POLICY RESEARCH WORKING PAPER           2843
A Practical Guide to Managing Sy-stemic
Financial Crises
A Review of Approaches Taken in Indonesia,
the Republic of Korea, and Thailancd
David Scott
The World Bank                                   E
East Asia and Pacific Region                       E
Financial Sector Group
May 2002



POLICY RESEARCH WORKING PAPER 2843
Abstract
Scott examines experiences in Indonesia, the Republic of      recapitalization, restructuring of banks, privatization of
Korea, and Thailand in confronting systemic financial         banks, restructuring of troubled debt, and use of asset
crises during the 1990s. He draws on the knowledge and        management companies. He goes on to develop the
experience of World Bank staff who managed the Bank's         conceptual underpinnings for two fundamental
financial and technical assistance to those countries. In    improvements in crisis management practices, one to
reviewing the principal actions taken by the governments      develop an explicit, comprehensive crisis resolution
to resolve the crises, the author describes key challenges    strategy, and the second to link the provision of support
that governments face in tackling crises, defines basic      to banks explicitly to the actual outcomes of troubled
guidelines and principles for responding to those             debt restructuring. A common theme in both is to
challenges, and proposes steps to improve the ability of      maximize the impact of public funds used in crisis
governments to deal with crises when they do occur, as        resolution. Finally the author identifies steps that
well as to mitigate the risk of crises in the first place.    governments can take to mitigate the risk of crisis and be
Scott addresses matters such as the provision of liquidity,   better prepared to deal with shocks should they occur,
institutional arrangements for crisis resolution, use of      including the use of contingency planning in the context
public funds, diagnosis of problems, resolution,              of liquidity management and intervention in weak banks.
This paper-a product of the Financial Sector Group, East Asia and Pacific Region-is part of a larger effort in the region
to disseminate lessons learned during the Asian crises. Copies of the paper are available free from the World Bank, 1818
H Street NW, Washington, DC 20433. Please contact Lynn Yeargin, room MC8-158, telephone 202-458-1553, fax 202-
522-3094, email address lyeargin@worldbanlc.org. Policy Research Working Papers are also posted on the Web at http:/
/econ.worldbank.org. The author may be contacted at dscott@worldbank.org. May 2002. (96 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
development sssues. An objective ofthe series is to get the findings oUt quickly, even if the presentations are less than tully polished. The
papers carry the miames 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 vieio of the World Bank, its Executive Directors, or the
countries they represent.
Produced by the Research Advisory Staff



A PRACTICAIL GUIDE TO MANAGING SYSTEMIC
FINANCIAL CRISES:
A REVIEW OF APPROACHES TAKEN IN INDONESIA,
THE REPUBLIC OF KOREA, AND THAILAND
David Scott
BFR



Acknowledgements
The author is grateful for substantial contributions to this paper by Ruth Neyens
(Indonesia), Tom Rose (Thailand), and Margery Waxman and for the contributions of
Emesto Aguirre, Gerard Caprio, Oliver Fratzscher, Sameer Goyal, James Hanson,
Patrick Hononan, Daniela Klingebeil, William Mako, Jo Ann Paulson and Rick Zechtei



Contents
Executive Summary ..........................................................................1
PART 1. RESOLVING THE ASIAN FINANCIAL CRISES .................................................................... . 7
CHAPTER 1. STABILIZING LIQUIDITY ..........................................................................8
CHAPTER 2. MAKING INSTITUTIONAL ARRANGEMENTS ................................................ 16
CHAPTER 3. MOBILIZING PUBLIC FUNDS ...................................................................... 24
CHAPTER 4. DIAGNOSING THE SCOPE OF FINANCIAL PROBLEMS ................................... 30
CHAPTER 5. RESOLVING, RECAPITALIZING, AND RESTRUCTURING BANKS ................... 35
CHAPTER 6. PRIVA1'IZING BANKS .........................................................................   51
CHAPTER 7. RESTRUJCTURING TROUBLED DEBT ............................................................ 56
CHAPTER 8. UITILIZING GOVERNMENT ASSET MANAGEMENT COMPANIES .................. 67
PART 2. IMPROVING THE EFFICIENCY OF CRISIS RESOLUTION .................................................... 77
CHAPTER 9. DEVELOPING A COMPREHENSIVE STRATEGY ............................................. 77
CHAPTER 10. LINKING BANK AND CORPORATE DEBT RESTRUCTURING            .   .   81
PART 3. PREPARING TO MITIGATE THE RISK OF CRISIS ............................................................... 87
CHAPTER 1 1. BANK LIQUIDITY MANAGEMENT ............................................................. 88
CHAPTER 12. RESOLVING WEAK BANKS ....................................................................... 89
References ......................................................................... .  94






EXECUTIVE SUMMARY
This paper examines ithe experiences of three Asian countries-Korea, Thailand, and
Indonesia-whose governments confronted systemic financial crises during the 1990s and
received substantial financial and technical assistance from the World Bank, International
Monetary Fund and others to support their efforts. It draws on the knowledge and experience of
the World Bank staff who managed the financial sector assistance programs in those countries as
well as others who participated in those efforts.
As in many other regions, the financial crisis in Asia menaced not only the financial
systems of countries but also the health of economies and the savings and well-being of citizens.
The crisis served both to reveal preexisting problems and to create new ones. In retrospect, it is
clear that many debtors were overextended prior to the crisis. The twin shocks of exchange rate
devaluations and interest rate spikes raised the real value of debts and debt service requirements
for many debtors. Many debtors were unable to service fully this increased debt burden,
especially in the face of economic contraction. Banks and other financial institutions suffered a
similar fate and were left economically insolvent.' The value of their assets was insufficient to
cover their liabilities to depositors and other creditors.
The paper describes the key challenges facing governments in tackling crises, defines
basic guidelines and principles for responding to key challenges, and proposes steps to improve
outcomes, mitigate the risk of crises, and promote the ability of governments to deal with crises
when they do occur. The focus is on the banking system, although many of the findings are
relevant to the financial system more generally.
Part 1. Resolving the Asian Financial Crises
Part 1 reviews the principal actions taken by governments in Korea, Thailand, and
Indonesia to resolve the crises in their countries. It briefly assesses those experiences and suggests
1. To limit repetition, this paper a:voids making repeated reference to "banks and other financial institutions" and
instead refers simply to "banks." MAany of the references to banks are applicable to other types of financial
institutions.



2
guidelines and principles that either were important to the governments' accomplishments or
might have produced better outcomes had they been adopted. Eight chapters cover the issues of
liquidity, institutional arrangements, use of public funds, diagnosis of the problem, resolution,
recapitalization, and restructuring of banks, privatization of banks, restructuring of troubled debt,
and use of asset management companies.
The first issue addressed is liquidity because sporadic or widespread runs on banks are
often precipitating events in a crisis.2 The central bank is the first line of defense against runs on
banks and may provide liquidity to the system overall or to specific banks. When the central
bank's finances come under pressure or it is no longer able or willing to support banks, the
government is forced to step in. Governments in Indonesia, Korea, and Thailand employed four
principal mechanisms for stabilizing liquidity: government guarantee of bank liabilities,
suspension of banks, nationalization of banks, and temporary capital controls. The paper observes
that in certain crisis situations broad bank liability guarantees may be unavoidable, but they
should be designed carefully to limit their potential negative consequences. Nationalization of
banks similarly may be necessary and can be effective in stemming runs. In contrast, the mere
suspension of banks experiencing runs can contribute to uncertainty and exacerbate liquidity
pressures on other banks.
Concurrent with taking urgent steps to stabilize liquidity, governments need to lay
foundations for managing the crisis, a task that may involve years of work. The challenge facing
governments is significantly managerial in nature, and steps can be taken to ensure that
appropriate institutional arrangements are in place for competent crisis management. It is
important to strike a balance between the political and technical work of crisis resolution,
including the delegation of authority and responsibility to technical experts. This balance can be
achieved by forming a special-purpose crisis management team with adequate skill, experience,
capacity, and funding.
2 The paper returns to the issue of liquidity in Part 3 in the context of steps that can be taken to mitigate the potential
for liquidity shocks to precipitate crises.



3
In a crisis, government likely will seek to salvage the financial system and to protect some
or many depositors. The central bank and the deposit protection entity (where it exists) may not
have sufficient resources to absorb the costs of doing so and the government likely will have to
arrange a (substantial) financing package. Public funds may be required to finance the repayment
or transfer of deposits of failed banks, the purchase of assets from banks, the purchase of bank
equity capital, and the fulfillment of commitments under guarantees granted in the course of
supporting and reprivatizing banks. Public funds also will be required to finance the operations of
the crisis management team, particularly the cost of skilled staff, advisors, and other contracted
professionals. Government should ensure that the initial financing package is of sufficient size to
be credible to the markets while maintaining the flexibility to provide additional financing should
it be required.
An early task of the crisis management team is to assess the scope of problems facing
individual banks and the financial system overall. An accurate diagnosis is necessary to determine
appropriate mechanisms for resolving distressed banks, to determine the amount of support
required by banks that are salvaged, and to estimate the aggregate financing needed to resolve the
crisis. Lessons of experience in this regard are that existing accounting and regulatory information
is substantially misleading and that the crisis management team will have to devote substantial
time to developing and analyzing a substantial amount of information necessary to support sound
decisions.
To a large extent, the actions discussed to this point are geared toward laying a solid
foundation for the resolution, recapitalization, and restructuring of banks. Systemic crises may
well have left banks so insolvent that they cannot earn a profit and therefore have no means to
internally rebuild capital. Governments must act to solve this problem in order to stem the growth
of losses. Alternative means are available for resolving deeply insolvent banks when existing
shareholders do not supply sufficient new capital, including liquidation, assisted acquisition, and
nationalization. Resolving bandks by means of assisted acquisition or nationalization entails
recapitalization and restructuring. The principal goal of recapitalization is to restore banks' cash-
based profitability, and the principal goal of restructuring is to enhance banks' potential to
achieve sustainable cash-based profitability. Under certain conditions forbearance from official
resolution action might be appropriate, but forbearance gives rise to risks that must be controlled.



4
The paper suggests that the investment of public funds by the three governments in resolving
banks could have been better leveraged to attract private sector capital into banks.
In tackling a crisis, the government may acquire ownership interests in banks in exchange
for equity capital support. A key task for the crisis management team is to develop a privatization
plan with the goal of returning governance and ownership of the banks to the private sector as
quickly as possible. In the countries examined, unrealistic expectations regarding the value of
banks and unwillingness to accept foreign investment in large banks proved to be formidable
impediments to privatization.
One of the key challenges in bank resolution and privatization is to restructure the
troubled debt held by banks. Policies, procedures, and skills that ensure prompt recognition of
troubled debts and maximize collection are key to restoring and sustaining bank profitability and
solvency. Despite considerable debate regarding the soundness of the strategies employed by the
three governments, the paper suggests that these governments could have done more to avoid
cosmetic restructuring and ensure that genuine debt restructuring took place, in part by taking a
more proactive role in debt restructuring when the government was a significant shareholder in
the bank.
In the context of a systemic crisis, asset management companies are potentially an
important tool for reducing the cost to government of crisis resolution. Asset management
companies can be used to maximize the value of banks and bank assets and to accelerate the
process of bank recapitalization, restructuring, and privatization. The three governments proved
largely ineffective in achieving these objectives because of political interference, lack of a clear
mandate and defined goals, and weak institutional capacity including limited private sector
involvement.
Part 2. Improving the Efficiency of Crisis Resolution
Part 2 develops the conceptual underpinnings for two fundamental improvements in crisis
management practices. One measure is to develop an explicit, comprehensive crisis resolution
strategy. The other is to link the provision of support to banks explicitly with the actual outcomes
of troubled debt restructuring. A common theme is to maximize the impact of public funds used



5
in crisis resolution.
Explicitly defining a comprehensive strategy is essential because it enables the crisis
management team to integrate the components of its work and to think through the strategic
elements before taking significant actions in any one area. Acting without an overall strategy
leads to mistakes and limits the options available in the future. The principal elements of a
comprehensive strategy are a long-term vision, concrete goals, clear operating principles, and a
realistic assessment of the problem. Obtaining political consensus on these elements is essential.
The second improvement is to link the provision of financial support to banks with the
outcome of corporate debt restructuring. Government financial support is a tool for promoting
constructive debt restructuring and for controlling the costs to government. It should have two
goals. The first is to remove the incentives that bankers and debtors have either to delay
restructuring or to engage in cosmetic restructuring and to create incentives for both parties to
engage in constructive debt restructuring. The second is to ensure the prudent use of the financial
support that government will provide and better control the potential moral hazard inherent in
providing that support. This can be accomplished by (a) making the financial support to banks
contingent on bankers' perfoimance in restructuring debts and achieving specific outcomes and
by (b) having the crisis management team monitor and ratify debt restructuring decisions made by
the managers of banks receiving public support. Political consensus is key. If the political will
exists, the challenge will be to assemble a crisis management team with the capacity to design,
organize, and implement the approach.
Part 3. Mitigating the Risk of Crisis
Part 3 draws on the e)iperiences in the three countries and elsewhere to identify steps that
government can take to mitigate the risk of crisis and be better prepared to deal with shocks
should they occur. Undertaking formal contingency planning before a shock occurs will help the
authorities and banks to identify the types of actions that may have to be taken in such a situation
as well as the skills, policies, and processes required to support those actions. This part discusses
contingency planning in the context of liquidity management and intervention in weak banks.
One key to mitigating the risk of crisis is to ensure that banks have the capacity to deal



6
with liquidity shocks. To promote bankers' ability to weather shocks, supervisors can ensure that
bankers have in place adequate risk management regimes and engage in contingency planning for
the eventuality of a sudden and significant unexpected shock. Supervisors also can prepare
themselves to closely monitor banks that experience liquidity shocks or problems. It is important
for the relevant authorities (supervisory authorities, the central bank, and the deposit protection
agency) to be prepared to play their respective roles in resolving a bank experiencing prolonged
liquidity problems. The central bank should not be forced to provide liquidity to a bank due to the
authorities' inability to implement a resolution mechanism.
Another key is to strengthen the legal, regulatory, and supervisory regimes to promote the
prompt resolution or exit of weak banks, including giving advance consideration to forbearance
policies. Not having in place policies for explicit forbearance in the event of a shock may lead
supervisors to grant implicit forbearance, which can lead to further systemic deterioration and
crisis. Government also can ensure that bank resolution mechanisms operate as intended by
employing both post-mortem exercises subsequent to bank failures and formal contingency
planning exercises. Engaging in contingency planning tests the authorities' likely response to a
sudden shock and identifies policy and operational weaknesses before they are exposed in
practice.



7
PART 1. RESO]LVING THE ASIAN FINANCIAL CRISES
At the core of resolving a financial crisis is solving the financial problems of banks and
their major debtors, specifically illiquidity and insolvency. In general, the challenge for
governments is to restore the performance and stability of core elements of the banking system, to
get the economy quickly back on track, and to minimize the long-run fiscal costs of doing so.
Governments in Indonesia, Korea, and Thailand issued extensive guarantees of financial
institution liabilities, both on and off balance sheet, either early on (Thailand, Korea) or in
response to continued panic amnong depositors and others (Indonesia). These decisions had
important implications for the nature of the task that governments faced in resolving the crises
and constrained the use of possible policy options. Specifically, the guarantees limited the ability
of governments to allocate losses to bank claim holders and set the governments on a course
either to provide substantial support to banks, in the case of Korea, or to grant forbearance to
existing owners, in the case ol Thailand. In examining the approaches taken by the three
governments, this paper takes as its starting point this particular context; it does not examine the
potential consequences and implications of a hypothetical decision not to afford broad protection
to financial institution claim holders.3
Part 1 reviews and assesses the principal actions taken by governments in Korea,
Thailand, and Indonesia to resolve the crises in their countries. It draws on those and other
experiences to suggest basic guidelines and principles that either were important to the
governments' accomplishments or, had they been adopted, might have improved the outcomes.
The chapters in part 1 address subjects in the rough chronological sequence in which they
confront authorities in a crisis Each chapter provides a brief introduction to the topic, describes
and assesses country experiences, and closes with suggested guidelines and principles.
3. Note that some researchers have iound that granting extensive guarantees contributes to higher resolution costs
(Honohan and Klingebiel 2000).



