POLICY RESEARCH WORKING PAPER 2901 Decentralized Creditor-Led Corporate Restructuring Cross-Country Experience Marinela E. Dado Daniela Klingebiel The World Bank Financial Sector Operations and Policy Department October 2002 | POLICY RESEARCH WORKING PAPER 2901 Abstract Countries that have experienced banking crises have nonperforming assets. The study suggests that out of the adopted one of two distinct approaches toward the seven cases, only Chile, Norway, and Poland successfully resolution of nonperforming assets-a centralized or a restructured their corporate sectors with companies decentralized solution. A centralized approach entails attaining viable financial structures. The analysis setting up a government agency-an asset management underscores that as in the case of a centralized strategy company-with the full responsibility for acquiring, the prerequisites for a successful decentralized restructuring, and selling of the assets. A decentralized restructuring strategy are manifold. The successful approach relies on banks and other creditors to manage countries significantly improved the banking system's and resolve nonperforming assets. capital position, enabling banks to write down loan Dado and Klingebiel study banking crises where losses; banks as well as corporations had adequate governments adopted a decentralized, creditor-led incentives to engage in corporate restructuring; and workout strategy following systemic crises. They use a ownership links between banks and corporations were case study approach and analyze seven banking crises in limited or severed during crises. which governments mainly relied on banks to resolve This paper-a product of the Financial Sector Operations and Policy Department-is part of a larger effort in the department to examine the resolution of financial crises. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room MC9-624, telephone 202-473-3722, fax 202-522- 2031, email address hvol@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at mdado@worldbank.org or dklingebiel@worldbank.org. October 2002. (53 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about developnment issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Research Advisory Staff Decentralized Creditor-Led Corporate Restructuring Cross-Country Experience By Marinela E. Dado and Daniela Klingebiel JEL classification codes: G20, G28, G34, G38 Keywords: Financial institutions and services, bank and corporate restructuring, emerging market economies We would like to thpnk Ying Lin for very useful research assistance. The authors thank Gerard Caprio and Stijn Claessens for helpful cornzments. I. Introduction In recent decades, many countries have experienced banking problems reflected in high levels of non-performing loans that required a major and expensive overhaul of their banking systems. By one count, 112 episodes of systemic banking crises occurred in 93 countries since the late 1970s (Caprio and Klingebiel 2002). The proper management and disposition of impaired assets is one of the most critical and complex tasks of successful and speedy financial restructuring. Successful asset management policies can facilitate bank restructuring by accelerating the resolution of non- performing assets and can promote corporate restructuring by providing the right incentives for voluntary debt restructuring. The two alternatives for asset management strategies include setting up a government agency with the full responsibility for acquiring, restructuring, and selling of the assets (the centralized approach) or letting banks and other creditors manage their own non-perfonning assets (the decentralized approach). Empirical studies and/or cross country analyses on the usefulness and success of either strategy remain sparse. While a companion paper evaluated experiences with centralized asset management companies (AMCs) (Klingebiel 2000), this paper will focus on experiences with banking crises where the responsibility for the workout of bad debt was mainly left with the banks. We apply a case study approach and analyze seven banking crises during which governments mainly relied on banks to resolve non-performing assets. Our study suggests that out of the seven cases, only Chile, Norway and Poland successfully restructured their corporate sectors with companies attaining viable financial structures. The analysis underscores that the prerequisites for a successful decentralized restructuring strategy are manifold. The successful countries significantly improved the banking system's capital position enabling them to write down loan losses; banks as well as corporations had adequate incentives to engage in corporate restructuring; and ownership links between banks and companies were limited or severed during the crises. The remainder of the paper is organized as follows. Section II illustrates the two altemative approaches to financial restructuring. Section Im presents the analysis of seven country cases in which governments mainly relied on decentralized creditor restructuring to deal with debt resulting from banking crises. Section IV concludes. II. Approaches to Corporate Restructuring Two approaches to financial corporate restructuring can be distinguished (Sheng 1996). Countries can use either (i) a centralized government-led approach via asset management companies; or (ii) a decentralized creditor-led restructuring strategy. Under a centralized, government-led approach, asset recovery is centralized in one public agency (asset management company, AMC). A specialized agency may be 2 required because the task, of dealing with non-performing loans is fundamentally different from that of making loans. Transferring assets to a centralized asset management company may also increase leverage over debtors and break perverse ownership links between banks and corporations allowing for better collections on loans. Notwithstanding these advantages, recent country experience shows that it is difficult to insulate an asset management company holding a large share of corporate claims against political pressures. Moreover, a transfer of the loans breaks the links between banks and corporations-relationships made valuable by banks' access to corporate information. And if an asset management company fails to actively manage the assets it holds, it can undermine credit discipline in the entire system. The evidence on how successful AMCs have been is mixed (Klingebiel 2000). Box 1: The Use of Asset Management Companies in the Resolution of Banking Crises - Cross Country Experience In the past, asset management companies (AMCs) have been employed to address the overhang of bad debt in the financial system. Two main types of AMCs can be distinguished: AMCs set up to help and expedite corporate restructuring and AMCs established as rapid asset disposition vehicles. A review of seven cases reveals that AMCs have a mixed record. In two out of three cases, corporate restructuring AMCs did not achieve their narrow goals of expediting bank and/or corporate restructuring. These experiences suggest that AMCs are rarely good tools to expedite corporate restructuring. Only the Swedish AMC successfully managed its portfolio, acting in some instances as lead agent in the restructuring process. It was helped by some special circumstances, however: the assets acquired were mostly real estate related, not manufacturing (that are harder to restructure), and were a small fraction of the banking system (which made it easier for the AMC to maintain its independence from political pressures and to sell assets back to the private sector). Rapid asset disposition vehicles fared somewhat better with two out of four agencies, namely Spain and the US, achieving their objectives. The successful experiences suggest that AMCs can be effectively used, but only for narrowly defined purposes of resolving insolvent and unviable financial institutions and selling of their assets. But even achieving these objectiyes required many ingredients: a type of asset that is easily liquifiable (real estate), mostly professional management, political independence, a skilled resource base, appropriate funding, adequate bankruptcy and foreclosure laws, good information and management systems, and transparency in operations and processes. In the Philippines and Mexico, the success of the AMCs was doomed from the start as the governments transferred politically motivated loans and/or fraudulent assets to the AMCs which are difficult to be resolved or to be sold off by a govermnent agency susceptible to political pressure and lacking independence. Both of these agencies did not succeed in achieving their narrow objectives. Source: Klingebiel, 2000. The decentralized, creditor-led work-out. approach relies on banks and other creditors to resolve non-performing loans. Since banks have the institutional knowledge of the borrower, and since their own survival depends on asset recovery, they may be better able and willing to maximize recovery value and avoid future losses. Furthermore, banks can provide new loans in debt restructuring. 3 Box 2: Advantages and Disadvantages of Decentralized Creditor led Approach to Financial Restructuring Advantages * Ensures that the informational capital that banks have accumulated on their borrowers is preserved. * Leaving loans in banks may provide better incentives for recovery and for avoiding future losses by inproving loan approval and monitoring procedures. * Leaving loans in banks avoids the general deterioration of payment discipline that can occur if assets are transferred to an AMC which fails to properly manage them. * Banks can provide additional financing which may be necessary in the restructuring process. * Political considerations in restructuring decisions are limited as the actual restructuring is left to the private sector and not transferred to a public agency which may be prone to political pressure. Disadvantages * Economies of scale - i. e. consolidation of scarce work out skills and resources - are not achieved. * Ownership links between banks and corporations are not dealt with and may thus imnpede corporate restructuring. * May prove a distraction for banks' core business of '"making loans". * Banks typically are not good at restructuring which requires different types of skis. The remainder of the paper looks at the experience of banking crises where the responsibility for the debt workouts was mainly left with the banks. HI. Cross Country Experience with Decentralized-Creditor Led Restructuring A. Methodology Sample selection. We adopted a two step approach in selecting country cases for our detailed analysis. First, on the basis of a survey of past banking crises (Caprio and Klingebiel 2002), we identify twelve cases in which governments largely adopted decentralized creditor-led strategies. These are seven emerging market economies (Argentina, Brazil, Chile, Colombia, Thailand, Turkey, Venezuela), two industrialized countries (Japan and Norway) and three transition economies (Hungary, Poland and Slovenia). Second, we conduct an extensive investigation of the availability of detailed information and data on the resolution process. In five out of the 12 cases, we have insufficient detailed information to undertake a thorough analysis as we do not have complete information on corporate restructuring strategies including the scope of corporate distress, applied work-out mechanism, and financial data on the corporate sector and banking sector. These country cases are Brazil, Colombia, Slovenia, Turkey and Venezuela. We therefore analyze seven country cases which include two industrialized countries [Japan (1991-present) and Norway (1987-93)], three emerging market economies [Argentina (1980-82), Chile (1981-86), and Thailand (1997-present)]' and two transition countries [Hungary (1991-95) and Poland (1992-95]. l It is important to point out here that the analysis of the Thai case has to a prelirninary evaluation as the crisis started in 1997, and the latest corporate data we have for Thailand dates from mid-2001. 4 Information sources. Our analysis relies on published reports and World Bank internal documents. We supplement these sources with extensive interviews with country experts familiar with the details of the individual country cases. Case studies. We use a case study approach and carry out an analysis that is aimed at characterizing the incentive structure under which banks and firms operated - or initial conditions - at the onset of the crisis and five years after the crisis started. While institutional changes are not always easy to implement, especially when they need parliamentary approval- as in the case of bankruptcy regimes-this period should provide governments in those countries where the incentive framework is not conducive to corporate restructuring with sufficient time to improve the framework. We proceed by first summarizing the main characteristics of the specific banking crisis - type of distress, size of the nonperforming loans at the peak of the banking crisis and scope of corporate distress to get a better understanding of the type and severity of the banking crises in the sample countries. We continue by analyzing the incentive framework that banks and corporations are subject to at the beginning of the crisis and then examine the changes governments made to the framework five years after the start of the crisis. We focus particularly on four components of the incentive framework that have been found in the literature to be important to encourage banks and corporations to engage in meaningful corporate restructuring: (i) banks' capital positions and therefore their ability to withstand losses; (ii) the accounting and (iii) legal framework in which banks and corporations are operating as it indicates to what extent banks and corporations have (correct) incentives to come to the negotiating table and reach solutions that result in sustainable corporate financing patterns; and (iv) existing ownership links between banks and corporations (Claessens, Klingebiel and Djankov 1999). Extensive ownership links between banks and corporations would weaken either incentives to engage in meaningful corporate restructuring. Evaluating outcomes. The aim of corporate restructuring is to attain viable financial structures within a reasonable timeframe. Therefore we judge the success or failure of a decentralized restructuring strategy on the financial health of the corporate sector and evaluate to what extent the restructuring has led to financially viable corporate sectors five years after the onset of the crisis. B. Main Characteristics of Banking Crises Figure 1 and Table 1 (below) provide information on the type and scope of distress in the seven country cases. All countries in the sample experienced systemic financial crises, that is, a major part of the banking system of each sample country was affected and its aggregate capital base was exhausted. The scope of distress in the corporate sector is partly reflected in the share of non- performing loans (NPLs) at the peak of the crises (Figure 1). The level of non-performing loans can therefore be used as a rough proxy for the extent of corporate distress. Figure 2 indicates that levels of NPLs were significant in all sample countries at the height of the crisis - exceeding 30 percent of banking system assets - with the exception of Norway and Hungary. Argentina's 5 financial sector appears to have been hit the hardest among the sample countries with NPLs amounting to over 50 percent of banking system assets (Caprio and Klingebiel 2002). Figure 1. Peak Level of Nonperforming Loans (NPLs) as Percent of Total Banking System Loans Thandk (198) _ Pobnd (1M3) Norway (1r1 Japan (1998) Hunguy (1994) Chdie (19_6) Argoftina (9I9 S1) _4 0 10 20 30 40 50 60 Note: * denotes NPLs as percent of total banking assets. Source: Caprio and Klingebiel 2002: Intemational Monetary Fund, International Financial Statistics The increase in the number of bankruptcies (Table 1) also reflects the extent of corporate distress. Among the countries for which data were available, the most significant increase in bankruptcies was recorded in Argentina, where bankruptcies rose by 76% in the first year of the financial crisis (Balino 1991). In Hungary and Poland, over 50 percent of the banking system's non-perforning loans were owed by loss-making state enterprises that made up over half of the enterprise sector and were related to the transition from central planning to a market economy (World Bank 1996). 