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Bankruptcy: Is It Enough to Forgive or Must we Also Forget?

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Author Info
Piero Gottardi () (Dipartimento di Scienze Economiche, Università di Venezia)
Ronel Elul (Federal Reserve Bank of Philadelphia)

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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. 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. We 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 by improving an entrepreneur’s reputation, forgetting increases the incentive to exert effort to preserve this reputation. Our 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. 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.

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Publisher Info
Paper provided by University of Venice "Ca' Foscari", Department of Economics in its series Working Papers with number 2007_23.

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Length: 57
Date of creation: 2007
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Handle: RePEc:ven:wpaper:2007_23

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Related research
Keywords: Bankruptcy; Information; Incentives; Fresh Start;

Other versions of this item:

Find related papers by 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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References listed on IDEAS
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  2. Tullio Jappelli & Marco Pagano, 2005. "Role and Effects of Credit Information Sharing," CSEF Working Papers 136, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy. [Downloadable!]
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  12. Rafael Rob & Arthur Fishman, 2005. "Is Bigger Better? Customer Base Expansion through Word-of-Mouth Reputation," Journal of Political Economy, University of Chicago Press, vol. 113(5), pages 1146-1175, October.
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  15. 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)
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  18. Hirshleifer, Jack, 1971. "The Private and Social Value of Information and the Reward to Inventive Activity," American Economic Review, American Economic Association, vol. 61(4), pages 561-74, September. [Downloadable!] (restricted)
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