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Forgiving features for failed entrepreneurs vs. cost of financing in bankruptcies.

Abstract:

* An entrepreneur-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.

Keywords: Bankruptcy law. Entrepreneurship. Failure

Introduction

Bankruptcy filing as a final exit option available to entrepreneurs has received increasing attention in the entrepreneurship literature. For example, Lee et al. (2007) argued that a more lenient bankruptcy law would encourage greater risk-taking and lead to increased entrepreneurship development. Here we define entrepreneurship development as the entry of new firms. More specifically, Lee et al. (2007) argued that at the societal level a bankruptcy law may positively affect entrepreneurship development by both limiting the downside losses of entrepreneurial failures and facilitating the potential upside gains for entrepreneurs who claim bankruptcies. An entrepreneur-friendly bankruptcy law therefore not only lowers exit barriers by exposing failed entrepreneurs to comparatively less painful bankruptcy procedures, but also reduces risks and lowers entry barriers for entrepreneurs to launch new businesses.

These arguments are interesting and innovative; however, a more lenient bankruptcy law may not come without its own costs. For financial institutions such as banks a more lenient bankruptcy law can mean that their loans to entrepreneurs come with a higher risk of insolvency cases. Simply stated, while a more lenient bankruptcy law might inspire entrepreneurs to take higher risks, this higher risk-taking by entrepreneurs may become a burden to financial institutions since loans made to these entrepreneurs are also at a higher risk. Under a more lenient bankruptcy law the responsibility of financial institutions is asymmetric compared to that of entrepreneurs; this forces banks to raise their interest rate (e.g., lending rate) for entrepreneurs, particularly those at a higher risk of bankruptcy.

This interaction between a more lenient bankruptcy law and the cost of financing has not yet been explored in the bankruptcy law and entrepreneurship literature. In this study we begin exploring this relationship by examining how a more lenient bankruptcy law can affect the lenders' (e.g., banks) interest rate, and the impact on the level of new firm entry within a country. We extend the work of Lee et al. (2007) by showing that it is important to consider the cost of encouraging greater risk-taking entrepreneurial behaviors at the societal level. We show that while it is important to recognize the positive aspect of limiting downside risks for failed entrepreneurs, the cost of financing new firm entry must also be considered in order to understand the more complete larger picture. We therefore ask: How and under what conditions do bankruptcy laws' forgiving features for failed entrepreneurs and the cost of financing coexist in order to let new firms enter?

Personal and Corporate Bankruptcy Laws

Before diving into the forgiving features of a bankruptcy law we must consider that there are two kinds of bankruptcy laws: Personal and corporate bankruptcy laws. In examining the relationship between bankruptcy law and entrepreneurship development there has been at least two different approaches: Focusing on personal bankruptcy law or on corporate bankruptcy law. For example, while Armour and Cumming (2008) examined how personal bankruptcy law affects entrepreneurship development, Claessens and Klapper (2005) explored the implications of corporate bankruptcy law on entrepreneurship development. However, either approach is limited in fully examining the forgiving features of bankruptcy laws since both personal and corporate bankruptcy laws may apply to bankruptcies declared by entrepreneurs.

Indeed, it is important to recognize the limitations and difficulties of examining the influence of either bankruptcy law separately. Although personal bankruptcy law may seem more relevant to an entrepreneur's failure, its impact might be limited because many entrepreneurs settle their cases via out-of-court settlements (Altman 1983). Under financial trouble many entrepreneurs settle their cases with banks and therefore do not need to actually claim personal bankruptcy. Additionally, variations in regimes worldwide make it difficult to examine the impact in a multi-country study (Claessens and Klapper 2005). While it is common in the United States for entrepreneurs to begin a business with sole proprietorship and accordingly only need to file personal bankruptcy during exit, in many other countries entrepreneurs begin their businesses as corporations. For example, Acs et al. (2008) argued that in many countries (such as Hong Kong, Norway, Israel, and Denmark) the rate of incorporation is much higher than that of sole proprietorship.

On the other hand, while personal bankruptcy law is potentially less relevant in countries with less entrepreneurial start-up activities (such as in Japan), corporate bankruptcy law may also be less relevant to bankruptcy cases taking place where it is relatively easy to begin new businesses without incorporating (such as the United States). Furthermore, as explained above in countries such as Hong Kong, Norway, Israel, and Denmark it is more common to run businesses as corporations rather than sole proprietorships. In these countries examining only the impact of personal bankruptcy law on entrepreneurship development is therefore incomplete at best. Likewise, examining the impact of corporate bankruptcy law only on entrepreneurship development in countries such as the United States can also be incomplete where sole proprietorship may be the dominant form of business--particularly for entrepreneurial firms.

It is therefore difficult to argue that one bankruptcy law is more important than the other, or that one should be examined and the other excluded. Furthermore, even when a corporation borrows money from banks the lenders are required to either cosign and guarantee the debt repayment, or provide security in the form of second mortgage on the owner's home (Berkowitz and White 2004; Claessens and Klapper 2005; White 2005). This is because an incorporated firm becomes a legal person and when liquidated this legal person of the firm will not exist anymore; banks therefore tend to ask the owner to cosign in order so the debt is inherited by the owner even when the legal person of the firm ends its life. When a corporation borrows money from banks the loans taken out by the legal person of the firm must be guaranteed for repayment by the firm's owner. It therefore makes more sense to incorporate both personal and corporate bankruptcy laws simultaneously when examining the impact of bankruptcy laws on entrepreneurship development. Before proceeding further we should accordingly specify the similarities and differences between the two types of bankruptcy law (Table 1).

Perhaps the most significant difference between personal and corporate bankruptcy laws concerns liquidation. Unlike corporate bankruptcy law where corporations can cease to exist after liquidation, under personal bankruptcy law there can be no true liquidation (White 2005). While liquidation is possible for a corporation since it is a legally created entity that can cease to exist, the owner as a human being cannot cease to exist even at the liquidation of the business s/he founded. For this reason, while a personal bankruptcy stipulates fresh start and a discharge of debt, this is not a component in a corporate bankruptcy. Corporations do not need to be given the opportunity for a fresh start since it can cease to exist, and this is not the case for the owners. A fresh start is therefore more significant for the owners since the owners are given the opportunity to begin a new business. Accordingly, when scholars have examined personal bankruptcy a fresh start has been one of the key interests as the level of forgivingness is extremely high and only available at the personal bankruptcy level (Ayotte 2007).

On the other hand, when scholars study the impact of corporate bankruptcy law on entrepreneurship development a fresh start is not a major concern (Claessens and Klapper 2005). A firm being a legally created person can cease to exist, while the owner as a human being cannot. A fresh start therefore functions as insurance at the personal bankruptcy level since a fresh start exempts debtors from forfeiting future earnings in debt repayment; this is not included in corporate bankruptcy law (Rea 1984; Jackson 1986). However, an automatic stay of assets applies to both personal and corporate bankruptcy laws, as well as partnerships.

It is therefore evident that there are differences in examining the relationship between bankruptcy law and entrepreneurship development at either the personal or corporate level. For example, many small and medium-sized corporations are required to cosign debt repayment guarantees to their lenders. During bankruptcy for this type of firm it is very likely that both personal and corporate bankruptcies will be filed at the same time. While the firm files for corporate bankruptcy, the owners (or loan guarantors if different) file for personal bankruptcy (White 2005); this makes it difficult to interpret the implications of either law separately.

Furthermore, when examining the differences in the implications of bankruptcy law on international entrepreneurship development we also find there are quite significant differences across countries. For example, countries such as the United States are more heavily focused on the use of personal bankruptcy since establishing firms is a relatively easier process, and the process for failed entrepreneurs to begin new businesses is less painful (Fan and White 2003; Ayotte 2007; White 2005). On the other hand, in countries such as Japan firms filing bankruptcy are much larger than their United States counterparts and there are many additional corporate bankruptcies involved. Given that total number of bankruptcies is not less than that of the United States in relative basis in Japan (Altman 1983), assessing entrepreneurship development only from the forgiveness side (particularly in the international context) cannot be correctly done without examining the effects of both personal and corporate bankruptcy laws.

We therefore find it beneficial to examine the impact of both personal and corporate bankruptcy laws on entrepreneurship development in order to acquire a better and more complete picture of this relationship. In this paper we specifically focus on the most forgiving features of these two bankruptcy laws and their respective impacts on entrepreneurship development. We use fresh start as the most forgiving feature under personal bankruptcy law (Ayotte 2007), and automatic stay of assets as the most forgiving feature in corporate bankruptcy law (Claessens and Klapper 2005). We examine each bankruptcy law to demonstrate how these forgiving features affect the costs of entrepreneurial financing.

Forgiving Failed Entrepreneurs vs. Cost of Financing

For entrepreneurs in the United States there are at least three ways to deal with financial distress: Liquidation bankruptcy (i.e., Chap. 7), reorganization bankruptcy (i.e., Chap. 11 under corporate bankruptcy law and Chap. 13 under personal bankruptcy law) (1), and out-of-court settlement (Ayotte 2007; Lee et al. 2007; White 2001). Liquidation bankruptcy is filed when an entrepreneur decides that the business has little future potential and therefore liquidates the assets in hand for the best interest of the shareholders. Reorganization bankruptcy is filed when an entrepreneur seeks one more chance to revive the business without being pressured by creditors to dissolve the firm's assets in order to reimburse all or part of the ongoing business's outstanding debts.

