Asset Liquidity, Moral Hazard, and Bank Loan Rescheduling

We analyze the bank's decision to reschedule or to foreclose on a loan in default and the borrower's decision to divert lender-financed assets to personal use, i.e., to consume the assets. We show that the debt of borrowers in financial distress that have substantial intangible or highly specialized assets--i.e., illiquid assets--is likely to be rescheduled. Alternatively, banks will likely foreclose on borrowers in distress that have assets that are difficult to monitor. It is the interaction of the asset's liquidity and the borrower moral hazard that helps determine the nature of the equilibrium. When the condition of the borrower upon default is observable, we find that suboptimal foreclosures are possible but reschedulings are always optimal; when the borrower's condition is private information, however, reschedulings may also be suboptimal. Additionally, borrowers whose lenders foreclose are more impaired then those whose debt is rescheduled. Finally, we show that randomization of the rescheduling/foreclosure decision by the bank and the decision to consume by the borrower may be optimal for particular assets. Copyright 1999 by Kluwer Academic Publishers