6 Table 1. Characteristics of Banking Crises Countrv T_Re of distress Corporate sector distress Argentina Private sector debt The peak rate of increase of business failures was 76% (1980-82) in 1980, the first year of the crisis (Balino 1991). Chile Private sector debt Estimated increase in number of bankruptcies from 81 (1981-86) in 1975 to 810 in 1982 (Velasco 1991). Hungary Debts owed by state-owned Gross enterprise losses increased from less than 1% of (1991-95) enterprises, mainly, to state- GDP in 1988 to 14% in 1992. By 1993, 50% of 70,000 owned banks. enterprises (mainly in industry) were loss makers. The largest loss-makers accounted for 60% of total enterprise losses and 50% of overdue bank debt (World Bank 1997a). Japan Private sector debt Corporate balance sheets deteriorated over the 1990s (1991- ongoing) and ROEs dropped from 7.5% in late 1980s to an average of 2.8% in the 1990s (International Monetary Fund 2000). Norway Private sector debt (corporate Bankruptcy rates rose by 40% a year during 1986-89. (1987-93) and household) Bank losses concentrated in primary sectors (14%), mining & export-oriented manufacturing (15%) and real estate (13%) (Norway's Royal Ministry of Finance and Customs 1992). Poland Debts owed by state-owned In 1992, 67% of enterprises remaining in state hands (1992-95) enterprises, mainly, to state- were loss makers, mostly in heavy industry (World owned banks. Bank 1993). Thailand Private sector debt (real estate) In 1997, 32.6% of corporations could not service their (1997- ongoing) debts (Claessens, Djankov, Klingebiel 1999). Source: Compilation by authors. C. Assessment of the Incentive Framework at the Onset of the Crisis We analyze the incentive framework at the onset of the crisis by evaluating (i) banks' capital positions; (ii) accounting framework and (iii) legal framework; and then (iv) existing ownership links between banks and corporations. a. Banks ' capital positions. To engage in meaningful corporate restructuring banks need to be adequately capitalized as they need capital to write down loans. To determine the level of capitalization in our sample crises countries, or in other words, the incentives of banks at the initial stage of the crisis to engage in any meaningful corporate restructuring, we classify the crises countries into four categories according to the risk adjusted capital level of their financial institutions. Since the level of non-performing loans in the banking system is highly correlated with the level of capital, we also use the level of non-performing loans (NPLs) if information on capital adequacy is not available. We classify financial institutions' capital base as follows. A four indicates that banks are well capitalized as their capital adequacy ratio is beyond eight percent and non-performing loans in the banking system are beyond five percent of total banking system loan. At the other end of the spectrum a one denotes a system in which banks are clearly 7 insolvent as their reported capital level is below two percent of risk adjusted capital or total banking system NPLs exceed 25 percent. In four (Argentina, Chile, Hungary, Poland and Thailand) out of the sample of seven countries, individual banks were severely undercapitalized and mostly insolvent with an adjusted capital adequacy ratio of minus two percent. To illustrate this rating with a few numbers, the Chilean banking system had a negative net worth of 12.2 billion pesos in the first year of the crisis while it faced losses of 70 billion pesos by the second year of the crisis (Sheng 1996c). The shortfall in the capital of the seven banks in Poland participating in the restructuring program accounted for 18 percent of their assets at the start of the crisis (World Bank 1993). The collapse of the real estate and stock mnarkets in Thailand rendered substantial shares of bank portfolios as nonperforming and as banking problems reached crisis proportions, the capital positions of banks weakened. According to 1998 market estimates of capital shortfalls for Thai banks, the latter would need US$30 billion to weather the crisis (World Bank 2000b). Japan's banks appeared to be better offin the mid-1990s with most of them reporting a risk adjusted capital adequacy ratio of between minus two to plus two percent (Kanaya and Woo 2000). But their capital positions did not improve significantly through the remainder of the decade (International Monetary Fund 1998). Out of the seven crises, countries Norway's banks appeared to be the best positioned in the initial phase of the crisis to deal with corporate distress. Their risk adjusted capital adequacy ratios were between two and eight percent. Figure 2. Banks' Capital Positions Prior to Recapitalization 3.5- 3 -~~~~~~~~~j 0 2E 5 - - 0 06 B~.1.5 r- 1- 1-E~ --X _ t g 0. .5 - Notes: We group countries into four categories with regards to the capital adequacy position of their banks and or the level of non-performing loans in the banking sector. A four indicates that all banks in the system are well capitalized and that the adjusted capital adequacy ratio (CAR) of the banks exceeds eight percent or the minimum legal requirement whatever is higher and non-performing loams (NPLs) of the banking system are below 5 percent. A three indicates that banks are slightly undercapitalized with their CAR ranging between two and eight percent and overall banking sector NPLs are between 6 and 10 percent. A two indicates that banks are significantly undercapitalized with their CAR ranging from minus two to plus two percent and banking sector NPLs are between 10 and 25 percenL A one denotes a system in which banks are severely undercapitalized and insolvent with a CAR below minus two percent and NPLs exceed 25 percent Sources: Balino 1991; Bbrish, Ding and Noel 1996; Claessens 2001; Claessens, Djankov and Klingebiel 1999b; Kanaya and Woo 2000; Sheng 1996c; World Bank 1993; World Bank 2000b. 8 Table 2. Accounting Framework Comparison of the accounting framework at the onset of the crisis and during the crisis Loan Loan Interest Countrv classification provisionin, accrual Average Argentina Onset I 1 1 1.0 During I I 1 1.0 Chile Onset 3 2 to 3 2 2.5 During 4 3 4 3.7 Hungary Onset 3 2 to 3 2 2.5 During 4 3 3 3.3 Japan Onset 2 2 2 2.0 During 2 2 2 2.0 Norway Onset 3 4 4 3.7 During 4 4 4 4.0 Poland Onset 3 2 to 3 4 3.2 During 3 3 4 3.3 Thailand Onset 1 1 1 1.0 During 3 3 2 2.7 Note: Countries are scored on a scale from I to 4 for each indicator with 4 indicating best practice and I indicating furthest away fromn best practice. Loan classification Specific loan loss provisioning: Interest Accrual I = loan past due more than 360 days I = 0%/o substandard; 50% doubtful; 1000%6 loss. I = up to 6 months, no clawback. 2 = loan past due more than 180 days 2 = 10- 15% substandard; 50% doubtful; 1000/o loss. 2 = up to 3 months, no clawback. 3 = loan past due more than 90 days 3 = 20% substandard; 75% doubtful; 100%/o loss. 3 = up to 6 months, with clawback. 4 = repayment capacity of boTTower/forward 4 = present value of future cash flow or fair value of 4 = up to 3 months, with clawback looking collateral. Sources: Argentina: Balino 1991; Chile: Barandiaran and Luders 2000, Larrain, M. 1989, Sanhueza 2000b; Hungary: Borish, Ding and Noel 1996, World Bank Various years(b); Japan: Kanaya and Woo 2000, Intemational Monetary Fund 2000; Norway: Karlsen 2000; Poland: Borish, Ding and Noel 1996, World Bank Various years(a); Thailand: Claessens, Djankov and Klingebiel 1999b b. Accounting framework for banks. Financial institutions incentives to engage in corporate restructuring is also influenced by the accounting framework under which they operate. Here loan classification and loan loss provisioning rules for banks determine to what extent banks can carry non-performing loans on their books without classifying them as such and can accrue uncollected interest. As a result, capital and income will be overstated and banks have limited incentives to engage in corporate restructuring since they can simply hide losses. The sample countries were scored according to how accounting rules compared with intemational best practice defined as follows: (i) loan classification according to the repayment capacity of borrower; (ii) loan provisioning based on the present value of future cash flow or fair value of collateral; and (iii) interest accrual rule requiring the recognition of overbooking of interest income when a delinquent loan is declared nonperforming (up to 90 days) (Claessens, Djankov and Klingebiel 1999b). Table 2 indicates that those rules were poor and trailed 9 international best practice significantly in five (Argentina, Chile, Hungary, Japan and Thailand) out of seven country cases. Banks in Argentina and Thailand operated under a weak accounting framework that allowed them to postpone the recognition of loan losses and overstate their capital positions. Banks in Thailand had to classify a loan as non-performing only after it had not been serviced for 360 days. At the same time, they were allowed to accrue uncollected interest income for up to twelve months (Alba, Hemandez and Klingebiel 1999). In contrast, Norway's and Poland's accounting framework was significantly better in the initial phase of the cnsis. c Legal framework. The bankruptcy system is crucial in disciplining borrowers and forcing them to come to the negotiating table with good restructuring proposals. Table 3 compares important features of the bankruptcy framework - so-called creditor rights - across the sample countries. As shown in Table 3, the legal framework in five of the sample countries contains two out of four creditor rights. Argentina only has one creditor right in its laws and Thailand affords creditors a relatively high protection - on paper, at least - by having three out of four creditor rights in its laws. Table 3. Legal Framework and the Existence of Ownership Links No Efficiency Restrictions for automatic Secured Manager does . Sum of ofjudicial Enforcement going into stay on creditor not stay in creditor system of creditor Ownership Count reorganizations assets paid first reoreanization rights index index nigts structures Argentina 0 0 1 0 1 6.0 0.6 2 Chile 1 0 1 0 2 7.2 1.4 1 Hungary I 1 0 0 2 3.0 0.6 1 Japan 0 0 1 1 2 8.0 1.6 3 Norway 1 0 1 0 2 10.0 2.0 3 Poland 1 0 1 0 2 .3.0 0.6 1 Thailand I I 0 1 3 3.2 0.9 1 Notes: Legalframework. The score for the legal framework is measured as the sum of four indicators of creditor rights: (i) restrictions on organizations; (ii) no automatic stay on assets; (iii) secured creditors paid first; and (iv) management does not stay in reorganization. An indicator is scored as I if the particular creditor right is provided in the country' s conmmercial laws; otherwise, it is scored as zero. At the outset of their transition, Hungary and Poland had to develop (i) legal frameworks that were compatible with laws in market economies; and (ii) judicial institutions to enforce the new laws. Efficiency of judicial system index assesses the efficiency and integrity of the legal environment as it affects businesses, particularly foreign firms. (The scoring ranges from I to 10.) The enforcement of creditor rights is calculated as the product of the creditor rights and judicial efficiency indices divided by 10. Ownership structure (Based on methodology developed by La Porta, Lopez-de-Silanes, and Shlcifer 1999). 4 = Widely dispersed ownership (firms do not have any shareholders with voting rights exceeding 20 percent) 3 - Widely dispersed ownership and cross-shareholdings allowed (firms are allowed to own shares in corporations that belong to its chain of control) 2 - Controlling shareholder (corporations in which shareholders' voting rights exceed 20 percent) and no cross-shareholdings in publicly held corporate shareholder I = Controlling shareholder and at least one publicly traded company in the chain of control Sources: La Porta, Lopez-de-Silanes, and Shleifer 1998 and 1999; Claessens, Djankov and Nenova 2000; World Bank 1985; Barandiaran and Luders 2000, Sanhueza 2000b; Kopanyi 2000b; Intemational Monetary Fund 1999b; Karlsen 2000 and Norway's Ministry of Finance; authors' estimates. 10 But for an insolvency system to be effective, creditors need to be able to rely on the judicial system to have these laws enforced. Therefore, Table 3 also provides information on judicial efficiency which assesses the efficiency and integrity of the legal framework on a scale from 1 to 10 with 10 indicating the highest degree of efficiency. As Table 3 indicates, among the crisis countries, Norway has the most efficient legal system. Japan's judicial system also ranked well followed by that of Chile and Argentina. Thailand trails the sample countries significantly indicating that enforcement of creditor rights faces serious impediments and limits creditor's ability to use the bankruptcy system as disciplining mechanism.2 Hungary and Poland did not only have to carry out a fundamental transformation of their legal frameworks to make them compatible with laws in market economies, a process that was almost completed by the late 1990s but they also had to develop modem and efficient judicial institutions to be able to enforce them (World Bank 1996; Borish, Ding and Noel 1996a). Therefore, enforcement capacity was relatively weak during these countries' financial crises. de Ownership structures. The effectiveness of decentralized work-outs may also be hampered by ownership links between banks and corporations as the same party would be both debtor and creditor (Claessens, Djankov, Klingebiel 1999). Using a methodology developed by La Porta, Lopez-de-Silanes, and Shleifer (La Porta, Lopez-de-Silanes, and Shleifer 2002) we score countries on their prevailing ownership structure at the onset of the crisis on a scale from 1 to four with one indicating that one controlling shareholder and at least one publicly traded company is in the chain of control (for further detail see Table 3) and ownership links are pervasive. The results of the analysis reflected in Table 3 show that ownership of the corporate sector was relatively concentrated and significant direct ownership links between financial institutions and companies existed in four out of six countries for which information was available. These countries were Chile, Hungary, Poland and Thailand. In Thailand, ownership of both financial and corporate institutions is concentrated in a limited number of families (World Bank 2000b). Chilean banks and companies enjoyed significant ownership links in the form of "grupos" or financial and manufacturing conglomerates which had acquired nearly all the largest manufacturing and banking firms in the mid 1970s (Velasco 1991). In the case of the transition countries - Hungary and Poland - the large shares of non-performing loans held by state-owned banks were largely the result of lending practices to state-owned enterprises (World Bank 1996). The ownership structure in which the government was the main shareholder in both banks and enterprises continued during the early part of the transition. Also, that period was marked by continued lending on the part of state banks to loss-making state-owned enterprises even as the banking crises had emerged (World Bank 1996). The practice prevailed initially at least not only due to banks' limited capacity to assess credit risk but also to occasional interventions by their major shareholder - the government - to support socially sensitive state enterprises (Borish, Ding and Noel 1996a). 