However, the legal procedures associated with bankruptcy filing vary significantly across countries (Alexopoulos and Domowitz 1998; Claessens and Klapper 2005; Djankov et al. 2008). The United States is considered one of the most tolerant and forgiving countries for failed entrepreneurs. Although some other countries also have entrepreneur-friendly bankruptcy laws (e.g., Canada and France), others provide little protection for entrepreneurs who declare bankruptcy (e.g., Germany and Hong Kong). This raises the question: What are the implications of the varying degrees of entrepreneur-friendly bankruptcy laws around the world? Lee et al. (2007) argued that friendly bankruptcy laws would provide incentives for nascent entrepreneurs starting new firms since lowered exit barriers also provide lower entry barriers. More recently, Peng et al. (2010) demonstrated multiple aspects of bankruptcy laws around the world, arguing that the less painful the bankruptcy process is for failed entrepreneurs the more likely that those failed entrepreneurs will be willing to launch another business in the future. However, both of these studies pay less attention to the financing aspect of new firm generation, which is the primary focus of this study.

Among the different possible features of a bankruptcy law the "fresh start" in liquidation bankruptcy under personal bankruptcy law and the "automatic stay of assets" in restructuring bankruptcy under corporate bankruptcy law are the two most forgiving features in each law directly related to the issue of debt payment for entrepreneurs who file bankruptcy (Lee et al. 2007). A fresh start gives, "the honest but unfortunate debtor ... a new opportunity in life and a clear field for future effort unhampered by the pressure and discouragement of preexisting debt," as expressed in the United States Supreme Court decisions that is well-known as the Local Loan v. Hunt case 292 U.S. 234, 244 (1934). Unlike a fresh start used during liquidation bankruptcy under personal bankruptcy law, an automatic stay of assets is used during reorganization under corporate bankruptcy law by entrepreneurs attempting to revive a business at a time of financial distress. An automatic stay of assets means that creditors are restricted from proceeding with debt collection (Alexopoulos and Domowitz 1998).

Creditors such as financial institutions certainly have reason to be concerned when their loans are at risk (Lee et al. 2007). Therefore while these two forgiving features of bankruptcy law allow nascent and failed entrepreneurs to take additional risks and start new businesses, it is not clear if simply forgiving more is the best option for encouraging entrepreneurial activities from a societal point of view. This is particularly true when we consider the costs that financial institutions incur due to these two features. For example, a higher potential default rate would encourage financial institutions to strictly screen potential entrepreneurs attempting to secure financial resources. Since forgiveness may come at an increased cost to financial institutions and subsequently for potential entrepreneurs, this dynamic must be considered as a coexisting factor in predicting new firm entry.

As stated earlier, the level and standard of forgiving bankruptcy law features are not uniform among countries, but vary greatly among different countries. For example, a bankruptcy law can either discharge the bankrupt entrepreneur from an outstanding debt or allow debtors haunt the bankrupt entrepreneurs for years (OECD 1998). With a "fresh start" the personal bankruptcy law mandates that failed entrepreneurs are exempt from repaying outstanding obligations. While residual assets can be claimed, creditors cannot pursue any remaining claims when failed entrepreneurs declare bankruptcy. Since future earnings are exempt from obligations to repay past debts from bankruptcy the name "fresh start" is very appropriate (White 2001). However, in the absence of a legally protected "fresh start" creditors can pursue any remaining claims. For instance, until recently debtors in Germany remained liable for unpaid debt for up to 30 years and creditors could go beyond claiming residual assets (Ziechmann 1997, pp. 12-25); German managers at bankrupt firms could also be held personally liable for criminal penalties (Fialski 1994). When examining the comparative risks it is therefore unsurprising that the United States has enjoyed a higher level of new firm entry compared to Germany.

In some (but not all) countries a corporate bankruptcy law may come with an "automatic stay of assets." An automatic stay of assets at the beginning of bankruptcy proceedings means that creditors cannot pursue debt collection efforts and must move claims to the court (Alexopoulos and Domowitz 1998). While creditors and firms negotiate the entrepreneur can remain in charge of operations (Kaiser 1996). Before the firm's liquidation is ultimately decided an automatic stay of assets allows entrepreneurs to seek ways of solving the insolvency problem with their creditors (Franks et al. 1996). La Porta et al. (1998) found that nearly half of the 49 countries they studied did not offer an automatic stay on assets. While the United States automatically allows a stay on assets in the case of reorganization bankruptcy (i.e., Chap. 11), countries such as Germany, Great Britain, and Japan do not guarantee an automatic stay of assets (Alexander 1999, Hashi 1997). Without this protection entrepreneurs file for reorganization bankruptcy infrequently even when this option is legally allowed; (2) when firms do file for reorganization bankruptcy where an automatic stay of assets is not in place creditors rush to claim residual assets, eventually leading firms to fail (Alexander 1999).

Meanwhile, the level of financial development and financing costs are also different in each country. Since financial institutions must instill their own safeguards against the costs of forgiveness the positive effects of forgiveness on new firm entry can easily be canceled out by safeguards such as high interest rate (e.g., lending rate).

Hypotheses Development

Fresh Start: The most Forgiving Feature Under Personal Bankruptcy Law

By not holding failed entrepreneurs liable for their failures after they file for liquidation bankruptcy a fresh start provides entrepreneurs with a significant incentive to try again even after filing for bankruptcy, providing a source of further entrepreneurial development (Ayotte 2007). Without this mechanism it is likely that creditors would rush to claim their shares when a firm is in financial trouble (Jackson 1986), destroying any hope of starting over in the near future. Without knowing which entrepreneurs will be successful ex ante, it is socially optimal to give all entrepreneurs the incentive to file bankruptcy when their businesses are failing. Since future earnings are exempt from repaying the debt, entrepreneurs can acquire a fresh start if their businesses go sour.

Prior research shows that when a fresh start is not available entrepreneurs do not file bankruptcy even when they are losing money and a business's future is bleak (White 2001). For example, the recent Asian economic crisis revealed that the lack of protection against creditors kept entrepreneurs from filing bankruptcy; this cost more at the societal level than when entrepreneurs did file bankruptcy (Ahlstrom and Bruton 2004; Lee et al. 2007). On the other hand, in countries where a fresh start is readily available for firms filing bankruptcy approximately half of those filing for liquidation bankruptcy (Chap. 7 bankruptcy) between 1989 and 1993 began new ventures in 1993 (Landier 2001). A fresh start provides failed entrepreneurs an opportunity to retain assets at the time of filing; if an entrepreneur can reverse a poor entrepreneurial effort without cost then the lowered downside risk would encourage the entrepreneur to start new ventures (O'Brien et al. 2003). We therefore argue:

Hypothesis 1: When a bankruptcy law is more forgiving in providing entrepreneurs a greater opportunity for a fresh start (i.e. under personal bankruptcy law), more new firm entry will take place.

Automatic Stay of Assets: The most Forgiving Feature Under Corporate Bankruptcy Law

Unlike the fresh start used for liquidation bankruptcy under personal bankruptcy law, an automatic stay of assets under corporate bankruptcy law is used by entrepreneurs attempting to revive their businesses at the time of financial distress by filing for reorganization bankruptcy. An automatic stay of assets means that creditors cannot proceed with debt collection (Alexopoulos and Domowitz 1998); once the automatic stay of assets is exercised the business will remain in operation until the entrepreneur either recovers from the financial distress or decides to file for liquidation bankruptcy (Franks et al. 1996). Since it is impossible to predict whether or not a particular entrepreneur in financial trouble will go on to become a future star, offering every entrepreneur the opportunity to recover from financial distress keeps potentially valuable entrepreneurs active. Prior research has found that when risky entrepreneurial activities increase the overall survival rates of entrepreneurial ventures decrease, but those that survive tend to come back stronger (Audretsch 1991; Porter 1990).

In countries where an automatic stay of assets is not in place businesses are more likely to be liquidated even if once revived the business might have had a better future (Wruck 1990). Entrepreneurs who are given an additional opportunity thanks to an automatic stay of assets are able to use their intimate knowledge of their businesses' potential, leading to a greater opportunity for the future success of entrepreneurial endeavors than folding the business outright (Povel and Singh 2007). The opportunity to revive a failing business provides entrepreneurs greater incentive to run it well by reducing moral hazards from their side.

The capable entrepreneurs are more likely to take advantage of an automatic stay of assets than incapable ones since it can provide the opportunity to prove that the bankruptcy filing was due to an unlucky event rather than a lack of entrepreneurial capabilities (Landier 2001). As with the fresh start in personal bankruptcy where entrepreneurs have incentives to pursue entrepreneurship because they know they can salvage part of their assets even in the event of liquidation bankruptcy, an automatic stay of assets can also provide incentives for entrepreneurs to start new businesses (Bebchuk 2002). The greater later success of entrepreneurs due to the existence of automatic stay of assets would entice additional latent entrepreneurs to start businesses who would not have should the failure rate were higher. Overall, more entrepreneurs would therefore start new businesses when an automatic stay of assets is in place. We argue:

Hypothesis 2: When a bankruptcy law is more forgiving by providing entrepreneurs an automatic stay of assets (i.e. under corporate bankruptcy law), more new firm entry will take place.

