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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. 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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Cited by:
  1. Marieke Bos & Leonard Nakamura, 2012. "Should defaults be forgotten? Evidence from legally mandated removal," Working Papers, Federal Reserve Bank of Philadelphia 12-29, Federal Reserve Bank of Philadelphia.
  2. Philip Bond & Andrew F. Newman, 2006. "Prohibitions on Punishments in Private Contracts," Boston University - Department of Economics - Working Papers Series, Boston University - Department of Economics WP2006-060, Boston University - Department of Economics.
  3. 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.

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