Forbearance vs Foreclosure in a General Equilibrium Model

We build a business cycle model characterized by endogenous firm dynamics, where banks may prefer debt renegotiation, i.e. non-performing exposures, to outright borrowers' default. Debt renegotiations per se do not have adverse effects in the event of financial crisis episodes, but a large share of non-performing firms is associated with a sharp deterioration of economic activity if there are congestion effects in banks' ability to monitor non-performing loans and the opacity of such loans adversely affects banks’ moral hazard problem. Aggressive interest rate reductions and quantitative easing limit defaults and the output contraction caused by a financial crisis, without adverse effects on the entry of new firms. The decline in the natural interest rate, due to slower productivity growth and persistent liquidity shocks, might explain the observed long-run trend in the share of non-performing loans