8
CHAPTER 1. STABILIZING LIQUIDITY
Financial crises typically are triggered by runs on banks and a flight of funds from the
financial system as a whole and from the country. Runs on banks usually involve the withdrawal
of domestic deposits and cuts in domestic interbank and international funding lines. Runs also can
involve the withdrawal of funds that are placed in off-balance-sheet instruments known as trust
accounts, money desks, mutual funds, and the like, but that have deposit-like characteristics in
that the bank is legally or feels morally liable for maintaining the value of the claim. In effect,
these deposit substitutes often are used to circumvent regulations (reserve requirements, for
example), but the public makes little distinction between them and deposits.
Additional pressure on bank liquidity arises when borrowers draw down lines of credit,
perhaps anticipating that those funds will not be accessible in the near future, or when holders of
financial assets (such as equity and debt securities) sell those assets and withdraw the proceeds
from domestic banks.
Through the process of contagion, funding pressures can spread from the weakest banks to
the strongest. Foreign banks and state-owned banks typically benefit from the initial stages of this
flight to quality, but if confidence is not restored quickly, even those institutions can come under
liquidity pressure.
Central banks are, of course, the first line of defense in dealing with runs. Among the
international financial institutions, the International Monetary Fund is principally responsible for
advising central banks in fulfilling their role of lender of last resort while simultaneously
maintaining monetary control. This chapter focuses on stabilizing bank liquidity and not on
monetary management as such.
Central banks work to stabilize liquidity by providing liquidity to the system overall or to
specific banks. They use tools such as open market operations, discount window lending, repo
and reverse repo operations, overdraft (unsecured) lending, and reduced reserve requirements to
supply liquidity. When the efforts of the central bank prove insufficient, the government is forced
to step in. The three Asian countries covered in this paper employed four principal mechanisms



9
during the crisis: guarantee of bank liabilities, suspension of banks, nationalization of banks, and
imposition of temporary capital controls.
Country Experience
All three countries issued extensive bank liability guarantees. Korea and Thailand issued
such guarantees quickly after funding pressures emerged in banks, while Indonesia did not do so
until the banking system was near collapse. In Korea, the government guaranteed banks'
international liabilities in August 1997 in response to cuts in international funding lines. In
November 1997, the Korean government fully guaranteed all bank deposits for a period of three
years.4 These measures, along with the adoption of a sound macroeconomic program, helped to
stabilize liquidity.
In Thailand, the guararntee took the form of an August 1997 amendment to the Bank of
Thailand regulation making the Financial Institutions Development Fund responsible for insuring
the repayment of principal and interest to depositors and creditors of financial institutions
experiencing financial problems. The guarantee covered all deposit-taking institutions other than
the 58 finance companies previously suspended (see below).
In contrast with governments in Korea and Thailand, the Indonesian government did not
initially adopt a comprehensive guarantee. Prior to the crisis, Indonesia had no explicit deposit
insurance, yet most deposits were perceived to be covered by an implicit government guarantee.
However, when the government closed 16 nonviable banks in November 1997, it announced that
it would only guarantee repayrnent of small depositors (up to Rp2O million per depositor per
bank). Closing the banks in the absence of a broader deposit guarantee reflected the belief that
market-based solutions are the most efficient approach and the least expensive for taxpayers. In
fact, these closures gave only limited protection to -deposits. Coupled with uncertainty regarding
how the limited guarantee would be honored, political tensions over the state of President
4. In effect, the government fully guaranteed virtually all unsubordinated liabilities of financial intermediaries,
including life insurance conpanies. At that point, the Bank of Korea was providing substantial domestic and foreign
currency liquidity support to banks (and other financial institutions). Foreign currency support was provided by
depositing a substantial portion of th, countries' foreign currency reserves with domestic banks.



10
Suharto's health, uncertainties regarding his impending reelection, and growing fears over the
country's corporate debt and banking sector problems, the closures contributed to the widespread
panic that led to deposit runs on many private banks.
By end-November 1997, Indonesia's private banks had lost some 12 percent of their
rupiah deposits and 20 percent of their foreign currency deposits. Roughly two-thirds of the
country's private banking system (representing half of the entire banking system) experienced
deposit runs. Bank of Indonesia began supplying liquidity in large amounts to keep banks afloat
and protect the integrity of the payments system, but this did not stave off the panic that had set
in. Deposit outflows continued throughout December 1997, financed in large part by Bank of
Indonesia liquidity support. In January 1998, the rupiah fell to an all-time low against the dollar,
and there were stampedes in Jakarta as shoppers rushed to horde food and withdraw cash from the
banks. Demonstrations and protests shook the country, as the effects of economic turmoil filtered
down to the population.
By January 1998, with the economy in free fall and market confidence all but lost, the
risks of moral hazard paled in comparison to the risks associated with not attempting to fashion a
safety net. A presidential decree establishing a more extensive guarantee scheme was
promulgated, but it did not specify which instruments would be covered, under what
circumstances payments would be made, and which agency would implement the guarantee,
among other matters. The decree represented, in effect, a broad government commitment to
guarantee all third-party depositors and creditors. In practice, the government honored the
commitment by providing sufficient liquidity so that all banks (no matter how insolvent) would
be able to meet all claims (whether legitimate or not) in the clearing and settlement system.5
Korea and Thailand suspended specific banks in an effort to stop runs. Suspension meant
that banks were temporarily closed for business, including for deposit withdrawals, pending a
decision on their viability. (See box 1 for a further definition of suspension and other terms used
5. This liquidity support ultimately reached some Rpl44 trillion, of which a subsequent audit deemed approximately
95 percent to have been subject to "abuse." The government and Bank of Indonesia reached a negotiated settlement
that avoided the need to recapitalize the central bank.



in this paper.) In Korea, 14 small merchant banks were suspended in December 1997.6 In
Thailand, 58 finance companies were suspended in the second half of 1997. A number of these
finance companies happened to be subsidiaries of banks.
Box 1: Definition of Failure Resolution Mechanisms
Financial institution insolvency and failure can be dealt with using a number of different
mechanisms. The following te,rms and definitions are used in this paper.
Liquidation is a legal mnechanism under which an insolvent institution is closed, its
license is withdrawn, and its assets are sold or collected over time to meet the claims of
depositors and other creditors. The applicable legal regime may be the general bankruptcy law or
a special regime for financial institutions. The extent of court involvement varies from country to
country. Where deposits are insured, the deposit protection entity pays insured claims in advance
of the sale or collection of the assets.
Assisted acquisition, also known as business transfer (Korea) and purchase and
assumption (United States), is a mechanism under which an insolvent institution's license is
withdrawn, and some of its assets and liabilities are sold to one or more other financial
institution(s). Most commonly, insured deposits are transferred to (assumed by) the other
institution, with payment to that institution made in the form of cash or official debt (for
example, bonds issued by the deposit protection entity and guaranteed by the government),
perhaps along with some of the failing institution's assets (for example, branches). This
resolution mechanism can minimize or eliminate potential disruption of service to depositors.
Depending on the development of the markets and the extent of preplanning by the authorities, it
is possible to arrange the sale of a large portion of a failed bank's assets and liabilities in this
manner.
Nationalization is a mechanism under which the government assumes (temporary)
ownership of an insolvent insititution. The institution's license is not withdrawn, and it remains
open for business. Nationalization can be engaged in under various labels. Nationalized banks
were considered "intervened" in Thailand and "taken over" in Indonesia. The term
"nationalized" was used in Korea.
Conservatorship is a period of temporary government control during which management
may be removed and shareholder rights at least partially and temporarily constrained. It is not a
resolution mechanism, but rather an interim step.
Suspension was used in the three countries covered in this paper. Under suspension, an
institution is closed for business (perhaps with limited exception, for example, for limited deposit
withdrawals), yet its license is not withdrawn pending further analysis of its solvency. In this
6. Of these, 12 eventually lost their License, and their assets and liabilities were transferred to a newly created
governrent-owned bank under assisted acquisition transactions. See chapter 5.



12
sense, suspension is not a resolution mechaniism, but only an interim step. Suspension is the
Asia crisis involved limited numbers of banks. In other countries, suspension has involved all
banks (sometimes referred to as a general bank holiday).
Initially in Korea, and later in Indonesia, the government nationalized banks to help
stabilize liquidity. By early 1998, Korean authorities had completed the nationalization of Korea
First Bank and Seoul Bank, both large, nationwide banks, in response to runs triggered in part by
rumors that the banks were to be closed.7 In Indonesia, the authorities used this technique to deal
with massive outflows of deposits from Bank Central Asia immediately after widespread riots in
May 1998. Thailand nationalized several banks and finance companies in 1998, but not in the
context of efforts to stabilize liquidity. Similarly, Korea nationalized more banks in the fall of
1998 due to their insolvency and not in response to runs.
To help stabilize foreign currency funding, Thailand and Indonesia employed limited,
temporary capital controls. Thailand limited local currency lending to nonresidents offshore,
while Indonesia imposed limits on forward sales of foreign exchange by domestic banks to
nonresidents. In Korea, the government kept the capital account open and alleviated international
funding pressure by reaching agreement with foreign banks in late January 1998 to roll over
short-term debt (Lindgren and others 2000).
At the outset of the crisis, in none of the countries was the deposit insurance entity (in the
case of Korea) or the bank supervision authority in a position either to put banks in liquidation
and immediately begin repaying protected deposits or to effect the prompt transfer of deposits
from a failing bank to a more sound institution under an assisted acquisition transaction. In
Indonesia, for example, closures were hampered by the lack of a legal framework adequate to deal
with bank resolutions. Under the existing regulations, once a bank was closed and its license was
revoked, it was liquidated under the company law. This required the shareholders, not the
supervisor or another authorized government agency, to form the liquidation team and supervise
7. As of the end of 1996, Korea First Bank had 403 domestic and 20 foreign offices. Seoul Bank had 355 domestic
offices and six foreign branches, two foreign agencies, two representative offices, and subsidiaries in Hong Kong and
Luxembourg. Each bank reportedly had more than 5 million customers.



13
the liquidation and deposit repayment process. Absent the necessary legal and procedural tools,
uncertainty persisted and contagion spread.
Assessment
The ability to restore depositor confidence so as to stabilize liquidity rapidly can be an
important milestone in minimizing the damage caused by financial crises. The relatively positive
results in Korea and Thailand stand in contrast to the experiences in Indonesia (and more recently
Ecuador). A key distinguishing characteristic seems to be the relatively early adoption of
extensive bank liability guararntees in Korea and Thailand and the limited credibility of the
guarantee eventually adopted iin Indonesia.
In principle, offering extensive bank liability guarantees should have been avoided, since
they limited governments' flexibility in allocating losses and may well have undermined
incentives for markets to mon:itor banks in the future. In practice, however, given the systemic
nature of the crises and the ensuing loss of confidence, governments may have had few other
options than to offer a broadly based guarantee of many or most bank liabilities.
The guarantees in Korea and Thailand seem to have been effective in stabilizing domestic
currency funding, but they were less effective with respect to foreign currency funding, especially
from foreign sources. The experience of Indonesia (and elsewhere) suggests that the extent to
which such guarantees inspire the confidence of claim holders depends on a number of factors,
including whether the guarantee is codified in law, perceptions regarding the government's
financial capacity to honor the guarantee, the past record of government in meeting its
commitments, as well as the perceived credibility of the government's overall response to the
crisis. Regardless, guarantees may not be effective if there is a loss of confidence in the national
currency.
By issuing a broadly based guarantee of bank liabilities, governments made more concrete
their contingent liability for claims on banks and potentially expanded the scope of that liability.
The mechanisms by which governments met their commitments under the guarantees influenced
their cost. Three mechanisms were used in Asia, two effective and one less so. Putting failed
banks into liquidation and repaying protected deposits or transferring deposits to other banks were



14
effective means. The third mechanism, used in Indonesia, was to provide extensive liquidity
support to help open private banks meet the guarantee. The Indonesian experience suggests that
this mechanism is to be avoided. A related lesson from Indonesia is the potentially high cost of
not having appropriate controls on the use to which liquidity support is put.
Although suspension seemed to be an expedient means for dealing with runs, the
experience in Korea and Thailand suggests that it can exacerbate uncertainty and precipitate more
runs. The case of Thailand also suggests that suspension can encourage willful default by debtors
otherwise able to service their debts. There the suspension of 58 finance companies resulted in a
wave of business failures, as some firms lost access to their deposit accounts and lines of credit.
Depositors in other deposit-taking institutions, including commercial banks, apparently foresaw
the potential suspension of their institution and began withdrawing deposits as a preventive
measure. Similarly, debtors apparently foresaw the loss of access to lines of credit and ceased
repayment of debts so as to conserve working capital, leading to the so-called strategic defaulter
phenomenon. In addition, borrowers of some suspended finance companies who had been
servicing their loans ceased debt repaymnents, an action apparently consistent with the loss of
access to their deposit accounts and reinforced by the failure of suspended finance companies to
8
issue payment notices.
Nationalization proved an effective means for dealing with runs. Of course,
nationalization brought with it a wide range of responsibilities for government, which are covered
in chapter 5.
Finally, Asian governments were slow to address the policy and procedural implications
of ensuring their ability either to pay out deposits in banks put into liquidation or to transfer
protected bank deposits to other banks. Had they performed better in this regard, they might have
been better able to reduce uncertainty and stem runs on banks.
8. These lessons would appear to apply to another means sometimes used by governments (most recently in Ecuador)
to deal with runs: "freezing" deposits in open banks by placing restrictions on deposit withdraws.



15
Guidelines and Principles
Broadly based guarantees should be avoided, where possible, because they increase
government's contingent liability and likely increase moral hazard.9 Where they are employed,
they should be crafted carefully to limit their scope and cost. When issuing a broad guarantee,
government should attempt to exclude certain classes of liability holders (bank shareholders and
subordinated debt holders, for example). They should avoid guaranteeing instruments such as
mutual funds and trust accounts. There also may be considerable scope not to guarantee claim
holders of certain peripheral nonbank institutions.
The three countries tciok several steps to litmit the moral hazard inherent in guarantees. In
all three countries, the expanded liability guarantee was explicitly temporary.'0 In Indonesia and
Thailand, interest rates on protected deposits were capped relative to an established index rate so
as to prevent weak banks from aggressively bidding up their price.
Regardless of the scope of government undertakings to protect depositors or others, their
credibility depends on whethler policies, procedures, and institutional capacity are in place to meet
those undertakings. When funding pressures are brought to bear on banks, government should
move rapidly to evaluate existing arrangements and strengthen them where necessary.
Finally, suspending banks can exacerbate uncertainty. Perhaps the best means to avoid the
need to rely on suspension is for government to have the ability to intervene and rapidly resolve
banks experiencing runs.
In summary, the following guidelines and principles are applicable to stabilizing liquidity:
*      Limit the scope of guarantees.
*      Limit the moral hazard inherent in guarantees.
9. The degree to which government's contingent liability under a guarantee actually materializes will be determnined,
to a perhaps significant extent, by the quality of its crisis management response, which is the general focus of parts 1
and 2 of this paper.
10. This, then, raised the challenge of how to roll-back the guarantee.



16
*     Put in place the means to meet deposit protection commitments promptly.
*     Take steps to avoid the suspension of banks.
CHAPTER 2. MAKING INSTITUTIONAL ARRANGEMENTS
Concurrent with taking urgent steps to stabilize liquidity, the government needs to begin
laying adequate foundations for resolving the many financial and structural problems that the
crisis has created, revealed, or exacerbated. It needs to move quickly to organize an extraordinary,
comprehensive solution to these problems. The challenge is significantly managerial in nature.
For that reason, a key step is to ensure that strong institutional arrangements are in place. Making
institutional arrangements involves striking a balance between the political and the technical work
of crisis resolution. It involves delegating authority and responsibility to technical experts. It
involves ensuring that the necessary technical expertise is mobilized and managed effectively.
Effectiveness in dealing with a financial crisis depends on the response of the top political
authorities. One critical factor is the cohesiveness of the political response. Crises are best
resolved when political differences can be set aside in the interest of restoring confidence in the
near term and efficiently solving serious financial and structural problems over the medium and
longer terms.
Even where a sufficient degree of political cohesiveness can be achieved, the top political
authorities will feel threatened by the crisis and will have to respond to pressures from any
number of vested interests. For this reason, they likely will seek to oversee and influence the
government's response and to be seen as in control of the situation. However, to be most
effective, the government's response needs to be seen as objective, fair, and free from
inappropriate political inference. The institutional arrangements should be designed to balance
these needs.
Effectiveness in dealing with a financial crisis also depends on the technical capacity and
competence of the individuals responsible for carrying out the wide range of specialized tasks
involved in crisis resolution. These tasks are discussed in detail throughout this report.
Summarizing briefly, they include gathering, verifying, and analyzing information; preparing
financial projections; formulating and evaluating options for the investment of public funds;



17
making investment decisions (granting or denying public support to banks, for example); defining
specific terms and conditions for support; negotiating contracts; designing reporting requirements
and systems; monitoring performance against contract terms and other benchmarks; and enforcing
contracts. These tasks likely will have to be performed over a period of time measured in years.
The institutional arrangements will have to provide the managerial and organizational capacity
necessary to carry out this work professionally.
In each country, pract:ical means need to be found to accommodate politicians' need to
provide leadership in a crisis and to feel comfortable in their ability to oversee government's
response, while at the same time ensuring that the work is done expeditiously, professionally,
consistently, sustainably, and in a fair and objective manner. This paper elaborates one means that
may have broad applicability: specifically, explicit delegation of the work of crisis management
to a technically competent government team, a crisis management team, where the ongoing role
of the political leadership is to oversee the work of the team."1 Clearly delegating responsibility to
a crisis management team has, several key advantages. It publicly identifies the locus of
responsibility for dealing withl the crisis. It consolidates decisionmaking and promotes the
government's ability to speah; with one voice, two objectives that can be critical to the
effectiveness of government's response.
To provide for oversight, the crisis management team would best report to some form of
governing body. This governing body might consist of representatives of senior political interests
and perhaps the private sector. The governance arrangements should be designed so that the crisis
management team is seen as operating largely independently of inappropriate political
interference. It should operate transparently, reporting publicly on the results of its analyses, on its
decisions, and on its actions, to the extent practical. The combination of reporting to the
governing body and to the public would allow interested politicians, affected parties, the public at
large, and the domestic and international media to judge the performance of the team; over time it
would contribute to restoring confidence and building public support for resolution actions. It also
would allow politicians to deflect some or much of the potential criticism and lobbying that
11 This section is based on advice provided by the World Bank to the Korean govermnent at the outset of the crisis.