Cost of Financing

In addition to the leniency of bankruptcy law, prior research also shows that the degree of access to financing is an important factor in new firm entry (Armour and Cumming 2008; Mankart and Rodano 2007). Entrepreneurs must bear a significant portion of the opportunity cost of borrowing money from financial institutions in the form of interest rate (Choi and Phan 2006; Schumpeter 1934; Shane 1996). In a country where financial institutions believe that the cost of financing entrepreneurs should be high due to the greater risks involved, a higher interest rate will therefore be levied on the money borrowed by entrepreneurs. Where there are a greater number of overly optimistic entrepreneurs it is natural that financial institutions would build stronger safeguards by increasing their interest rate, which can become a burden for entrepreneurs starting businesses (Brocas and Carrillo 2004). (3)

When banks charge exceptionally high rate for lending it is more likely that entrepreneurs will engage in riskier projects (with higher potential returns) that are less likely to be successful (Meza and Webb 1999). Entrepreneurs planning to engage in safer projects with a higher likelihood of success will therefore be the first to drop the idea of starting a new business when interest (e.g., lending) rate is high. We therefore argue:

Hypothesis 3: When banks charge higher interest rate for entrepreneur financing, less new firm entry will take place.

Mediating Effect of the Cost of Financing on Forgiving Features for Failed Entrepreneurs

Fresh Start

Among the different aspects of personal bankruptcy law the forgiving nature of the "fresh start" bankruptcy law can make it more difficult for bankers to recover loans made to entrepreneurs. If a fresh start forgives entrepreneurs for their potential business failures, then once an entrepreneur files for bankruptcy the banks are forced to deal with the potential losses. When a liquidation bankruptcy is filed a fresh start would exempt entrepreneurs from having to repay outstanding debts after filing. Since the burden of paying these debts falls on the lenders once entrepreneurs file bankruptcy, it is more likely that banks would charge higher interest rate to entrepreneurs when a fresh start is available. Moreover, marginally capable entrepreneurs may also join the force by starting new firms since the risks or costs of failure are lowered when a fresh start is available (Ayotte 2007). These marginal entrepreneurs are less capable and less likely or inclined to avoid bankruptcy in the first place since filing bankruptcy can save at least some portion of the assets when a fresh start is available (Adler et al. 2000; Bebchuk 2002). These marginal entrepreneurs may further deteriorate their assets values by remaining in business and building a greater incentive to file bankruptcy in a failed attempt to salvage a larger portion of their assets under a fresh start.

A more lenient bankruptcy law might therefore inspire entrepreneurs to take greater risks. However, this greater risk-taking by entrepreneurs comes with a cost to a society by burdening financial institutions such as banks that fall responsible for the costs of these failures. This asymmetric responsibility between entrepreneurs and financial institutions incentivizes banks to raise their interest rate. For example, Berkowitz and White (2004) showed that within the United States entrepreneurs were more likely to be denied credit when located within a state with a more forgiving bankruptcy law. They found that in these states the available loans are smaller and the interest rate is higher.

When the interest rate is high it is also more likely that entrepreneurs would take on riskier projects (Meza and Webb 1999); knowing that entrepreneurs may take on riskier projects with higher failure rates, banks may become more hesitant to finance entrepreneurs (Stiglitz and Weiss 1981). While countries with a more forgiving bankruptcy law provide greater incentives for entrepreneurs to take greater risks, these laws also make banks less likely to loan money to entrepreneurs or make these loans more difficult to acquire. Since the cost of financing greatly affects the likelihood of entrepreneurs actually starting a new business we posit:

Hypothesis 4: The relationship between a more forgiving bankruptcy law such as providing a fresh start (i.e. under personal bankruptcy law) and new firm entry will be mediated by the interest rate.

Automatic Stay of Assets

Although an automatic stay of assets provides a valuable opportunity for entrepreneurs, it places enormous pressure on financial institutions. Lee et al. (2007, p. 263) argued that, "[a]n automatic stay upon commencement of bankruptcy proceedings means that creditors must cease debt collection efforts and direct their claims to the court (Alexopoulos and Domowitz 1998). The firm will be in operation while the creditors and managers negotiate (Kaiser 1996)."

When the entrepreneur is in charge of operations creditors have priority over shareholders in recovering the entrepreneur's debts, called "absolute priority." However, when the entrepreneur files corporate bankruptcy and an automatic stay of assets is guaranteed this absolute priority is violated; the entrepreneur can retain some value even when investors and debt holders are not fully repaid (Bebchuk 2002). When an entrepreneur files a reorganization bankruptcy in a country where an automatic stay of assets is guaranteed the investors and debt holders must wait until the reorganization plan is approved to recover their assets. The existence of an automatic stay of assets makes investors and debt holders (banks) bear the downside risks, working as an adverse incentive against lending money to entrepreneurs from a bank's standpoint (Meza and Webb 1999). It is not surprising that Berkowitz and White (2004) found that within the United States entrepreneurs located in states with a more forgiving bankruptcy law were more likely to be denied loans, and even when approved tended to pay higher interest rate. We argue:

Hypothesis 5: The relationship between a more forgiving bankruptcy law such as providing an automatic stay of assets (i.e. under corporate bankruptcy law) and new firm entry will be mediated by the interest rate.

The overall framework of our arguments is summarized in Fig. 1.

[FIGURE 1 OMITTED]

Data and Methodology

We collected data for testing our hypotheses by exploring several sources including the Organisation for Economic Co-operation and Development (OECD), the World Bank, the International Monetary Fund (IMF), and the Global Entrepreneurship Monitor (GEM) project, as well as past studies on commercial bankruptcy filings collected from government and private sources on the legal rules covering the protection of corporate shareholders and creditors, their origins, and the quality of their enforcement (Claessens and Klapper 2005; La Porta et al. 1997, 1998). (4) Since we are examining the detailed nature of bankruptcy laws and new firm entry across countries the availability of appropriate data was limited. However, we were able to collect data from 28 countries for a 15-year time period (1990-2004 inclusive). (5)

New Firm Entry Rate

We used the rate of new firm entry as the dependent variable of our model in order to measure entrepreneurship development within a country (Klapper et al. 2004, 2006; Lee et al. 2011). We used OECD data in order to obtain the new firm entry rate (the ratio of the number of new firms to the total number of firms during the previous year) among countries and across time.

Fresh Start

We measured the degree to which a fresh start is allowed due to the variance in terms of legal treatments across countries in the context of bankruptcy using dimensions from the "index of creditor rights" originally developed by La Porta et al. (1998) and further updated by Djankov et al. (2007) in order to capture the extent to which creditors (as opposed to debtors or failed entrepreneurs) control the bankruptcy process. Specifically, we aggregated priority of creditors (coded on a binary basis of whether or not secured creditors are paid first out of the proceeds of liquidation) and the protection of creditors (a value of one added for each of the powers a country's laws and regulations provide protection to creditors or lenders) into a single indicator ranging from zero to three. We assumed that the more likely the creditors are to have rights and powers over an insolvent firm, the fewer assets that can be recovered by failed entrepreneurs, and the less likely entrepreneurs are to have a flesh start. We therefore invert this single indicator by calculating four minus the value for each country as a proxy for flesh start.

Automatic Stay of Assets

We captured whether or not the reorganization procedure imposes an automatic stay on assets using the data originally collected by La Porta et al. (1998) and frequently used in subsequent research (Claessens and Klapper 2005; Pistor 2000). In La Porta et al. (1998) this is represented as "no automatic stay on secured assets." In our reverse form it is noted here as "automatic stay of assets." Accordingly, this variable equals one if there is an automatic stay of assets, and zero otherwise.

Interest Rate

For each country we used the "annual lending rate" obtained from the Euromonitor IMF (International Financial Statistics) that capture the average lending rate for each year in its entirety. While rates are normally differentiated according to the creditworthiness of borrowers and objectives of financing, this variable represents the bank's interest rate that usually meets the short- and medium-term financing needs of entrepreneurs.

Control Variables

We controlled for six sets of factors. First, we controlled for countries' general levels of development and macroeconomic performance. The economic performance of a country can affect its rate of new firm entry (Shane 1996), and countries experiencing positive growth may also have higher rates of new firm entry (Kawai and Urata 2002). We therefore included the lagged real GDP per capita in U.S. dollars as the general level of economic development. We included the lagged growth rate of real GDP obtained from the IMF as macroeconomic performance (Claessens and Klapper 2005). Second, we controlled for time effects across all countries (Caprio and Klingebiel 2002). We included a variable measuring the number of years elapsed since 1990 in order to capture any time trend associated with changes in the bankruptcy rate (Boeker 1997; Goot and van den Brink 2003; Rhee and Haunschild 2006). Third, we controlled for regional variations among countries' regulatory environments. We created dummy variables for the origin of law (e.g., English, French, or German), as well as account for what La Porta et al. (1997) labeled as the rule of law--an assessment of law and order traditions within a country (from a scale of 1-10).

