Forbearance versus Foreclosure in a General Equilibrium Model

Abstract

In a business cycle model with endogenous firms' dynamics and debt renegotiation, we show that during financial crises loan forbearance does not harm the economy unless banks imperfectly monitor loans, and loan opacity worsens banks' moral hazard problem. Aggressive interest rate reductions and quantitative easing limit defaults and financial crisis-induced output contractions without hampering the entry of new firm entries. The decline in the natural interest rate, due to slower productivity growth and persistent liquidity shocks, potentially explains the observed long-term trend in nonperforming loan shares.