Liquidation policy and credit history in financial contracting: An experiment

In the presence of contract incompleteness and asymmetric information, liquidation policy plays an important role in financial contracting. Liquidation is a double-edged sword. It deters borrowers from defaulting strategically, but it could be harsh to borrowers experiencing short-term liquidity problems. This paper presents an experimental analysis of the impacts of (1) liquidation policy on borrowers’ incentive to engage in strategic default and (2) disclosure of credit history information on lending relationships and borrowers’ behaviors. We show that liquidation policy deters borrowers from defaulting strategically. The availability of credit information softens the liquidation policy when the equilibrium liquidation policy is relatively lenient and helps to reduce strategic defaults.