Fourth, we controlled for the informal aspects of the institutional environment including the "uncertainty avoidance" as obtained from Hofstede (2001) that can affect new firm entry (Baughn and Neupert 2003; Wennekers et al. 2007). The same entrepreneur-friendly bankruptcy law may have different implications for entrepreneurs within different institutional environments (Lee et al. 2007; Shepherd 2003; Sutton and Callahan 1987).

Fifth, we controlled for the number of banks within a country during a given year in order to capture the variance and stability of a country's banking infrastructure (Bandiera et al. 2000; Caprio and Honohan 1999). We accounted for a country's financing infrastructure by controlling for the annual informal investment per GDP obtained from the GEM data in consideration of the variation among countries in their prevalence of informal investments. Finally, we controlled for the rate of bankruptcy filings in the previous year in order to examine whether or not the previous level of death rate (compared to new firm entry as the birth rate) affects the rate of new firm entry during a given year.

Models

We adopted a cross-sectional time series feasible generalized least squares regression model in order to analyze our panel data and test our hypotheses (Greene 2002; Wooldridge 2002). Since we include time-invariant independent variables in our model we used a random-effect model. This is confirmed by running the Hausman test comparing the coefficient estimations of fixed versus random effects. The result (insignificant P-value) indicated that a random-effect model would be better suited for further analysis. We conducted a mediation analysis following the procedures outlined in the seminal work of Baron and Kenny (1986). In order for a variable to act as a mediator it must meet three conditions: The independent variable is significantly associated with the mediator variable, the mediator variable is significantly associated with the dependent variable, and when both the independent and mediator variables are considered together the influence of the independent variable on the dependent variable is reduced (Gong et al. 2007; Nakos and Brouthers 2008). (6)

We tested these three conditions in three steps. In step one we established the relationship between the independent variables (fresh start and automatic stay of assets) and the mediator (interest rate). (7) In step two we established the relationship between the mediator (interest rate) and the dependent variable (new firm entry rate). In step three we predicted the dependent variable (new firm entry rate) by adding the mediator (interest rate) to the equation with the independent variables (fresh start and automatic stay of assets). In this final step the mediator (interest rate) should be significant, while the previously significant effects of the independent variables (fresh start and automatic stay of assets) should either be reduced or become insignificant.

Results and Findings

Table 2 presents the means, standard deviations, and correlations for the variables in our models. We assessed the potential threat of multicollinearity by estimating the variance inflation factors (VIFs) and condition indexes. Ali VIFs are well below the suggested ceiling of 10 (average: 2.21), indicating little problem with multicollinearity (Kleinbaum et al. 1988).

Table 3 depicts the regression results of step one for our mediation analysis. Model 1 provides the results for control variables. This is followed by two models with the mediator regressed on each of our primary independent variables. In Model 2 we find that while marginal a fresh start is still positively and significantly associated with interest rate ([beta] = 1.084, p < 0.10). In Model 3 we find that an automatic stay of assets is also positively and significantly associated with interest rate ([beta] = 3.066, p<0.05). Our results therefore suggest that ceteris paribus, the degree of fresh start and automatic stay of assets as specified by bankruptcy law are both positively associated with higher interest rate within a given country and given year. Wald (chi-square) tests indicate that all models are statistically significant (p<0.01).

Table 4 presents the regression results for Hypotheses 1, 2, and 3, as well as the results of steps two and three for the mediation analysis assessing our Hypotheses 4 and 5.

Model 1 is the base model containing only the control variables. In Model 2 we examined the primary effects of a fresh start and automatic stay of assets on new firm entry rate as a test of our Hypotheses 1 and 2. In Model 3 we examined the effect of interest rate on new firm entry rate as a test of our Hypothesis 3; this also constitutes step two of our mediated regression analysis for Hypotheses 4 and 5 (a model with the dependent variable regressed on the mediator). Finally, Models 4, 5, and 6 provide the results of step three and conclude our mediated regression analysis (models with dependent variable regressed on the mediator and independent variables both individually and combined).

Hypothesis 1 investigates the effect of fresh start on new firm entry rate. While marginal, the positive and significant result ([beta] = 0.015, p < 0.10) in Model 2 (Table 4) supports our argument that a fresh start is associated with a higher rate of new entry. The more a bankruptcy law provides failed entrepreneurs with the opportunity for a fresh start, the more new firm entries will take place. Model 2 (Table 4) also tests whether or not an automatic stay of assets will be associated with more new firm entry (Hypothesis 2). Our result is significant but negative ([beta] = -0.043, p <0.05). We find that a stay of assets does not lead to a higher rate of new firm entry; and instead actually dampens new firm entry. In Hypothesis 3 we posited that a higher interest rate will be associated with reduced new firm entry. The negative and significant result ([beta] = -0.001, p<0.05) in Model 3 (Table 4) supports our argument. This result indicates that when a higher interest rate is charged for entrepreneurs' financing then less new firm entry will take place.

In Hypotheses 4 and 5 we explored the mediating effect of interest rate on the impact of fresh start (Hypothesis 4), and automatic stay of assets (Hypothesis 5) on new firm entry. Following the three necessary conditions for identifying the existence of mediation (Baron and Kenny 1986) we show that: Both independent variables (fresh start and automatic stay of assets) are significantly (p < 0.10 and p < 0.05 respectively) associated with the mediator variable (interest rate) (Models 2 and 3 in Table 3), the mediator variable (interest rate) is significantly (p < 0.05) associated with the dependent variable (new firm entry rate) (Model 3 in Table 4), and when both the independent variables and mediator variable (fresh start, automatic stay of assets, and interest rate) are combined in one equation (Models 4, 5, and 6 in Table 4) the influence of both independent variables (fresh start and automatic stay of assets) on the dependent variable (new firm entry rate) becomes insignificant. We therefore provide support for our arguments in Hypotheses 4 and 5 that interest rate mediates the relationship between both of our independent variables (fresh start and automatic stay of assets) and new firm entry.

In order to confirm that our findings hold for both personal and corporate-level bankruptcies we incorporated "exemption" in our model(Armour and Cumming 2008) in order to assess a similar impact of "automatic stay of assets" at the personal bankruptcy level. Since these two measurements can be highly correlated due to their nature, we orthogonized the two variables to each other in order to address the possibility of multicollinearity. This reduces the correlation of the variables close to zero (Choi and Prasa 1995; Elton and Gruber 1991; Lee and Makhija 2009). When we ran our analysis using the newly created orthogonized variables we found that our results were consistent with those derived from our original model. Specifically, our results indicate that both the significant and negative effects of an exemption (personal bankruptcy) and an automatic stay of assets (corporate bankruptcy) are mediated by interest rate. We accordingly reasonably confirm that our results hold for the effects on personal and corporate-level bankruptcies?

As an additional robustness check we set out to confirm the significance of the mediating relationship (Lee 2008). A necessary component of mediation is a statistically and practically significant indirect effect; this is rarely addressed in research (Preacher and Hayes 2004). We therefore conducted a formal significant test of the indirect effects in order to verify the role of interest rate as a significant mediator, as well as examine the degree of mediation, by performing a Sobel-Goodman mediation test in STATA using the sgmediation command. From the Sobel test statistics, we found support that the mediation effect of interest rate on the relationship between both fresh start and automatic stay of assets on the rate of new firm entry are significant (p <0.01, p < 0.05 respectively). Approximately 61% of the total effect of fresh start on the rate of new firm entry and approximately 16% of the total effect of automatic stay of assets on the rate of new firm entry are mediated. These results support our Hypotheses 4 and 5 that interest rate indeed mediates the relationship between fresh start, automatic stay of assets, and new firm entry.

Robustness Checks

We increase the robustness of our analyses by conducting further analysis incorporating variables other than our main and control variables. We used "the rate of recovery" from an insolvent firm (cents on the U.S. dollar) obtained from the Doing Business Report (2006) produced by the World Bank as a proxy for failed entrepreneurs' fresh start. We used closing recovery (associated with the likelihood of the pursuit of remaining claims) in order to measure the degree to which a fresh start is allowed. We assumed that the fewer claimants an insolvent firm has the greater the amount of assets entrepreneurs can recover, and the more likely entrepreneurs are to have a fresh start. We calculated fresh start as one U.S. dollar (100 cents) minus the number of cents on the dollar claimants such as creditors, tax authorities, and employees recovered from an insolvent firm. In addition to the lending rate obtained from IMF, we also collected data from the World Bank (World Development Indicators 2006) and tested the real interest rate. (9) We further controlled for the impact of a specific year by creating Internet or Dotcom bubble and burst variables (Armour and Cumming 2008) for the years 1999, 2000, and 2001. We further controlled for the social dimension of the bankruptcy law by testing the level of social stigma concerning failure by incorporating the suicide rate (by year per 100,000 populations) obtained from the World Health Organization. (10) Since entrepreneurs in countries with ample venture capital financing for risky projects might be able to start new businesses more easily, we also controlled for classic venture capital investment per GDP obtained from the GEM data. (11) We also accounted for cost of bankruptcy filings, which can affect the proceeds, using data obtained from the World Bank (Doing Business Reports). In addition to the rate of bankruptcy during the previous year, we also tested the rate of new firm entry during the previous year as a control to determine whether or not the previous level of new firm entry affects the rate of new firm entry during a given year.

