The Prevention of Default

Abstract

DEFAULT IS A MAJOR problem in many capital markets. In some cases it is so severe that it even prevents the formation of a market. The purpose of this paper is to consider the effect of this problem on contracts between lenders and borrowers. It could be argued that default will not be a problem provided there are criminal penalties which are effectively enforced and sufficiently severe. However, a number of objections can be made to this. Firstly, the penalties may be very difficult to enforce. Payments on loans are due on a particular date which is known to both parties in advance. The borrower usually knows some time beforehand that he will default and has the opportunity to leave the country, or to cover his tracks and disappear in some other way. Although this problem of discovering defaulters may be offset to some extent by the imposition of severe penalties on those apprehended, this may be unacceptable to a society for humanitarian reasons. In an uncertain world default may be unintentional. If the expected penalties are high then people may be discouraged from taking loans, so that the formation of a capital market is again hampered or prevented. For reasons such as these, criminal penalties are likely to be an ineffective way of solving the problem of default. Instead it seems resonable that lenders will ensure that contracts are specified in such a way that the borrower will have an incentive to make the required payments. Collateral is perhaps the most obvious way in which this can be achieved. In this case the borrower surrenders to the lender, the deeds of ownership of property worth at least as much as the total value of the loan repayments. If these are not met the lender acquires the property. This way of preventing default would appear to be extremely widespread. However, it has the major defect that it limits access to loans to those who already have substantial wealth and who are therefore less likely to want to borrow. This raises the question of whether there is any way to prevent the default of people without collateral. In cases where lenders have no security it seems unlikely that they will lend to people who have already defaulted since this is an indication that they are likely to do so again. If the rule that only those who have not defaulted can borrow without collateral is adopted by lenders then it may be possible to design profitable contracts which prevent default. If a borrower knows that when he defaults he will in future be unable to gain