the loan, reduce the interest rate, or include a debt reduction component to make debt service more manageable for the borrower. In some cases, loan modifications can combine elements of forbearance and debt forgiveness. To what extent the predictions of our conceptual framework extend to debt restructuring will therefore depend on the design of a given restructuring program. Namely, whether the cost of these modifications are borne by lenders or subsidized by the government.

How effective is debt restructuring at improving the ability of borrowers to repay their debt? The answer to this question depends on the extent of restructuring and type of credit. In a sample of delinquent credit card borrowers in the US, Dobbie and Song (2020) find that loan modifications that reduce interest payments lead to a substantial reduction in short-term default even when they are deferred and do not immediately affect liquidity. Aydin (2023) uses a randomized experiment with consumer loan borrowers in Turkey to compare how alternative debt relief policies affect loan payments and the probability of default and shows that the effects of forbearance are short-lived, while rate reductions, which lower the net present value of future payments, persistently reduce the probability of default.

In contrast to these findings, Ganong and Noel (2020) compare the effect of debt reduction and temporary forbearance in a sample of mortgage borrowers and find that debt writedowns that do not increase short-term liquidity have no effect on loan defaults and consumption. Instead, the authors find that restructuring payments, which can alleviate liquidity constraints, lead to large reductions in loan default and increase consumption. This suggests that designing debt relief to address short-term liquidity, rather than longer-term wealth, can better prevent defaults and create substantial gains for borrowers, lenders, and taxpayers.

Like any discretionary debt relief policy, unanticipated loan modifications can affect not only the ability but also the willingness to repay through their effect on borrower expectations. When loan modifications are offered voluntarily by a bank or microfinance lender, this may lead borrowers to update their expectations about the availability of debt relief and the leniency of credit enforcement in the future. This can generate both ex ante and ex post moral hazard.

Loan modifications can also affect access to credit. On the one hand, a successful loan modification can restore a borrower’s solvency and preserve access to formal credit; it is therefore typically in the borrower’s interest to renegotiate a loan when the option is available. However, a debt restructuring is typically reported to the credit bureau by the lender and may therefore negatively affect a borrower’s ability to obtain credit at least in the short term.

Loan modifications may also affect access to credit through their effect on credit supply. When loan modifications are mandated by a government or regulator, one important choice variable is whether lenders are forced to absorb credit losses or compensated for writedowns. If banks and microfinance lenders are recapitalized in proportion to their losses, it is likely to encourage more lending to beneficiaries. If, on the other hand, lenders are forced to absorb losses from mandated debt restructuring, this is likely to reduce credit supply and access to credit for beneficiaries of the policy.

One limitation of debt restructuring programs as a policy to address widespread financial distress is that loan modifications are administratively taxing. Agarwal et al. (2017) and Kim et al. (2022) study mortgage loan modifications in the United States and show that the overall impacts of these programs 17