Strategic loan defaults and coordination: An experimental analysis

► Strategic defaults due to coordination failure are observed in an experiment. ► Bank and borrower fundamentals affect the prevalence of strategic defaults. ► Loss aversion and negative past experiences reduce repayment. ► Low repayment rates after experiences of bank failures suggest contagion. This paper experimentally studies the impact of bank and borrower fundamentals on loan repayment. We find that solvent borrowers are more likely to default strategically when the bank’s expected strength is low, although loan repayment is a Pareto dominant Nash equilibrium. Borrowers are also less likely to repay when other borrowers’ expected repayment capacity is low, regardless of banks’ fundamentals. We show that changes in expectations about bank and borrower fundamentals change the risk dominance properties of the borrowers’ coordination problem, and that these changes subsequently explain strategic defaults. For the individual borrower, loss aversion and negative past experiences reduce repayment, suggesting that bank failure can be contagious in times of distress.