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Lumifer comments on Rationality Quotes Thread November 2015 - Less Wrong
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Well, moral hazard is a thing. Besides, the borrower always has the option of bankruptcy. You're talking about the situation when the debtor thinks he might not pay back the loan and not declare bankruptcy, right? I don't see why the bank should be sympathetic.
I also have trouble imagining the situation you're describing. Banks rarely lend money outright to individuals without any protection. The great majority of loans involve collateral -- a house (in the case of a mortgage), a car (in the case of an auto loan), securities (in the case of the margin loan at the broker), etc. And in practice, if you default, the bank gets the collateral and that's the end of it.
Given this, what kind of "debtor forgiveness clauses" do you have in mind and what protections against abuse will be there?
An example might be an auto loan with a clause that allows a debtor who is rendered unable to pay through no fault of their own (as judged by a court or other agreed upon mediator, for example) does not lose their car (the collateral) despite not being able to pay. And to compensate the bank for this low probability but high impact loss, they pay slightly higher interest rates.
So, this is basically mandatory partial insurance on loans? Economically this means (assuming your proposal is revenue-neutral for banks) forced wealth transfer from borrowers who were able to pay off the loans to borrowers who were not able to.
I don't think it's a terribad idea which will doom the Western civilization, but I don't think it's much good, either. You're effectively setting up a "bankruptcy lite" regime where you still have to go to court and show that you're destitute ("unable to pay", so presumably you have no cash and nothing in your bank accounts), but if the court decides it was not your fault, you get to keep some of your assets. Meh.
You'll also get a bunch of unintended consequences, as usual. Off the top of my head here are two:
If there is a significant chance the loan will be forgiven if the debtor has no money, banks will start to take credit scores seriously. People with a healthy bank account will be given loans, people who live paycheck to paycheck will be denied loans or charged exorbitant rates. There is no right to credit, and no right to low rates either. Make it too easy to default on a loan and the banks will react by just not giving loans to people likely to default.
Specifically with respect to auto loans, if there is a chance you won't be able to get your collateral (the car) back, the banks will have incentives to find other ways to finance. For example, you can structure a lease with an option to buy at the end to be much like a car loan: make the monthly payments larger, make the residual value smaller, and it's quite similar. But the crucial difference is that you can always repossess the leased car. Therefore under your proposed regime, leases will become more frequent.
I read them less as proposing it should be mandatory and more as proposing it should be opt-out. In a perfectly efficient market the latter would make no difference compared to opt-in, and in the real world it would move some trivial inconveniences around.
To quote from RichardKennaway's comment
googles "Payment Protection Insurance" and educates self