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

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 opti- mal. 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 pun- ishment for failure. However, following a default it is generally good to forget, because pooling riskier agents with safer ones makes exerting high eort to preserve their reputation more attractive. Our key result is that if agents are suciently patient, and low eort is not too inecient, then the optimal law would prescribe some amount of forgetting — that is, it would not permit lenders to fully utilize past information. We also show that such a law must be enforced by the government — no lender would willingly agree to forget. Finally, we also use our model to examine the policy debate that arose during the adoption of these rules.