2 Thailand has complemented its framework for corporate reorganization and asset resolution for large corporation with out-of-court, extra-judicial systems, the Corporate Debt Restructuring Advisory Committee. This committee and associated restructuring processes generally rely on the so-called London rules-principles for corporate reorganization first enunciated in the United Kingdom in the early 1990s. Since the London rules were not designed for systemic corporate distress, Thailand tried to tighten them in various ways to make those rules conducive to out- of-court restructuring (For greater detail, see Claessens, Djankov and Klingebiel 1 999b). ' That is, credit under socialism was extended primarily on the basis of the government's assessment of a state enterprise's importance in the economy, rather than its profitability and ability to service its loans. 11 While direct ownership links are limited in Japan, its traditional keiretsu structure fosters not only long held ties among Japanese corporations belonging to the same industrial group but also close connections with particular financial institutions (International Monetary Fund 1999b). In Norway, direct and indirect ownership links between banks and corporations were limited at the onset of the crisis, therefore limiting disincentives for corporate restructuring. Overall conduciveness of the incentiveframeworkfor corporate restructuring. To show the overall conduciveness of the incentive framework for corporate restructuring we construct a overall incentive framework index. This index reflects the unweighted average of the scores sample countries received on the four components of the restructuring framework at the initial phase of the crises. These four indicators are again: (i) the banking system's capital position; (ii) the accounting framework; (iii) the legal framework; and (iv) existing ownership links between banks and corporations. Table 4 shows that, except for Norway, the sample countries' banks and corporations operated within a weak overall incentive framework that was not particularly conducive for corporate restructuring at the onset of the crisis. Table 4. The Overall Incentive Framework at the Onset of the Crisis Bank capital Accounting Legal Ownership Overall Framework Cqumr positions framework fiamework structure Incentive Index Argentina (1980-82) 1.0 1.0 0.6 2.0 1.2 Chile (1981-86) 1.0 2.5 0.7 1.0 1.5 Hungary (1991-95) 1.0 2.5 0.6 1.0 1.3 Japan (1991- 2.0 2.0 1.6 3.0 2.2 ongoing) Norway (1987-93) 3.0 3.7 2.0 3.0 2.9 Poland (1992-95) 1.0 3.2 0.6 1.0 1.5 Thailand (1997- 1.0 1.0 0.9 1.0 1.0 ongoing) Source: Tables I - 3 and Figure 1. D. Government Efforts to Upgrade the Incentive Framework The previous section indicated that the framework for decentralized restructuring showed significant weaknesses in most of our sample countries in the initial phase of the crisis. In this section, we evaluate to what extent countries improved the overall incentive framework to make it more conducive to and accelerate corporate restructuring. As mentioned earlier, in this 12 analysis we will only consider changes made within a period of five year after the crisis began. While institutional changes are not always easy to implement, especially when they need parliamentary approval-as in the case of bankruptcy regimes-this period should provide governments with sufficient time to adjust the incentive framework for corporate restructuring. We focus our attention on the question to what extent governments strengthened the major components of the overall incentive framework, Annex tables 1, 2 and 3 provide a more detailed summary of govermnents' efforts or measures, to support financial and corporate restructuring. a. Strengthening the loss absorption capacity of banks. In six out of the seven sample countries, (Argentina, being the exception) the authorities attempted to shore up banks' capital position by providing public funds. In all cases, governments used ex-ante upfront schemes rather than employing a recapitalization strategy with an ex-post recapitalization mechanism that links banks' recapitalization to corporate restructuring. Ex-ante recapitalization may be implemented quickly and can signal to the market that problems are being resolved. Provided that it is accompanied by substantive improvements in corporate govemance and bank operations and is well monitored, it can be an up-front investment that leads ultimately to lower costs. But ex-ante recapitalizations also carry large risks. Governments routinely respond to such systemic bank solvency problems by injecting capital into insolvent banks, without requiring changes in governance and bank operations and the recapitalizations turn out to be futile. Banks will have better capacity to work out loans and to take losses, when recapitalized but they may still delay restructuring and roll over non-perform-ing loans since they are able to attract new funds anyhow. And likewise, corporations may have little incentive to undertake necessary operational restructuring, if they have access to new funds anyway (Claessens 1998). Therefore, the success of these recapitalization schemes depend on the following three factors: (i) the size of the recapitalization scheme; (ii) the timeliness of the provision of capital; and (iii) the conditionality attached to the recapitalization schemes. Size of the recapitalization schemes and repeated recapitalizations. In three out of seven cases - Chile, Hungary and Japan - the government failed to provide recapitalization schemes of sufficient size, making additional injections of capital necessary. Insufficient capital injections do not only reduce the loss absorption capacity of financial institutions but they also limit these institutions' incentives to engage in corporate restructuring as they await the next bail-out. In Chile, repeated loan purchases reinforced the perception by both debtors and creditors alike of the government's readiness to keep providing additional support (Barandiaran and Hemandez 1999; Brock 1999; Larrain, M. 1989; Sheng 1996c; Velasco 1991). Similarly, after three recapitalizations in Hungary, banks remained too poorly capitalized to be able to engage in earnest restructuring (World Bank 1999a; 1999b). Japan only provided public support to their banks seven years into the crisis. To date, Japan has implemented two rounds of recapitalizations - in 1998 and in 1999. Yet according to market observers, the Japanese banks continue to remain severely undercapitalized (Goldman Sachs 2002c). Timing of the recapitalization schemes. As important as the size of the schemes is their timeliness. In five out of six cases - Chile, Hungary, Norway, Poland and Thailand-capital infusions took place within three years of the onset of their crises (Barandiaran and Hernandez 1999; Brock 1999; Larrain, M. 1989; Sheng 1996c; Karlsen 1994; Norway's Royal Ministry of Finance and Customs 1992; Velasco 1991; World Bank 1993; 1994; 1999a; 2000a). In contrast, 13 Japan relied on economic growth to restore bank solvency for a seven year period (International Monetary Fund 1999a). During that time, Japanese banks were expected to recapitalize via increased earnings over time and-this was to be made possible by govemment macroeconomic programs to stimulate growth, implicit forbearance and low interest rates. This approach did not result in stronger balance sheets for banks and enhanced their ability to take losses. The authorities took a more forceful approach to restructuring in the eighth year of the crisis that included government injection of capital into the banking system (Kanaya and Woo 2000). Conditionality. Govemrnent can attach two types of conditionality to the disbursement of public funds. Governments can either link disbursements to a repayment schedule (with penalties for non-compliance) andlor to financial and operational restructuring criteria that banks have to meet to be eligible for receiving funds. Except for Hungary, all of the public recapitalization schemes attached some conditionality to the disbursement of funds. The public recapitalization programs in Chile and Poland required time-bound repayments by the banks to the government. In Chile, the government recapitalized banks through repeated direct purchases of substandard loans with zero coupon notes under a ten year repurchase agreement. The banks in turn had to commit to repurchasing all loans sold to the central bank. Banks had to redeem 5 percent of the recapitalization bonds every six months. Under Poland's enterprise and bank restructuring program, seven commercial banks received new capital in the form of fifteen year government restructuring bonds that had to be repaid every six months. Banks were, however, allowed to sell the bonds after three years. In both cases, banks' inability or failure to service their obligations would have resulted in government sanctions. For example, conciliation agreements under Poland's program carried penalties for non-compliance and the authorities required the supervisory boards of the participating banks to establish incentive compensation schemes that linked managers' bonuses to banks' profits (van Wijnbergen, 1994). In Norway and Thailand, public funds were injected into banks only after the write down of shareholder capital, thereby resulting in a (potential) severe dilution of ownership. In addition, the capital injections of banks in Norway were also made contingent upon operational restructuring. For example, banks participating in the recapitalization programs had to substantially reduce the number of branches and the level of operating costs so as to raise bank profitability and thereby help the banks sustain their capital adequacy. Thailand's program included the option for the govemment to require changes in bank management. In Japan, the long delayed government recapitalization required banks to meet two criteria to qualify for public funds - positive net worth and the ability to generate long-term profits (Kanaya and Woo 2000). Results of the public recapitalization efforts. Public recapitalization schemes appeared to have been successfiul, i. e. resulting in sustainable financial structures in banks in three out of the six countries (second column of Table 5). These are Chile, Norway and Poland. Despite initially underestimating the extent of the crisis and engaging in several rounds of recapitalization, the Chilean government considerably strengthened the capital base of the banks enhancing their ability to withstand losses (Brock 1999; Velasco 1991). Five years into the crisis, the banking system moved from a capital shortfall to an equity surplus and banks reached capital levels between two and eight percent (Skarmeta 1999). 14 In Norway, the government injected public funds into one large commercial bank and three large savings banks as well as a number of smaller savings banks. Capital levels in banking institutions improved with risk adjusted capital adequacy ratios reaching beyond eight percent and system wide NPLs dropping significantly. The commercial banking system's risk adjusted capital adequacy ratio rose from 7 percent during 1981-85 to 10.58 percent in 1993. The share of commercial banks' after-tax profits in total assets improved from -0.3 percent in 1987 to 1.2 percent in 1994. Commercial bank losses as a share of total loans fell from its peak of 5.2 percent in 1991 to 0.2 percent by 1994. The capital provision in Poland led to adequate capital levels (the risk adjusted capital adequacy ratios in these banks ranging from 2 to 6 percent) in the seven banks participating in the restructuring program and allowed them to write off a significant portion of unrecoverable debts (World Bank 1997b; 2000a). The public recapitalization program allowed the seven banks to achieve a capital adequacy ratio of 12 percent by 1995, i.e., three years after the crisis began. For the banking system as a whole, the share of NPLs to total loans declined from 28 percent in 1992 to 10 percent in 1997, i.e., five years after the onset of the crisis. By 1998, all seven banks were sold to foreign investors. The public schemes were less successful in the other three sample countries that provided public funds for recapitalizations. Three capital injections (1991-93) in Hungary continued to leave banks undercapitalized and their overall capital positions did not improve (compare Table 5). The recapitalization programs were neither conditioned on operational restructuring of the banks or changes in bank management nor did they provide sufficient incentives to banks to address corporate distress. While the third scheme required banks to sign consolidation agreements, the latter did not include specific quantitative performance criteria nor specific remedial measures that, not surprisingly, rendered the agreements ineffective. In 1995, i.e., four years after the onset of the crisis, a new Hungarian government moved towards a strategy of bank privatization, largely through sales to foreigners, to improve banks' capacity to sustain losses. The government also made great strides in privatizing the enterprise sector. Nevertheless, Hungarian banks reached adequate capital levels towards in 1998-despite repeated recapitalizations-seven years after the onset of the crisis and only after 60 percent of the banking system had been sold to foreigners (World Bank 1999a; 1999b). In Japan, the government's strategy to engage in capital forbearance left banks severely undercapitalized five years after the onset of the crisis, the timeframe of this study. Public recap schemes initiated in 1998 and 1999 continued to leave banks severely undercapitalized and while the second round of recapitalizations was conditioned on improvernents in the operating environment of the financial institutions, it did not result in these institutions undertaking serious corporate restructuring efforts (Goldman Sachs 2002c). At the beginning of 2002, the market estimate of non-performing loans in the Japanese banking system stood at 35 percent of outstanding loans (Goldman Sachs 2002c). Therefore, even today, eleven years after the onset of the crisis, banks remain significantly undercapitalized. Thailand's commercial banks were reluctant to take advantage of government recapitalization because of the resulting dilution of ownership and the requirement for change of management. The recapitalization program offered banks Tier 1 capital support conditioned on 15 these banks adhering to stringent conditions including meeting strict loan loss provisioning standards and changing bank management. This market based approach ensured that public funds would have only been provided when shareholders had been wiped out. Notwithstanding, banks that needed fresh capital could delay the application for such assistance since they were allowed to recapitalize on a flow basis and comply with more stringent capital adequacy requirements at a later point in time. As a result, only two non-intervened private banks have accessed public funds. Instead, banks have raised expensive capital on their own. Still in the end they remain substantially undercapitalized because of high levels of non-performing loans. By 2002, system wide NPLs stood at one-third of total loans (Standard and Poors 2002). Additional mechanism for debt relief In addition to capital infusions, governments have employed schemes to bail out specific groups of private debtors which are essentially equivalent to bank recapitalization. However, such efforts create disincentives for borrowers to make earnest efforts to repay their debts.4 The loan reprogramming programs in Chile led to moral hazard problems as borrowers expected more generous debt relief to be forthcoming (Barandiaran and Hemandez 