18
otherwise would be directed at them. To a significant extent, the heat could be shifted to the crisis
management team.
The crisis management team could be conformed around one or more of the permanent
official agencies of government. This likely would involve temporarily streamlined operating and
decision-making procedures. In some instances conforming the team around existing agencies
may not prove satisfactory due to institutional weaknesses, rivalries among agencies, or
conflicting responsibilities that cannot be overcome practically. In those cases the crisis
management team might be conformed as a specific-purpose, temporary entity outside these
agencies. This structure could serve to overcome institutional weaknesses and rivalries and better
insulate crisis resolution activities from other responsibilities and potential conflicts of interest.12
Country Experiences
The three countries covered in this paper employed various institutional arrangements for
resolving the crisis. In Korea, the govemment assigned responsibility for crisis resolution,
including both the financial and corporate sectors, to the Financial Supervisory Commission
(FSC), the body created in April 1998 to oversee the planned Financial Supervisory Service
(FSS), which was to be launched in early 1999 to integrate all functions of financial sector
supervision. The government designated a high-ranking and capable manager, who later became
finance minister, to chair the FSC and serve simultaneously as governor of the FSS. A cabinet
committee chaired by the president of the republic, including the FSC chairman, provided
oversight of and direction to the FSC in its financial and corporate restructuring activities.
While the Korean Deposit Insurance Corporation (KDIC) continued to report to the
Ministry of Finance and the Economy, the FSC chairman became a member of the KDIC board.
The Korean Asset Management Corporation (KAMCO) reported directly to the FSC. As is
discussed in more detail in chapter 4, KDIC and KAMCO were the principal vehicles for
financing crisis resolution. The FSC determined the use of public funds in consultation principally
with the Ministry of Finance and the Economy. The FSC also coordinated the activities of
12 For an in-depth case study of the challenges in orchestrating the political and technical work of crisis resolution
see De Krivoy (2000).



19
Hanaerum Bank, a so-called "bridge bank" temporarily established by the government to acquire
and liquidate the assets and liabilities of insolvent merchant banks.
In Thailand, the central bank was assigned primary responsibility for crisis resolution. The
Bank of Thailand's Financial Institutions Development Fund provided financial and managerial
assistance to banks facing difficulties. At the same time, the minister of finance played a key
decisionmaking role, in particular with respect to the use of public funds. In addition, the
government established by emrrergency decree the Financial Sector Restructuring Authority (FRA)
as an independent state agency to oversee the rehabilitation or liquidation of the 58 finance
companies suspended in 1997 and the Thai Asset Management Corporation as the buyer of last
resort for the lowest-quality assets that did not receive reasonable bids in the FRA auctions. In
mid-1998, the Corporate Debt Restructuring Advisory Committee (CDRAC) was established
within the Bank of Thailand to enable viable debtors to continue business operations and promote
fair and equitable debt repaynient to creditors.
In Indonesia, a presidential decree in January 1998 established the Indonesian Bank
Restructuring Agency (IBRA'j to be responsible for crisis resolution, including the financial and
corporate sectors. IBRA's mandate was defined broadly to include supervision and restructuring
of the most illiquid and insolvent banks (including determining the best means for resolving
unsound banks), assumption of the claims deriving from Bank of Indonesia's extensive
emergency liquidity support to banks, administration of depositor and creditor guarantees,
management and sale of assets (including loans) acquired in the course of bank resolution, and the
privatization of banks acquired in the process.
Assessment
While the relatively strong performance of Korea in dealing with the crisis attests to the
soundness of the institutional arrangements put in place, as a crisis management team Korea's
Financial Supervisory Commission suffered certain weaknesses. One apparent weakness was that
coordination between the FSC and the Ministry of Finance and the Economy was not publicly
perceived as seamless, suggesting failure to create a truly integrated crisis management



20
structure.13 This inherent structural weakness had a cost, as the government was unable to act
decisively and to speak with a single voice.14 When some of these differences became public
knowledge, they set back the government's efforts to restore domestic and international
confidence and contributed to uncertainty.
A second and less ambiguous weakness was that Korea's FSC also was responsible for
financial sector supervision. The dual roles of crisis resolution and financial sector supervision
can give rise to serious conflicts of interest.15 The conflicts relate both to the supervisor's prior
involvement in permitting the financial system to fall into crisis (and thus its incentives to
underestimate or at least underreport the scope of distress) and its responsibility for effectively
supervising the system going forward.'6
The third weakness with Korea's FSC was the manner in which it was financed. The
FSC's limited budget precluded its ability to attract to the crisis management team some of the
top talent in the country, including private sector experts such as corporate financiers and lawyers.
Rather, it had to rely mainly on seconded public sector employees.
In Thailand, similar weaknesses existed. First, although the Financial Institutions
Development Fund played a major role in the resolution process, the Thai minister of finance
himself also was a key decisionmaker. Although it was essential to have the minister involved, his
13. To some extent, potential conflicts between FSC and the Ministry of Finance and the Economy were mitigated by
the nature of the FSC's staffing, which included a substantial number of the ministry's secondees.
14. One notable example is the privatization of Korea First Bank and Seoul Bank, where the Ministry of Finance and
the Economy may have hampered efforts to sell the banks by claiming, in effect, that they were worth more than
buyers were willing to pay. Its position may have reflected, at least in part, a conflict of interest arising from its
earlier role in nationalizing and recapitalizing the banks and its claim at that time that the banks had been restored to
health.
15. This was evident in the Mexican crisis of 1994-95.
16. In Korea, several factors mitigated against the potential damage that these conflicts can cause. One was the
internal separation of responsibilities and personnel between the crisis management unit and the supervisory function.
A second factor was the fact that the FSC was created during the crisis and its leader came from outside the existing
supervisory agencies. As such, the FSC was somewhat insulated from the past actions of the Bank of Korea and the
Ministry of Finance and the Economy in supervising the financial system. It could assert that it was not acting under
any pressure or incentive to cover up past mistakes. Nonetheless, its role as crisis manager will undermine its ability
to supervise the system to the extent that banks are not fully restored to health.



21
involvement did not necessarily facilitate or accelerate the decisionmaking process, given his
need to attend to numerous other priorities. His direct involvement, with only limited delegation
of authority, may have slowed the process. Second, communication and coordination
impediments between and wilhin the Bank of Thailand and the Minister of Finance delayed the
implementation of crisis resolution measures. Third, having a single institution responsible for
resolving finance companies instead of two (the Financial Sector Restructuring Authority and the
Asset Management Corporation) may have resulted in more value being realized in the
disposition of their assets, since under Thailand's dual-entity arrangement the FRA did not have
the power to restructure debts, but rather was limited to selling them. It took considerable time to
establish the entity and organize the sales, during which no restructuring took place. Finally, the
resolution of distressed banks was hindered by the conflict inherent in the Bank of Thailand's
roles of supervisor of financial institutions, decisionmaker on forbearance or the provision of
public support, and manager of the liquidation of closed banks. Bank of Thailand's multiple
responsibilities may have created incentives not to accept the insolvency of a bank or act to close
it and rather to acquiesce to a proposed recapitalization plan in hopes that the bank would recover
with time.
Institutional arrangements in Indonesia suffered more severe weaknesses. The decree
laying the groundwork for IIBRA was vague. To overcome this shortcoming, it was necessary to
amend the Banking Law to establish the agency. Yet the amendments merely made reference to
the possibility that such an agency could be established. The operating parameters for IBRA were
not issued until February 1999, more than a year after it came into being. During this period, it
had four chairmen and was unable to take effective action. Even after IBRA was established,
ultimate authority continued to vest in the country's president, so that effective decisionmaking
was substantially influenced by political considerations. IBRA's legal standing was, in fact,
challenged in the courts. Although IBRA's powers ultimately were upheld, the court strongly
suggested that they should be enshrined in law. Yet at the time of this writing, the government has
not moved to strengthen IBRA's legal standing.
The decision to give IBRA supervisory responsibility over banks transferred to it also was
costly. Bank of Indonesia sought to regain control over the supervisory function, and a climate of



22
distrust and lack of cooperation was fostered between the two institutions, which continued to
hamper effective crisis resolution for some time.
To strengthen coordination among the various government agencies so as to eliminate
legal and institutional impediments to bank restructuring and drive the reform process forward,
the Financial Sector Advisory Committee was established in mid-1998. The committee comprised
the coordinating minister of economy, finance, and industry, the finance minister, the
development planning minister, the minister for industry and trade, the governor of the Bank of
Indonesia, and the head of IBRA. The Financial Sector Advisory Committee remained dormant,
however, and was succeeded in 1999 by the Financial Sector Policy Committee, comprising the
same membership. In part under external pressure, the Financial Sector Policy Committee
functioned better and served to decide all financial sector resolution activities. As a result,
coordination and consensus among the various official bodies improved.
Guidelines and Principles
Formation of a specific-purpose, temporary crisis management team should be considered.
Key objectives would be to consolidate responsibility, promote consistency of work and
decisions, provide for the necessary specialized skills, and insulate the work from other official
responsibilities and related conflicts of interest. The team might explicitly have a limited life to
provide incentives to conclude the work in a timely manner and not prolong its existence
unnecessarily.
The governing body of the crisis management team would encompass both key political
interests and the private sector. The governing body should harmonize political interests and
mitigate the impact of differences of opinions among the permanent official agencies of
government. Finance ministries, prime ministers or heads of state should play a leading role.
The governing body should delegate in explicit terms the responsibility and authority for
crisis resolution. Clear delegation is critical to the effectiveness of the team. Objectives and
responsibilities need to be clearly defined, ideally articulated in terms of explicit outcomes, and
basic principles to guide the work must be agreed.



23
The goveming body needs to define the authority, powers, and protections available to the
crisis management team and may need to codify them in law. The relevant authorities and powers
are those necessary to ensure the ability of the team to undertake its work (including the power to
recruit and contract outside expertise), to coordinate supporting actions by the permanent official
agencies of govemment (including the means to arbitrate differences of opinion among those
agencies and raise unresolved differences to the governing body), and to act as the chief
spokesperson with respect to the actions being taken.17 The team would require legal protection
for actions taken in good faith., for example, protection from unjustified lawsuits filed against
individual members of the teain.
The goveming body needs to ensure that the crisis management team has the necessary
resources to do its job. The ke:y resource is the government financing necessary to invest in banks,
repay deposits in liquidated banks, and serve as an inducement to new private capital. Failure to
grant sufficient financing undermines the chances for success. The team also needs to have
adequate financing for its owrn operations, including funds to hire experts with the necessary
skills.
Central banks and supervisory agencies should play clearly circumscribed roles in crisis
resolution. Due to their official responsibilities for financial sector supervision and for the lender-
of-last-resort function, these agencies are usually the first to become involved in dealing with the
effects of a crisis. Nonetheless, when crises become systemic, they are often not prepared to play
the leading role in crisis resolution. Moreover, forcing them to do so may undermine their
capacity to perform their pemianent functions. Although central banks certainly will play a role,
govemment should not compel them to bear an excessive burden in financing crisis resolution.'8
A more appropriate role for a supervisory agency is as an independent check on the
17. The probable need to establish the team?s authority and powers by law reflects the likelihood that the team's
actions will conflict with (overstep) the legal authorities of the permanent institutions of government. In addition,
special legislation also can be used to overcome weaknesses in existing legal arrangements. In some cases, effects
similar to those created by these special legal powers might be achieved by executive decision. With respect to the
team's dealings with the private sector (banks, bank shareholders, bank managers, and debtor firms and their owners),
similar effects can be achieved by contract.
18. Assigning principal responsibility for crisis management to central banks also may increase the pressure to lend
excessively, possibly undermining their finances and risking the loss of monetary control.



24
recapitalization transactions being organized by the crisis resolution team, much the same role
that supervisors routinely play in approving changes in the control of banks or.in the monitoring
of agreements by banks to raise additional capital and carry out institutional improvements.
In summary, the following guidelines and principles are relevant to making institutional
arrangements for crisis resolution:
*     Form a specific-purpose, temporary crisis management team.
*     Create a governing body for the crisis management team that encompasses key political
interests and perhaps the private sector.
*     Have the governing body delegate in explicit terms the responsibility and authority for
crisis resolution.
*     Have the governing body define the authority, powers, and protections available to the
crisis management team and to codify them in law, if necessary.
*     Have the governing body ensure that the crisis management team has the necessary
resources to do its job.
*     Ensure that the central bank and supervisory agencies play clearly circumscribed roles in
crisis resolution that do not undermine their ability to perform their permanent functions.
CHAPTER 3. MOBILIZING PUBLIC FUNDS
With institutional arrangements in place, the political authorities and the crisis
management team need to begin mobilizing sufficient public funds to salvage the financial system
and protect depositors and perhaps other bank creditors. In a truly systemic crisis, the central
bank-often the first entity that commits financial resources-will be constrained in its ability to
finance significant costs by its responsibilities for monetary management. Likewise, the deposit



25
protection entity (where it exists) probably will not have sufficient resources to absorb all the
costs. The authorities will have to arrange an extraordinary financing package.19
Beyond the initial liquiidity support provided by the central bank, public funds may be
used for several specific purposes. They may finance the repayment of deposits of failed banks or
the assumption by more sound banks of the deposits (and perhaps other liabilities) of failed banks.
They may be used to purchase assets (such as nonperforming loans) from banks and to inject
capital by purchasing bank equity. They may be used to fulfill government commitments under
guarantees granted and put options written in the course of supporting or privatizing banks. In
connection with each of these purposes, public funds can be used to induce new private capital
into the banking system. Public funds also may be required to finance the operations of the crisis
management team, particularly the cost of skilled staff, advisors, and other contracted
professionals (such as asset mranagers).
The resources mobilized under the financing package can take several forms, including
cash; government notes or bonds; government guarantee of debt issued by official or quasi-
official agencies such as the central bank, deposit protection entity, or asset management
company; government guarantee of asset values; government indemnification against contingent
losses; and government comnnmitments to purchase assets at predefined prices (put options written).
The financing package must contemplate both the cost of directly issued securities as well as the
potential cost of contingent liabilities.20
Country Experiences
All three countries had relatively sound fiscal and debt positions prior to the crisis and
thus had more capacity to finance the cost of crisis resolution than many other countries that have
experienced crises in recent years.
19. Of course, multilateral financial institutions and other official lenders can play a role in mobilizing the necessary
financing package.
20 For additional considerations in mobilizing public funds see Honohan 2001.



26
In Korea, under an umbrella arrangement totaling KRW65 trillion, representing around 30
percent of gross domestic product (GDP), the National Assembly approved the government
guarantee of debt issued by KAMCO and KDIC on three separate occasions in 1997 and 1998.
This initial umbrella package eventually proved insufficient, and the National Assembly approved
a second round of fiscal support totaling some KRW40 trillion in late 2000.
In Thailand, substantial fiscal expenditures were incurred for the purpose of financing
liquidity support by the Financial Institutions Development Fund and for financing the August 14,
1998, financial restructuring package (the bank recapitalization program discussed in chapter 5).
The legislature approved Bt500 billion in bonds for the Financial Institutions Development Fund
and Bt300 billion for the August 14 recapitalization package. The cost of the blanket guarantee as
well as loss sharing agreements related to the privatization of banks is yet to be determined but is
expected to be high.
In Indonesia by end-December 2000, Parliament had approved the issuance of new
government bonds totaling some Rp644 trillion (representing around 58 percent of GDP) for
crisis resolution. Of this amount, Rp426 trillion was used to recapitalize the banking system,
which included Rp282 trillion for state-owned banks. The remainder (Rp218 trillion) was used to
recapitalize Bank of Indonesia to offset the losses incurred in providing liquidity support to banks
under the government deposit guarantee program discussed in chapter 1. To manage the fiscal
burden of such a large issuance of debt, the government phased in the recapitalization program.
Private and nationalized banks were recapitalized first, and state banks were recapitalized later.
The government also used a mix of fixed-rate, floating-rate, and indexed bonds to reduce the
fiscal implications of the financing package.
Assessment
Securing sufficient public funds to finance resolution costs depends critically on the
political leadership and on political consensus. The Korean government, in particular, was able to
mobilize a significant financing package early on, signaling the government's determination to
tackle the crisis. Gaining quick political consensus on a financing package helped to restore
confidence by bolstering the credibility of the government's statements and commitments.



