312 - Strategic Loan Defaults and Coordination: An Experimental Analysis

DNB Working Papers
Date 25 August 2011

This paper experimentally studies the impact of uncertainty about bank and borrower fundamentals on loan repayment. We find that solvent borrowers are more likely to default strategically when stricter disclosure creates common knowledge about bank weakness. Borrowers are also less likely to repay in the presence of higher uncertainty regarding other. Borrowers’ financial health, regardless of  disclosure rules. We show that uncertainty about fundamentals changes the risk dominance properties of the coordination problem, and that these changes subsequently explain borrowers’ default. For the individual borrower, loss aversion and negative past experiences reduce repayment, suggesting that bank failure can be contagious in times of distress.

Keywords: credit market, strategic default, loss aversion, risk dominance, transparency.
JEL Classifications: D81, G21, G28.