1999; Brock 1999; Sheng 1996c). Repeated refinancing schemes in Argentina in 1982 did not help avert the deterioration in bank solvency that contributed to the second financial crisis that began in 1989 (Giorgio and Sagari 1996; Velasco 1991). b. Correcting deficiencies in the accounting framework. The third column in Table 5 indicates that the accounting framework improved in five out of seven countries. The adoption and enforcement of forward-looking loan classification soon after the crisis began brought Norway's framework fully to international best practice. Norway was also one of two countries (the other being Poland) that applied "best practice" provisioning rules for restructured debt, wherein the restructured loan is reclassified as perforning and the specific provisions are lifted after a period of regular debt servicing (Karlsen 2000). At the other extreme, accounting rules remained unchanged in Argentina by the end of the crisis of the early 1980s and its framework remained farthest from best practice throughout the crisis period (Balino 1991). Japan also left its accounting framework unchanged five years into the crisis. Only in 1998, seven years after the onset of the crisis, did Japan introduced forward looking loan classification rules making it in principle more difficult for institutions to hide their losses. Improvements to the regulatory regimes of Chile, Hungary, Poland, and Thailand, in that order, brought their frameworks closer to best practice although some rules still trailed behind best practice. Chile's bank regulations and the new banking law of 1986 which emphasized market information dismantled the 1982-84 practices of explicit regulatory forbearance to ease the crisis (Sheng 1996c). Hence, Chile's framework improved significantly five years after the crisis began. Hungary's amendment to the banking law in 1994, the fourth year of the crisis, 4 Argentina and Chile provided public debt relief to private debtors through repeated programs of across-the-board debt restructunings or debt reduction. These included exchange rate guarantee schemes, de-dollarization of debts (in which the government assumes foreign exchange losses of dollar denominated loans), or restructuring of loan terms for firms that meet certain eligibility criteria. In some instances, debt relief was extended to consumer and mortgage loans by rescheduling interest and repayment terms. In the case of Argentina, the authorities relied on a merger/liquidation strategy for bank restructuring and alleviation of indebtedness of the private sector (through across-the-board refinancing programs) to avert further bank failures. The programs entailed refinancing by the central bank of the loans of private borrowers, that is, extending loan maturities at favorable interest rates. While the government did not recapitalizd banks, it helped them by bailing out private borrowers. 16 resulted in a major upgrading of its accounting framework, including the introduction of forward-looking loan classification and provisioning norms. Thailand significantly upgraded its classification and provisioning requirements and somewhat tightened interest accrual rules in 1999 bringing the overall accounting framework much closer to international best practice. Yet, immediate loan reclassification for restructured debt was allowed, freeing up previously made provisions after a debt workout (World Bank 2000b). Table 5. Comparison of the Restructuring Framework for Banks and of the Financial Results for the Corporate Sector (at the onset of the crisis (in brackets) and five years into the crisis) Framework for decentralized restructuring Result Country Bank Efficiency Improvement Financial capital Accounting and Ownership Overall in overall condition of positions framework enforcement structure index index corporate sector Argentina (1980-82) (1) 1 (1.0) 1.0 (0.6) 0.6 (2) 2 (1.2) 1.2 +0.0 (1) 1 Chile (1981-86) (1) 3 (2.5) 3.7 (0.7) 0.7 (1) 3 (1.5) 2.8 + 1.3 (2) 3 Hungary (1991-95) (1) 1 (2.5) 3.0 (0.6) 0.7 (1) 3 (1.3) 1.9 +0.6 (1) 2 Japan (1991- (2) 2 (2.0) 2.0 (1.6) 1.6 (3) 3 (2.2) 2.2 + 0.0 (2) 2 ongoing) Norway (1987-93) (3) 4 (3.7) 4.0 (2.0) 2.0 (3) 3 (2.9) 3.3 + 0.4 (3) 4 Poland (1992-95) (1) 3 (3.2) 3.3 (0.6) 0.7 (1) 3 (1.5) 2.5 + 1.0 (1) 3 Thailand (1997- (1) 2 (1.0) 2.7 (0.9) 0.9 (1) 1 (1.0) 1.7 + 0.7 (2) 2 ongoing) _ __ _ _ I _ I_I _ -_I_I Source: Tables 2-4 ; Borish, Ding and Noel 1996; Claessens 2001; Claessaens, Djankov and Klingebiel 1999a and 1999b; European Bank for Reconstruction and Development 1998; Kanaya and Woo 2000; Karlsen 2000; Sheng 1996c; World Bank 1985; World Bank 2000b. c Improving the legal framework. None of the countries in our sample made significant changes to their formal balnkruptcy regime and therefore a number of weaknesses in the formal bankruptcy law were not eliminated (see fourth column Table 5). However, four out of seven countries complemented their formal framework for reorganization and debt workouts with out-of-court extra-judicial procedures to accelerate restructuring. In the 1980s, Chile used private arbitration to resolve liquidations and bankruptcies as an altemative to the outdated and slow judiciary system (Barandiaran and Luders 2000). In the absence of fully developed liquidation and bankruptcy legislation as well as a skilled and efficient court system, Poland launched its well known program of bank and 17 enterprise conciliation in 1993 that allowed enterprises to enter into time-bound, out-of-court, bank-led conciliation agreements aimed at restructuring and/or asset resolution. At the same time, the governnent required banks to initiate bankruptcy or liquidation procedures if they failed to reach agreemnent with their nonperforming enterprise borrowers (World Bank 1993). Out-of-court programs in Hungary and Thailand appeared to have been less successful. Hungary tried to circumvent an overburdened court system with a conciliation program but it failed due to a lack of transparent rules and penalties for non-compliance. This resulted in persistent interventions by competing government ministries which completely undermined the out-of-court process (Kopanyi 2000a; World Bank 1997a). A weak structure and inadequate enforcement of the out-of-court framework adopted in Thailand have not facilitated restructuring. At the end of 1999, thirteen percent of the restructured cases reverted to non- performing status in just a few months (Claessens, Djankov and Klingebiel 1999b). Thailand also established a separate bankruptcy court that was intended to increase the efficiency of judicial procedures in bankruptcy cases to address the main weakness in its formal bankruptcy regime in early 1999. Following the establishment of the court, the number of bankruptcies in Thailand still remained low, however, and fraught with difficulties (Foley 2000). Table 6. Features of Out-of-court Corporate Restructuring Accord provides for Accord imposes All or most banks formal arbitration with penalties for signed on to accord deadlines nonconpliance Argentina No No No Chile No Yes n.a. Hungary Yes No No Japan No No No . Norway No No No Poland Yes Yes Yes Thailand Yes Yes Yes Note: In Chile, private agents were allowed to resolve bankruptcies by hiring specialized private consulting firns. Sources: Barandiaran and Luders 2000; Kopanyi 2000a; World Bank 1997a; World Bank 1993; Claessens, Djankov and Klingebiel 1999b d. Severance of ownership links. As the fifth column of Table 5 suggests, in Chile, Hungary and Poland where direct ownership links were significant impediments to restructuring, the introduction of new regulations, public recapitalizations and foreign entry into the financial system effectively severed or at least significantly reduced ownership links. In these crisis countries the government used the crisis as an opportunity to change ownership structures and sever ownership links that can hamper corporate restructuring. After the crisis emerged, Chile began to tighten limits on cross-ownership between financial institutions and corporations but more importantly, started to enforce them (Sheng 1996c).5 Moreover, foreign entry into the banking system further severed ownership links between corporations and banks (World Bank 1997c; 1999b). Recapitalization programs in Hungary effectively nationalized banks and wiped 5 Banks were required to reduce loans to related companies to no more than 5 percent of their total portfolios. By the last year of the crisis, a new banking law attempted to eliminate the practice of related lending and defined more precisely the concept of "client". 18 out the equity of state-owned enterprises that were also the banks' main borrowers, thus breaking the ownership links between the two entities (Abel and Szakadat 1997; Borish, Ding and Noel 1996a). The Polish govermment prohibited the seven bank participants of the recapitalization program from making new loans to non-performing borrowers (i.e., state-owned enterprises) (World Bank 1993). All seven banks were sold to foreign investors within five years of the launch of the conciliation program. The subsequent privatization of the banks in Hungary to foreign investors had a more profound impact ultimately than the repeated public injections of capital (World Bank 1997c; 1999b). To the contrary, in Thailand bank and corporate restructuring continued to be hampered by direct ownership links. And while direct ownership links are limited in Japan, indirect links or the keiretsu structure remained intact and continued to hamper bank and corporate restructuring. Overall conduciveness of the incentiveframeworkfor corporate restructuring. Column 6 in Table 5 summarizes the overall conduciveness of the incentive framework for corporate restructuring in the sample countries five years after the onset of the crises. As the table illustrates, only Chile and Poland upgraded its incentive framework significantly to reach 2.8 and 2.5 respectively on a scale from one to four with four signaling a highly conducive environment for corporate restructuring. Norway, which started out with a relatively conducive regime, as indicated by its score of 2.8, improved its framework to 3.3 thereby nudging it closer to international best practice. The remaining four countries made only limited improvements to their framework leaving impediments to corporate restructuring largely unaddressed. Out of these four countries Argentina's framework remained furthest away from international best practice with a score of 1.2, followed by Thailand (1.7), Hungary (1.9), and Japan (2.2). E. Results of the Restructuring Efforts The aim of corporate restructuring is to attain viable corporate financial structures in a reasonable amount of time. Therefore, we determine that a country's decentralized restructuring approach was successful if it has led to viable financial structures of corporations within a five year time frame. We assess on a scale from one to four the financial situation of the corporate sector. The decentralized restructuring strategy is then judged to be successful if the overall sector either scores a three or a four meaning that the weighted average interest coverage ratio of corporations exceeded three and that the share of companies with an interest coverage ratio of below one is less than 20 percent. Figure 4 illustrates that the corporate sectors in only three out of the seven sample countries attained viable financial structures within a five year timeframe. In Chile, Norway and Poland corporate distress was significantly reduced during the crisis period and corporations were put on a sounder financial footing. The remaining four countries-Argentina, Hungary, Japan and Thailand-were less successful in encouraging creditor led workouts and therefore the finns in these countries still exhibited substantial distress five years after the onset of their respective crises. While Chile started out with a weak overall incentive framework for corporate restructuring, the country updated several components of the framework significantly by 19 strengthening the capital base of the banking system, upgrading the accounting framework and severing ownership links between banks and corporations. After underestimating the extent of the crisis initially, the Chilean government launched successive and massive programs to recapitalize the banks and to bail out borrowers in order to resolve the crisis. However, Chile's experience also showed that the government's lack of a realistic assessment of corporate distress proved very costly since repeated recapitalization and debt relief schemes served to reinforce the perception by creditors and borrowers that the government would continue to provide additional assistance (Barandiaran and Luders 2000). The programs for bailing out borrowers created a serious moral hazard problem that initially deterred rapid corporate restructuring. Following several across-the-board rescheduling programs in 1984-85, the corporate sector started to show signs of profitability and improved financial conditions (Barandiaran and Hemandez 1999). The quick pace of the economic recovery was similarly a reinforcing factor for corporate restructuring. Figure 4. The FinazcialW Health of the Corporate Sector 4.5 - 4 3.5 2.5 io~~~~~~~~~~~~~~- '- DAt the onset of the cisis 2.5 - =Five years after the start of the nsis 1.5 ' ^ _ _ * || ___ | _ | °. F--5;1- 2 ll Note: We rate the financial health of the corporate sector according to two factors. One, the sector weighted interest coverage ratio and second, the share of companies with an interest coverage ratio of less than one. We assess the financial situation of the corporate sector on a scale from one to four based on data availability for either of the two factors and therefore we classify corporations into four categories. A one denotes a situation in which the weighted average interest coverage ratio of all firms is below one and/or the share of companies with an interest coverage ratio of one or less is higher than 30 percent. A two denotes a situation in which the weighted average interest coverage ratio of all firms is between three and one and/or the share of companies with an interest coverage ratio of one or less is between 21 and 30 percent. A three denotes a situation in which the weighted average interest coverage ratio of all firms is between five and three and/or the share of cornpanies with an interest coverage ratio of one or less is between 11 and 20 percent. A four denotes a situation in which the weighted average interest coverage ratio of all firms exceeds five and/or the share of cornpanies with an interest coverage ratio of one or less is less than ten percent. Sources: Argentina: World Bank 1985; Chile: World Bank 1987; Hungary and Poland: Pohl, Anderson, Claessens and Djankov, 1997; Japan: Goldman Sachs 2002a; Norway: staff calculations using Bloomberg data; Thailand: Claessens 2001. 