Furthermore, since our data contains more than one observation (multiple and unbalanced) per country we also used an estimation procedure that accounts for the within-group (intra-group) dependence (Barkema and Shvyrkov 2007). Specifically, we used the cluster command in STATA in order to obtain a robust variance estimate that adjusts for within-country correlation (Williams 2000). These additional tests and robustness checks further confirm that our results are not qualitatively different from our primary findings.

Discussion

This article leverages insights from the existing literature, extending the argument that at the societal level an entrepreneur-friendly bankruptcy law can lower exit and entry barriers by encouraging entrepreneurs to take additional risks and to start more new firms (Lee et al. 2007, 2011). Lee et al. (2007) argued that when risk-taking behaviors are encouraged by a more lenient bankruptcy law it can generate greater variety by increasing the number of firms with growth potential within a country. This in turn can lead to greater entrepreneurship development at the societal level. This argument pinpoints the anti-failure bias in past literature and shows that failure can be good for the economy at the societal level (Knott and Posen 2005; McGrath 1999).

While acknowledging the contribution of those few articles attempting to demonstrate that failure is not always negative, we include the cost of financing in the picture in order to better understand the dynamics between a lenient bankruptcy law, interest rate, and new firm entry. We extend this line of research in two ways. First, the results of our analyses show that while both a fresh start and an automatic stay of assets are similarly forgiving aspects of bankruptcy law, each type functions differently. We find that a fresh start under personal bankruptcy law better provides for a once-failed entrepreneur (in liquidation bankruptcy) and is associated with more new firm entries. On the other hand, we find that an automatic stay of assets under corporate bankruptcy law (in reorganization bankruptcy) dampens new firm entry by providing the entrepreneur with an opportunity to revive his or her failed business. These results are particularly interesting since while we argue that both a fresh start and an automatic stay of assets encourage entrepreneurs to take risks (Lee et al. 2007), our findings suggest otherwise and show how these two "friendly" laws influence new firm entry in different ways.

It is interesting that an automatic stay of assets dampens entrepreneurship development. The negative effect of an automatic stay of assets on new firm entry might have been the result of our study's relative emphasis on developed countries. It is likely that developed countries might have more capable entrepreneurs compared to developing countries. Since an automatic stay of assets provides an opportunity for capable entrepreneurs to stay in business (and come back stronger) even if they encounter bad luck, fewer of them would need to re-launch new businesses. If these quality entrepreneurs can stay in business the pool of potential entrepreneurs starting new businesses shrinks in areas where an automatic stay of assets is guaranteed. In countries where an automatic stay of assets is well protected it is not difficult to find entrepreneurs successfully finding ways out of restructuring bankruptcies.

For example, Harvard Industries filed reorganization bankruptcy four times (called Chap. 44 in this case) in the United States (Economist 2002). Over 20% of the entrepreneurs who file for reorganization bankruptcy in the United States actually revive and remain in business, resulting in a smaller pool of quality entrepreneurs to start new businesses. Since these entrepreneurs are more capable of reviving their failing firms (and do not need to start another business), and providing additional incentive for capable entrepreneurs to start new businesses might provide less incentive for marginal entrepreneurs to start businesses instead, we posit that examining developing countries might provide different results. Future research may examine this issue in order to determine how the quality of the entrepreneurs within a country affects new firm entry.

It is also interesting that an automatic stay of assets increases the lending rate of banks. The information asymmetry between firms and banks potentially makes it difficult for banks to differentiate between capable and incapable entrepreneurs. In addition, creditors are more cautious than debtors in their relationships since lenders have more to lose when entrepreneurs fail; any bankruptcy filing (regardless of whether or not it is reorganization bankruptcy) can therefore be considered a sign of risk for banks.

At the same time; however, we also find that Lee et al. (2007) supported our findings in a different light. Our results align with their reasoning that both a fresh start and an automatic stay of assets encourage the entrepreneurial spirit: A fresh start provides entrepreneurs with incentives to start new businesses by forgiving unpaid debts when they file liquidation bankruptcy, and an automatic stay of assets protects entrepreneurs during financial difficulty so they can revive their businesses for potential future success. In other words, both forgiving aspects of bankruptcy law encourage entrepreneurs to be entrepreneurial, but in different ways--wherein one encourages them to start new businesses and the other helps revive financially troubled businesses. This demonstrates the importance of examining both personal and corporate bankruptcy laws in order to understand the full picture rather than focusing only on one at a time. For example, only focusing on personal bankruptcy law may include many mom and pop stores that involve less risk. On the other hand, primarily examining corporate bankruptcy law may exclude many small firms and sole proprietorships that are the growth engine of the economy.

Second and more importantly, the results of our analyses indicate that both of these forgiving features of the bankruptcy law are associated with higher interest rate that in and of itself negatively influences new firm entry. We find that when either a fresh start or an automatic stay of assets is combined with higher interest rate then less new firm entry takes place. While a more forgiving bankruptcy law provides greater incentive for entrepreneurs to take greater risks, lenders (e.g., banks) might build safeguards by increasing the interest rate and dampening new firm entry. Banks may also place more emphasis on screening in order to make certain that they only provide loans to entrepreneurs who can repay the loans, particularly when a more forgiving bankruptcy law provides incentive for entrepreneurs to take on less viable and riskier projects (Stiglitz and Weiss 1981).

Limitations and Future Research

This study is not without limitations. First, while we controlled for venture capital investments, the extant work indicates there may be other important sources of capital including corporate investors and members of conglomerate groups (Dushnitskly and Lenox 2006a, 2006b; Gompers and Lerner 2001; Guler 2007; Mayer et al. 2005) that we did not account for in this study. Another implicit assumption made is that entrepreneurs require external financing. One may argue that if entrants are fully capitalized by their own funds then the effect of bankruptcy would be minimal. Future research may benefit from exploring whether resorting to self-financing versus external financing makes a difference in this regard.

Second, the differences in liability shields among different countries have not been fully incorporated into our arguments. For example, many countries in Eastern Europe did not traditionally have any private incorporation. These countries accordingly had no bankruptcy law because all firms were government-owned, and firms were closed by government orders rather than entrepreneurs' declaring bankruptcies. Our study sample primarily focused on developed countries with a United States-equivalent incorporation system. (12) Significant differences may exist between developed and developing countries regarding how formal and informal rules of the game govern entrepreneurial behavior and action (Peng et al. 2005). It would be interesting to examine the implications of a more lenient bankruptcy law for countries in emerging or transition economies; for example examining how this change affected new firm entry in many Asian countries following bankruptcy law changes after the economic crisis in 1997.

Third, we were not able to incorporate time-varying changes into our analyses. We accounted for the varying assessments of law and order traditions among countries (e.g., origin of law or rule of law), but we could not capture the development of fresh start and automatic stay of assets among countries over time. Future research could incorporate this information.

Finally, we were not able to differentiate bad new entry from good new entry. For example, Baumol (1990) differentiated between productive entrepreneurial endeavors and unproductive ones. In developing our theory we argued that it is likely that unproductive entrepreneurs will become more motivated to start businesses via a fresh start, while more productive ones would prevail due to an automatic stay of assets. Future studies might further examine this area to discover whether or not more lenient bankruptcy law gives greater incentives to more productive entrepreneurs.

Conclusions

In answering the broad question of how bankruptcy law impacts entrepreneurship, we find that unlike the arguments made by Lee et al. (2007) entrepreneurial development in the form of new firm entry is not always spurred by a more forgiving bankruptcy law. Even in a forgiving environment allowing a fresh start for failed entrepreneurs leads to new firm entry, while an automatic stay of assets does not. More importantly, when a bankruptcy law is more forgiving then financial institutions such as banks may be forced to pay the cost of failure for entrepreneurs. If a more forgiving bankruptcy law makes entrepreneurs more likely to take on riskier projects then banks may react by increasing their interest rate. Therefore when a forgiving bankruptcy law does not help banks recover from the failures of entrepreneurs the resulting higher interest rate will lead to lower new firm entry; this is the case for both fresh start and automatic stay of assets. Given the increasing number of bankruptcies (both small and large firms) and recent changes in the bankruptcy laws around the world, it seems important that we devote our attention to this relevant and challenging research agenda.