27
Conversely, delay in securing a credible financing package can undermine the
effectiveness of crisis resolution efforts. Delay often results from a lack of political commitment
or cohesion and is a symptom of weak capacity for crisis management. Delay can allow
uncertainty and insolvency to persist and costs to rise.
The three governments faced a difficult challenge in determining the appropriate size of
the financing package. Initially, there was great uncertainty about the scope of insolvency and the
amount of financing required. The governments faced a tradeoff between speed in arranging
financing (with the benefits that conveys) and certainty as to the amount of financing required.
The govemments had difficulty raising additional financing when the initial packages
proved insufficient. Thus government and the crisis management team need to maintain the
flexability to seek additional financing at a later date, should that be necessary, but do so without
creating expectations that additional financing will necessarily be made available, which may
undermine the incentives facing potential beneficiaries of support. This suggests that the initial
package must be sufficiently large to be credible to the domestic (and intemational) market.
To the extent that assets acquired by government in the course of crisis resolution can be
sold quickly, the proceeds cain be used to reduce the size of the financing package. In Korea, this
technique was referred to as "recycling" public support. Although a valid tactic, it raised concems
that the government would securitize assets with recourse (retaining ongoing liability for loss)
rather than sell the assets back into the private sector. Moreover, unrealistic expectations
regarding the speed with whi,h assets can be sold or the values that can be obtained can render
insufficient the projected financing requirements.
The financing package may have to make provisions for the repayment of central bank
liquidity support. If, in the initial stages of the crisis, the central bank extended substantial
liquidity support to insolvent banks, it may well have to write off that support. As in the case of
Indonesia, the government may have to reimburse the central bank for some or all of those losses.
All govemments used indirect methods of financing such as issuing guarantees or writing
put options as a substitute for issuing direct government debt. In principle, these can be valid and
useful financing techniques, particularly in the context of inducing new private capital into the



28
financial system. At the same time, these obligations give rise to contingent liabilities and may
obscure the cost of crisis resolution. They also may lead to a breakdown in government debt
management. These financial liabilities have to be identified, monitored, and managed in much
the same manner as direct liabilities.
In principle, the private sector (both domestic and foreign) can provide some of the
investment required to salvage core elements of the financial system and to fulfill government's
commitment to protect depositors. In practice, the three governments failed to have much success
in this regard.
Guidelines and Principles
Involving the political opposition in crisis management, for example by including them in
the arrangements for oversight of the crisis management team, can promote political consensus on
a financing package.
The special legislation needed to authorize the use of public funds on the scale required
should define the basic objectives and principles for the use of those funds in crisis resolution. It
can be the vehicle for establishing the crisis management team and the oversight arrangements.
The financing package needs to be of sufficient size to be credible. The markets need to be
able to relate the size of the package to their own estimates of the losses existing in the banking
system. The crisis management team must quickly determine a rough order of magnitude, keeping
in mind the near-universal experience in other countries of underestimating the amount of
financing required.
Despite best efforts, the initial financing package may prove insufficient. Although it is
important to limit expectations for further financial support, it is also necessary to maintain the
flexibility to seek additional financing. Commitments not to seek further financing must be
avoided.
The package should make sufficient resources available for financing the operations of the
crisis management team, including adequate resources to hire expert private sector advisors and
practitioners. This can readily sum to several millions of U.S. dollars. Exemptions from civil



29
service rate and salary restrictions also likely will be a necessary part of the package.
The financial instruments underlying the financing package generally should be on market
terms and conditions. For example, to restore bank profitability, notes or bonds issued to banks to
pay for nonperforming loans, buy equity capital, or honor guarantees should bear market rates of
interest and pay interest regularly. Those instruments also should be tradable so as to promote the
ability of banks to manage liquidity and reduce the interest rate paid and thus the financing cost to
government.21
An adequate government debt management function is needed to mitigate the risks and
reduce the costs arising from the substantial increase in government debt associated with crisis
resolution. It is important that the new debt issued be integrated with the regular program of debt
issuance and management. Both contingent liabilities under guarantees and put options written
need to be taken into consideration. The crisis can be a good opportunity to strengthen the debt
management regime, including the management of maturity, refinancing, and interest rate risk.
In summary, the following guidelines and principles are intended to support efforts to
mobilize public funds:
*     Involve the political opposition in the arrangements for oversight of the crisis management
team.
*     Use the special legislat:ion authorizing the use of public funds to define the objectives and
principles for the use cf those funds.
*     Ensure that the financing package is of sufficient size to be credible.
*     Maintain flexibility to seek additional financing.
*     Make sufficient resources available for financing the work of the crisis management team.
21. At the same time, making these instruments tradable can facilitate looting by bank insiders, against which
effective provisions must be made.



30
*     Structure the financial instruments underlying the financing package to be on market
terms and conditions.
*     Ensure an adequate government debt management function is in place to mitigate the risks
and reduce the costs arising from the government debt issued for crisis resolution..
CHAPTER 4. DIAGNOSING THE SCOPE OF FINANCIAL PROBLEMS
In a crisis, it is important to differentiate between banks that are winners and those that are
losers. The winners are those banks that, in relative terms, have the best management,
governance, finances, and operations. The losers are those banks that have unsuitable
shareholders, poor governance, unqualified, reckless, or criminal managers, have become
insolvent, or have poor business prospects.
Simultaneous with supporting action necessary to secure a financing package, the crisis
management team needs to begin diagnosing the scope of problems facing individual banks and
the financial system overall. The team requires accurate information to determine appropriate
resolution mechanisms for distressed banks and to estimate the potential requirements for
financing crisis resolution. This diagnostic work is of particular importance in determining the
amount of support required by individual banks.
The team likely will learn that the authorities do not have accurate information regarding
the financial condition of banks. Their basic sources of information are the accounting data
prepared by banks and debtors and the regulatory indicators and supervisory analyses prepared by
supervisory authorities. This information can be inaccurate even in normal circumstances, but
especially in times of financial distress.
Contributing substantially to the problem of accounting and regulatory information are the
incentives facing most stakeholders to underestimate the scope of financial problems, especially
in a systemic crisis. Bankers who risk losing their jobs or investments should the bank be shown
as economically insolvent have strong incentives to hide its actual condition from the authorities.
Owners and managers of firms who risk losing control of their business or its assets should the
firm be revealed as insolvent have similar incentives. Supervisory authorities, who may expect to
be held accountable for the current situation by politicians, the media, and the public, have



31
incentives to downplay the scope of the problems. Finally, the political leaders who are asked to
authorize the financing for support have incentives to minimize the problems so as to minimize
(at least initially) the amount of financing required.
Accounting information suffers three weaknesses of particular relevance in a crisis. First,
asset values can be overstated'. The financial statements of debtors may not reflect the lower value
of plant, equipment, and inventories. The balance sheets of banks may not reflect the lower value
of loans, securities not marked to market, and perhaps other assets. Second, liabilities may be
understated. Debtors may not disclose the true extent of their liabilities.22 Banks often are found
to have undisclosed off-balance-sheet liabilities, including financial transactions engaged in as
principal but inappropriately carried off balance sheet, as well as genuine contingent liabilities.
Third and most critical, routine accounting information fails to identify the underlying cash flow
situation of banks and debtors. Understanding cash flow is critical to valuing assets. Bankers can
readily manipulate accounting information to obscure the actual cash debt service performance of
debtors, which obscures the banks' underlying financial condition.
Regulatory indicators also suffer weaknesses. The regulatory indicators that receive most
attention in a crisis are nonperforming loans and bank capital. Since bankers can manipulate
accounting information to obscure the actual cash debt service performance of debtors, the
regulatory measure of nonperforming loans can be substantially understated. In turn, the
overstatement of asset values and understatement of liabilities mean that bank regulatory capital
can be substantially overstated. Moreover, regulatory capital can include both equity and debt.
Debt capital may contribute little to the profitability of a bank and, in practice, can contribute to
an erosion of equity capital.23 From the perspective of restoring bank profitability, measures of
regulatory capital overstate actual capital.
The challenges arising from weaknesses in accounting information, regulatory indicators,
22. One dramatic example is Korea's Daewoo Corporation. When the conglomerate fell into bankruptcy it was
discovered only over some period of time that its liabilities were not $50 billion, as indicated by available reports, but
closer to $80 billion.
23. This occurs where, in order to achieve the narrow objective of bolstering the regulatory capital ratio, debt is
issued at interest rates exceeding th- marginal yield on assets.



32
and poor incentives are compounded by the heightened uncertainty regarding financial and real
asset prices, especially during the initial phases of a crisis. Interest rate spikes, sizable exchange
rate depreciation and overshooting, and near-frozen markets for assets such as land, buildings,
and equipment make it difficult to gauge realistic medium- and long-term values and prices. To
some extent, the uncertainties may persist sufficiently long as to undermine government's ability
to determine recapitalization needs.
The likely result of these factors is a misdiagnosis of the nature and extent of the financial
problems afflicting banks and debtors. It is not surprising, therefore, that early diagnoses tend to
underestimate substantially the scope of the problems and the amount of financing that will be
required of government.
Country Experiences
The Korean Financial Supervisory Commission attempted to develop better information
on the condition of banks in at least four ways. One step was to hire international accounting
firms to perform diagnostic reviews of the troubled banks. The focus was on the prospective level
of asset losses as well as other financial and operational problems. This work was performed by
the local affiliates of major international firms supplemented by experts from offices in other
countries, especially bank supervision experts from the United States. The work was performed in
two phases, first for the largest and most troubled banks and subsequently for the remaining
banks. The banks themselves were required to finance the work. A second step was to require the
banks to submit rehabilitation plans containing detailed information regarding their prospective
financial and operating condition. Progressively improved plans were demanded. A third step was
to commission a major international firm to perform an industry analysis. This work generated
detailed information on the possible evolution of the post-crisis financial system that supported
the valuation of financial sector business lines, for example. A final step was to commission
another international firm to develop a financial analysis model that could incorporate various
inputs, including the results of the diagnostic reviews and the industry analysis, and project future
profitability, trends in equity capital, and equity recapitalization needs by bank.
To gain better information on the financial problems of major debtors to the financial
system, the Financial Supervisory Commission also required the larger chaebol to enter into debt



33
reduction agreements with their banks. These agreements were to provide complete information
regarding the liabilities and cash flows of chaebol.
In Thailand, the Bank of Thailand did not conduct or organize diagnostic reviews of
troubled banks. Rather, banks were asked to conduct self-diagnostics that were then verified by
the Bank of Thailand. The banks also submitted business plans to the Bank of Thailand for
review. The consequences of the exercise were unexpected in that, even though no outside
reviews were conducted, the ]Bank of Thailand received sufficient information to justify a
decision to liquidate or nationalize some of the banks.
In Indonesia, independent international auditors were engaged to conduct diagnostic
reviews of all banks, to deternine the level of solvency or insolvency, and to judge the relative
costs of resolving each bank through assisted acquisition, merger, or recapitalization and
privatization. Banks were asked to prepare business plans demonstrating their continued viability.
An international consultant then reviewed these plans using a financial analysis model similar to
that employed in Korea.
Assessment
The experience of the three countries confirms a situation common in crisis countries.
Routine accounting information was misleading and did not provide the cash flow information
necessary to understand the extent of financial problems facing debtors and banks. Regulatory
indicators did not reflect the true condition of banks' loan portfolios or the level of real capital. In
the course of crisis resolution, significant additional liabilities of banks and major debtors were
discovered. The quality of information submitted by poorly govemed banks and banks with
extensive insider lending was judged to be particularly poor.
In principle, the steps taken by the Korean government provide a fairly good example of
the general approach a government can take to overcome information deficiencies in a crisis.
Bankers were required to provide detailed information regarding banks' prospective viability.
Intemational experts were hired to assess banks' condition, especially loan quality. International
experts also were hired to prepare a forward-looking assessment of the post-crisis operating
environment of the financial services sector, which provided a context in which to judge banks'



34
prospective viability. A model based on experts' experiences in other crisis countries supported
this financial analysis. In practice, there were shortcomings. For example, the assessments
performed by international experts suffered due to unrealistically short deadlines and the lack of
sufficient financing for the necessary work.
It can be argued that, regardless of the steps taken to gather information and build
analytical capacity, governments cannot niatch the private sector in judging the prospective
viability of banks. To leverage the analytical capacity of the private sector, governments have to
build mechanisms to attract private sector capital at the time of government investment in
salvaging individual banks. Although the three countries took steps in this direction, in practice
none achieved this objective.
Guidelines and Principles
Although significant uncertainties are inevitable in the early stages of a crisis, it is
essential to invest in information gathering and analytical capacity. It also is important to ensure
that the persons responsible for gathering, verifying, and analyzing this information do not have
incentives to underestimate the extent of the problems. This, in turn, has implications for the
organization and staffing of the crisis management team.
Gaining a first-cut assessment of the scope of the problem of individual banks is necessary
to estimating the overall size of the problem and to prioritizing resolution efforts on those banks
incurring the greater ongoing losses.
To support the investment of public funds, focus should be placed on the amount of equity
capital required by banks. It is important to distinguish between regulatory and economic capital.
Regulatory capital can include debt instruments that do not contribute significantly, if at all, to
bank profitability. The principal focus should be on equity capital. Key information should
include not only the range of losses likely to be incurred under troubled debt restructuring but also
the range of losses likely to be incurred under bank operational restructuring. For ascertaining
potential losses to be incurred in troubled debt restructuring, infornation on the cash flow
situation of major debtors is required.
In summary, the following principles and guidelines are intended to inform the efforts to



35
diagnose the scope of financial problems:
*     Make an early and significant investment in information gathering and analysis.
*     Ensure that those responsible for gathering, verifying, and analyzing information do not
have incentives to underestimate the extent of the problems.
*     Perform triage in order to have a first-cut assessment of the scope of the problem of
individual banks.
*     Focus on the amount of equity capital required by banks.
CHAPTER 5.. RESOLVING, RECAPITALIZING, AND RESTRUCTURING BANKS
To a large extent, the actions discussed to this point are geared toward laying foundations
for successfully resolving, recapitalizing, and restructuring banks and the banking system.
Systemic crises may well lead to losses of a magnitude that results in bank insolvency, where the
value of liabilities exceeds that of assets. These losses can result in a situation where the bank,
absent an increase in equity capital, cannot earn a profit and therefore has no internal means of
rebuilding capital by retaining earnings.
Promptly resolving insolvent banks is essential. The longer insolvent banks remain freely
engaged in business, the greater is the disruption to the performance of the financial system and
the higher are the potential costs to resolve them. Managers of insolvent banks tend to undertake
risky transactions for personal gain or in the hope that high returns will restore bank solvency.
They often bid aggressively for deposits in an effort to stave off-illiquidity. Higher resolution
costs can arise through a number of mechanisms, including excessive overhead expenditures,
losses arising from new loan disbursements to distressed borrowers,24 underpricing of new
business, the costs of financing nonperforming loans, and looting.25
24. This is distinct from simple rollover of principal and capitalization of unpaid interest into the principal balance.
25. Allowing insolvent banks to corntinue in business also may make monetary management more (lifficult.



36
The goal of recapitalizing banks is to restore sustainable cash-based profitability. It is not
sufficient to provide capital in an amount that satisfies a regulatory capital requirement if the bank
will continue to operate at a loss, insidiously eroding that capital. It similarly is not sufficient to
provide capital in an amount that restores accounting-based earnings when those earnings are not
likely to be realized in cash within a reasonable period of time. Recapitalization can be viewed as
complete only if sustainable cash-based profitability is reasonably assured in the medium term.
The principal goal of restructuring banks is to enhance their potential to achieve
sustainable cash-based profitability. Bank restructuring therefore is an important complement to
recapitalization. Although the crisis will contribute to bank insolvency, it also will reveal
preexisting poor financial performance such as chronically low or even negative earnings.
Restructuring can involve a large number of actions designed to strengthen bank profitability,
usually including refocusing business strategies, downsizing operations (such as reducing staff,
selling businesses, and closing offices and subsidiaries), repricing products, and upgrading
institutional capacities (such as the capacity to manage risk and perform intemal and external
audits). Bank restructuring also entails restructuring troubled debts, the subject of chapter 6.
Responsibility for recapitalizing a bank must reside in the first instance with its
shareholders, particularly where there is a controlling group of shareholders. Bank supervisors
and the crisis management team may employ a range of practices to motivate shareholders to
recapitalize the bank. These practices ultimately are based on the potential to suspend and revoke
the shareholders' ownership rights.26
Should existing shareholders prove unable or unwilling to recapitalize, the remaining
private sector solution is to seek new investors. One possible means is to use the threat of loss to
force unsecured creditors of the bank to convert their claims into equity. Another means is to seek
new investors willing to recapitalize the bank.
Should the private sector fail to recapitalize adequately, the government can step in to
resolve the bank. In essence, government can apply three basic mechanisms to resolve an
26. These practices often takes the form of formal agreements (potentially legally binding) between the shareholders
or their representatives and the bank supervisory authority, such as memorandurns of understanding.



37
insolvent bank: liquidation, assisted acquisition, and nationalization (refer to box 1 for the
definition of these terms). Each has different implications for bank recapitalization and
restructuring. Often they are used in combination. Government may employ some form of
conservatorship to oversee bank operations pending execution of a definitive resolution
mechanism.
Liquidation does not involve recapitalizing and restructuring the bank; rather it involves
winding up the bank's operations. Government financial support may be required to support the
repayment of protected deposi ts and claims. Shareholders lose their investment, and some
creditors likely incur losses. Capacity and costs are removed from the banking system.
Assisted acquisition involves the transfer of some or all of the insolvent bank's liabilities,
assets, and operations to another bank or financial institution. For example, the trarnsfer of
deposits may be financed in part by the simultaneous transfer of certain assets of the insolvent
bank, such as sound financial assets (government securities, for example) or physical assets
(branch offices, equipment). Any shortfall in assets is filled by government financial support to
the acquirer. The assets of the insolvent bank that are not acquired by other institutions typically
are liquidated to repay creditors' claims that were not transferred. As with liquidation,
shareholders lose their investrnent, and some creditors likely incur losses. No recapitalization is
required, although government financial support may be needed to finance the transfer of
liabilities and protect against contingent liabilities. The acquiring institution undertakes any
required restructuring. Assisted acquisitions can be a good means to reduce the overall cost
structure in the banking system, while minimizing the disruption to users of financial services that
is inherent in bank liquidation.
Nationalization typically involves the temporary assumption of ownership rights and
responsibilities by government. In principle, shareholders lose their investment, but in practice
they may retain some (greatly reduced) equity claim.27 Government assumes responsibility not
only for recapitalizing the bank but also for exerting governance and overseeing bank
27. Most commonly, this may be so due either to legal limitations on the ability to write off shareholders entirely or
to a tactical decision intended to mitigate the potential for legal action by existing shareholders.



