maximization. Inertia is evidenced by significantly less variable firm (dis)investment during bankruptcy as compared to the matched industry counterparts. Importantly, given lengthy bankruptcy procedures, the firm’s ability to recover out of bankruptcy - as measured by several financial indicators - is negatively affected by the length of bankruptcy procedures. The connection between worsening financial performance and the length of bankruptcy procedures can be explained by the (1) lack of managerial monitoring of business processes during bankruptcy as well as (2) the lack of firm adaptation in terms of the firm’s capital structure to the changing market environment during bankruptcy.

The second chapter entitled “Bankruptcy as Filtering Failure” investigates how well U.S. corporate bankruptcy procedures perform the task of distinguishing economically viable but financially failed firms from economically failed firms. I provide novel evidence that suggests the bankruptcy process is not able to distinguish between financially failed but viable firms and economically unviable firms. Specifically I show that firms emerging from bankruptcy do not exhibit performance catch-up behavior to their going concern industry counterparts as is expected from viable firms that are relieved from financial distress. Additional evidence on matched performance differences between bankrupt firms and industry counterparts indicate that there is no improvement in the performance gap between bankrupt firms and industry right before and after bankruptcy. Moreover, employing a logistic regression analysis of the determinants of bankruptcy survival, I find that the bankruptcy judge may be a source of filtering failure: Bankruptcies featuring more employees as well as with operations closer to the judge’s district are more likely to emerge.  

In the third chapter “Bankruptcy Filtering Failure and Recession Cleansing” I incorporate the possibility of bankruptcy filtering failure in a macroeconomic model of business dynamics. The model, originally designed by Osotimehin and Pappada (2015), is a model based upon the study of business dynamics and firm exit   supplemented with firm exit under credit frictions.  The institutional addition to the business dynamics model illustrates the mechanism through which bankruptcy filtering failure affects the extent by which recessions are cleansing. The model shows that the degree to which recessions are cleansing depends on bankruptcy filtering accuracy. The recession cleansing effect worsens, when I incorporate the fact that firms with bigger asset valuations have a higher likelihood of bankruptcy survival.

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