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Bankruptcy: Is it enough to forgive or must we also forget?

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Ronel Elul
Piero Gottardi

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Abstract

In many countries, lenders are not permitted to use information about past defaults after a specified period of time has elapsed. The authors model this provision and determine conditions under which it is optimal. ; They 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. They show that forgetting a default makes incentives worse, ex-ante, because it reduces the punishment for failure. However, following a default it is generally good to forget, because pooling riskier agents with safer ones makes exerting high effort to preserve their reputation more attractive. ; The authors' key result is that if agents are sufficiently patient, and low effort is not too inefficient, then the optimal law would prescribe some amount of forgetting --- that is, it would not permit lenders to fully utilize past information. The authors also show that such a law must be enforced by the government - no lender would willingly agree to forget. Finally, they also use their model to examine the policy debate that arose during the adoption of these rules. ; Also issued as: Payment Cards Center Discussion Paper No. 07-05

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 07-10.

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Date of creation: 2007
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Handle: RePEc:fip:fedpwp:07-10

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  13. Brown, Martin & Jappelli, Tullio & Pagano, Marco, 2007. "Information Sharing and Credit: Firm-Level Evidence from Transition Countries," CEPR Discussion Papers 6313, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  18. Ronel Elul & Narayanan Subramanian, 2002. "Forum-Shopping and Personal Bankruptcy," Journal of Financial Services Research, Springer, vol. 21(3), pages 233-255, June. [Downloadable!] (restricted)
  19. Avery, Robert B. & Bostic, Raphael W. & Samolyk, Katherine A., 1998. "The role of personal wealth in small business finance," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 1019-1061, August. [Downloadable!] (restricted)
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  21. Dan Bernhardt & Ed Nosal, 2004. "Near-sighted Justice," Journal of Finance, American Finance Association, vol. 59(6), pages 2655-2684, December. [Downloadable!] (restricted)
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