38
restructuring pending reprivatization. For that reason, nationalization represents a substantial
challenge to the capacity of the crisis management team, although some of these responsibilities
can be subcontracted to others.
In practice, there may be limits on the extent to which government can employ liquidation,
assisted acquisition, and nationalization as mechanisms for resolving insolvent banks.28 Its option
in this case is to leave existing shareholders in control by granting temporaryforbearance from
resolution action. In effect, government chooses some winners among the existing banks and
shareholder groups and allows time for a private sector solution to be organized before a public
sector resolution is undertaken.29 This usually involves a phase-in of full enforcement of capital
adequacy, asset classification, and asset provisioning rules. It might also involve a simultaneous
tightening of those rules.
There are many possible variations on and combinations of the manner in which these
alternatives, including forbearance, can be employed. For example, government might finance the
assisted acquisition of an insolvent bank by a financially weak yet well-managed bank, while
simultaneously supporting the recapitalization of the weak bank itself (in effect, a partial
nationalization). Or the government itself might charter a new bank (often referred to as a bridge
bank) to engage in assisted acquisitions of certain liabilities and assets of insolvent banks.
Country Experience
In Korea, the government relied principally on assisted acquisition and nationalization to
resolve insolvent commercial banks. Two large banks that were disproportionately exposed to
chaebol that fell into bankruptcy in 1997 were nationalized early in 1998 in reaction to emerging
deposit runs (Korea First Bank and Seoul Bank). Top managers were removed or reassigned, and
the new managers were instructed to cut costs substantially. Eventually, 51 percent of Korea First
28. Extensive liquidation may be too economically or politically disruptive and may actually destroy value, assisted
acquisitions may be constrained by a lack of qualified buyers, and government may be unwilling or unable to assume
responsibility for governance of all banks that would otherwise be nationalized.
29. The strategy is that government will achieve better outcomes (for example, quicker action, lower long-run costs)
by allowing shareholders of certain banks to retain governance responsibilities and an ownership stake.



39
Bank was sold to new investors, who took over governance and management responsibility. After
attempts to privatize Seoul Bank failed, management of the bank was contracted to a major
foreign bank.
Five smaller banks were wound up in July 1998 by means of transferring their assets and
liabilities to other banks under assisted acquisitions.30 Assisted acquisitions covered all assets and
liabilities to ensure that there would be no disruption of business for bank customers.
Shareholders lost their investmnent, but creditors were protected. The five acquiring banks had
significant foreign shareholding stakes and were considered to be among the best-managed banks
in Korea. They had access to ]3ank of Korea liquidity support to minimize the disruption of
banking services for customers of the failed banks. They also received a put option on
nonperforming loans and KD]C capital injections to maintain their capital levels at pre-
acquisition levels.31
Later in the year, after further analysis, the government nationalized three more large
banks, while insisting that they merge.32 The KAMCO agreed to purchase 80 percent of the
combined banks' nonperforming loans. The KDIC agreed to inject equity capital in exchange for
more than a 90 percent stake in the banks, raising the banks' Basel regulatory capital ratio to 10
percent after projected increases in loss reserves for further loan deterioration. The government
also provided financial support for the acquisition of two troubled banks by two healthier banks,
although in amounts much less than in the case of the nationalized banks. As a condition for
granting public support, the FSC imposed performance contracts containing severe terms on the
top management of the banks to promote restructuring. Managers were most successful in their
efforts to reduce staff expenses and close or sell branches. On average, Korean domestic banks
reduced staff personnel costs around 35 percent and reduced the number of branches 20 percent.
30. In the termiinology used in Korea, these were referred to as "business transfers."
31. In supporting the acquisition of troubled banks by healthier banks, as in the case of the five smaller banks, the
FSC committed to maintain the mrerged banks' capital at the pre-acquisition level of the acquiring bank.
32. Two large banks-CBK and Hanil-merged to form Hanvit Bank, while a third large bank-Cho Hung-agreed
to merge with two smaller banks. IvMergers were required, in part, to generate public support for the use of taxpayer
funds in recapitalizing banks, under the notion that merger involved a cost to the bank.



40
The FSC had indicated its desire to attract private sector capital to complement public
funds invested in banks. The government of Korea liberalized applicable regulations to permit
100 percent ownership of a bank by a foreign financial institution. Nonetheless, the government
was unable to attract private capital at the time of taking a resolution action due to its apparent
failure to acknowledge the reduced value of banks and to articulate clearly to potential investors
the terms and conditions under which public support would be available.
The Thai government relied on a combination of approaches, including nationalization,
capital support, and forbearance (through phased-in provisioning requirements) in its efforts to
resolve the banking sector crisis. After suspending the 58 finance companies in mid-1997, the
Bank of Thailand committed to a policy of recapitalization of the core banks. The strategy was
based on a progressive strengthening of provisioning requirements designed to prompt banks to
obtain fresh capital. By the end of 1997, 56 of the 58 suspended finance companies were closed,
and Bank of Thailand had signed recapitalization memorandums of understanding with the
weakest banks. By May 1998, four critically undercapitalized banks unable to meet
recapitalization deadlines had been nationalized, along with seven finance companies. Another
two banks and four finance companies were nationalized in August 1998, and another bank was
nationalized in July 1999. In all cases, shareholders of nationalized banks were written down to a
negligible interest in the bank.
To facilitate recapitalization of the banking sector, the Thai government announced the
Financial Sector Restructuring Program in August 1998, centering on two capital support
facilities (the so-called Tier 1 and Tier 2 support programs). Under the Tier 1 program, the
government would match on a one-to-one basis private investors' fresh capital to help recapitalize
banks that agreed to provision immediately for their potential loan losses. To implement this, the
banks were required to adopt loan classification and provisioning rules that otherwise would
become fully effective at the end of 2000 and to constitute the necessary loss provisions. Under
the Tier 2 program, with the goal of facilitating economic recovery, the government would inject
nontradable debt qualifying as regulatory capital into banks meeting specified corporate debt
restructuring and new lending targets. The programs were voluntary, and most private banks
viewed them as a last resort because they feared that accepting public investment would be
perceived as a sign of weakness by the market and would invite government interference in



41
management.
In order to recapitalize without having to join the government program, Thai banks
resorted to raising regulatory capital from the market, including through innovative debt
agreements called SLIPS and CAPS, which were short term and high cost. By June 2000, Thai
private banks had raised from private investors over Bt300 billion in Tier 1 capital (including
traditional common stock and more exotic debt-like instruments) and Bt58 billion in debt
qualifying as Tier 2 capital. Although significant unrealized losses remained on the balance sheets
of some banks, regulatory forlbearance allowed them to delay loss recognition such that they did
not have to recapitalize quickly and sufficiently. One form of explicit forbearance, the phase-in of
required loss provisions over time, ceased at the end of 2000. However, other forms of explicit
forbearance (for example, the immediate release of existing provisions at the time of debt
restructuring) and widespread, but less transparent, implicit forbearance (for example, generous
valuation methodologies and tolerance of cosmetic restructuring) remain in place.
The Tier 1 program was accompanied by strict conditions intended to motivate bankers to
raise capital from the private markets without matching public money. Fear of having to join the
program and thus risk government interference in management indeed did catalyze the private
banks to seek capital from the market. In some cases, this resulted in improved bank governance,
although in others (where shares were sold widely to small investors), it did not.
In Indonesia, the government quickly decided to recapitalize all state-owned banks,
regardless of cost. For the private banks, however, the government sought to preserve a small core
of the best banks, for which ilt developed a recapitalization program. Those banks with a capital
adequacy ratio above 4 percent were deemed healthy and ineligible for public assistance. Thirty-
eight banks with a capital adequacy ratio between 4 percent and minus 25 percent and with a
viable business plan were deemed eligible for assistance.
Under the terms of the recapitalization program, which sought to raise Tier 1 regulatory
capital to 4 percent of risk-adjusted assets, private owners were required to contribute a minimum
of 20 percent of the total cost of recapitalization, and the government would provide the



42
remainder. In recognition of its substantial investment, the government was to be granted
preferential treatment in the event of liquidation of the bank and in the receipt of any dividends.33
Recapitalization agreements to be signed with the banks were to include provisions limiting the
government's involvement in daily bank operations, creating incentives to induce private owners
to participate in the program, and encouraging compliance with the business plan targets and
prompt repayment of the government's support.
Under the terms of the recapitalization agreements, private owners were granted the
opportunity to buy back the government's shares within the stipulated three-year period of the
business plan, provided there was no unresolved material breach of the business plan and
provided the government was fully compensated, with interest, for its investment. Any sale of the
government's shares within the three-year period would require prior approval of the private
owners, who would be given preemptive rights. At the end of the three-year period, the
government was to grant private owners the right of first refusal to purchase its shares, after
which the government's shares would be sold in the market. In addition, the private controlling
shareholders who provided the additional equity would be issued a certificate entitling them to
benefits from recoveries on nonperforming loans transferred from the bank to IBRA.34
The contract also included financial and operational targets for each bank and its
managers; these targets were based on the business plans as well as the actions that bankers were
to take to meet those targets. Furthermore, the contract identified relevant management positions,
the holders of which would be responsible for ensuring compliance with the contract. Failure to
meet the minimum financial or operatioital targets set out in the contract (including targets for the
reduction of nonperforming loans) would result in regulatory actions against the bank, its
controlling shareholder, or management. These actions could include the dismissal of
commissioners or directors or the exercise by Bank of Indonesia or IBRA of their powers to
assume control of management of the bank. Although Bank of Indonesia was not a counterparty
33. However, it was not anticipated that the banks would pay dividends during the period of government ownership,
since earnings would need to be retained in order to reach an 8 percent capital adequacy ratio.
34. Under the terms of the program, problem loans were written off entirely and transferred to IBRA at no cost. IBRA
nonetheless booked the assets at face value, as is discussed in chapter 8.



43
to the contract, as bank supervisor, it had responsibility for supervising all banks and for
monitoring compliance with the contracts.
As the recapitalization agreements were being finalized, some of the banks experienced
sporadic deposit runs. The aulhorities, in a premature move to demonstrate the commitment of
banks' shareholders, invited thle owners of the nine banks to sign preliminary investment contracts
at a signing ceremony in Jakarta held on April 15, 1999, to which the press was invited. Not all
the counterparties to the contracts attended, and the content of the contracts became public. Not
only did some contracts remain unsigned, but also the terms of the contracts immediately gave
rise to market questions regarding the government's ability or willingness to fulfill its
commitment to provide new capital. This called into question the credibility of the
recapitalization program.
The owners of the nine banks were given until April 21 to place their 20 percent portion of
the recapitalization in an escrow account with Bank of Indonesia. The total amount was based on
end-December 1998 estimates of required new capital. Eight banks met this requirement.35 The
owners of the ninth bank (Bark Niaga, one of Indonesia's large banks, with more than 458,000
36
accounts) were unable to provide the necessary capital, and the bank was nationalized.  Another
problem now arose. Revised audits conducted by independent auditors as of end-March 1999
showed significantly higher recapitalization requirements for the remaining eight banks, reflecting
the losses that these banks hacd incurred since December, which arose mainly from ongoing
excessive expenditures for premises and staff and the carrying costs associated with
nonperforming loans. Under the terms of the contract, the controlling shareholders of the eight
banks were obligated to increase their capital contribution to 20 percent of the updated
recapitalization requirement. They were given a deadline of June 30, 1999. In the event the banks'
35. The controlling shareholders of ]Lippo, BII, and Universal-all three listed banks-conducted rights issues
between January and April to raise the required capital. The controlling shareholders of Bank Bali, also a listed bank,
signed an agreement with Standard Chartered, which provided the necessary capital. The shareholders of Bukopin,
Artamedia, Patriot, and Prima Express, all four of which were unlisted, also provided funds amounting to 20 percent
of the recapitalization amount.
36. Thus almost seven months after the process of selecting banks for joint recapitalization was initiated, and at the
end of a time- and resource-intensive process of evaluation, only eight of 38 potentially qualified banks had reached
agreement for joint recapitalization.



44
shareholders did not provide the additional funds and the government committed itself to
increasing its own shareholding, as necessary, to ensure that banks reached the required 4 percent
capital adequacy ratio. In effect, all nine banks were nationalized.
Assessment
The experiences of Indonesia, Korea, and Thailand underscore what has been learned in
crises elsewhere, chiefly that bank resolution, recapitalization, and restructuring are monumental
tasks presenting substantial challenges that governments are hard-pressed to tackle. Three years
after the outset of the crisis, many banks in all three countries continue to exhibit substantial
weaknesses. The persistence of these problems might call into question governments' overall
performance in bank resolution.
In all three countries, bank shareholders were reluctant to recapitalize insolvent banks. For
widely held banks with no controlling shareholders, such as the large Korean banks, this probably
was inevitable. It was less so in Thailand and Indonesia, where many banks had controlling
shareholders. There, governments nonetheless were largely unsuccessful in motivating
shareholders to recapitalize.37
Similarly, shareholders and governments had limited success in raising capital from new
investors. New investors were unwilling to accept the risk of loss of their investment, and
governments generally offered insufficient protections against this outcome. Only in Thailand
was an explicit program of matching government assistance for new investment publicly
announced, but shareholders were left in a position to take the decisions, which probably
undermined the program. The potential hostility of existing management and staff also deterred
new investors in some countries (for example, Indonesia). The public sector thus became the
principal source of new equity capital in the short run.
The governuments made use of the full range of resolution options, including liquidation,
assisted acquisition, and nationalization. More use probably could have made of liquidation as a
resolution mechanism. In general, liquidation is appropriate for banks that can be wound up
37. This also occurred in Mexico in the mid-1990s.



45
without significant economic or political implications and where there is not substantial franchise
value. The governments' lack of capacity to promptly pay out protected deposits may have
constrained the authorities' use of liquidation. Failure to invest sufficiently in information
gathering and analytical capacity may have led to overestimation of franchise value.
The ability to use assisted acquisitions by domestic banks as a resolution mechanism was
limited in practice because there were few sound domestic banks to which to transfer the
liabilities (and assets) of insolvent banks. Even where this resolution mechanism was employed,
such as in Korea, banks were reluctant to undertake the acquisitions because they would distract
managers and perhaps present unacceptable financial risks.
Governments probably could have done much more either to use assisted acquisitions by
foreign acquirers or to induce foreign acquirers to participate as partners in bank nationalization.
Had they had more success in this regard, governments would have substantially reduced their
burden in bank governance and restructuring oversight and would have attracted more private
sector capital. These types of public/private joint ventures were not achieved for several reasons.
A fundamental impediment was the failure of governments to define and communicate the
financial and other support they were willing to offer, which itself derived in part from their
inexperience in soliciting and concluding complex transactions of that nature, an institutional
weakness that was not overcome with the crisis management arrangements that the governments
put in place. Uncertainties regarding valuations and contingent liabilities, denial of the probable
extent of value impairment, and political and public opposition to allowing foreign control of
major banks were additional impediments.
Even if governments had been more successful in forcing existing shareholders to inject
capital and in using public funds to attract domestic or foreign private sector investment, and if
they had made greater use of liquidation as a resolution mechanism, nationalization probably still
would have been employed a.. a key resolution mechanism in all countries, especially for larger
banks. To the extent that private sector solutions cannot be achieved and forbearance for existing
shareholders is not warranted, nationalization often was required to salvage core elements of the
banking system. Nationalization brought with it major responsibilities for bank governance and
restructuring oversight that, given the weak condition of many of these banks, governments have



46
struggled to fulfill.
A shortage of public funds for recapitalization was a key constraint to the overall bank
resolution program in all three countries. Lack of adequate resources created incentives to
manipulate the outcomes of diagnostic work (or fail to initiate it). It led to the failure to provide
sufficient new capital to restore and sustain the profitability of nationalized banks, which in turn
undermined incentives for bankers to undertake operational and troubled debt restructuring. It
likely played a role in the failure of government to offer adequate protections to new private
investment in troubled banks.
The appropriateness of forbearance in dealing with insolvent banks has been the subject of
much debate. Forbearance for insolvent banks runs counter to generally agreed principles of
insolvent bank resolution dictating that shareholders lose their investmnent with a consequent loss
of control. The risk is that banks will remain in the hands of shareholders who may have no
capital at risk and thus have poor incentives. Although implicit forbearance was granted in each
country, in Thailand forbearance was explicit. The judgment seems to be that it was preferable to
keep shareholders in place rather than have the government nationalize and run the bank. Part of
the rationale related to the perceived weak capacity of government. Government did not consider
it feasible to make institutional arrangements to undertake the governance and management
responsibilities inherent in nationalization.
The structure of explicit forbearance in Thailand had consequences for incentives in the
debt restructuring process. Forbearance there involved phased-in provisioning requirements, but
no adjustment to the regulatory capital rule. In principle, an equal outcome could have been
achieved by forbearing on the capital rule, but not the provisioning requirements. By forbearing
on the provisioning requirements, government may have inadvertently created incentives to delay
genuine debt restructuring, which would have resulted in immediate recognition of losses in
excess of the (reduced-by-forbearance) provisioning requirement. See chapter 7 for more details
on debt restructuring.
Guidelines and Principles
Government should take aggressive action to promote recapitalization by existing



47
shareholders. Standard supervisory methods for promoting recapitalization (such as restricting
new business or dividend payments or removing top managers) have limited effects in a crisis.
The credible threat of immediate suspension or revocation of shareholders' ownership rights, even
where supported by adequate legal infrastructure (law, judiciary), may not be sufficient. In
addition, government can investigate transactions involving bank insiders for evidence of
impropriety and illegality, and. prosecute offenders. It can use the tax regime to create incentives
for recapitalization, for examp-le, allowing the full deduction from taxable income of losses to be
taken in the context of debt or operational restructuring and offering generous tax-loss carry-back
and carry-forward provisions.
The choice of alternative resolution mechanism (liquidation, assisted acquisition, and
nationalization) should be based, in principle, on an assessment of cost. The crisis management
team will need to define least-cost decision criteria and make a quantitative analysis. For larger
banks, the decision criteria also will need to take into consideration potential systemic
implications.
Public funds should be leveraged to attract equity financing from the private sector for
assisted acquisitions or as a participant in nationalization. Securing investment of new private
capital at the time of bank resolution can be particularly advantageous to the extent that new
investors can assume responsibility for bank governance and thus for overseeing restructuring.
For example, government can provide protections for new investment of necessary capital in the
context of assisted acquisitions. In nationalizing banks, government can attract equity capital from
new investors in an amount sufficient to warrant granting primary responsibility for governance to
those investors, even though they would hold only a minority equity interest in the bank.
Nationalization carries significant risks that need to be actively managed. The risks are
those commonly associated with public bank ownership (political interference in lending
decisions, for example), combined with government's limited expertise in overseeing operational
and troubled debt restructuring. These risks and capacity limitations may be mitigated somewhat
by making the institutional arrangements noted in chapter 2 (assuring the organizational and
technical capacity of the crisis management team). Government also can contract for professional
management of nationalized banks (as in the case of Korea's Seoul Bank).