20 The absence of ownership links and the existence of a well functioning legal framework in Norway were favorable initial conditions for restructuring - as evident in its overall incentive structure's score of 2.9 (see Table 4). Adequately capitalized banks as well as the improvements in banks' operations and in the accounting framework during the crisis period provided creditors and borrowers with the incentives to engage in restructuring. Among the seven countries, Norway's framework - which scored the highest of the country cases (3.3) -was the best placed for applying the decentralized approach. While it is difficult to separate the effects of proper incentives from the economic recovery that began in the last year of the crisis, the financial positions of both banks and corporations quickly turned around. While the incentive framework was relatively weak in Poland at the start of the crisis (compare Table 5), the government enhanced the framework by significantly augmenting bank capital positions and accounting regulations and severing ownership links between banks and corporations. Moreover, the bank and enterprise restructuring program included conditions on bank recapitalization and time-bound limits on debt workouts. Poland succeeded to reduce the bad debt problems of the seven participating banks and managed to encourage some operational restructuring by enterprises during the period of the program. The restructuring program led to improved quality of borrowers, increase in bank equity, improved bank lending and strict prudential rules (International Monetary Fund 1999c). Nevertheless, two Bank studies have concluded that operational restructuring as a result of the debt workouts occurred at a much slower pace than expected (Gray and Holle, 1996a; World Bank 1997b). In the end, the quick resumption of growth in Poland, as GDP rose at an average 6 percent per year in 1993-96, helped accelerate enterprise restructuring (World Bank 1997c; 2000a; Barbone 2000). The decentralized corporate restructuring strategies that governments adopted in Argentina, Hungary, Japan and Thailand were and in some cases are still severely hampered by an inadequate incentive framework. In these countries, corporate debt levels continued to be high and companies' financial structures remained weak, five years into the crisis. Argentina's overall incentive framework was barely strengthened such that the framework was still not conducive for corporate restructuring five years after the onset of the crisis. The government aggressively implemented a costly strategy of bailing out insolvent borrowers. Along with such strategy, the authorities relied on liquidations or forced mergers of financial institutions to resolve the crisis. Despite these efforts, the corporate sector was persistently in financial distress (World Bank 1985) and the government failed to address weaknesses in the capital position of banks, accounting rules and legal framework amidst a fragile macroeconomic environment. With a weak incentive framework (a score of 1) at the outset (compare Table 5), Hungary relied heavily on public injections of capital to strengthen the incentives for restructuring. However, repeated public recapitalizations - without strengthening bank incentives and supervision nor empowering the out-of-court system - did achieve little progress in enterprise restructuring. Five years later, Hungary's banking problems continued to remain unresolved and the financial position of the corporate sector continued to be weak. The situation improved markedly only after the authorities changed course four years after the crisis began and opted not only for bank privatization but also for a comprehensive reform of the regulatory framework and 21 serious macroeconomic adjustment (World Bank 1997a). Following the wide-reaching and aggressive privatization program of the Hungarian economy, a World Bank country study concluded that, towards the end of the decade: (i) most firms have restructured their operations although those that remained state-owned have restructured the least; and (ii) foreign direct investment has been the key to the pace and scope of enterprise restructuring in Hungary (World Bank 1999b). Weakly capitalized banks, inadequate accounting framework and indirect ownership links persisted in Japan, encumbering the decentralized approach. For seven years after the crisis began, the authorities relied on growth to restore the health of the corporate and financial sectors. The authorities largely pursued accommodating fiscal and monetary policies to stimulate growth hoping that such a strategy would resolve the problems in the corporate and baniking sectors. Undercapitalized banks were allowed to languish for quite an extended period. This strategy only delayed the much-needed restructuring. For most of the crisis period, the incentive framework for corporate restructuring hardly improved as it scored 2.2 at the onset and five years hence. Only in 1998 the government began to take a more aggressive approach and started to strengthen the framework for restructuring in earnest with a public recapitalization program. This was followed by improvements in the accounting rules and their enforcement. Nevertheless the corporate sector continues to be weak and non-performing loans in the banking sector are again on the rise (Goldman Sachs 2002c). Thailand's overall incentive framework showed some improvement as the crisis ensued as the score for the overall index changed from 1.0 to 1.7. While the government was quick to offer the injection of public funds into the banking system, banks were slow to take this up as the government also allowed them to recapitalize on a flow basis via retained earnings and because the acceptance of public funds would have resulted in the dilution of ownership and or in a change in management. The capital inadequacy of banks is compounded by impediments caused by accounting rules that trail behind best practice, a weak enforcement of the legal framework and continued, although slightly reduced ownership concentration and ownership links between banks and corporates. Progress with corporate restructuring has been limited and, for the most part, banks have been willing to engage only in cosmetic restructuring of assets that are "easy to restructure". While the level of corporate distress improved significantly in Thailand compared to the onset of the crisis, a large share of companies continue to have weak financial structures and more than 24 percent of companies did not have enough cash to service their interest (Claessens 2001), in the middle of 2001, four years into the crisis. IV. Conclusions The scatter plot in Figure 5 indicates that the decentralized restructuring strategy resulted in viable financial structures of the corporate sector in those country cases where the incentive framework was conducive for bank-and corporate restructuring, i.e. countries scored relatively high on the incentive framework index. Firms in only three countries - Norway, Chile, and Poland attained viable financial structures through decentralized restructuring. The experience of Chile and Poland also suggests that weak incentives frameworks at the onset of a crises does not necessarily need to be a severe impediment to resolving corporate distress if governments 22 upgrade the incentive framework significantly in a timely manner making it more conducive to corporate restructuring. As Figure 5 suggests the financial health of corporations in Argentina, Thailand, Hungary, and Japan did not improve significantly amidst an environment characterized by weak incentives for corporate restructuring. The results of the country case studies point to the manifold prerequisites for the success of decentralized strategies. They require: (i) adequately-capitalized banks; (ii) proper incentives for banks and borrowers; and (iii) limited or no ownership links between banks and corporations (as otherwise the sarne party would be both debtor and creditor). The results also indicate that the speed with which governments improve the incentive framework for corporate restructuring is important to achieve sustainable financial structures of corporations and to accelerate corporate restructuring. Figure 5. Success of Decentralized Corporate Restructuring Strategies 4 3.5 Norw ay t 3 -Iifle, PIand * 2.5 2 -j* * *Japan 2i 1.5 ThaDand HIngary 1.5 I 1 * Argentina 0.5- 0 0 0.5 1 1.5 2 2.5 3 3.5 Incentive Frarrework Financial institutions need to be adequately capitalized to have the loss absorption capacity to engage in sustainable corporate restructuring. If governments allow banks to recapitalize via increased earnings over a longer time horizon, either through implicit or explicit forbearance, banks' ability to engage in meaningful corporate restructuring is limited. Forbearance does not create stronger balance sheets necessary for the absorption of losses. Marginally capitalized banks often tend to engage in cosmetic restructuring such as maturity extension or interest rate reduction which may not lead to sustainable corporate financial structures. And, cross country experience shows that forbearance dilutes financial institutions' incentives to negotiate more forcefully with the controlling shareholder of distressed corporations. Thus, decentralized strategies often require governnents to help strengthen banks' capital position, if financial institutions deemed viable cannot obtain capital exclusively from private 23 sources. One option governments can consider for strengthening banks' capital position is ex- post rather than ex-ante recapitalization. Experience, including that of Hungary, Japan, and Thailand has shown that recapitalizing banks ex-ante does not necessarily ensure that restructuring will take place, and may create considerable moral hazard. Ex-post recapitalization links government support to a financial institution's progress in debt restructuring. The most explicit form of ex-post recapitalization would be to implement a loss sharing rule by which the government would cover a certain percentage of the loss arising from corporate restructuring deals. To put bite into the incentive framework for restructuring, governments need to tighten provisioning and classification rules for bank loans if these rules are not in line with international best practice and also adjust rules for corporations. It often also means requiring financial institutions to apply those rules uniformly to standard, restructured, or rescheduled loans and to ensure that classification is based on a borrower's demonstrated ability to repay. Implementing tougher accounting requirements often present a trade-off for governments. Requiring financial institutions to more realistically mark their assets to market and to provision restructured debt properly has short-term repercussions on financial institutions' capital positions and often increase their capital needs. Yet, international experience shows that meeting these up- front costs early on improves banks' incentives for loan recovery and proper restructuring and may thus yield significantly lower fiscal costs ultimately (Honohan and Klingebiel 2000). Effective insolvency systems facilitate the rehabilitation of enterprises and also provide an efficient mechanism for the liquidation of those enterprises that cannot be rehabilitated. In addition, rehabilitation procedures may help overcome coordination problems of different creditors if they allow courts to impose restructuring agreements over the objections of creditors. Moreover, in economies undergoing transition, making state-owned enterprises subject to insolvency laws sends a clear signal that there is a limit to the amount of public financial support the firms can count on. A question, however, here is whether indeed rehabilitation can be achieved most effectively through the application of a formal procedure. In a systemic crisis in particular, many countries rely on liquidation proceedings as the principal mechanism for rehabilitating enterprises. The very existence of liquidation proceedings create incentives for an out-of court restructuring and because an enterprise can be sold as a going concern liquidation can provide an effective vehicle for rehabilitation (Hagan 2000; International Monetary Fund 1999). If bankruptcy procedures are lengthy and weak, debtors have incentives to ride out the economic downturn without diluting ownership which may inhibit deeper restructuring. Well functioning legal procedures and good access to courts are therefore crucial. Even if an adequate bankruptcy law exists, cross-country experience shows that effective implementation of the framework is even more important. In particular, given the complexity and the urgency of insolvency proceedings, effective implementation requires judges and administrators who are efficient, ethical and adequately trained in commercial and financial matters (Hagan 2000; International Monetary Fund 1999). 24 Finally, ownership links between debtors and borrowers also hamper the effectiveness of decentralized work-out strategies. Extensive ownership links can lead to a deadlock of claims that may be difficult to break as the same party is both debtor and creditor. 25 Sources and Selected Bibliography Abel, I., and L. Szakadat. 1997. "Bank Restructuring in Hungary." Acta Oeconomia: Periodical of the Hungarian Academy of Science; 49, No. 1-2:157-90. Hungary. 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Government Policies to Resolving Bank and Corporate Distress Country Type of Scope of distress Government resolution strategy distress (Peak level of NPLs as percent (public or of financial system assets) private debt) Financial Sector Corporate Sector Provision of Closure of Public recapitalization program Private injection of Public debt relief (level of NPLs liquidity financial capital program at peak as % of support institutions Public funds for Take up banking system) recapitalization (conditions and type of program) Argentina * Private Estimated at Peak real rate of No Yes. No Not applicable Not applicable Yes. (198042) sector debt 50% increase of business 83 institutions (i) Repeated (1979-81) failures was 76% in closed by end refinancing 1980, the first year of 1982. programs for the crisis. (Measured private debt in as liabilities of firms 1981-82; (ii) declared bankrupt government deflated by WPI.) assunmpion of private foreign debt liabilities in 1981 - 82 and a portion of the debt was exchanged for pesos at below-market exchange rate. a Prinmay resolution mechanism was liquidabon of financial institutons. Fiscal cost of refinancing amounted to 7% of GDP. 33 Country Type of Scope of distress Government resolution strategy distress (Peak level of NPLs as percent (public or of financial system assets) private debt) Financial Sector Corporate Sector Provision of Closure of Public recapitalization program Private injection of Public debt relief (level of NPLs liquidity financial capital program at peak as % of support institutions Public funds for Take up banking system) recapitalization (conditions and type of program) Chile * Private 35.4% of loans Estimated increase in Yes. Yes. Yes. 25 of 42 institutions Yes. Yes. (1981-86) sector debt (1986) number of Errergency 3 of II financial Feb 1984 loan purchase sold bad loans to the 'Yapitalismo Repeated programs: USS5.5 billion bankruptcies from 81 loans institutions programs to non- central bank Popular"program (i) various across- in 1975 to 810 in extended to intervened in intervened banks but no amounting to 20/ of for privatization of the-board debt 1982. banks at the 1981-82 were conditions on bank the total loans in the 4 intervened banks rescheduling start of the liquidated in restructuring were banking system. to small individual programs (such as crisis. 1983.' required. The central bank Loan purchase investors injected debts of "productive purchased loans up to improved the solvency new capital into the debtors", medium- 150%o of capital and of non-intervened banks accompanied sized businesses, reserves and the banks in banks and accelerated by subsidies. transport tum purchased interest- the recognition of companies, bearing central bank required provisions. mortgage & promissory notes at . consumer loans); favorable terms. Bank (ii) preferential shareholders were required exchange rate to commit all dividends to scheme; (iii) the repurchase until the govemment's purchase obligation was assumption of completed. Administration foreign exchange of the purchased loan losses through de- portfolio, however, dollarization of remained in each bank. foreign loans. I Also, smaller debt reliefprograms for mortgage and consumer loans and debts of medium- sized businesses, transport comnpanies. Cumulative cost of liquidations amounted to 11% of GDP (Barandiaran and Hemnandez 1999). The fiscal coats toGDP oftheprograms were2.7%, 14.7% and 6.1%ofGDP. 