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Borrower runs: Behavioural motives and their policy implications

One of the most iconic images from the subprime mortgage crisis in 2007 was the queue of people outside the British bank Northern Rock demanding their deposits back. This column uses experimental evidence to discuss another type of bank run – a borrower run – when mortgage holders strategically default on their loans.

The typical bank run is a “lender run”; lenders and/or depositors take back their money in fear of the bank going bankrupt – and in doing so, make their fears come true. But there is another type of bank run – a “borrower run”.

A strategic default occurs when a solvent borrower chooses not to repay. If many solvent borrowers believe that their lender will become distressed because of defaults by others, they may strategically delay payments or even default on their loans, leading to self-fulfilling confirmation of their beliefs. In other words, banks can be vulnerable to coordination failure from the asset side of their balance sheet, a situation labelled a “borrower run”.

So far, the borrowers’ coordination problem has received little empirical attention. However, headlines in the Wall Street Journal such as “Is Walking Away from Your Mortgage Immoral?” (Hagerty 2009) or “When It’s OK to Walk Away From Your Home” (Arends 2010) suggest that the phenomenon is significant, potentially affecting the stability of the banking system due to its ability to amplify downward trends. A thorough understanding of the determinants of strategic defaults and borrowers’ coordination failure is thus warranted.

Coordination problems on the asset side: Historical examples

This problem has a precedent. Borrowers’ reluctance to repay their loans in a situation of expected distress of their lender, and subsequent loan-contract modifications, was identified as one of the main factors that exacerbated the 1994 Mexican banking crisis (De Luna-Martinez 2000; Krueger and Tornell 1999).

Bond and Rai (2009) discuss evidence of borrower runs causing failure of microfinance organisations, while recent evidence suggests that an important sector where banks may become subject to runs by their borrowers in times of distress is the mortgage market (Feldstein 2008). US mortgage lenders often abstain from foreclosing and enforcing repayment because of low recovery rates and lengthy and costly legal procedures (FT 2011, Mayer et al 2011). Therefore individuals with negative equity have a strong incentive to default.

Consistent with this view, Cohen-Cole and Morse (2009) show that borrowers who have experienced a small financial shock are more likely to default on mortgage debt than on other forms of debt (eg, credit cards) in order to secure access to liquidity.

Recent examples: US mortgage problems

Hundreds of US small lenders have failed during the 2007-10 crisis (FDIC Bank Failures Report 2010), and Guiso et al (2011) provide evidence that approximately 1 in 3 defaults was driven by strategic behaviour of solvent borrowers, while Hull (2009) claims that the downward trend in house prices during the subprime crisis was reinforced by the decision of many borrowers to walk away from their mortgage obligations.

New research: Distinguishing between strategic and forced default

In contrast to depositors withdrawing their own money, coordination failure resulting from borrowers strategically delaying or defaulting on loan payments involves a breach of contract. It will therefore be confined to situations of diffused financial distress of either borrowers or banks or both. At the same time, observing runs from the asset side of the bank’s balance sheet is more difficult because of the problem of distinguishing genuine insolvency from strategic default.

In recent research (Trautmann and Vlahu 2011), we use experimental methods to identify factors conducive to strategic default and coordination failure. We study the impact of two sources of uncertainty – one related to the regulatory rules for transparency and disclosure, and the other one to the state of the economy – on the incidence of strategic default. That is, we test whether public policy to improve disclosure has a different effect on repayment incentives in different stages of the business cycle, and whether the impact of the economic environment depends on disclosure rules.

Impact on incentives to default strategically

We find clear evidence for strategic default. Our results suggest that more information about bank fundamentals is not always better. When full disclosure reveals bank weakness, it increases strategic non-repayment regardless of economic conditions. Similarly, solvent borrowers default strategically more during economic downturns when fundamentals of other borrowers are more uncertain, regardless of disclosure rules.

Behavioural determinants

We identify behavioural concepts that explain the observed variation in repayment.

  • First, we argue that changes in borrowers’ uncertainty about the actions of other borrowers (and the impact of these actions on their payoff) can explain borrowers’ default. In particular, both disclosure and uncertain borrower fundamentals lead to more coordination failures.1
  • Second, individual borrowers’ characteristics, such as a strong preference to avoid losses, as well as personal negative experiences, have a strong and robust influence on repayment decisions.

On one hand, loss-averse borrowers place a higher value on the available cash they hold than on the higher but uncertain future monetary outcome which is conditional on bank survival. Hence, they have a strong preference towards non-repayment, which allows them to avoid the immediate financial loss caused by a potential bank failure. On the other hand, people who have experienced defaults in the past and subsequent bank failures are more likely to default strategically. The role of (negative) experiences has been shown relevant in various financial decision settings (Hommes et al 2005, Malmendier and Nagel 2011), and our results indicate that it will also affect the behaviour of borrowers who lost a banking relationship in times of crisis.