48
The risks in granting forbearance are high, and government needs to mitigate those risks.
Forbearance often simply delays required action, adds to costs, and raises the potential for
political interference. To mitigate these risks, forbearance should be granted only under defined
rules, should be transparent (and thus explicit), and should be subject to close monitoring. For
example, forbearance might be granted only to banks meeting specific eligibility criteria, such as
being relatively well managed and having a controlling shareholder or group of shareholders able
to exert positive governance over managers and to contribute financially to bank recapitalization.
Transparency in the process of granting and monitoring forbearance would include announcing
eligibility criteria, disclosing the analytical basis for decisions, and publicly reporting on
performance. Government must make provision to carefully monitor the behavior of managers of
the banks benefiting from forbearance. Enforcement of breach of agreements (especially to raise
new capital within specified periods of time) should be swift and resolute.
Recapitalization should take the form principally of equity capital. The principal goal of
bank recapitalization is to attain sustainable cash-based profitability in the medium term with
reasonable assurance. Focusing primarily on restoring regulatory capital or accounting-based
earnings is likely to result in insufficient recapitalization. To restore cash-based profitability, new
equity capital will be required. Debt qualifying as Tier 1 or Tier 2 regulatory capital may do little
to restore profitability and may actually undermine it.
Before investing new equity capital in a bank, the government should conduct rigorous
analysis of prospective profitability. This requires analyzing the evolution of the bank's business
under different scenarios and the resulting earnings projections. It requires both bank-specific and
overall industry analysis inputs. As a condition for receiving financial support, bankers should be
required to provide all necessary information required to perform the analysis.
Recapitalization should be accompanied by aggressive restructuring. Aggressive
restructuring can lower long-run recapitalization costs (initial outlays less the resale value of the
equity interest) by improving the core profitability of the bank. Recapitalization must take into
account the costs that will be incurred in operational restructuring (such as severance payments)
and the losses that will be incurred in restructuring troubled debt. Bank restructuring should
involve substantial downsizing and refocus operations on more profitable lines of business.



49
Recapitalization should involve sufficient new equity capital so as not to create the
expectation of further rounds of public support. Adoption of this principle is intended to ensure
that bankers (and, under extraordinary circumstances, perhaps shareholders) have incentives to
maximize the use of public support, principally by undertaking aggressive restructuring.
Attempting to implement this principle in practice is a significant challenge for government, since
it requires making a judgment (supported by rigorous analysis) of recapitalization requirements in
an environment of information constraints and significant uncertainty. In practice, governments
rarely attempt to implement or succeed in implementing this principle, which may be one reason
why granting multiple rounds of support to banks is common.
When uncertainty is high, steps may be needed to insulate a bank against further major
losses. To increase the probability that the new equity capital will result in sustainable
profitability, government should attempt to insulate the bank from the significant adverse effects
of lingering uncertainty. The most common example pertains to large debtors or groups of
debtors, where uncertainties regarding possible losses inherent in debt restructuring will have a
material impact on the ability of government to ascertain the amount of new equity required to
restore sustainable profitability. Government can use at least two types of mechanisms to mitigate
these uncertainties and to attract private capital to participate in bank recapitalization (see box 2).
Box 2: Mechanisras to Mitigate the Effects of Uncertainty and Attract Private
Capital
Interest rate spikes, sizable exchange rate depreciation and overshooting, near-frozen
markets for physical assets, as well as general macroeconomic uncertainty can make it difficult
to determine the appropriate amount of capital a bank requires in order to reestablish sustainable
cash-based profitability. To recapitalize banks adequately but not excessively, the government
needs tools to constrain the effects of uncertainty.
One mechanism is to sell to a government-owned asset management company the debts
giving rise to excessive uncertainty, eliminating future risk to the bank arising from these debts
and thereby eliminating the source of uncertainty. In this case, bank managers would have no
future responsibility for restructuring the debts. (Against a decision to sell the debts to an asset
management company must be weighed considerations such as the impact of severing the bank
relationship on the value of the debts. See chapter 8.)
A second mechanism that can be used when banks retain the debts is to issue a
government guarantee to, in elffect, constrain uncertainty regarding the range of possible
outcomes in debt restructuring. One example would be where government provides a guarantee
against losses in excess of a predetermined amount. Another example is where banks establish a



50
subsidiary to which the debts are sold (for example, a so-called "bad bank"), but where the value
of the subsidiary's asset portfolio benefits from some form of government guarantee. There are
many possible variations on this type of mechanism.
In effect, these mechanisms for eliminating or constraining uncertainty can overcome an
information constraint that otherwise may undermine the implementation of support to banks.
They allow for the adequate recapitalization of banks with government support, while permitting
additional time to determine the outcomes of the restructuring of certain debts. They can be
particularly useful for inducing new strategic investment by the private sector as part of the
provision of government financial support.
In summary, the following principles and guidelines are intended to inform the process of
resolving, recapitalizing, and restructuring banks:
*     Take aggressive action to promote recapitalization by existing shareholders
*     Base the choice of resolution mechanism (liquidation, assisted acquisition, and
nationalization) on an assessment of least-cost
*     Leverage public funds to attract equity financing from the private sector for assisted
acquisitions or as a participant in nationalization
*     Actively manage the risks associated with nationalization
*     Take steps to minimize the risks associated with granting forbearance
*     Have recapitalization take the form principally of equity capital
*     Base the government's decision to invest new equity capital in a bank on rigorous analysis
of prospective profitability
*     Ensure that recapitalization is accompanied by aggressive restructuring
*     Ensure that sufficient new equity capital is involved in recapitalization so as not to create
the expectation of further rounds of public support
*     When uncertainty is high, take steps to insulate recapitalized banks against further major
losses.



51
CHAPTER 6. PRIVATIZING BANKS
The preceding chapter described how the government may acquire an ownership interest
in banks in conjunction with the provision of equity capital support. A key task for the crisis
management team is to develolp an exit plan for those ownership positions. The basic goal is to
return the governance and ownership of banks to the private sector as quickly as possible. Early
privatization should be pursued for at least four reasons.
First, early privatization can demonstrate the resolve of government to do what is
necessary to restore the financial and operational soundness of the banking system. 'This can give
an important boost to domestic and international market confidence and reactivate the functioning
of the banking system. It also can stimulate more investor interest, which can increase
competition and raise values.
Second, privatization can reveal the true condition and value of the bank and, by
extrapolation, can help the crisis management team and others in government to diagnose more
accurately the depths of the prcblems facing other banks and their major debtors. It creates a
market test that provides valuable information not obtainable by other means.
Third, experienced and well-qualified private sector owners and managers with capital at
risk are likely to do a better job than government in carrying out the operational and troubled debt
restructuring necessary to achieve sustainable profitability. Investors able to exert professional
governance and bring to bear expert management likely will upgrade strategic and business
planning, risk management practices, and internal controls. These practices and teclmologies
eventually can be transmitted tci other banks.
Finally, the authorities can use the transparency arising from selling banks to informed
investors to test the veracity of their supervisory, accounting, and auditing processes for
measuring and reporting the condition of banks. They can use this information to improve
regulation and supervision.
There are several alternative means for selling government's ownership stakes in banks. In
general, stakes can be sold via a formal auction process, via direct negotiations with an interested
buyer, or via the sale of shares on a stock exchange. In circumstances where government has



52
provided support to a bank while allowing shareholders to retain an equity interest and role in
governance, the shares might be sold back to those shareholders.38
Bank privatization via auction or direct negotiation requires that potential purchasers have
access to the information necessary to perform due diligence. An auction will have to
accommodate the information needs of several interested investors. Providing for the conduct of
due diligence is not necessary when government's stake is sold on a stock exchange. Rather, the
listing requirements of the exchange nee(d to be fulfilled.
To upgrade the governance and management of a bank and promote sound operational and
troubled debt restructuring, potential purchasers should be strategic investors with demonstrated
experience in operating banks or other significant financial institutions. In a systemic crisis, this
may well imply the acquisition of domestic banks by foreign investors or financial institutions.
Although the crisis management team may be responsible for organizing the process of
bank privatization, the bank supervisory agency will have to be involved as well. Consistent with
international standards of effective bank supervision, supervisors will need to vet the potential
acquiring shareholders and new senior management team. They also should vet the financial
terms of the transaction to satisfy themselves that the post-privatization bank is adequately
capitalized and meets other prudential standards.
Country Experiences
In Korea, the government nationalized a number of large insolvent banks beginning in
early 1998 and immediately launched a process for privatizing them.39 This involved several
steps. To oversee the privatization process, the government formed a steering committee chaired
initially by a senior staff of the Ministry of Finance and the Economy and then by a senior staff of
the Financial Supervisory Commission when it was created in April 1998. The committee
initiated a process to evaluate and select investment banks to market the banks and assist the
38. This mnight be the case where government has financed the assisted acquisition of an insolvent bank by a
financially weak yet well-managed bank, while simultaneously supporting recapitalization of the weak bank itself.
39. The two banks nationalized in early 1998 were subjects of the initial privatization process.



53
government with the sales. An international accounting firm was contracted to generate and
organize the information necessary to support due diligence. An independent international
consultant was hired to provide general advice and support to the government, especially in
clearly defining its privatization objectives, managing the process of contracting with the
investment banks, and agreeing on the overall structure of transactions that would be acceptable
to government.
Although the originally stated intention was to privatize the banks through a transparent
international auction, that process broke down. Apparently, the investment bank's estimated value
of the banks to be sold did no t meet government expectations. When the banks were first
nationalized and partially recapitalized, the authorities publicly declared that the banks were fully
recapitalized, which may have unrealistically raised expectations. There also were concerns about
the structure of the deal propcosed by the investment bank, especially about the contingent
liabilities that government likely would have to accept. In the end, the one privatization
transaction that was achieved, involving the sale of 51 percent of Korea First Bank, was
concluded via direct negotiations between the purchasers (a private investment group) and the
government.
In Thailand, the sale of some nationalized local banks to foreign banks, which for the first
time were granted the right to operate full branch networks and to raise local funding, was a
significant milestone for the financial system. Sales were conducted by sealed bids followed by
direct negotiation with the winner.
Although foreign banks are not expanding aggressively due to the lack of sound lending
opportunities, competition aniong banks has intensified. The entry of global banking networks
with local distribution capacity, the rising costs of information technology and multiple
distribution channels (branch, telephone, Internet), scarce management talent, competition from
nonbanks, and declining margins throughout the region have increased competition. These forces
may favor further consolidation.
In Indonesia, the government nationalized 13 banks in all. Four large, but severely
insolvent, banks were nationalized early in the crisis. Another nine were nationalized as a
consequence of the failure of the private bank recapitalization scheme (see chapter 5). IBRA has



54
merged nine of these banks into a single bank (Bank Danamon).
Privatization results to date have been limited to the partial privatization of Bank Central
Asia, where Parliament approved the sale of up to 40 percent of the government's shareholding in
two tranches-30 percent through a strategic sale and 10 percent through a public offering. The
divestment of 51 percent of the government's holdings in Bank Niaga also was approved. In
addition, Bank Mandiri-the state bank formed by the merger of four state banks-has
announced its intention to sell a minority interest in the fourth quarter of 2001.
Assessment
The slow progress in selling nationalized banks in the countries covered here suggests that
bank privatization presents difficult challenges for governments. Although part of the challenge is
procedural, much of it relates to unrealistic expectations and failure to the lay the necessary
political groundwork to build a consensus for privatization.
Unrealistic expectations by senior politicians, government officials, and the public may be
the most formidable threat to privatization. These groups often lack a clear understanding of
market-based valuation principles and practices, which consider not only the finances of the bank
but also the country's legal and judicial regimes, overall business environment, tax laws, and
other factors that weigh on the potential risk-adjusted return on an investment in a bank. Although
they may genuinely believe that the government's stakes in banks are worth far more than
potential investors' valuations, these beliefs rarely are supported by hard financial analysis. Yet
from the experiences of the countries reviewed here, these expectations clearly can undermine
bank privatization.
Laying the political groundwork to facilitate privatization would have helped. For
example, the costs associated with continued government ownership of banks was not made clear
in any of three countries. Similarly, the potential benefits of foreign entry for domestic users of
financial services were never widely advocated. Steps such as these would have helped to
overcome political resistance to privatization.
Guidelines and Principles



55
It is important to consider the consequences for privatization when providing interim
support to nationalized banks. P'ublicly proclaiming that partial recapitalization has restored the
bank to health (likely done in an effort to restore market confidence, but implying full
recapitalization) can undermine the ability of government subsequently to privatize the bank,
since the investor's due diligence will reveal that further government support is required. The
authorities will be constrained by their prior public statements and will have incentives to delay
privatization in the hope that thle condition of the bank will improve and the gap in valuation will
diminish. The opposite is more likely to occur.
It also is important to lay the political groundwork to support privatization. The crisis
management team needs to have a political strategy to support privatization. In part, this includes
promoting realistic expectations regarding the value of nationalized banks among top political
authorities and the public. It also means promoting an understanding of the costs of prolonged
government ownership, in temis of not only fiscal costs but also the scope and quality of financial
services.
The structure of the deal can be used to mitigate the potential consequences of unrealistic
expectations. One means is by structuring transactions with upside potential for government.
Another is by offering guarantees that can boost the headline sales price.
Privatization by means of selling shares on the stock exchange should be approached with
caution. Weaknesses in the listing requirements of a stock exchange can mean that selling shares
will result in insufficient disclosure of the bank's financial condition, in particular the adequacy of
equity capital to support the risks run by the bank. As a consequence, it is unlikely that the bank
will be adequately recapitalized prior to sale, a fact that investors eventually will discover, to the
discredit of government. Moreover, in many countries, the resulting widespread bank ownership
may not provide for adequate bank governance. Banks sold in this manner may be left poorly
governed and managed and financially vulnerable.
Financial crises provide unique opportunities to achieve higher levels of professional
ownership of banks, while at the same time reducing costs to government and reducing
institutional demands. Selling banks to investors with the capacity and resources necessary to
ensure the sound governance and management of the bank in may instances may imply increased



56
foreign entry. The potential benefits and drawbacks of foreign entry continue to be the subject of
much debate. Nonetheless, it seems clear that increased ownership of domestic banks by world-
class international financial groups has important benefits.40 To the extent that foreign capital can
substitute for public sector capital in recapitalizing core elements of the banking system, the up-
front cost to government of financing crisis resolution can be reduced. To the extent that foreign
financial groups can assume governance responsibilities, the institutional burden on the crisis
management team can be reduced.
In summary, the following guidelines and principles are intended to improve the
privatization of banks:
*      Consider the consequences for privatization when providing interim support to
nationalized banks
*      Lay the political groundwork to support privatization
*      Structure the deal to mitigate the potential consequences of unrealistic expectations
*      Approach with caution privatization by means of selling shares on the stock exchange
*      Seize the unique opportunities to achieve higher levels of professional ownership of
banks, while reducing the costs to government and the demands on its institutions.
CHAPTER 7. RESTRUCTURING TROUBLED DEBT
One of the most critical, yet difficult, tasks involved in bank recapitalization and
restructuring is the restructuring of troubled debt. Troubled debt restructuring should be a routine
function for banks, an integral part of the lending business. Prudent bankers act aggressively to
minimize losses when debtors are unable to meet the contractual terms of their obligations.
40. Among these benefits at the bank level are improved governance, strategic, and risk management practices and
higher standards for accounting, auditing, disclosure, and transparency. The bank supervision function can be
strengthened as a result of the bilateral arrangements with the home-country supervisor of the acquiring bank. Even
though foreign banks may serve only a limited segment of customers, at least initially, countries in which foreign
banks have a meaningful presence tend to have better banking services and more resilient banking systems.



