Forbearance lending and soft budget constraints in a model of multiple heterogeneous bank financing

Abstract

Empirical evidence suggests that banks often engage in refinancing of intrinsically insolvent debtors instead of writing off their non-performing loans. Such forbearance lending may induce soft budget constraints for the debtors, as it diminishes their incentives to thwart default. This paper introduces a model of coordination failure to analyze how a relationship bank affects the incidence of forbearance lending and soft budget constraints by signaling its credit decision to other creditors. We find that the relationship bank's signaling ability enhances its incentives to engage in forbearance lending and influences the conditions under which debtors face soft budget constraints.