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 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.