intended to allow borrowers to self-select into forbearance. This has advantages and disadvantages. On the positive side, allowing borrowers to opt into forbearance improves the targeting of benefits to liquidity constrained households, who can use forbearance like a line of credit that they can draw on when necessary to avoid debt distress. The available evidence suggests that this is in fact how forbearance is used in practice: households that select into forbearance are, on average, more financially constrained but no more likely to default based on observables than borrowers who do not opt into forbearance (Cherry et al., 2021; Battaglia et al., 2023; Fiorin et al., 2023).

On the other hand, selection into forbearance has important distributional effects and makes the benefits of forbearance more regressive, given that borrowers with larger loans have a higher incentive to select into forbearance. Cherry et al. (2021), examine the characteristics of households that selected into forbearance under the CARES act in the United States and find that forbearance benefits are indeed skewed towards wealthier households – 55 percent of the total dollar amount of forbearance accrued to borrowers with above median incomes. The regressive impact of forbearance is an even more important concern in emerging economies, where access to credit is highly unequal so that qualifying for forbearance requires an even higher income cutoff.

Another channel through which debt moratoria can have distributional effects is their potential impact on credit scores. When forbearance is mandated, it is typically accompanied by a freeze on credit reporting. However, in many cases where forbearance is voluntary, selection into forbearance has the potential to damage a borrower’s credit score. This may add as a deterrent to take up forbearance or disproportionately reduce access to finance for borrowers with a thinner credit file. This is especially relevant for low-income households and microfinance borrowers whose loans are increasingly likely to be included in conventional credit bureau data, and who are less likely to be informed about the consequences of a debt moratorium on their credit score and future access to finance (de Janvry et al., 2010; de Roux, 2021). This affects not only access to finance, but may also adversely impact labor market outcomes (Bos et al., 2018).

Finally, because mandated debt forbearance is a temporary policy, an important consideration is how to optimize the time horizon of debt moratoria and how to unwind forbearance without triggering financial distress. To reduce moral hazard, banks and policymakers need to clearly communicate the extent and duration of forbearance. Because the amount of deferred debt payments is often substantial, borrowers need clarity about the repayment schedule after forbearance as well as the treatment of accrued interest. It is generally in the interest of the lender to extend the term of the loan by the number of deferred payments to avoid forcing borrowers whose incomes have not fully recovered into default.

# **3.3 Debt Restructuring**

Debt restructuring refers to a modification of a loan contract intended to reduce loan payments and avert default. Like debt forbearance, debt restructuring can be mandated by a regulator or offered voluntarily by banks and microfinance institutions. Voluntary restructuring typically occurs when a borrower’s income and ability to repay have permanently changed and temporary forbearance is not sufficient to ensure loan repayment.

Debt restructuring can modify different aspects of a debt contract. It can extend the maturity of 16