34 Country Type of Scope of distress Government resolution strategy distress (Peak level of NPLs as percent (public or of financial system assets) private debt) Financial Sector Corporate Sector Provision of Closure of Public recapitalization progran Private injection of Public debt relief (level of NPIs liquidity financial capital program at peak as % of support institutions Public funds for Take up banking system) recapitalization (conditions and type of program) Hungary * Debts owed 26% of loans Gross enterprise Yes Yes. Yes. 14 banks (including Yes. No (1991-95) by state- (1994) losses increased from But not until Three recapitalization the 5 largcst state- Govemment owned less than 1% of GDP 1986. programs of one per year owned conunercial adopted new enterprises, in 1988 to 14% in One bank was during 1991-93 without banks) and 60 savings strategy after the mainly, to 1992. In 1993, on the liquidated and subjecting the banks to any cooperatives 1991-93 state-owned basis of A MOF one specialized serious conditions, In the pasticipated in the recapitalizations banks. survey, 50% of bank surrendered 1992-1993 programs, the 1992 scheme. But in that focused solely 70,000 enterprises bank license. government carved out 1993, 8 banks, on bank (mainly in industry) 90°h of the face va!ue of including 3 of the privatization from were loss makers. the NPL portfolio in largest banks, and 1994 onward. The largest loss- exchange for government many cooperatives making firms (about bonds, while the banks were found to be 500) accounted for assumed lO!Yo of the face significantly capital- 60% of total value of losses. The 1993 deficient. The 1993 enterprise losses and scheme required banks to scheme entailed an 50% of overdue bank sign a consolidation initial recapitalization debt. I agreement with the of the insolvent banks government to ensure their to K0 CAR and two operational and financial subsequent restructuring; in practice. recapitalizations to these agreernent did not bring the banks to 4% specify quantitative and 8% CAR. performance criteria and Cunulative targeTs nor specify recapitalization was remedial rnasures. " US$3.5 billion or 8% of 1994 GDP. Private banks consisted of small cooperative banks catering to the financing needs of pivate fannerm and rural households. 'G Gross enterprise losses rose from 1% of GDP in 1988 to 14% in 1992 (World Bank 1997a). Borish, Ding and Noel 1996a. 2 Also, thcre were no sanctions for nonr-conpliance. 35 Country Type of Scope of distress Government resolution strategy distress (Peak level of NPLs as percent (public or of financial system assets) private debt) Financial Sector Corporate Sector Provision of Closure of Public recapitalization program Private injection of Public debt relief (level of NPLs liquidity financial capital program at peak as % of support institutions Public funds for Take up banking system) recapitalization (conditions and Mye of progmam) Japan * Private 30% of loans Corporate balance Yes. Yes. Yes. In 1998,18 najor and No (1991- sectordebt (1998) sheetsdeteriorated Forthefirst Up to late 1997, Government threeregionalbanks ongoing) over the 1990s and seven years of government recapitalization scheme put received Yen 1.8 ROEs dropped from the crisis, relied on in place in 1998 and again trillion in public funds. 7.5% in late 1980s to authorities 'convoy" system in 1999; ex-ante The govermment either an average of 2.8% in attempted to in which strong recapitalization; purchased preferred the 1990s. keep banking banks were Banks had to meet two shares or subordinated system afloat called upon to criteria to qualify for debt. Thus, all major by providing support weaker public funds banks except for one liquidity banks. Closure * positive net worth received public funds. loans. of 7 housing and In March 1999, 15 companies * ability to generate banks received Yen (usen) down in long-term profits. 7.5 trillion 80% of 1995. Second time around, which was in the form Two major banks conditionality was more convertible preferred nationalized in strictly adhered to. stock. 1998 Norway * Private 4% of assets Bankruptcy rates rose Yes. No Yes. Direct capital No No (1987-93) sector debt (1991) by 40%ayear during "Special terr" Injection ofequitytoone injections during 1989- (Corporate, 1986-89. 1 loans large commnercial bank 92: NOK I billion mostly, and Bank losses extended in (besides the three largest (US$ 155 million) to household) concentrated in 1991-92 by that were nationalized) and one comnmercial bank; primary sectors the central to 3 large savings banks NOK 3 billion (USS (14%), mining & bank to the and other savings banks. 465 million) to the export-oriented banking savings banks. manufacturing (15%) system at and real estate (13%). interest rates lower than other central bank loans. I Finance companies were the first to show the effects of the emerging crisis in 1986-87 with losses nainly from property investments exceeding 5% of loans and many companies went out of business and were restructured. In 1987, three medium-sized banks recorded heavy losses that wiped out their equity capital. Then, in 1990, the largest banks encountered problems due to heavy loss provisions. In contrast to the first phase of the crisis in 1987-89 when newly established firmns faced problemn, well-etablished companies especially in trade, hotels and restaurants and real estate, defaulted on their loans. 36 Country Type of Scope of distress Government resolution strategy distress (Peak level of NPLs as percent (public or of financial system assets) private debt) Financial Sector Corporate Sector Provision of Closure of Public recapitalization program Private injection of Public debt relief (level of NPLs liquidity financial capital program at peak as % of support institutions Public funds for Take up banking system) recapitalization (conditions and type of program) Poland * - Debts owed 35.7% of loans 67% of enterprises Yes No Yes. Upfront No No (1992- 95) by state- (1993) remaining in state Tobe eligible for recapitalization of US$ owned bands were loss recapitalization, banks 750 million in 1993 of enterprises makers, mostly in were required to have seven commercial (SOEs), heavy industry (1,992) independent audits and banks (18% of the total mainly, to Is portfolio reviews, assets of those banks). state-owned assignment of NPLs to Recapitalization banks. 14 sepamte workout units and permitted these banks strategic plan submitted to to write off a MOF to deal with troubled significant portion of assets. unrecoverable debts. Thailand * Private 32% of loans 32.6% of corporations Yes. Yes. Yes Govemment injected No (1997 - sector debt (1998) (1997) could not Substantial 57 of 91 finance In place since August $8.9 billion into ongoing) problem. service their debts (20% of GDP) companies; 1998; Ex-ante private banks and I of 15 domestic recapitalization through $11.7 billion into banks tier 2; a weak link to public banks corporate recapitalization exists through tier 2 capital. Current shareholder capital expected to be written down to zero before infusion and govemment can change nmanagement; however weak sticks in place to make program credible. '' Private banks consisted of small coopeative banks catering to the financing needs of private farmers and rural households. " Loss-making SOEs not servicing their debts numbered 2000 and accounted for 40% of the total loan portfolio of nine state owned commecial banks. As of September 1992, some 3000 non-commercialized enterprises remained in state hands. 37 Annex Table 2. Incentive Framework at Onset of Crisis Country Ownership links between banks and corporations Banks' and non- Accounting framework 16 rmancials' capital (Countries are scored on a scale from 1 to 4 for adequacy positions each variable with 4 indicating best practice and 1 indicating furthest away from best Framework Pracice practice.) Banks allowed Non-financial Significant Significant links Financial and to own non- companies ownership links between non- non-financial Loan Loan loss Interest Average financial firms allowed to own between banks and banks and companies linked classification provisioning accrual financial firms corporations corporations through family owncrship Argentina Limnited. Pernitted but No. But the Yes. No One of the largest private I (1980-82) subject to prior interfirm market If any, through the banks, three other banks approval of developed a highly interfirrn narket. and a number of non- authorities. interconnected bank institutions, all of infrastructure that which expanded quickly allowed participants were considered insolvent to void reserve and were closed or requirements and intervened in 1980. The regulations on only institutions that related Iending, appeared solvent were portfolio those backed by the concentration and government or those minimum capital. private banks with well- established reputation. By 1983, many non-bank institutions were liquidated and the rest were eithe merged or transformed with banks. 1 Note: Countries are scored on a scale from I to 4 for each indicator with 4 indicating best practice and I indicating furthest away from best practice. Loan classification Specific loan loss provisioning: Interest Accrual I = loan past due more than 360 days I = 0%/o substandard; 50%0 doubtful; 100%/o loss. I = up to 6 months, no clawback. 2 = loan past due more than 180 days 2 = 10 - 15% substandard; 50% doubtful; 100% loss. 2 = up to 3 months, no clawback. 3 = loan past due more than 90 days 3 = 20% substandard; 75% doubtful; 1 00%/6 loss. 3 = up to 6 months, with clawbackL 4 = repayment capacity of borrower/forward 4 = present value of future cash flow or fair value of 4 = up to 3 months, with clawback looking collateral. 38 56 Country Ownership links between banks and corporations Banks' and non- Accounting framework ' financials' capital (Countries are scored on a scale from 1 to 4 for adequacy positions each variable w/ith 4 Indicating best practice and 1 indicating furthest away from best Framework Practiee practice.) Banks allowed Non-financial Significant Significant links Financial and to own non- companies ownership links between non- non-financial Loan Loan loss Interest Average financial firms allowed to own between banks and banks and companies linked classification provisioning accrual financial firms corporations corporations through family ownership Chile In 1980, limit In 1978,the Yes. Through Yes. Alsothrougb No Bytheendof 1983, 3. Between 2 and 2 2.5 (1981-86) on bank maximum "grupos"or grupos. banking system's net 3 "9 investment in individual financial and worth stood at-12.2 a given holdings of manufacturing billion pesos as it faced enterprises' bank shares of conglomerates. losses of 70 billion shares was 3%by After liberalization pesos.' (OrNPLto raised from companies (in the mid- 1 970sa, equity raio rose from 100/h to 20% allowed under grupos acquired 22.4% in 1981 to 158.1% of bank's paid the 1974 law nearly all the largest in 1985.) capital and was abolished and manufacturing reserves. because it was and banking fitn$s." difficult to Grupos often used enforce. bank credit to purchase shares in In 1980, a limit the banks being of 5% for acquired, with the unsecured stock themselves as credits and 25% loan collateral. By for secured 1982, related credits was lending accounted introduced and for 14% of total halved in the loans and 21% of case of the loans of the five borowers largest private linked to the banks. bank. Hungary Permitted Permtitted When the banking Links, if any, were No Despite the 1991-92 3 Betwccn 2 and 2 21 2.5 (1991-95) sector was through state rewapitalizabions of the 3 20 organized in 1987, ownership. banking system, eight SOEs could own large banks (and some shares of state- cooperatives) were still owned banks. The technically insolvent as big debtors were the of 1993. shareholders. 7 Velasco 1991. " Sheng 1996. " Specific provisions of 100% of past due loans (Sanhueza 2000b). 200% substandard; 500/o doubtful; 100% loss 21 1993 Banking Actanmendment (effecdve 1994) introduced mandatory 100% provision forpast due but unpaid interest although interest suspension was not provided (Borish, Ding and Noel 1996a). 39 Country Ownership links between banks and corporations Banks' and non- Accounting framework 16 financials' capital (Countries are scored on a scale from 1 to 4 for adequacy positions each variable with 4 indicating best practice and 1 indicating furthest away from best Framework Practice practice.) Banks allowed Non-financial Significant Significant links Financial and to own non- companies ownership links between non- non-financial Loan Loan loss Interest Averagc financial firms allowed to own between banks ard banks and companies linked classification provisioning accrual financial firms corporations corporations through family ownership Japan Limited to Permitted, Banks and firms are 15 largest The collapse of the real 2 2 2 2 (1991 - holding 5% provided total linked through families own 7% estate market and equity ongoing) interest. investnent does extensive web of of banks, 16% of prices turned many loans not exceed relationships corporations, and non-performning and investing firm's between core 13% of non- considerably reduced capital or net shareholders and banks. banks' capital position. assets. main customers Jusen companies and smaller banks were affected the worst. Norway Investments of Generally, there No No No Banks were poorly 3 4 4 23 3.7 (1987 - 93) up to 490/% in is a maximum capritalized and had little single ownership limit to cushion themselves companies; of 10% of any against loan losses. only 4% of single owner of Baning Law of 1972 total bank a financial required each bank to assets institution; maintain 6.5% CAR permitted to some when the prevailing ratio be invested in exceptions. prior to 1972 was 8%. shares. Poland Permitted up Permitted Links, if any, were Links, if any, were No 1991 portfolio reviews of 3 2 Between 2 and 4 2 3.2 (1992-95) to 25% of the through state through state the seven state-owned 3 27 bank's capital. ownership. ownership. commercial banks 24. showed them to be insolvent in the aggregate. The capital shortfall of these seven banks was significant and estimrated at US$750 million. 21 22 Bank holding companies and their subsidiaries are allowed to bold in the aggregate up to 15% of the total shares of non-financial companies. 22 1987 banldng regulations stipulated that banks could not enter as income any unpaid interest on NPLs (Karlsen 2000). 24 The central bank may grant exceptions to the limitation. Non-financial assets acquired by banks during bank conciliation or restructuring agreements were encouraged to be sold within 2-3 years. 25 Agricultural bank and the housing bank. '6 Substandard loans include those past due between 7 and 90 days. 27 20% substandard; 50%/o doubtful; I100% loss 2' Interest due but not received was not taxable. Provisions for losses can be made before tax as in the case of loans classified as doubtful or loss. 40 Country Ownership links between banks and corporations Banks' and non- Accounting framework 16 financials' capital (Countries are scored on a scale from 1 to 4 for adequacy positions each variable with 4 Indicating best practice and 1 indicating furthest away from best Framework Practice practice.) Banks allowed Non-financial Significant Significant links Financial and to own non- companies ownership links between non- non-fnancial Loan Loan loss Interest Averge financial finns allowed to own between banks and banks and companies linked classification provisioning accrual financial firmns corporations corporations through family ownership Thailand Yes Yes; statutory No. No. Yes 29 Many weakpublic and I 1 l (1997- linit 5%; private conumercial ongoing) banks. 29 It hasbeen estimnated, forexarrple, thatthetop 10 famniliescontrolled46.2percentofthenuarketcapitalization of listed fimisasofend-1996,ofwhichholdings in financial institutions accounted for 18.3 percent of their wealth and in corporations for the rest (World Bank 2000b). 