Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning
58 Pages Posted: 14 Jan 2016 Last revised: 5 Dec 2018
Date Written: December 2018
I use a unique data set of loans to small business owners to examine whether lenders face adverse consequences when they grant debt forgiveness to borrowers. I provide evidence consistent with borrowers communicating their debt forgiveness to other borrowers, who then more frequently strategically default on their own obligations. This strategic default contagion is economically large. When the lender doubles debt forgiveness, the default rate increases by 10.9% on average. Using an exogenous shock to the lender’s forgiveness policy, my findings suggest that as the lender learns about the extent of borrower communication the lender tightens its debt forgiveness policy to mitigate default contagion.
Keywords: Debt forgiveness, contracting, strategic default contagion, learning
JEL Classification: D10, D83, G21, M41
Suggested Citation: Suggested Citation