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Bankruptcy: Is it enough to Forgive or must we also Forget?

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  • Ronel Elul
  • Piero Gottardi

Abstract

In many countries, lenders are not permitted to use information about past defaults after a specified period of time has elapsed. We model this provision and determine conditions under which it is optimal.We develop a model in which entrepreneurs must repeatedly seek external funds to finance a sequence of risky projects under conditions of both adverse selection and moral hazard. Forgetting a default typically makes incentives worse, ex-ante, because it reduces the punishment for failure. However, following a default it may be good to forget, because by improving an entrepreneur’s reputation, forgetting increases the incentive to exert effort to preserve this reputation. Our key result is that if (i) borrowers’ incentives are sufficiently strong, (ii) their average quality is not too low, (iii) the output loss from low effort is not too large, and (iv) agents are sufficiently patient, then the optimal law would prescribe some amount of forgetting — that is, it would not permit lenders to fully utilize past information. We also argue that forgetting must be the outcome of a regulatory intervention by the government — no lender would willingly agree to ignore information available to him. Finally, we show that the predictions of our model are consistent with the cross-country relationship between credit bureau reporting regulations and the provision of credit, as well as Musto (2004)’s evidence on the impact of these regulations on individual borrower and lender behavior.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2008/wp-cesifo-2008-05/cesifo1_wp2313.pdf
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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2313.

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Date of creation: 2008
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Handle: RePEc:ces:ceswps:_2313

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Keywords: bankruptcy; information; incentives; fresh start;

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References

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  1. Mailath, George J & Samuelson, Larry, 2001. "Who Wants a Good Reputation? Erratum," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 68(3), pages 714, July.
  2. Brown, Martin & Jappelli, Tullio & Pagano, Marco, 2007. "Information Sharing and Credit: Firm-Level Evidence from Transition Countries," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6313, C.E.P.R. Discussion Papers.
  3. Padilla, A. Jorge & Pagano, Marco, 2000. "Sharing default information as a borrower discipline device," European Economic Review, Elsevier, Elsevier, vol. 44(10), pages 1951-1980, December.
  4. Jose Marin & Rohit Rahi, 1996. "Information Revelation and Market Incompleteness," Archive Working Papers, Birkbeck, Department of Economics, Mathematics & Statistics 024, Birkbeck, Department of Economics, Mathematics & Statistics.
  5. Martin Brown & Christian Zehnder, 2006. "Credit Reporting, Relationship Banking, and Loan Repayment," Working Papers 2006-03, Swiss National Bank.
  6. George J. Mailath & Larry Samuelson, . "Who Wants a Good Reputation?," Penn CARESS Working Papers, Penn Economics Department a3e3219aee004bd237f8112f9, Penn Economics Department.
  7. Jappelli, Tullio & Pagano, Marco, 1991. "Information Sharing in Credit Markets," CEPR Discussion Papers, C.E.P.R. Discussion Papers 579, C.E.P.R. Discussion Papers.
  8. Hirshleifer, Jack, 1971. "The Private and Social Value of Information and the Reward to Inventive Activity," American Economic Review, American Economic Association, American Economic Association, vol. 61(4), pages 561-74, September.
  9. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 68(3), pages 351-81, July.
  10. Dan Bernhardt & Ed Nosal, 2004. "Near-sighted Justice," Journal of Finance, American Finance Association, American Finance Association, vol. 59(6), pages 2655-2684, December.
  11. Rafael Rob & Arthur Fishman, 2005. "Is Bigger Better? Customer Base Expansion through Word-of-Mouth Reputation," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 113(5), pages 1146-1175, October.
  12. Djankov, Simeon & McLiesh, Caralee & Shleifer, Andrei, 2007. "Private credit in 129 countries," Journal of Financial Economics, Elsevier, Elsevier, vol. 84(2), pages 299-329, May.
  13. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(4), pages 865-88, October.
  14. Vercammen, James A, 1995. "Credit Bureau Policy and Sustainable Reputation Effects in Credit Markets," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 62(248), pages 461-78, November.
  15. Aghion, Philippe & Hermalin, Benjamin, 1990. "Legal Restrictions on Private Contracts Can Enhance Efficiency," Journal of Law, Economics and Organization, Oxford University Press, Oxford University Press, vol. 6(2), pages 381-409, Fall.
  16. Berkovitch, Elazar & Israel, Ronen & Zender, Jaime F., 1998. "The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 33(04), pages 441-464, December.
  17. Avery, Robert B. & Bostic, Raphael W. & Samolyk, Katherine A., 1998. "The role of personal wealth in small business finance," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(6-8), pages 1019-1061, August.
  18. Cremer, Jacques, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 110(2), pages 275-95, May.
  19. Philip Bond & Arvind Krishnamurthy, 2004. "Regulating Exclusion from Financial Markets," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 71, pages 681-707, 07.
  20. Ronel Elul & Narayanan Subramanian, 2002. "Forum-Shopping and Personal Bankruptcy," Journal of Financial Services Research, Springer, Springer, vol. 21(3), pages 233-255, June.
  21. Douglas W. Diamond, 1998. "Reputation Acquisition in Debt Markets," Levine's Working Paper Archive 602, David K. Levine.
  22. David K. Musto, 2004. "What Happens When Information Leaves a Market? Evidence from Postbankruptcy Consumers," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 77(4), pages 725-748, October.
  23. Tullio Jappelli & Marco Pagano, 2005. "Role and Effects of Credit Information Sharing," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 136, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
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Cited by:
  1. Andrew Newman & Philip Bond, 2004. "Prohibitions on Punishments in Private Contracts," Econometric Society 2004 North American Winter Meetings, Econometric Society 143, Econometric Society.
  2. Margherita Bottero & Giancarlo Spagnolo, 2013. "Limited credit records and market outcomes," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 903, Bank of Italy, Economic Research and International Relations Area.
  3. Marieke Bos & Leonard Nakamura, 2012. "Should defaults be forgotten? Evidence from legally mandated removal," Working Papers 12-29, Federal Reserve Bank of Philadelphia.

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