41 Changes in Incentive Framework During Crisis Country Ownership links between banks and corporations Banks' and non- financials' capital Changes in framework Changes in ownership structure adequacy positions Banks allowed to Non-financials Nationalization Privatization Sale to Concentration of Assets Assets held by own non-financials allowed to own (share of assets held foreigners ownership carved out state as shalm of financials by state-owned) control among GDP top 15 families Argentina Not applicable Not Not applicable Analysis of banks covering (1980-82) applicable 1982-86 showed continuous decline in ROE and weakening of loan portfolios. By 1986, banks representing 26% of total bank assets had lost at least 50% of their equity while institutions accounting for 41% had negative real return on equity. 30 Chile Not permitted. Pernitted up to In 1981/2, 11 The five Two banks Not applicable Not Not applicable Loan purchase programs in (1981-86) 1O0/o of bank's institutions were intervened intervened in applicable general gave the banks the shares and intervened of which banks that 1981/82 possibility of writing off bad Superintendent's 9 finance were not were sold to loans over a 1 0-year period. prior approval. companies were liquidated foreigners. Privatization of 4 intervened liquidated. Two were Of the banks banks allowed them to be (Loans to related large banks were privatized by intervened in fully capitalized by 1986. companies were to later sold to 1986. 1983, those be reduced to no foreigners. that were more than 5% of the In 1983, the restructured total portfolio by government were sold end 1990.) intervened in 7 mainly to banks (& I finance domestic company) though 3 investors institutions were through liquidated. capitalismo popular for individual investors and sales to groups of domestic private investors. 30 World Bank 1998. 42 Country Ownership links between banks and corporations Banks' and non- financials' capital Changes in framework Changes in ownership structure adequacy positions Banks allowed to Non-financials Nationalization Privatization Sale to Concentration of Assets Assets held by own non-financials allowed to own (shlme of assets held foreigners ownership carved out state as share of financials by state-owned) control among GDP top 15 fanmilies Hungary No changes No changes Recapitalization in Government Majority Not applicable Not As of 1998, state Average CARs of the large (1991-95) 1991-94 through implemented stake in held applicable held minority mostly privatized banks exchange of bonds bank by foreign stakes in 2 banks improved to 13% in 1998. for NPLs resulted in privatization investors in 7 and 100% Average in medium private nationalization such in eamest largest ownership of I (de novo) banks was 17% in that out of 44 banks starting in commercial bank (due to 1998. " in operation in 1995. By year banks as of recapitalization 1995,17 were end,about 1999. in 1997-98), majority state- three fourths equivalent to owned and 5 had of the banks 0.3% of GDP. minority state were majority ownerhip. 3' private. Previously, bank shareholders included state- owned enterprises. Norway No changes No changes By 1991, In 1995, two The sale of Not applicable Not As of 1998, the Average CARs of (1987-93) recapitalization years after the third applicable state maintained commercial banks increased resultedinthe resolutionof largestbank 61%and51% from7%in 1981-85to government's sole the crisis, the was mostly stake in the two 10.6% in 1993. By mid- ownership or govenment to foreign largest banks that 1990, banks' capital rajority sold the third investors. accounted for positions were considered shareholding of the largest bank. 40% and 30%/o of healthy and sufficient to three largest total commercial absorb losses. commercial banks bank lending. 3 which accounted for 85% of all commercial bank assets. In the mid- 1990s, the government expressed its intention to reduce its shareholding to 50%/o of the two largest banks by fall 1997 and to at least one third thereafter. "Recapitalization effectively renationalized the banks with the MOF receiving 75% of shares of the banidng system (Borish, Ding and Noel 1996a) 32 World Bank 1999b. 3 As of 1998, GDP = NOK 1100 billion and deposit money bank assets = NOK 1030 billion; government's holdings of the two largest banks = NOK 9195 million. 43 Country Ownership links between banks and corporations Banks' and non- financials' capital Changes in framework Changes in ownership structure adequacy positions Banks allowed to Non-financials Nationalization Privatization Sale to Concentration of Assets Assets held by own non-financials allowed to own (share of assets held foreigners ownership carved out state as share of financials by state-owned) control amnong GDP top 15 famnilies Poland No changes ' No changes Seven of 9 state Authorities Sale of four Not applicable Not 38% of banking Recapitalization allowed 7 (1992-95) owned connnercial ainwd at banks applicable system equity 36 banks to achieve 12% CAR. banks received privatization resulted in (1995) But two specialized banks government bonds of all nine foreign (26% of total bank assets, to raise their capital state-owned ownership 1995) are in need of adequacy. commercial shares in the restructuing. But mnany banks. As of range of 25- private banks created in the end 1995,4 56%. early 1990s with loose banks with Initially, licensing standards would 13% of total bank face capital shortfalls under banking assets privatization existing requirements. were faced Thus, overall CAR for the privatized. By political entire banking system stood 1998, only resistance to at6%in 1995.' In 1996,if two state- foreign loan classification standards owned banks investment, had been strictly applied, the remained. " specialized banks and nmany- small banks would have been out of compliance. 3' Tbailand No changes No changes 4 institutions; Intended for 2 banks sold 53.5 percent 2 percent 127 percent No. Main private and large (1997 - 43 percent (1999) public to foreigners; (finance (1999) public banks continue to be ongoing) institutions 4 pending companies, weakly capitalized. (1999) 1999) 74 Unclear about the position of equity holdings swapped for bad debts in 5 commercial banks (imnplications for managenment and banks' regulatory conmpliance) (World Bank 1994). " Following the first bank privatization, the banks' shares were put on the market and the subsequent price jumnp led to criticismn of the MOF for having undervalued the shares before going public. This prompted the authorities to be more cautious in selecting investment advisors and caused a slowdown in the process. '6 As of 1995, total bank assets stood at 42% of GDP. State held 55% of bank assets. " World Bank 1997c. " World Bank 1997c. 44 Country Tax or other Loan classification and loan loss provisioning Troubled Debt Restructuring Framework impediments to framework revelation of losses (Same framework as above) Loan Loan loss Interest Average Classification Debt/Equity Swap Mergers and classification provisioning: accrual guidelines of Acquisitions reclassified loans Argentina * Long tradition of the I 1 I 1.0 No separate Not applicable Not applicable (1980-82) banking framework. superintendency of overlooking analysis of loan portfolio quality and operating efficiency of banks. Chile * Tax deductibility of 4 3 39 4 3.7 Not immnediate. No debt-equity swaps (1981-86) specific provisions was Required permission under loan purchase Changes to allowed. of the and rescheduling prudential * Until the tax reform of Superintendency. programs. Swaps were regulations 1984, the tax rate on used mainly by non- were made in dividends exceeded intervened banks, 1985-86. that of interest income especially with foreign debt Hungary * Authorities announced 4 3 4 3 3.3 No separate Under the (1991-95) their intention to adopt framework. " recapitalizationt loan regulations on consolidation program accounting, reporting in 1992, it was unclear and valuation of whether debt equity restructured debt in swaps were legal or 1996-97. As of June illegal. 1999, such regulations had not been introduced. Japan * Banks were not 2 2 2 2.0 No separate (1991 - allowed to deduct from * Still framework ongoing) taxable income losses inadequate Changes to incurred as recognition framework consequence of out-of and under were made in court restructuring. provisioning 1998 This was corrected of loans. only in June of 1998. * The book Also, provisions and value is still debt forgiveness have used for not been tax valuing deductible. securities. 39 Under 1982 law: 20% substandard, 400O/ doubtful, 100%/o loss (Sanhueza 2000b). '° 1993 Banking Act amendment (effective 1994) introduced the use of forecasts of potential losses in classification and provisioning (Borish, Ding and Noel 1996a). 4' As of June 1999, troubled debt restructuring regulations had not been adopted. 45 Country Tax or other Loan classification and loan loss provisioning Troubled Debt Restructuring Framework impediments to framework revelation of losses (Same framework as above) Loan Loan loss Interest Average Classification Debt/Equity Swap Mergers and classification provisioning: accrual guidelines of Acquisitions reclassified loans Norway * Specific loan loss 4 4 4 4.0 Reclassification Equity was valued at None. (1987 -93) provisions were fuilly allowed only after mrarket value or tax deductible. regular servicing. present value, whichever was lower. Provisioning made if the value of the equity was lower than the original debt exposure. Poland 3 3 4 3.3 Reclassification only Unfavorable tax (1992 - 95) after 3 months of debt treatment of equity servicing, swaps. Thailand 3 3 2 2.7 Innediate (1997- reclassification ongoing) possible. 46 Legal Framework42 Country Restrictions for No automatic Secured Manager does Sum of Efficiency of Enforcement Rule of law Couption Specific Impediments going into stay on assets creditor paid not stay in creditor judicial system of creditor index index reorganizations first reorganizations rights index rights index43 Argentina 0 0 1 0 1 6.0 0.6 5.35 6.02 (198042) Chile 1 0 1 0 2 7.2 1.4 7.02 5.30 (1981-86) Hungary " 1 0 0 2 3.0 0.6 n.a. n.a. The lack ofrmodem and (1991-95) efficient institutions and judicial capacity is evident in the huge court backlog for liquidation procedures during 1992-96. Japan 0 0 1 1 2 8.0 1.6 8.98 8.52 (1991 - ongoing) Norway 1 0 1 0 2 10.0 2.0 10.0 10.0 None (1987 - 93) Poland 1 0 1 0 2 3.0 0.6 n.a. n.a. Shortage of trained judges; (1992 - 95) weak enforcement of court judgments; high court costs for case filing; weak administration of courts; outdated/inefficient registries for property rights, entry and exit. Thailand I t 0 1 3 3.2 0.9 6.25 5.18 (1997 - ongoing) 12 Sources for indices of creditor rights, efficiency of judicial system, rule of law and corruption: La Porta Lopez-de-Silanes, and Shleifer 1998, Claessens, Djankov and Nenova 2000; World Bank 1985; Barandiaran and Luders 2000, Sanhueza 2000b; Kopanyi 2000b; Intemational Monetary Fund 1999b; Karlsen 2000 and Norway's Ministry of Finance; authors' esdmates. '3 Computed as the product of the creditor rights and efficiency of judicial system indices divided by 10. " 1993/94 bank and debtor conciliation program was unsuccessful. Only t4% of the eligible enterprises applied to the program. Banks were less willing to write offdebts and preferred to sell assets pledged as collateral. The negotiations were frequently interrupted by interventions from the State Property Agency; the selection process of enterprises was based on non-financial considerations; the agreements failed to specify quantitative performance criteria and targets and to impose penalties for non-compliance (Kopanyi 2000a). 47 Annex Table 3. Characteristics of Financial Restructuring Approach Adopted and Results Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other Impediments to Corporate Results Restructuring Argentina None Capiral position ofbanks Unsound and poorly managed Unmited use of April 1981 refinancing n The second scheme precluded (1980-82) * nTe government's strategy of bank mnergers public finances coupled with a scheme due to: (i) announcement of an enterprises with fiscal obligations and transformation was not sufficient to tight monetary policy led to upconming more generous scheme; (ii) in arrears or had distributed attain a capital base that could support tosses high interest rates and widespread perception that much of debt dividends above a certain amount when loan portfolios began to deteriorate hyperinflation. relief was convened to foreign exchange in the past or were considered again, that subsequently left the country. already bankrupt. A higher than expected number of enterprises did Accountingframework not meet the eligibility criteria. As * Central bank tightened its supervisory ofend 1981, on)y about 4% of the function. But despite inmproved supervision debt estimated eligible for and a comprchensive set of prudential restructuring had been refinanced. regulations, recognition of loan losses still * Debt distress recurred after 1982 suffered from (among others) the lack of an and reached crisis proportions in apprpriate systern for classifying loan 1989. portfolio according to risk and toleration by the authorities of banks' own ad hoc accounting practices towards loss- provisioning. Legal framnework * No out-of-court mechanism put in place (except for blanket restructuring program); no changes to bankruptcy framework. Ownership sSructure * No changes 48 Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other Impediments to Corporate Results Restructuring Chile None Capital position of banks The govermnent pursued tight Across-the-board restructuring schenmes The decentralized approach bailed out (1981-86) * The public and private recapitalization fiscal policy in the years did not distinguish between fints with borrowers and strengthened the capital programs improved the capital base of banks leading up to and during the varying degrees of difficulties. The lack position of banks at a fiscal cost to absorb losses. crisis. Chile also experienced of realistic assessment of the conditions estimated to exceed 40% of GDP. But it extraordinarily high real of the schemes eroded its credibility in helped to improve the corporate balance Accounrtingframework interest rates during the same the long run. Thus, repeated schemes sheet, together with the economic Bank Superintendency cracked down on period. Beginning in 1982, the reinforced the perception held by both recovery beginning in 1985, thereby excessive related lending in 198142 and governient used monetary debtors and creditors alike of the allowing for the reduction of long-term imposed loan limits to single enterprises. policy to actively moderate govemment's readiness to provide indebtedness. The restructuring Such measures carne too late to reverse the increases in interest rates. additional debt relief and led to a serious prograns provided working capital and deterioating situation. In fact, the authorities moral hazard problem. " financial relief for 700/o of debtors and mistakenly perceived the problemns to be helped them regain their temporary and allowed accounting flexibility creditworthiness.a to banks in reflecting their losses (e.g. extending threhold for declaring delinquent loans non-perfornning). These practices were dismantled only in 1984-85. Legalframework * Bankruptcy framework remained outdated and the judiciary system was slow. In the early 1980s, private agents were allowed to resolve bankruptcy cases by hiring specialized private consulting firms to engage in resolution (instead of relying on the government agcncy or the judicial system). Ownership structure * In 1982, the authorities enforced existing ownership limits. Also, the Banking Act of 1986 introduced stringent restrictions on related lending. F