57
Policies, procedures, and skills that ensure prompt recognition of troubled debts and promote
actions to maximize collection are key to sustaining bank profitability and solvency.
Although debt restructuring is never an easy process for either bankers or debtors under
the best of circumstances, if it is addressed sufficiently early, bankers and the shareholders and
managers of firms can have incentives to work together to achieve mutually beneficial
restructuring outcomes. Bankers typically employ options such as those set out in table 1 in order
to improve long-run collection and salvage the profitability of the customer relationship.
Table 1: Basic Options for Restructuring Troubled Debts
Option                For firms                     For banks
Extend principal  Reduces d.ebt service  For firms with temporary problems that
and interest    (cash flow            can service all accumulated debt. Bank
maturity (due    requirements) over the  incurs no economic loss.
date)            near term, with no
effect on profitability
and no effect on
capital.
Reduce interest  Reduces debt service,  For viable firms unable to service all
rates           improves profitability,  accumulated debt. Bank recognizes an
and increases capital.  economic loss over time in accounting
terms.
Accept equity in  Reduces debt service,  For viable firms with prospects for
lieu of debt    improves profitability,  recovery. Bank immediately recognizes a
repayment (debt- increases capital, and  likely economic loss in accounting terms
equity swaps)    changes ownership    when equity is recorded at minimal value.
structure            Increases the potential to exert governance
over firms, but creates potential conflicts
of interest with the bank as owner and
creditor. Creates upside potential to
participate in firms' recovery.
Accept assets in  Reduces debt service,  For downsizing or nonviable firms. By-
lieu of debt    reduces assets, and   passes weak foreclosure framework.
repayment        may increase capital.  Requires management of real estate, plant,
equipment, and so forth.



58
Forgive a portion  Reduces debt service  For firms unable to service all
of the debt (debt  and increases capital.  accumulated debt, where repayment of
write-downs)                         remaining debt is more certain and
exceeds the anticipated proceeds from
liquidation. Bank immediately recognizes
an economic and accounting loss without
the potential for recovery.
The nature of the contracting environment in a country can substantially influence the
incentives facing banks and debtors. Especially important are contract enforcement provisions
such as foreclosure and bankruptcy. Where lenders are unable to execute liens on collateral or
force debtors into bankruptcy, debtors may have incentives to avoid constructive debt
restructuring, and lenders may have few incentives to pursue it.
The usual role of government in troubled debt restructuring is to provide an enabling
environment. Debt restructuring negotiations and decisions are left to bankers and debtors.
Providing an enabling enviromnent involves establishing guidelines for accounting treatment
(such as when income and losses are to be recorded), regulatory treatment (loan classification,
provisioning, and disclosure requirements), and tax treatment (such as the deductibility of loan
write-offs from taxable income and the taxability of write-offs for firms). It involves adopting
sound bankruptcy and foreclosure laws and putting into place the necessary public institutions to
support use and enforcement of those laws. Beyond this, government involvement will be limited
to overseeing bankers' performance in restructuring debts as part of routine bank supervision.
In certain situations, the authorities (usually central banks or bank supervisors) may
become more active in facilitating the conclusion of a debt restructuring agreement. This may be
the case for large, complex, systemically important, or politically sensitive firms indebted to a
large number of banks. Governments use techniques such as the so-called "London rules" for
motivating and coordinating restructuring actions by bankers and debtors. In essence, these
techniques involve a standstill period that allows bankers and debtors to negotiate what is
essentially an out-of-court restructuring. Rules governing parties' conduct during the negotiation
and voting procedures for approval also are likely to be included.



59
In systemic crises, where large numbers of banks and debtors are experiencing severe
financial (and-operational) problems, the incentives facing bankers and debtors may well change,
with neither party willing to restructure troubled debts. Managers of banks that may be revealed
to be insolvent in accounting or regulatory terms as a result of the losses they would incur under
debt restructuring may either (lelay restructuring or engage in cosmetic restructuring that defers
recognition of the inherent economic losses (see box 3). Similarly, debtors that may well be
insolvent under the contractual terms of their debts may have few incentives to enter into
restructuring negotiations that may reveal insolvency, require the sale of assets to raise cash, or
result in foreclosure or bankruptcy. Moreover, suspecting that banks are economically insolvent,
debtors may see no long-term relationship value (especially the possibility of new loans) in
continuing to service their banik debts. Debtors may conserve cash for internal working capital
rather than service their debts.
Box 3: Common Forms of Cosmetic Restructuring
Cosmetic restructuring essentially postpones the recognition of losses and can take many
forms. Most common is the dejferral of required debt service payments by granting extended
grace periods but where the debtor is unlikely to be able to make the payments. Another is to
remove the weak asset from a bank's books, while retaining the ultimate credit risk (by, for
example, selling debts to bank-owned or bank-funded affiliates like so-called "bad banks"). A
third common formn is the transfer of debts to government-owned asset management companies
"with recourse," where the originating bank retains some or full responsibility for losses.
Conversion of debt into equity carried at inflated values is a fourth common form. Finally, it is
not uncommon for bank managers to engage in reciprocal transactions with managers of other
banks for the purpose of postponing the recognition of losses.
Government action in response to a systemic crisis can compound this problerm. Action
that increases uncertainty (for example, by suspending, but not resolving, banks) or demonstrates
indecisiveness (such as failing to determine the disposition of assets in banks to be closed) can
further undermine the basic credit culture in a country. Asset resolution processes that allow
defaulted debtors to buy back thzeir debts at low prices have a similar effect. Ill-designed programs
for reducing nonperforming loanis can encourage debtors to default.
Regardless of their cause, these types of breakdowns in the normal debt restructuring
process can be costly. For banks, the suspension of debt service by even a small number of
debtors can result in negative cash flow, contribute to bank illiquidity, and drive up funding costs



60
(see box 4).41 This growing illiquidity reinforces banks' unwillingness to lend to any firm, further
curtails the availability of credit in the economy, and may lead to a larger than necessary decline
in output.42 The failure of debt restructuring to proceed also may delay necessary operational
restructuring by banks and firms.
Box 4: When Bank Cash Flow Turns Negative
Table B4. 1 depicts the financial structure of a sample bank. Given this financial structure
and the annual level of non-interest earnings and non-interest expenses, table B4.2 depicts the
point at which the suspension of debt service can cause the bank's cash flow to become negative
under different interest rate scenarios, expressed as a percentage of total loans. For example, in a
market where the average asset yield is 20 percent and the average cost of funds is 15 percent,
cash flow can be negative when debtors cease meeting interest payments on 22 percent of total
loans.
In a systemic financial crisis, the stakes for governments therefore become much greater,
and it may no longer be in government's best interest to limit its role to creating an enabling
environment. It may become appropriate, perhaps urgent, for government to take a more active
role in promoting debt restructuring.
Government can have at least four goals in more actively promoting debt restructuring.
One is to stem the flow of new finance to nonviable firms, since this flow may well increase bank
losses.43 A second is to promote the operational restructuring of debtors so as to improve
profitability, solvency, and liquidity. A third goal is to prevent a general deterioration in credit
discipline among debtors as a result of widespread inaction by bankers. Finally, government
might wish to ensure that the debts of sound but overly indebted corporations are restructured in
order to prevent excessive liquidations of firms, although in practice this is rarely a threat.
41. Banks will respond to the cash flow problem by bidding more aggressively for funding, raising deposit rates. This
increases the carrying costs associated with debts on which debt service has been suspended, accelerates the
decapitalization of banks, and raises government's contingent liability as the guarantor of bank deposits. By putting
upward pressure on mnarket interest rates, it also may increase government's own financing costs.
42. Declining output, in turn, reduces tax revenues, increases social expenditures and tensions (such as those arising
from higher unemployment), and worsens the condition of banks and firms, further raising potential costs for the
government. A downward spiral may ensue.



61
A more active role for government in promoting debt restructuring can involve
establishing incentives for bankers and debtors to engage in debt restructuring, such as
preferential tax or accounting Ireatment of losses. It can involve adopting more strict prudential
regulations addressing debt restructuring (such as loan classification and provisioning rules) and
aggressive enforcement efforts. It can include regulating the financial structure of firms.
Government can act directly in debt restructuring by leveraging its ownership interests in banks
(either public banks or those in. which it has acquired an ownership interest in exchange for
financial support) or by creating a public asset management company that purchases debts from
banks. In general, the governments of Korea, Thailand, and Indonesia employed all these roles in
a variety of forms and combina.tions.4
Country Experiences
The Korean government took a multipronged approach to corporate restructuring. First,
the most troubled chaebol were forced into court-supervised insolvency during 1997 prior to the
onset of the crisis. Second, the government adopted regulations requiring chaebol to, for example,
reduce their debt to equity ratios to 200 percent and eliminate cross-guarantee of affiliated firm's
debts. Third, the government required the five largest chaebol to agree to capital structure
improvement programs with their lead creditors, tightened exposure limits, and investigated
improper transactions among related affiliates within each chaebol. And fourth, for the less
troubled groups from among the second tier of chaebol (the "6-64"), the government promoted
bank-led out-of-court debt restricturing by orchestrating a corporate restructuring agreement
among local financial institutions. This agreement, which was signed by nearly all Korean
financial institutions, set a two- to five-month timeline for concluding debt workout agreements,
designated a lead creditor, established a creditor standstill period, and set a 75 percent threshold
for creditor approval of workoul agreements. A Corporate Restructuring Coordination Committee
was formed to provide guidance and arbitrate differences between creditors.
43. Bankers mnay have incentives to provide new finance to nonviable firns so as to obscure the debtor's true
financial condition.
44. For a detailed treatment of the troubled debt restructuring process in the three countries, see Mako (2001).



62
The Korean government used KAMCO initially as a means to remove nonperforming
loans from the portfolios of all banks (and some other financial institutions).45 Over time,
KAMCO was used more selectively to purchase nonperforming loans from troubled banks
benefiting from government support. See chapters 5 and 8.
In Thailand, the government relied on bank-led, out-of-court restructuring. Initially, the
government promulgated principles modeled on the London rules and established the Corporate
Debt Restructuring Advisory Committee (CDRAC), representing debtors and creditors. Later,
through CDRAC, the Bank of Thailand promulgated workout contracts between debtors and
creditors specifying timelines for progress on reaching workout agreements and requiring
creditors to pursue court-based remedies in cases of failure to make satisfactory progress. The role
of the Financial Sector Restructuring Authority was limited to bundling and auctioning the assets
of closed finance companies. The government created a public asset management company to
serve essentially as a buyer of last resort for finance company assets, with the intention of creating
competition for the assets and preventing them from being sold for too low a price. Later,
Thailand promoted creation of asset management companies by banks and established other
government-owned asset management companies (see chapter 8).
In Indonesia, the government's strategy for corporate restructuring had a number of
components. The Indonesian Bank Restructuring Agency acquired most of the nonperforming
loans of state-owned banks and private banks benefiting from government support. It was felt that
this specialized institution would be able to realize greater value from the assets than would the
bankers. The government also introduced the so-called Jakarta Initiative Task Force (JITF) to
facilitate non-IBRA corporate restructuring. JITF was geared toward restructuring involving
mainly foreign creditors. It was intended as a one-stop shop that would serve as an efficient
interface for the various government agencies with a role in authorizing and executing debt
restructuring. Modeled on a program used in Latin America, the government established the
Indonesia Bank Restructuring Agency to protect creditors and lenders against foreign exchange
45. KAMCO is a govermnent-controlled entity. The government and a public bank (Korea Development Bank) own
69 percent of KAMCO, with the remaining shareholdings spread among 32 other Korean financial institutions.



63
risk, in effect guaranteeing the availability of foreign exchange to service restructured debts.46
The government also sought to improve the bankruptcy process.
Assessment
Korea's performance has been distinguished by the ability of creditors to put a number of
chaebol into receivership and gain control of the affiliates of one of the top five chaebol
(Daewoo), thus demonstrating that no chaebol is "too big to fail." When the Daewoo crisis broke
in mid-1999, creditors resorted to a package of rate reductions, term extensions, grace periods,
and debt/equity conversions to stabilize $80 billion in Daewoo debt, while proceeding with the
breakup and sale of the chaebol. Quick agreement among bankers and nearly 20 of the second-tier
chaebol helped to restore financial stability. These involved roughly a 4:1 mix of debt
restructuring and corporate "self-help" (such as asset sales). Less progress has been seen with the
weaker second-tier chaebol, which are in "workout." Although there have been sonme sales of
businesses and real estate and some additional changes in management, Korea's workout chaebol
have yet to undertake deep operational restructuring. Indeed, 17 companies entered second-round
workouts by mid-2000-with further extensions of terms and grace periods, rate reductions, and
additional debt/equity conversSions. Overall in Korea, debt levels have not been substantially
reduced, and many firms continue to be unable to meet accrued interest payments.4
Corporate restructuring in Thailand has been stymied by the country's weak insolvency
and foreclosure regimes, which left almost no incentive for debtors to cooperate with voluntary
workout efforts. The Financial Sector Restructuring Authority's limitation on the management of
assets and its lack of super-administrative powers further encouraged the rise of "strategic
defaulting." Corporate workouts picked up momentum in 2000, but the emphasis was on
extensions of maturity and some modification of interest rates, with little evidence of operational
restructuring. Creditors have gained some successes in bankruptcy court, notably control over
Thai PetroChemical's $3 billion reorganization, suggesting that there may be some long-term
46. Only one borrower used this program, which, being judged not successful, was terminated.
47. In the summer of 2000, the government announced a second round of financial restructuring aimed, in part, at
resolving these firms.



64
deterrent benefits from the crisis, but even that case is still a question.
To date, Indonesia has achieved neither financial stabilization nor operational
restructuring. IBRA has assumed responsibility for some Rp256 trillion in face value of loans, the
bulk of which is represented by just 21 politically well-connected obligors. IBRA is committed to
restructuring 70 percent of these loans by the end of 2000. The quality of the recently announced
restructuring of several large corporate debtors (for example, Texmaco), however, is not
encouraging. Lengthy maturities (12-15 years) coupled with long grace periods (up to eight years
for principal) raise concerns about the true economic viability of the underlying firms. Since mid-
2000, however, there has been a surge in debt restructuring deals coming out of the JITF, as
fatigued creditors and debtors have attempted to normalize their relationships in the face of
macroeconomic recovery. Like the IBRA restructurings, the JITF restructuring agreements
heavily emphasize rate reductions, term extensions, and grace periods.
Overall, there remains considerable debate regarding the soundness of the debt
restructuring strategies employed by the three governments. A final conclusion can be drawn only
after the passage of more time. One key question is whether governments have done enough to
leverage public funds as a means to change the incentives facing bankers and debtors to promote
constructive debt restructuring. This question is explored in chapter 10.
Guidelines and Principles
Early steps to upgrade the legal framework and judiciary processes may be required. Weak
regimes for bankruptcy and foreclosure may provide incentives for bankers and debtors to avoid
participating in restructuring negotiations and may distort the outcomes of restructuring. They
may increase losses for banks and for government. If improvements cannot be made directly to
the permanent legal regime, temporary powers might be granted under special legislation adopted
for tackling the crisis.
London club-type approaches (moral suasion) may not work well in markets with weak
legal regimes. Without the threat of a credible alternative such as bankruptcy, borrowers have
little incentive to undertake and conclude debt-restructuring negotiations. London club-type
approaches provide a good guide to the organization of negotiations, information requirements,



65
and obligations of the various parties to the negotiation. To be truly effective, however, they need
enforceable timelines and credible alternative actions that will lead to a worse outcome for all
participants.
A key challenge for the crisis management team is to adopt and monitor controls on
cosmetic restructuring. One gcal is to control the abuse of grace periods for interest and principal
payments. Normally, grace periods should be limited to reasonable periods of time--say, less
than two years-and should be granted only to debtors able to demonstrate that their cash flow
problems are only temporary and that they can service the debt in full under its restructured terms.
Controls also should be placed on equity valuations to ensure that debt/equity swaps are not used
to avoid loss recognition. Unless the equity of the company is actively traded and a market price
is readily determined, it should. be booked at a negligible value. Transfers to affiliated companies
or transfers to third parties with recourse (continuing liability for loss) should not be permitted to
reduce the required levels of loss provisions.
Banks should be inhibiled from refinancing unsustainable levels of corporate debt. A
common source of higher costs to government is the continuing provision of finance to firms
unable to repay the new credit. These funds frequently are squandered or looted.
When government has substantial ownership interests in banks, it must act as principal in
the debt-restructuring process. Promoting sound debt restructuring is a key element of
government's role in exerting governance over the banks it has nationalized. The crisis
management team needs to ens are that bank management is operating under clear guidance and to
monitor bankers' performance. There is considerable risk of political interference in debt
restructuring decisions. This, again, emphasizes the importance of making up-front institutional
arrangements for crisis management that serve to insulate the technical work of crisis resolution
(see chapter 2).
Effort should be made to ensure that debts are restructured before debtor cash flow is
exhausted. One shared goal of the debt restructuring process is to salvage as much value as
possible. When firms with valuable facilities and operations exhaust cash flow (and are unable to
pay for salaries, supplies, facilities maintenance, and the like), there may be significant
destruction of value. This fact highlights the importance of obtaining information on the cash flow



66
situation of large debtors (see chapter 4).
Shareholders of firms unable to service their debts and requiring debt relief should be
made to bear significant losses. If many otherwise sound firms are unable to service their debts
fully, debt restructuring may well imply debt relief to firms, which benefits shareholders. In these
cases, firm shareholders cannot be immunized from loss; rather, they should be made
substantially poorer.
The domestic financial system should be inhibited from refinancing the foreign debts of
firms. Substantial pressure may be brought to bear on government to see that foreign creditors are
repaid by means of new credit obtained from the domestic financial system, deepening the losses
for domestic banks and for government. The crisis management team and government need to
ensure that losses are allocated appropriately to foreign creditors.
Operational restructuring is a key component of debt restructuring. Successful troubled
debt restructuring is more than simply a financial engineering exercise. Debtor operational
restructuring usually will be required so as to increase the capacity to service debt and minimize
losses to debtors, banks, and government. This has clear implications for the base of skills
necessary for banks and the crisis management team.
In summary, the following guidelines and principles are intended to improve the
restructuring of troubled debt:
*     Upgrade the legal framework and judiciary processes early in the process
*     Have limited expectations for London club-type approaches (moral suasion) in markets
with weak legal regimes
*     Take steps to limit cosmetic restructuring
*     Inhibit banks from refinancing unsustainable levels of corporate debt
*     Have the government act as principal in the debt-restructuring process when it has
substantial ownership interests in banks



