Depositor Confidence and Creditor Rights: Evidence from State Bankruptcy Exemptions

Abstract

Banking theories highlight the critical role of depositor confidence in maintaining financial stability. In this study, I examine how banks' legal rights during borrower bankruptcies influence depositor confidence and market dynamics. Exploiting staggered changes in U.S. state bankruptcy exemptions for personal bankruptcies from 1994 to 2023 as a quasi-natural experiment, I find that increases in exemptions lead to significant declines in uninsured deposits. I estimate that raising exemptions in the least generous state to match those in the most generous state could decrease uninsured deposits at an average bank by between 2.5 and 6.1 percentage points. The effect is amplified for banks with larger consumer/credit card lending, smaller banks, and banks with lower capital ratios. Conversely, banks specializing in mortgage or agricultural lending, which are less affected by bankruptcy exemptions, experience no significant change in uninsured deposits. In further support of these observations, I find that the enactment of a 2005 federal law that strengthened creditor rights led to an increase in uninsured deposits. Finally, I show that higher exemptions are associated with greater consumer lending concentration, suggesting a shift towards greater specialization amid increased market frictions. These findings underscore the impact of legal frameworks governing creditor rights on depositor confidence and the competitive landscape of lending markets.

Keywords: Banking, Deposits, Creditor Rights, Loan Concentration, Bankruptcy Exemptions