For example, the 1982 loan purchase program was successful because banks were still reluctant to stop rolling over loans because it would force them to start legal action against delinquent debtors, when it was still likely that the govemment would provide additional relief. a As of end 1986, the financial indicators of 100 firms surveyed whose stock is traded on the Santiago stock exchange had improved substantially, a reflection of the corporate sector's improving financial situation. (World Bank 1987) 49 Country Government Resolutdon Approach AMC mechanism used Decentralized Mechanisms Growth Other Impediments to Corporate Results Restructuring Hungary None Capitalposition of banks Macroeconomic policy in the * The lack of capacity in banks to * Despite the repeated (1991-95) One of the recapitalization * The new strategy taken by the government early 1990s was characterized conduct troubled debt restructuring recapitalization, some attempts to programs intended to transfer that came into power in 1995 was a by a stalled fiscal reform and a and the lack of strategic skills improve the accounting and legal NPLs to a central entity but decentralized approach to debt restructuring. relaxed rmonetary policy. Real among enterprise managers framework (including out-of-court the latter never became Its reliance on eamest bank privatization interest rates were negative in discouraged them from conciliation), corporate operational. eventually led to the strengthening of the 1992-93. However, with a participating in the earlier restructuring was limited. In about banks' capital base. Its success contrasts newly elected government in conciliation scheme. two-thirds of the cases that entered with the failure of prior public 1995, a reform program was * The repeated government financed into the conciliation program, the recapitalization programs. launched and included bailouts of 1991-93 without a bank creditors and debtors failed to reach structural measures, a strong incentive and regulatory framework agreement. Most claims were sold Accountingframework fiscal adjustment and sterilized resulted in further inmprudent risk through public tender to factoring Banking Act of Dec 1991 introduced loan monetary interventions. taking and adverse selection in the companies. classification and provisioning rules in line corporate and fuancial sectors. The 1995 pmgram that emphasized with BIS standards. But the responsibilities bank privatmzation and of supervision were split between two comprehensive regulatory and agencies and weakened its function. The incentwve framework proved to be 1995 program included a comprehensive more effective in upgrading capital reform of regulations and bank supervision bases and encouraging powers. restructuring. The quality of bank Legalframework assets improved with the share of * A tough bankruptcy law took effect in Jan loss and doubtful loans in the total 1992 and later amended in 1993. While the banking system's loan portfolio law led to a substantial number of filings for declined steadily from 25% in 1993 bankruptcy and liquidation, such cases wem to 3% by the late 1990s. subject to long delays in processing and adjudication. The 1993 bankruptcy aamendment aimed to remedy certain deficiencies also partly led to the decline in the number of filings. The 1995 pTogram improved the efficiency of insolvency proceedings. * 1992 and 1993 recapitalization pmgrams envisaged a transparent out-of-court debt conciliation procedure in the face of overburdened courts and liquidators. The 1992 program was thwarted by: (i) the absence of rules on how to settle state claims; (ii) lack of clarity if debt-equity swaps were legal or illegal. The 1993 program became mired in persistent interventions by competing govemment ministries and moral hazard concerns that contibuted to its termination. Ownership structure * Towards the end of the 1990s, the largest conunmercial banks had been privatized in addition to other banks, largely to foreign investors. 50 Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other Impediments to Corporate Results Restructuring Japan Yes. Authorities set up three Accountingframework The government put in place * With prospects for loan recovery * The authorities' strategy for (1991 - entities. * Until 1998, the loan classification and loan repeated fiscal stimulus limited, banks had little incentive to banking sector recovery was ongoing) Cooperative Credit Purchase loss provisioning framework clearly favored packages that boosted the liquidate questionable parts of their predicated on a resumpbon of Company Was set up in the hiding of losses rather than the budget deficit from 70 percent portfolios, as the cost of carrying growth that would restore banks 1993 as a mechanism for recognition of losses. Moreover, banks of GDP to 120 percent and a bad loans was insignificant due to and borrowers to financial strength banks to transfer loans at a heavily used a mechanism of shifting their loose monetary policy with low interest rates, and potential for * Yet, despite large and repeated discount, thus satisfying losses off-balance by creating related ovemight rates at zero percent upswing in value of asset is greater fiscal stimulus packages and loose requirements in the tax law companies which were neither subsidiaries which reduced the cost to than that of a further loss. monetary policy, sustained growth while avoiding the nor affiliates and to which they non- banks of carrying NPLs * Multiple liens attached to most real has not occurred. bankruptcy of debtors (loan performing loans at above market value. tremiendously and thus also estate used as collateral proved * Only recently did the authorities loss provisions are reduced banks' incentives to difficult to rank, consolidate and take a more aggressive approach to automatically tax deductible Legalfrumework restnucture the loans. cleir. strengthening the framework for only when they follow * Japan's present bankruptcy law is * In order for the government to decentralized restructuring by foreclosure of collateral or cumbesonme and emphasizes protectton of force banks to restructure balance strengthening the balance sheets of sale of loan at a loss). Loan . creditor rights through liquidation and a lack sheets (dispose of the loans), the banks with public money, moving amount transferred Yen 15 of other mechanisms that enable debtors to construction industry would have toward consolidated accounting trillion. engage creditors in negotiations. While a had to mark its assets to market as and increasing supervisory pressure Housing Loans variety of mechanism exist for coUrt- tax regulations do not favor banks' on banks to recognize problem Administration Corporation, supervised reorganization, these have not unilateral actions. In the process, loans. Created in 1996 to resolve proved to be effective tools for corporate niany firmns in the construction and * While these measures have led to within a 10 year period the rehabilitation which may have contributed to property related industry would an acceleration of corporate loans of the 7 housing unnecessary liquidations. Moreover, the legal likely have been declared insolvent restructuring in 1999, much still companies that were closed in infrastructure in Japan is not suited for with adverse implications on remained to be done. 1995. dealing with recovery and debt restsuctunng employment The Resolution and in an expeditious fashion. Foreclosure and * Corporate restructuring has faced Collection Bank Was created bankruptcy procedures are cumbersonme and significant institutional in 1995 to deal with the assets can be time consuming. Moreover, all loans ignedifents such as the high cost of failed credit cooperatives are extended on a full recourse basis, to fisms of reducing and had received loans of face implying that foreclosure of one loan would untrmsploynent Court n lingg in the value of Y 1.5 trillion in the threaten the whole comnpany. late 1 970s made dismissals first half of 1998. * Compounding the legal ftamework issues is cumnbersomTe which led firms to All three agencies have been the fact that the capacity of bankruptcy courtS offer voluntry early retirement very slow in selling the in Japan is limited as there are only two programs. In 1999, the authorities assets. bankruptcy courts, nxoved to introduce measures to * Before the crisis, the lack of effective formal facilitate labor mobility and the procedures might not have caused a major serpping of excess capaciry. problem because banks were not financially constrained and thus could initiate work-outs. * In 1999, the govemment presented legislation to Parliament attempting to facilitate the formal corporate restructuring framework. Ownership strciure: * Limited changes in ownership structure have taken place and the complex web of relationships between bank shareholders and main customrns reduced the incentives for banks to address bad debt problem. 51 Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other Inpediments to Corporate Results Restructuring Norway None CapUalposition of bns An expansionary fiscal policy With a proper bankruptcy framework, (1987 -93) * Public recapitalization accompanied by the and considerable tax relief strengthened accounting regulations, the requireffent for banks to improve operating (associated with the tax absence of ownership links between profits and reduce risk-weighted asses reform) prevailed in 1992. The banks and debtors and recapitalized improved the capacity of the banking system floating of the Norwegian banks, the decentralized approach proved to sustain losses. currency in late 1992 led to a successful as banks and fitms began to monetary and exchange policy tum around in the last year of the ctisis. Accountingframework aimed at the maintenance of * With increased competition after the the exchange rate against deregulation, baiks increased lending in the European currencies at the 1980s in real estate and stocks thereby 1993 level. Money growth increasing their exposure to *noveoents in slowed thereafter. asset prices. * Before 1987, there were no specific regulations on loss provisions. Regulations were issued only in 1987 which led to an increase in provisions. In 1990, bank supervision was strengthened. Legalframework * Banks could file for bankauptcy of firms at any time during the crisis. Ownership structure * Public injection of capital resulted in the transfer of the three largest private banks into state hands. 52 Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other tmpedimensts to Corporate Results Restructuring Poland None Capital position ofbanks The period was characterized * Lack of developed secondary * As of March 1994, the banks (1992 - 95) * Public recapitalization strengthened the by pnudent macroecononmic markets and problems with tax completed debt conciliation capital base of the commercial banks that policies allowing for a gradual treatment initially discouragcd debt procedures with respect to debtors participated in the restructuring progran. declines in inflation. The sales and swaps. whose debts amounted to 83% of Two state-owned specialized banks remained authorities exercised sorme * Tax deductibility for loan write- classified loans. 25% of the total problem ridden, including weak capital flexibility with interest rates, offs and associated corporate tax enterprises that entered into bank positions. In 1996, enforcement of though they were niaintained at changes was not adopted until conciliations went into bankruptcy accounting standards were viewed to lead to positive real levels,. 1994. or liquidation. The rest regained some other banks to be out of compliance creditworthiness or their debts were with questionable capacity to absorb losses. auctioned off by banks or their collateral seized" " Banking Accountingframework system NPLs fell from 28% of total * Interest due but not received was made not loans in 1992 to 10% in 1997. so taxable in 1992. Bank regulations were The ovcrall cvidence on operatonal tightened just before the introduction of the restructuring by enterprises in restructuring program. Troubled debt Poland during the period covered restructuring rules were adopted during the by the restructuring program and restructuring period. Despite upgraded thereafter points to a notably banking regulations in 1992-93, problems sluggish pace. However, a World remained in the quality and application of Bank survey of some 1000 Polish adequate accounting standards for some firnms between 1992 and 1995 banks that were not included in the alludes to evidence that sorne restructuring program. restructuring has taken place as 80% of those enterprises showed Legalframework irmprovements in their degree of * Govemment allowed enterprises to enter into profitability or loss-making. out-of-court Chapter II typc procedure, called conciliatory agreements led by the banks. If a bank participating in the restructuring program failed to reach agreement with a nonviable debtor, the bank was required to file for bankruptcy or sell the bad loans. Ownership structure v Privatization of the banking system was slow with over WI./o of the banking system still in state hands in 1996. 53 Country Government Resolution Approach AMC mechanism used Decentralized Mechanisms Growth Other Impediments to Corporate Results Restrucuring Thailand Only used for liquidation of Capital position of banks After a brief initial period of Despite the govemrnments efforts to (1997 - assets of closed finance * Despite public and private injection of capital tight fiscal and monetary strengthen the decentralized mechanisms ongoing) companies that accounted for in banks, banks remained capital constrained policy, the government for corporate restructuring, meaningful 2% of assets. and would have been at least severely implemented fiscal stimulus progress on the corporate restructuring undercapitalized if they had acknowledged programs and lowered interest side remains limited. As of 2000, not loan losses properly and thus continued to rates to historical low levels. surprisingly, banks restructured mostly lack the loss absorption capacity to enpge in those assets that were "easy to any meaningful restructuring. restructure", i. e. where financially sustainable structures could be achieved Accounllngfraznework by srbetching maturities or lowering of * While loan classification and loan loss interest rates. According to analysis of provisioning strengthened; framework still companies' balance sheets, the not in line with international best practice restructuring of these NPLs largely and still favors hiding of losses. required haircuts, debi to equity swaps Lep] fiwmwork ~~~~~~~~~~~~~~~~~~~~~~~~~~~and liquidation. Yet, banks continued to Legal fbameworck be capital constrained and lacked the * Reform of bankruptcy law but creditors still tools to force debtors to the negotiating lacked tools to force foreclosure and table. After almost three years, armunt liquidation and judicial capacity renained of NPLs still stood at 38 percent. In limited. The formal bankruptcy regime was 2002, system wide NPLs amounted to complemented with out of court framework one-third of total loans. but it has limited sticks and carrots. Ownership strixtures * While concentation of family ownership declined sonewhat during crisis, it continues to be an impediment Policy Research Working Paper Series Contact Title Author Date for paper WPS2881 Returns to Investment in Education: George Psacharopoulos September 2002 N. Vergara A Further Update Harry Anthony Patrinos 30432 WPS2882 Politically Optimal Tariffs: Dorsati Madani September 2002 P. Flewitt An Application to Egypt Marcelo Olarreaga 32724 WPS2883 Assessing the Distributional Impact B. Essama-Nssah September 2002 0. Kootzemew of Public Policy 35075 WPS2884 Privatization and Labor Force Alberto Chong September 2002 H. 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