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

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Listed:
  • 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

Suggested Citation

  • Ronel Elul & Piero Gottardi, 2007. "Bankruptcy: Is it enough to forgive or must we also forget?," Working Papers 07-10, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:07-10
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • K35 - Law and Economics - - Other Substantive Areas of Law - - - Personal Bankruptcy Law

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