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

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

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In many countries, lenders are restricted in their access to information about borrowers' past defaults. The authors study this provision in a model of repeated borrowing and lending with moral hazard and adverse selection. They analyze its effects on borrowers' incentives and access to credit, and identify conditions under which it is optimal. The authors argue that “forgetting” must be the outcome of a regulatory intervention by the government. Their model's predictions are consistent with the cross-country relationship between credit bureau regulations and the provision of credit, as well as the evidence on the impact of these regulations on borrowers' and lenders' behavior.
In many countries, lenders are restricted in their access to information about borrowers' past defaults. The authors study this provision in a model of repeated borrowing and lending with moral hazard and adverse selection. They analyze its effects on borrowers' incentives and access to credit, and identify conditions under which it is optimal. The authors argue that “forgetting” must be the outcome of a regulatory intervention by the government. Their model's predictions are consistent with the cross-country relationship between credit bureau regulations and the provision of credit, as well as the evidence on the impact of these regulations on borrowers' and lenders' behavior.

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Published by: Federal Reserve Bank of Philadelphia on Apr 22, 2011
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WORKING PAPER NO. 11-14BANKRUPTCY: IS IT ENOUGH TO FORGIVE OR MUST WEALSO FORGET?
Ronel ElulFederal Reserve Bank of PhiladelphiaPiero GottardiEuropean University Institute andUniversità Ca’ Foscari di VeneziaApril 2011
 
Bankruptcy: Is It Enough to Forgive or Must We AlsoForget?
Ronel Elul
and Piero Gottardi
This version: November 9, 2010
Abstract
In many countries, lenders are restricted in their access to information about bor-rowers’ past defaults. We study this provision in a model of repeated borrowing andlending with moral hazard and adverse selection. We analyze its effects on borrowers’incentives and access to credit, and identify conditions under which it is optimal. Weargue that “forgetting” must be the outcome of a regulatory intervention by the gov-ernment. Our model’s predictions are consistent with the cross-country relationshipbetween credit bureau regulations and the provision of credit, as well as the evidenceon the impact of these regulations on borrowers’ and lenders’ behavior.
Keywords:
Bankruptcy, Information, Incentives, Fresh Start
JEL Classification Numbers:
D86, G33, K35.
This paper is a revised version of Federal Reserve Bank of Philadelphia Working Paper No. 07-10. Theauthors thank Mitchell Berlin, Philip Bond, Subir Bose, Satyajit Chatterjee, Kevin Huang, Dirk Krueger,Nisan Langberg, Rafael Rob, and Nicholas Souleles, as well as seminar participants at Ben-Gurion University,Finance and Accounting in Tel Aviv, Midwest Theory and Trade, the Philadelphia Fed, Stanford (SITE),and the Wharton School.
Federal Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106-1574. E-mail:ronel.elul@phil.frb.org. The views expressed in this paper are those of the authors and do not neces-sarily represent the policies or positions of the Federal Reserve Bank of Philadelphia, nor the FederalReserve System. This paper is available free of charge at http://www.philadelphiafed.org/research-and-dataa/publications/working-papers/.
Department of Economics, European University Institute, Villa San Paolo, Via della Piazzuola 43, 50133Florence, Italy and Dipartimento di Scienze Economiche, Universit`a Ca’ Foscari di Venezia, Fondamenta SanGiobbe, Cannaregio 873, 30121 Venezia, Italy. E-mail: piero.gottardi@eui.eu
 
I Introduction
In studying the “fresh start” provisions of personal bankruptcy law, economists typicallyfocus on the
forgiveness
of debts. However, another important feature is the
forgetting 
of past defaults. In many countries, lenders are not permitted to use information about pastdefaults after a specified period of time has elapsed.In the United States, the Fair Credit Reporting Act (FCRA) prescribes that a personalbankruptcy filing may be reported by credit bureaus for up to 10 years, after which it must beremoved from the records made available to lenders.
1
Similar provisions exist in most othercountries. In Figure 1 we summarize the distribution of credit bureau regulations governingthe time period of information transmission across countries.
2
Of the 113 countries withcredit bureaus as of January 2007, over 90 percent of them had provisions for restricting thereporting of adverse information after a certain period of time.
3
Differences in information-sharing regimes across countries — whether a credit-reportingsystem exists, and whether there are time limits on reporting past defaults — are associatedwith differences in the provision of credit. In Figure 1 we also graph the average ratioof private credit to GDP according to whether the country restricts the time period of information sharing. It is interesting to note that countries in which defaults are alwaysreported tend to have
lower 
provision of credit than those countries in which defaults arenot reported (“erased”) after a certain period of time.
4
Musto (2004) studies the effect on lenders and individual borrowers of restrictions on thereporting of past defaults, using U.S. data. He shows that (i) these restrictions are binding— access to credit increases significantly when the bankruptcy “flag” is dropped from creditfiles;
5
and (ii) these individuals who subsequently obtain new credit are subsequently likelierto default than those with similar credit scores.In this paper we analyze these restrictions in the framework of a model of repeatedborrowing and lending, and determine conditions under which they are welfare improving.
1
Other derogatory information can be reported for a maximum of seven years; see Hunt (2006) for adiscussion of the history and regulation of consumer credit bureaus in the United States. This time periodis often even shorter in other countries; Jappelli and Pagano (2004) report several specific examples.
2
Source: Doing Business Database, World Bank, 2008. Throughout, we use the term “credit bureau” torefer to both private credit bureaus and public credit registries.
3
See also Jappelli and Pagano (2006).
4
Private credit/GDP is constructed from the IMF International Financial Statistics for year-end 2006. Asin Djankov, McLiesh, and Shleifer (2007), private credit is given by lines 22d and 42d (claims on the privatesector by commercial banks and other financial institutions). The credit bureau regulations are current asof January 2007 (source: Doing Business Database 2008).
5
That is, after 10 years.
1

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