Forbearance Lending and Soft Budget Constraints in Multiple Bank Financing

Empirical evidence suggests that banks often engage in refinancing of intrinsically insolvent debtors instead of writing off their nonperforming loans. Such forbearance lending may induce soft budget constraints for the debtors, diminishing their incentives to thwart default. This paper introduces a model of coordination failure to analyze how the incidence of forbearance lending and soft budget constraints is affected by a relationship bank that signals its credit decision to other lenders. We find that the relationship bank's signaling ability fosters its willingness to engage in forbearance lending and influencesthe conditions under which debtors face a soft budget constraint.