DOI 10.1007/s11575-011-0112-1

Appendix A
Table 5: Sources of bankruptcy data in Claessens and Klapper (2005)

Country           Source

Argentina         Ministry of Justice
Australia         Australian Securities and Investment Commission
Austria           Statistical Office
Belgium           National Statistic Office
Canada            Office of The Superintendent of Bankruptcy
Chile             Fiscal Nacional De Quiebras
Colombia          Supersociedades
Czech Republic    European Bank of Research and Development
Denmark           Statistics Denmark
Finland           Statistics Finland
France            Institute National de la Statistique
                  et des Etudes Economiques
Germany           Wirtschaftsanalyse
Greece            National Statistical Service of Greece
Hong Kong         Government of Hong Kong
Hungary           European Bank for Reconstruction and Development
Ireland           Department of Enterprise, Trade and Employment
Italy             Annuario di Statisticch Giudiziarie
Japan             Teikoku Data Bank
Netherlands       Statistics Netherlands
New Zealand       New Zealand Insolvency and Trustee Service
Norway            Statistics Norway
Peru              INDECOFI
Poland            European Bank for Reconstruction and Development
Portugal          Ministry of Justice
Russia            Russian Economic Trends Quarterly,
                  Center for Economic Reforms
Singapore         Official Receiver and Public
                  Trustee Office, Singapore
South Africa      Ministry of Justice
South Korea       OECD Special Report
Spain             National (Spanish) Statistics Institute
Sweden            Statistics Sweden
Switzerland       Schweizerischen Verband Creditform
Thailand          Statistical Office
Turkey            Government of Turkey
United Kingdom    Department of Trade and Industry
United States     American Bankruptcy Institute


Appendix B
Table 6: New firm entry rate, interest rates, and forgiving features
of bankruptcy law

(Sources: Bae and Goyal 2007; Claessens and Klapper 2005;
Doing Business Report; World Bank; Euromonitor, International
Monetary Fund; La Porta et al. 1998; OECD Data)

Country            New firm           Lending
                entry rate*             rate*

Argentina               0.07             11.23
Australia               0.11              8.43
Austria                 0.08              5.95
Belgium                 0.08              7.65
Canada                  0.13              5.80
Chile                   0.07             20.46
Denmark                 0.10              7.83
Finland                 0.08              5.24
France                  0.08              6.73
Germany                 0.17              9.63
Greece                  0.06             27.48
Hong Kong               0.04              7.78
Ireland                 0.05              6.98
Italy                   0.08              7.14
Japan                   0.04              2.40
Netherlands             0.16              4.43
New Zealand             0.19              8.70
Norway                  0.11              8.75
Peru                    0.11             32.25
Portugal                0.08              5.97
Singapore               0.18              6.19
South Korea             0.03              9.47
Spain                   0.10              4.60
Sweden                  0.07              5.68
Switzerland             0.02               5.3
Thailand                0.09              11.2
United                  0.12              5.22
Kingdom
United States           0.11              8.29

Country        Real interest      Fresh start
                      rate*

Argentina              11.21                 3
Australia               5.29                 1
Austria                 5.52                 2
Belgium                 5.72                 3
Canada                  3.90                 3
Chile                  11.35                 2
Denmark                 5.62                 2
Finland                 3.08                 3
France                  4.63                 4
Germany                 8.90                 2
Greece                 10.83                 3
Hong Kong               4.64                 1
Ireland                 5.00                 3
Italy                   4.60                 2
Japan                   2.79                 2
Netherlands             2.47                 1
New Zealand             7.28                 1
Norway                  6.24                 2
Peru                   24.46                 4
Portugal                2.62                 3
Singapore               4.93                 2
South Korea             3.64                 2
Spain                   2.08                 3
Sweden                  4.31                 3
Switzerland             4.09                 3
Thailand                8.15                 3
United                  3.21                 1
Kingdom
United States           6.36                 3

Country        Recovery rate        Automatic
                 (cents/$)*        stay of as
                               sets (1 : stay;
                                  0: no stay)

Argentina               70.2                 1
Australia               19.7                 1
Austria                 26.9                 0
Belgium                 14.0                 0
Canada                  10.3                 1
Chile                   80.4                 1
Denmark                 36.9                 0
Finland                 11.7                 1
France                  54.3                 1
Germany                 43.6                 0
Greece                  75.8                 1
Hong Kong               18.8                 0
Ireland                 12.3                 1
Italy                   57.3                 1
Japan                    7.4                 1
Netherlands             12.6                 1
New Zealand             21.0                 0
Norway                   5.6                 1
Peru                    69.0                 1
Portugal                26.8                 1
Singapore                8.7                 0
South Korea             19.0                 0
Spain                   22.6                 0
Sweden                  29.0                 1
Switzerland             53.6                 1
Thailand                57.2                 0
United                  14.7                 0
Kingdom
United States           19.7                 1

* Average for available data during 1990-2004


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Endnotes

(1) Reorganization bankruptcy law under Chap. 11 includes partnerships.

(2) In many cases reorganization efforts take place before filing reorganization bankruptcy, particularly under pressure from creditors.

(3) We acknowledge that banks are not the only financial institutions that lend financial resources to entrepreneurs. However, other forms of financial institutions are exceptional rather than the norm. For example, in Europe only 13% of start-ups are supported by venture capital firms. Even in the United States start-ups backed by substantial venture capital are exceptional. Even Bill Gates (Microsoft) and Sam Walton (Wal-Mart), both highly successful entrepreneurs, initially pursued their entrepreneurial endeavors without venture capital support (Bhide 2000).

(4) See Appendix A for the Sources of Bankruptcy Data (Claessens and Klapper 2005). We thank Claessens and Klapper for sharing part of their data for our research.

(5) The 28 countries are: Argentina, Australia, Austria, Belgium, Canada, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Peru, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, Thailand, United Kingdom, and the United States. Since we do not have the same number of years available for each country the number of observations varies among countries. Due to missing variables (primarily from our dependent variable), we have an unbalanced panel of 131 country-year observations for analyzing our hypotheses. See Appendix B for the structural characteristics (i.e., friendliness) of bankruptcy laws among the countries.

(6) The use of the procedures outlined in Baron and Kenny's (1986) seminal work to test mediation hypotheses in the management literature has been prominent. See Shaver (2005) for details regarding the concerns, implications, and alternative strategies for testing mediational variables in management research.

(7) The model specification for estimating the lending rate: Prior research shows that the lending rate can reflect a variety of factors including (1) macroeconomic conditions, (2) market structure where the financial institutions operate, (3) overall financial structure or banking infrastructure, and the (4) risk and uncertainty levels of countries (Angbazo 1997; Demirguc-Kunt and Huizinga 1999; Bennaceur and Goaied 2008; Ho and Saunders 1981). In order to examine the determinants of the lending rate in each country we therefore included variables such as real GDP per capita, growth rate of GDP, and real interest rate in order account for countries' general levels of macroeconomic performance, market capitalization of listed companies (% of GDP) and total value of stock traded (% of GDP) to account for market structure, number of banks, bank capital to assets ratio, informal investments (% of GDP), and institutional investors 'financial assets in order to capture the variance and stability of countries' banking infrastructures including the prevalence of informal investments, and uncertainty avoidance and bankruptcy rate in order to account for the variation in countries' institutional environments.

(8) We would like to thank Armour and Cummings for sharing their data.

(9) The interest rate for each country is defined here as the real interest rate adjusted for inflation or price changes (Goderis and Ioannidou 2008; Ndikumana 2000). We measured inflation when computing the real interest rate using the change in the GDP-deflator. The computation of the real interest rate is: Since (1 + [i.sup.real])=(1 + [i.sup.nominal])/(1 + p), we can find the real interest rate as [i.sup.real] = ([i.sup.nominal] - p)/(1 + p) where I = interest rate and p = inflation rate.

(10) For example, in Japan where the stigma of failure is very high it is well known that bankrupt entrepreneurs often commit suicide (Time 1999). Approximately 30 people commit suicide per day for economic reasons in Japan (Takahashi 2003).

(11) Compared to funding from informal investors composed of family, friends, and foolhardy strangers (these are already accounted and controlled for), investments from professional venture capitalists as a source of equity funding for start-up entrepreneurs are quite rare and therefore less prominent (GEM 2004). The sample size for this variable is also limited.

(12) Limited liability partnership (LLP) is also widely used in many countries, although it has only been recently used for some countries. For example, in Japan the legislation for LLP passed in (http://en.wikipedia.org/wiki/Limited_liability_company). We therefore reworked our analyses by dropping Japan, and we do not find the revised results to be qualitatively different from the original results.