Policy implications

The recent financial crisis has shown the limits of market discipline, and consequently, there are many initiatives that promote more disclosure and transparency by banks.

  • Proponents of such initiatives argue that more information about bank fundamentals enhances investors’ assessment of bank activities and improves market discipline.2
  • An opposite view suggests that too much disclosure of information about bank’s fundamentals may increase the probability of failure.

Our results support the latter view, by showing that borrowers may not be able to overcome coordination problems if banks are transparently weak.

Disclosure of weak banks may be harmful because it lays open the strategic uncertainty in the coordination problem. As it has also been observed in various cases during the current crisis, once the weakness of the bank is established, the coordination is too difficult to be attained by market participants. This will be particularly true in situations of a weak real economy with a significant portion of borrowers potentially in genuine distress.

It is important to realise that, due to the role played by individual characteristics, coordination failure may be most relevant in credit markets with small individual borrowers who do not self-select according to their risk attitudes, such as mortgage markets, retail loans, or microfinance lending. Therefore, these markets might be subject to more strategic default than those in which entrepreneurial types participate, like small-business loans markets.

Runs on individual banks from either the borrower or depositors side are economically harmful, but of real concern are systemic crises. Uncertainty about the nature of a run may lead to contagion of otherwise stable banks, which may trigger a system-wide collapse or panic. If one bank goes bankrupt, borrowers and deposit holders may interpret this event as a signal for the existence of solvency problems in the entire financial sector and react by delaying the repayments of their loans or massive withdrawal of funds, respectively. Past experience is relevant because it can be one of those factors driving systemic risk. People who have experienced bank failures in the past or who have learned about strategic default of others are more likely to stop repaying if they hear bad news about their own lender, suggesting a novel channel for contagious aggravation of the beginning of crises through observation or word of mouth.

Further, our results regarding experiences suggest some range for welfare improvements by not letting banks in distress to fail. Large-scale intervention of central banks as lenders of last resort during the recent financial turmoil has helped most of the banks to avoid failure, and this might have buffered the impact of negative experiences and mitigated the strategic default of borrowers.


Our research indicates that in the credit market, as in the deposit market, there is the risk of contagion. Therefore, it is important for regulatory policy to try to assess and identify the conditions under which contagion occurs and how it can be avoided.

The views expressed in this article are those of the authors and should not be attributed to De Nederlandsche Bank (Dutch Central Bank).


Arends, Brett (2010), “When It’s OK to Walk Away From Your Home”, Wall Street Journal, 26 February.

Bond, Philip and Ashok Rai (2009), “Borrower Runs”, Journal of Development Economics, 88(2):185-191

Cohen-Cole, Ethan and Jonathan Morse (2009), “Your House or Your Credit Card, Which Would You Choose?”, Working Paper, University of Maryland.

De Luna-Martinez (2000), “Management and Resolution of Banking Crises”, World Bank, US.

FDIC, FDIC Bank Failures report (2010).

Feldstein, Martin (2008), “Misleading Growth Statistics Gives False Comfort”, Financial Times, 7 May.

Financial Times (2011), “US Housing: Cash for Keys:, 27 March.

Guiso, Luigi, Paola Sapienza, and Luigi Zingales (2011), “The Determinants of Attitudes towards Strategic Default on Mortgages”, Fama-Miller Working Paper Forthcoming; Chicago Booth Research Paper N0. 11-14.

Hagerty, James (2009), “Is Walking Away From Your Mortgage Immoral?”, Wall Street Journal, 17 December.

Hommes, Cars, Joep Sonnemans, Jan Tuinstra, and Henk van de Velden (2005), “Coordination of Expectations in Asset Pricing Experiments”, Review of Financial Studies, 18:955-980.

Hull, John C (2009), “The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?”, Journal of Credit Risk, 5(2).

Krueger, Anne and Aaron Tornell (1999), “The Role of Bank Restructuring in Recovering from Crises: Mexico 1995-98”, NBER Working Paper W7042.

Malmendier, Ulrike and Stefan Nagel (2011), “Do Macroeconomic Experiences Affect Risk-Taking?”, Quarterly Journal of Economics, 126(1):373-416.

Mayer, Christopher, Edward Morrison, Tomasz Piskorski, and Arpit Gupta (2011), “Mortgage Modification and Strategic Default: Evidence from a Legal Settlement with Countrywide”, NBER Working Paper 17065.

Trautmann, ST and RE Vlahu (2011), "Strategic loan defaults and coordination: An experimental analysis", DNB Working Paper No. 312.

Van der Cruijsen, Carin, Jakob de Haan, David-Jan Jansen, and Robert Mosch (2010), “Knowledge and Opinions about Banking Supervision: Evidence from a Survey of Dutch Households”, DNB Working Paper No. 275.



1 In behavioural terms, the uncertainty about bank and borrowers fundamentals affects the risk-dominance properties of the coordination problem.


2 It has also been shown that people who are better informed about banking supervision display more prudent financial behaviour (van der Cruijsen et al. 2010).

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