Received: 04.09.2009 / Revised: 18.06.2010 / Accepted: 17.08.2011 / Published online: 03.01.2012

[c] Gabler-Verlag 2011

Assoc. Prof. S.-H. Lee

Naveen Jindal School of Management, University of Texas at Dallas, Richardson, USA

Assist. Prof. Y. Yamakawa ([mail])

Arthur M. Blank Center for Entrepreneurship, Babson College, Babson Park, USA

e-mail: yyamakawa@babson.edu
Table 1: Differences between personal and corporate
bankruptcy studies

                          Personal bankruptcy law focused
                          studies

Main characteristics      No true liquidation because an
                          entrepreneur's human capital cannot
                          be liquidated

Most forgiving features   Fresh start

Advantages                More relevant to entrepreneurship
                          development

Disadvantages             Personal bankruptcy regimes vary
                          greatly across nations and so hard
                          to generalize (see Alexopoulos and
                          Domowitz 1998)
                          Less relevant to many entrepre
                          neurs who resort to out-of-court
                          settlements

Exemplary studies         Fan and White (2003)

                          Corporate bankruptcy law
                          focused studies

Main characteristics      No fresh start component
                          stipulated in corporate bankruptcy law

Most forgiving features   Automatic stay of assets

Advantages                Less variance in corporate
                          bankruptcy regimes

Disadvantages             More geared toward medium
                          and large sized firms and so
                          potentially less relevant

Exemplary studies         Claessens and Mapper
                          (2005)

Table 2: Descriptive statistics and Pearson correlation coefficients

Variable                           Mean         SD        Min

1. New firm entry rate              0.10       0.05       0.02
2. GDP/Cap (t-1)                20709.33   10421.90    1905.87
3. GDP growth (t-1)                 3.74       2.59      -2.10
4. Real interest rate (t-1)         5.50       4.16       0.13
5. Years since 1990                 8.96       2.95          1
6. Market capitalization of        78.00      58.12       7.70
   listed companies/GDP (t-1)
7. Total value of stock            50.63      52.17       1.61
   traded/GDP (t-1)
8. Number of banks (t-1)         1004.83    2394.87          4
9. Bank capital to assets           6.57       1.68       2.80
   ratio (t-1)
10. Informal investment/GDP         1.33       0.98       0.25
   (t-1)
11. Institutional investors'        2.68       1.39       0.08
   financial assets (t-1)
12. Uncertainty avoidance          62.97      23.58          8
13. Bankruptcy rate (t-1)           1.80       1.75       0.02
14. Rule of law                     8.91       1.54       2.50
15. English (origin of law)         0.20       0.40          0
16. French (origin of law)          0.28       0.45          0
17. German (origin of law)          0.24       0.43          0
18. Fresh start                     2.08       1.20          0
19. Automatic stay of assets        0.54       0.50          0
20. Lending rate (t-1)              9.17       6.25       2.20

Variable                            Max           1          2

1. New firm entry rate              0.24
2. GDP/Cap (t-1)                45296.63      -0.12
3. GDP growth (t-1)                12.28       0.08   -0.27***
4. Real interest rate (t-1)        24.82   -0.26***   -0.31 ***
5. Years since 1990                   14   0.26***     0.18**
6. Market capitalization of       267.30      -0.02   0.41***
   listed companies/GDP (t-1)
7. Total value of stock           326.30       0.08   0.26***
   traded/GDP (t-1)
8. Number of banks (t-1)           10500       0.14   0.31 ***
9. Bank capital to assets          11.90       0.04   -0.41 ***
   ratio (t-1)
10. Informal investment/GDP         5.25   -0.21**    -0.27***
   (t-1)
11. Institutional investors'        8.56   -0.20**    0.26***
   financial assets (t-1)
12. Uncertainty avoidance            112   -0.22***   -0.37***
13. Bankruptcy rate (t-1)          10.80       0.10   0.32***
14. Rule of law                       10       0.12   0.67***
15. English (origin of law)           l    0.34***        0.09
16. French (origin of law)             1    -0.16*    -0.45***
17. German (origin of law)             1      -0.11    0.19**
18. Fresh start                        4    0.17**       -0.04
19. Automatic stay of assets           1   -0.17**       -0.08
20. Lending rate (t-1)             35.10   -0.11***   -0.54***

Variable                               3          4          5

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)         0.01
5. Years since 1990             -0.34***      -0.06
6. Market capitalization of       0.16*    -0.19**        0.04
   listed companies/GDP (t-1)
7. Total value of stock            -0.06   -0.26***     0.15*
   traded/GDP (t-1)
8. Number of banks (t-1)           -0.09      -0.08      -0.06
9. Bank capital to assets       0.31 ***       0.14      -0.11
   ratio (t-1)
10. Informal investment/GDP      0.19**    0.52***     -0.15*
   (t-1)
11. Institutional investors'       -0.14      -0.11      -0.09
   financial assets (t-1)
12. Uncertainty avoidance          -0.06    0.21**       -0.14
13. Bankruptcy rate (t-1)        -0.14*    -0.21**        0.14
14. Rule of law                 -0.30***   -0.37***   0.38***
15. English (origin of law)         0.10      -0.05       0.11
16. French (origin of law)          0.08    0.19**     -0.16*
17. German (origin of law)      -0.25***   -0.32***   -0.25***
18. Fresh start                    -0.09       0.09       0.04
19. Automatic stay of assets        0.11   0.22***        0.05
20. Lending rate (t-1)            0.15*    0.70***    -0.33***

Variable                               6          7          8

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)
5. Years since 1990
6. Market capitalization of
   listed companies/GDP (t-1)
7. Total value of stock         0.67***
   traded/GDP (t-1)
8. Number of banks (t-1)          0.15*    0.40***
9. Bank capital to assets          -0.01    0.18**        0.12
   ratio (t-1)
10. Informal investment/GDP        -0.01   -0.18**    -0.22**
   (t-1)
11. Institutional investors'       -0.03      -0.08      -0.05
   financial assets (t-1)
12. Uncertainty avoidance       -0.45***   -0.37***    -0.17*
13. Bankruptcy rate (t-1)       0.29***    0.32***     0.19**
14. Rule of law                 0.25***     0.19**     0.21**
15. English (origin of law)     0.29***    0.30***    0.38***
16. French (origin of law)         -0.04       0.01   -0.18**
17. German (origin of law)      -0.27***   -0.17**        0.07
18. Fresh start                    -0.12      -0.06   0.27***
19. Automatic stay of assets        0.06       0.01       0.09
20. Lending rate (t-1)          -0.34***   -0.32***      -0.07

Variable                               9         10         11

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)
5. Years since 1990
6. Market capitalization of
   listed companies/GDP (t-1)
7. Total value of stock
   traded/GDP (t-1)
8. Number of banks (t-1)
9. Bank capital to assets
   ratio (t-1)
10. Informal investment/GDP       0.16*
   (t-1)
11. Institutional investors'       -0.01   -0.19**
   financial assets (t-1)
12. Uncertainty avoidance          -0.12       0.11    0.21**
13. Bankruptcy rate (t-1)       -0.23***   -0.29***    -0.15*
14. Rule of law                 -0.49***   -0.33***       0.00
15. English (origin of law)     0.32***       -0.14      -0.08
16. French (origin of law)        0.15*    0.35***       -0.10
17. German (origin of law)      -0.40***   -0.25***   0.31 ***
18. Fresh start                 -0.23***      -0.04      -0.01
19. Automatic stay of assets        0.13    -0.15*      0.16*
20. Lending rate (t-1)           0.21**    0.61***    -0.18**

Variable                              12         13         14

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)
5. Years since 1990
6. Market capitalization of
   listed companies/GDP (t-1)
7. Total value of stock
   traded/GDP (t-1)
8. Number of banks (t-1)
9. Bank capital to assets
   ratio (t-1)
10. Informal investment/GDP
   (t-1)
11. Institutional investors'
   financial assets (t-1)
12. Uncertainty avoidance
13. Bankruptcy rate (t-1)       -0.51***
14. Rule of law                 -0.39***   0.45***
15. English (origin of law)     -0.51***   0.26***        0.13
16. French (origin of law)      0.50***    -0.38***   -0.50***
17. German (origin of law)       0.19**        0.02       0.07
18. Fresh start                 0.39***        0.11      -0.10
19. Automatic stay of assets     0.22**        0.04      -0.10
20. Lending rate (t-1)          0.33***    -0.34***   -0.61***

Variable                              15         16         17

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)
5. Years since 1990
6. Market capitalization of
   listed companies/GDP (t-1)
7. Total value of stock
   traded/GDP (t-1)
8. Number of banks (t-1)
9. Bank capital to assets
   ratio (t-1)
10. Informal investment/GDP
   (t-1)
11. Institutional investors'
   financial assets (t-1)
12. Uncertainty avoidance
13. Bankruptcy rate (t-1)
14. Rule of law
15. English (origin of law)
16. French (origin of law)      -0.31 ***
17. German (origin of law)      -0.28***   -0.35***
18. Fresh start                    -0.02   0.23***       -0.06
19. Automatic stay of assets       -0.04   0.24***    -0.48***
20. Lending rate (t-1)          -0.18**    0.30***    -0.20**

Variable                              18         19

1. New firm entry rate
2. GDP/Cap (t-1)
3. GDP growth (t-1)
4. Real interest rate (t-1)
5. Years since 1990
6. Market capitalization of
   listed companies/GDP (t-1)
7. Total value of stock
   traded/GDP (t-1)
8. Number of banks (t-1)
9. Bank capital to assets
   ratio (t-1)
10. Informal investment/GDP
   (t-1)
11. Institutional investors'
   financial assets (t-1)
12. Uncertainty avoidance
13. Bankruptcy rate (t-1)
14. Rule of law
15. English (origin of law)
16. French (origin of law)
17. German (origin of law)
18. Fresh start
19. Automatic stay of assets    0.44***
20. Lending rate (t-1)           0.21**      0.16*

t denotes current year
*p<0.10; **p<0.05; ***p<0.01

Table 3: Estimates for annual lending rate

                                             Dependent variable: Annual
                                             lending rate

                                              Model 1

Control variables

GDP/Cap (t-1)                                -0.0002**
                                               (0.000)
GDP growth (t-1)                                 0.126
                                               (0.107)
Real interest rate (t-1)                      0.204**
                                               (0.098)
Year since 1990                              -0.245**
                                               (0.111)
Market capitalization of listed               -0.015*
companies/GDP (t-1)                            (0.008)
Total value of stock traded/GDP (t-1)          0.011*
                                               (0.007)
Number of banks (t-1)                           0.0004
                                               (0.000)
Bank capital to assets ratio (t-1)           -0.781**
                                               (0.302)
Informal investment/GDP (t-1)                3.931***
                                               (0.822)
Institutional investors' financial assets        0.000
(t-1)                                          (0.000)
Uncertainty avoidance                            0.018
                                               (0.033)
Bankruptcy rate (t-1)                           -0.082
                                               (0.264)
Main variables

Fresh start

Automatic stay of assets

Constant                                     13.302***
                                               (4.477)
R-Square                                         0.170
D.f.                                                12
N                                                  131
Test for significance of model
Wald Chi-Square                              186.79***

                                             Dependent variable: Annual
                                             lending rate

                                               Model 2

Control variables

GDP/Cap (t-1)                                -0.0002**
                                               (0.000)
GDP growth (t-1)                                 0.144
                                               (0.107)
Real interest rate (t-1)                      -0.160*
                                               (0.100)
Year since 1990                              -0.235**
                                               (0.110)
Market capitalization of listed              -0.015**
companies/GDP (t-1)                            (0.008)
Total value of stock traded/GDP (t-1)          0.01/*
                                               (0.007)
Number of banks (t-1)                           0.0003
                                               (0.000)
Bank capital to assets ratio (t-1)           -0.698**
                                               (0.301)
Informal investment/GDP (t-1)                4.255***
                                               (0.829)
Institutional investors' financial assets        0.000
(t-1)                                          (0.000)
Uncertainty avoidance                           -0.008
                                               (0.035)
Bankruptcy rate (t-1)                           -0.141
                                               (0.263)
Main variables

Fresh start                                    1.084*
                                               (0.594)
Automatic stay of assets

Constant                                     12.176***
                                               (4.458)
R-Square                                         0.208
D.f.                                                13
N                                                  131
Test for significance of model
Wald Chi-Square                              194.37***

                                             Dependent variable: Annual
                                             lending rate

                                              Model 3

Control variables

GDP/Cap (t-1)                                -0.0002**
                                               (0.000)
GDP growth (t-1)                                 0.107
                                               (0.107)
Real interest rate (t-1)                      -0.183*
                                               (0.098)
Year since 1990                              -0.267**
                                               (0.110)
Market capitalization of listed              -0.016**
companies/GDP (t-1)                            (0.008)
Total value of stock traded/GDP (t-1)          0.012*
                                               (0.007)
Number of banks (t-1)                           0.0003
                                               (0.000)
Bank capital to assets ratio (t-1)           -0.798***
                                               (0.297)
Informal investment/GDP (t-1)                4.254***
                                               (0.806)
Institutional investors' financial assets        0.000
(t-1)                                          (0.000)
Uncertainty avoidance                            0.001
                                               (0.032)
Bankruptcy rate (t-1)                           -0.143
                                               (0.262)
Main variables

Fresh start

Automatic stay of assets                      3.066**
                                               (1.462)
Constant                                     12.735***
                                               (4.340)
R-Square                                         0.210
D.f.                                                13
N                                                  131
Test for significance of model
Wald Chi-Square                              199.49***

Standard errors are in parentheses; t denotes current year
*p<0.10; **p<p.05; ***p<p.01

Table 4: Estimates for new firm entry rate

                             Dependent variable: New
                                 firm entry rate

                           Model 1        Model 2
Hypothesis

Control variables
GDP/cap (t-1)               -0.00001 **    -0.00001 **
                            (0.000)        (0.000)

GDP growth (t-1)             0.002 *        0.002 *
                            (0.001)        (0.001)

Years since 1990             0.000          0.000
                            (0.001)        (0.001)

Rule of law                  0.009 *        0.007
                            (0.006)        (0.006)

Origin of law (English)      0.029          0.012
                            (0.027)        (0.026)

Origin of law (French)       0.011         -0.002
                            (0.028)        (0.027)

Origin of law (German)       0.003         -0.026
                            (0.029)        (0.033)

Uncertainty avoidance        0.000          0.000
                            (0.000)        (0.000)

Number of banks (t-1)        0.000001 *     0.000001 *
                            (0.000)        (0.000)

Informal investment/        -0.003         -0.012
GDP (t-1)                   (0.011)        (0.011)

Bankruptcy rate (t-1)        0.000          0.000
                            (0.003)        (0.003)

Main variables

Fresh start                                 0.015 *
H4 supported
                                           (0.009)

Automatic stay of assets                   -0.043 **
H5 supported
                                           (0.022)

Lending rate (t-1)

Constant                     0.056          0.102
                            (0.068)        (0.069)

R-Square                     0.198          0.420

D.f.                        11             13

N                          131            131

Test for significance of
model

Wald Chi-Square             12.66 ***      18.62 ***

                              Dependent variable: New
                                  firm entry rate

                           Model 2        Hypothesis
                                          testing

Control variables
GDP/cap (t-1)              -00.00001 **
                            (0.000)

GDP growth (t-1)             0.001
                            (0.001)

Years since 1990             0.000
                            (0.001)

Rule of law                  0.007
                            (0.006)

Origin of law (English)      0.026
                            (0.026)

Origin of law (French)       0.008
                            (0.028)

Origin of law (German)      -0.003
                            (0.029)

Uncertainty avoidance        0.000
                            (0.000)

Number of banks (t-1)        0.000001 *
                            (0.000)

Informal investment/         0.000
GDP (t-1)                   (0.011)

Bankruptcy rate (t-1)        0.000
                            (0.003)

Main variables

Fresh start                               H1 supported

Automatic stay of assets                  H2 not supported

Lending rate (t-1)          -0.001 **     H3 supported
                            (0.000)

Constant                     0.084
                            (0.068)

R-Square                     0.235

D.f.                        12

N                          131

Test for significance of
model

Wald Chi-Square             18.03 ***

                              Dependent variable: New
                                 firm entry rate

                           Model 4         Model 5

Control variables
GDP/cap (t-1)               -0.00002 **     -0.00001 **
                            (0.000)         (0.000)

GDP growth (t-1)             0.001           0.001
                            (0.001)         (0.001)

Years since 1990             0.000          -0.001
                            (0.001)         (0.001)

Rule of law                  0.007           0.005
                            (0.007)         (0.007)

Origin of law (English)      0.023           0.020
                            (0.027)         (0.027)

Origin of law (French)       0.008           0.001
                            (0.028)         (0.029)

Origin of law (German)       0.001          -0.024
                            (0.030)         (0.035)

Uncertainty avoidance       -0.001           0.000
                            (0.001)         (0.001)

Number of banks (t-1)        0.000001 **     0.000002 **
                            (0.000)         (0.000)

Informal investment/         0.000          -0.004
GDP (t-1)                   (0.011)         (0.011)

Bankruptcy rate (t-1)        0.000           0.001
                            (0.003)         (0.003)

Main variables

Fresh start                  0.006
                            (0.009)

Automatic stay of assets                    -0.023
                                            (0.021)

Lending rate (t-1)          -0.001 **       -0.001 **
                            (0.000)         (0.000)

Constant                     0.082           0.109
                            (0.069)         (0.073)

R-Square                     0.298           0.279

D.f.                        13              13

N                          131             131

Test for significance of
model

Wald Chi-Square             18.37 ***       19.17 ***

                             Dependent variable: New
                                 firm entry rate

                           Model 6         Hypothesis
                                           testing

Control variables
GDP/cap (t-1)               -0.00001 **
                            (0.000)

GDP growth (t-1)             0.001
                            (0.001)

Years since 1990            -0.001
                            (0.001)

Rule of law                  0.005
                            (0.007)

Origin of law (English)      0.012
                            (0.027)

Origin of law (French)      -0.002
                            (0.028)

Origin of law (German)      -0.027
                            (0.034)

Uncertainty avoidance        0.000
                            (0.001)

Number of banks (t-1)        0.000001 **
                            (0.000)

Informal investment/        -0.008
GDP (t-1)                   (0.011)

Bankruptcy rate (t-1)        0.000
                            (0.003)

Main variables

Fresh start                  0.013         H4 supported
                            (0.009)

Automatic stay of assets    -0.036         H5 supported
                            (0.022)

Lending rate (t-1)          -0.001 **
                            (0.000)

Constant                     0.119 *
                            (0.071)

R-Square                     0.425

D.f.                        14

N                          131

Test for significance of
model

Wald Chi-Square             21.83 ***

Standard errors are in parentheses; t denotes current year

* p<0.10; ** p<0.05; *** p<0.01
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Title Annotation:RESEARCH ARTICLE
Author:Lee, Seung-Hyun; Yamakawa, Yasuhiro
Publication:Management International Review
Geographic Code:9JAPA
Date:Jan 1, 2012
Words:15019
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