67
*     Ensure that debts are restructured before debtor cash flow is exhausted
*     Ensure that shareholders of firms unable to service their debts and requiring debt relief are
made to bear significant losses
*     Resist pressures to refinance domestically the foreign debts of firms
*     Make operational restructuring a key component of debt restructuring.
CHAPTER 8. UTILIZING GOVERNMENT ASSET MANAGEMENT COMPANIES
In the context of a systemic crisis, a government asset management company (AMC) is
one means of reducing the cost to government of crisis resolution. In principle, a government
AMC can maximize the value of banks and bank assets.
A government AMC can maximize the value of banks by reducing the burden on bank
management, reducing risks, and improving information. Selling assets (usually nonperforming
loans) to an AMC relieves bankers of further responsibility for debt restructuring, eliminates any
future risk of loss arising from the assets, and makes transparent the losses inherent in the assets.
Bankers, freed from the burden of restructuring the assets sold to an AMC, are able to devote their
attention to other tasks. Eliminating the risks associated with the assets sold reduces uncertainty
regarding banks' finances, which can accelerate the process of recapitalizing and restructuring
banks, reduce recapitalization requirements, and improve the prospects for raising private capital
for recapitalization.
A government AMC also can maximize the value of bank assets. One means is by
bringing to bear more expert skills in the restructuring, management, and disposition of assets
than individual banks are able cr willing to acquire for themselves. Another means is by
consolidating debts to a single troubled debtor that are held by a number of different banks. This
centralizes the analysis and dec isionmaking associated with debt restructuring negotiations or
bankruptcy, foreclosure, or other liquidation proceedings.
The scale and scope of ciperations of an AMC can vary. It may have powers to restructure
assets or simply to collect or sell assets. It may handle a relatively narrow class of assets-for



68
example, only clearly nonviable firms with no bank/firm relationship value-or only debts that
can take advantage of an AMC's potential capacity for specialized liquidation (for example,
commercial real estate projects). Where a government nationalizes banks, the AMC might serve
as an organizational means to handle a wider range of debt restructuring and asset sales.48 In
severe crises, where many banks require financial assistance, the large volume of troubled debts
coupled with lack of bank institutional capacity may suggest a broad role for a government AMC
(see box 5 for a listing of the potential purposes, benefits, and drawbacks of using government
asset management companies).
48. Managers of private banks might use asset management subsidiaries in a similar manner.



69
Box 5: PURPOSES, BENEFITS, AND DRAWBACKS OF ASSET MANAGEMENT COMPANIES
IN THE CONTEXT OF SYSTEMIC CRISES
Possible purposes
*     Recapitalize banks by purchasing assets at greater than market value
*     Finance support to banks, while avoiding explicit fiscal consequences (the asset
management company buys assets with its own debt, which, though guaranteed by government,
is not accounted as a fiscal responsibility)
*     Reduce bank capital needs and bolster reported regulatory capital
*     Reduce uncertainty associated with bank assets when attracting new investment or selling
banks
*     Serve as a repository for credits to nonviable corporations (credit risk and management
responsibility are transferred to the asset management company)
*     Raise additional, nongovemment finance (the asset management company issues debt to
third parties)
Potential benefits
*     Specialized restructuring and collection expertise
*     Ability to aggregate debts from many banks into a single creditor unit
*     Economies of scale
*     Severance of personal or economic ties between bankers and debtors that give rise to
conflicts of interest
*     Special legal powers that facilitate restructuring and sale
Potential drawbacks
*     Loss of asset values
*     Loss of bank relationship value to firm and associated incentives to repay or restructure
debts
*     Loss of relevant information regarding the firm and its prospects
*     Deterioration in credit culture



70
*     Lost opportunity to develop troubled debt restructuring skills in banks
*     Less expert management
*     Drive for self-preservation and pressure to become a permanent (loss-making) institution
*     High degree of political influence.
The effectiveness of AMCs in maximizing the value of banks and bank assets has varied
in practice. Whether responsible for restructuring debts or simply liquidating assets, AMCs in a
number of instances have failed to achieve the objectives for which they were established. This
has been due to political interference and to weak legal and institutional environments (Klingebiel
2000).
Regardless of its scope, to be successful, an AMC needs a clearly defined mandate that is
consistent with government's crisis resolution strategies. Its objectives and goals must be
explicitly defined. Where possible, they should be quantified. An AMC requires clearly defined
operating policies and procedures. Like any organization, the AMC needs proper external and
internal governance and transparency to be credible and successful. It needs effective
management authorized to make business decisions in accordance with set goals and objectives
without political interference. It needs an appropriate organizational structure tailored to its scope
of operation, the types of assets handled, and the resolution strategy pursued. It should have
resources sufficient to build the necessary institutional capacity.
An AMC might be granted special powers to overcome deficiencies in the legal
framework and judicial processes. Such powers can enhance the AMC's ability to restructure
assets more quickly and to maximize recoveries. It also might be granted extraordinary powers to
hire and compensate staff outside the normal civil service limitations.
Country Experience
In Korea, KAMCO was created in the early 1960s to collect troubled debts for banks in
return for a fee. In late 1997, the government created within KAMCO the Fund for Resolution of
Nonperforming Loans, with initial capital contributions by the commercial banks, the Korean



71
Development Bank, and the KlDIC. This fund, to be managed by KAMCO, was used to acquire
nonperforming loans from bank and other financial institutions. Twice in 1997 and again in 1998,
the National Assembly authorized KAMCO to issue government-guaranteed bonds to finance
these acquisitions.
Between November and December of 1997, KAMCO purchased half the qualifying
nonperforming loans of commercial, merchant, and specialized banks.49 The principal purpose
was to improve these institutions' reported financial statements, including the regulatory measure
of capital. Initially, no substantive conditions were imposed for restructuring or recapitalization in
conjunction with these purchases. The government of Korea revised this policy in early 1998, and
thereafter purchases of nonperforming loans were limited to banks whose recapitalization and
rehabilitation plans were approved, usually in the context of government acquisition of an
ownership stake in the bank.
KAMCO acquired thousands of individual assets, principally operating and closed-down
factories and commercial real estate. Except in the case of Daewoo, it played little role in
corporate restructuring. Assets were originally acquired at above-market prices, but eventually at
approximate market prices, on average at around a 60 percent discount from face value. In many
instances, the selling banks retained some contingent liability for loss. KAMCO collects, sells
loans, and forecloses and sells collateral. It also engages in financing transactions (securitizations)
in order to raise additional cash to finance more purchases. Under these transactions, KAMCO
and the originating banks retain contingent liabilities for loss on the assets securitized. KAMCO
uses similar mechanisms to fonn joint ventures with private firms that have asset management
expertise. The joint ventures give the joint venture partner contract management responsibility
and give KAMCO the ability to participate in any increase in the value of the assets.
In Thailand, banks and the government tried to manage nonperforming loans through
several types of AMCs. A 100 percent government-owned AMC was created in 1997 specifically
as a bidder of last resort for the assets of 56 liquidated finance companies. Another state agency,
49. At that time nonperforming loans were defined as collateral-backed loans in which interest payments are overdue
for six months.



72
the Financial Sector Restructuring Agency (FRA), conducted the sale of those assets in a series of
auctions. The government AMC was allowed to bid competitively in the second round of bidding
of assets only if the private sector did not meet the reserve price in first-round bids. This AMC
issued debt not guaranteed by government to pay the FRA for assets purchased. Its mandate was
to preserve capital and to sunset, but management took a lenient approach to debt workouts.
The Financial Institutions Development Fund set up two other asset management
companies to manage nonperforming loans of individual state-owned banks. A group of private
third-party asset managers were to manage tranches of nonperforming loans on behalf of one
AMC. When the government sold a nationalized bank, its nonperforning loans were transferred
to a third AMC owned by the Financial Institutions Development Fund. The purchasing bank
manages this AMC under a gain- and loss-sharing agreement, under which the purchaser shares 5
percent of gains and 15 percent of losses incurred in loan workouts.
For the private banks, the government took a market-led solution by providing public
funds on a matching basis with new private capital as a last resort and by encouraging the
establishment of private asset management companies. Tax disincentives for the establishment
and operation of private AMCs were eliminated. However, private AMCs did not progress as
hoped. Most banks established asset management companies as wholly owned subsidiaries, and
the parent banks continued to bear the risk of the assets. Most asset management companies were
still managed by the banks rather than by third-party specialists. The transfer price of these
nonperforming loans was at book value, and auditors did not recognize these transfers as true
sales.
As described in chapter 2, in Indonesia the government set up IBRA in early 1998 with a
wide range of responsibilities, including that of an asset management company. IBRA in effect
acquired assets from banks at face value in exchange for direct governnent obligations, including
fixed and floating bonds and domestic currency bonds indexed to the U.S. dollar.50 IBRA set up
three operational units to manage the assets acquired: the Asset Management Credit Unit, the
50. In fact, the loans were written off by the banks, which then were recapitalized with direct government obligations
(not IBRA debt). IBRA booked the assets at face value, reportedly to avoid loss recognition on the government
accounts.



73
Asset Management Investment Unit, and the Bank Restructuring Unit.
The Asset Management Credit Unit restructured and disposed of nonperforming loans
transferred to IBRA from recapitalized state-owned and private banks and from nationalized
banks and banks placed in liquidation. Nonperforming loans transferred to IBRA from state-
owned banks accounted for the major portion of those assets. IBRA also was responsible for
disposing of a small portfolio of other assets, such as buildings, land, office equipment, artwork,
and vehicles, acquired from these banks.
The Asset Managemeni: Investment Unit was responsible for recovering assets pledged to
IBRA by the previous owners of nationalized banks and banks placed in liquidation to settle the
owners' liabilities stemming from violations of lending limit regulations. The pervious owners
were asked to sign shareholder settlement agreements and to pledge certain assets to IBRA. In
most cases, however, the owners were able to retain their operational control over companies
whose shares had been pledged.
The Bank Restructuring Unit was responsible for managing and disposing of shares of
banks recapitalized by the government. Its task was to improve performance and efficiency of
banks under its control and to enhance the value of government's investments in those banks.
Assessment
In the countries reviewed here, government asset management companies have not proven
to be a panacea, consistent with, prior experience in other countries (such as Mexico). They have
suffered a number of weaknesses, which are reviewed briefly here.
In the case of Korea, KAMCO initially was intended to strengthen banks' reported
financial statements using off-budget financing, as the debts were purchased from banks in
exchange for bonds issued by KAMCO. Similarly, IBRA faced problems stemming from a lack
of political consensus regarding its intended role, as well as an inability to recognize losses, a
weak and ineffective legal and judicial climate, and continued political interference. Maximizing
the value of the acquired assets was a secondary consideration in both countries when the AMCs
first began acquiring assets.



74
In Indonesia and in some instances in Thailand, the loans were acquired at book value,
which created incentives to hold rather than dispose of the assets, in order to avoid recognition of
the loss. This impeded the sale of assets by IBRA. Moreover, IBRA's sales targets were driven by
fiscal targets and were imbedded in IBRA's budget each year. This had the effect of setting the
ceiling for sales each year. The desire to ensure the ability to meet the next year's target
diminished the incentive to exceed the current year's target.
Thailand tried a number of structures for managing assets held by asset management
companies, including having the AMC manage itself, contracting third-party managers, and
allowing the assets to be managed by the acquirers of the originating (nationalized) bank. More
time will be required to evaluate the relative performance and merits of these alternatives in
Thailand.
The structure of sales transactions created problems in some instances. In Korea, the banks
often retained a residual exposure to losses arising from the "sold" assets (as, in effect, did the
Thai banks in selling assets to their AMC subsidiaries). The banks' full contingent liability may
not be reflected on their reported financial statements. The contingent liability in principle gives
rise to the need for ongoing management. Indonesia is an exception in that the selling banks
retained no further liability for loss.
A weakness common in all three countries was the failure to attract and retain the best
professional skills for asset management and disposition. Resource constraints and civil service
hiring and compensation restrictions were part of the cause. Failure to attract professional
management resulted in poorly defined strategies, weak operating policies and procedures, and
other institutional weaknesses. Asset management companies are complex institutions that require
a significant investment in capacity building. Building institutional capacity is difficult and costly.
Among the tasks are hiring a large number of staff in a short period of time, developing policies
and procedures, putting in place proper safeguards to reduce the likelihood of wrongdoing,
assembling information, reviewing assets and determining a resolution strategy, contacting
borrowers and negotiating repayment plans, organizing asset sales, preparing and filing litigation
and other court proceedings, and communicating progress to governance authorities and the
public.



75
These and other weaklesses in practice tended to negate the ability of asset management
companies to maximize the value of banks and bank assets. Debts often were warehoused and not
restructured in a timely fashion. Debtors had fewer incentives to service debts once they were
transferred to asset management companies.
Guidelines and Principles
The government has to be willing to recognize the losses incurred in the crisis. The
political will to recognize and finance the portion of losses that cannot be allocated to and
absorbed by others is necessary to be able to create appropriate incentives for the restructuring,
collection, and sale of debt.
If an AMC is used it should have a publicly defined mandate with clearly defined goals.
Making the goals public can reduce the potential for political interference. Senior management of
the AMC can be required to enter into performance contracts that include targets designed to
achieve the goals.
When determining how rapidly to sell assets, it is important to weigh the costs inherent in
holding them. Many factors must be taken into consideration. The assets must be financed, and
financing costs can be reduced by rapid sale. Management costs (AMC overhead) similarly can be
reduced if assets are sold promptly. By definition, ownership of assets gives rise to risks and
holding costs (maintenance, insurance), which normally are transferred to others on sale.
Although rapid sale into a market where uncertainty is high may mean receiving lower values,
failing to sell can produce an asset overhang (substantial ownership of a class of assets by
government), which can forestall the reduction of uncertainty. These factors must be weighed
differently for different classes of assets. In any case, the sale must be orderly and generally
should begin earlier rather than later.
It is important to craft carefully any special powers granted to AMCs. Although
potentially beneficial, the granting of special powers generally will reduce debtor rights and must
be viewed with caution. If granted, steps should be taken to prevent the potential for abuse,
including by promoting transparency and limiting the lifespan of such powers. Permanent changes
in the legal regime applicable to all debtors and creditors are preferable to temporary ones.



76
Private sector involvement is needed in the asset management process. Under the best of
circumstances, government could arrange for the sale of assets directly to the private sector. In
practice, this is difficult to orchestrate. In that case, the private sector can be tapped as managers
of assets owned by government and as financing and equity partners in asset management
companies. This might include the use of special-purpose vehicles in which the government may
retain the right to share in ultimate recoveries. Properly structured, such vehicles have the
advantage of bringing new money as well as international expertise to the restructuring efforts.
They also may speed up the pace of large, complex debt restructuring negotiations by
concentrating resources on a few targeted cases.
In summary, the following guidelines and principles are intended to improve the use of
government asset management companies:
*     Recognize the losses that have been incurred in the crisis
*     Provide the asset management company with a publicly defined mandate
*     Weigh the costs inherent in holding assets when determining how rapidly to sell
*     Carefully craft any special powers granted to AMCs
*     Maximize private sector involvement in the asset management process.



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PART 2. IMPROVING THE EFFICIENCY OF CRISIS
RESOLUTION
Part 1 reviewed the principal actions taken by governments in the three countries, assessed
those actions, and suggested guidelines and principles that either were important to the
governments' accomplishments or, if adopted, would have improved the results they achieved.
Part 2 draws mainly on work undertaken by the World Bank in Korea in 1998 to develop the
conceptual underpinnings for two fundamental improvements in crisis management techniques
that might have substantially imnproved outcomes. One key improvement is to have the crisis
management team develop an explicit, comprehensive crisis resolution strategy. The second
improvement is to link financial restructuring more closely with corporate restructuring. A
common theme in both recommendations is to improve the efficiency of government efforts by
maximizing the impact of the public funds used in resolving a crisis.
CHAPTER 9. DEVELOPING A COMPREHENSIVE STRATEGY
Resolving a financial crisis is similar to dealing with an urgent and complex business
problem in the private sector. As it is for managers in the private sector, a key task for the crisis
resolution team is to design and execute a strategy for solving the many problems posed by a
cnsis.
Explicitly defining a coinprehensive strategy is essential because it allows the crisis
management team to avoid working in a reactionary mode, merely responding to events. The
resolution process is long and complex. Some problems can be solved in weeks, some can be
solved in months, and still others may require several years to solve. The problems themselves are
intertwined. For example, solutions to financial problems in banks have implications for debt
workouts in the large corporate sector and vice versa. Steps taken in nationalizing banks have
implications for the government's ability to privatize them. The manner in which nationalized
banks are privatized has implications for government's ability to raise private capital to resolve
other banks. Moreover, solutions to financial.problems have to be tempered by recognition of
their political and social implications (for example, foreign entry or layoffs). Adopting a
comprehensive strategy enables the crisis management team to integrate the various components



78
of its work. This form of discipline helps to ensure that the major strategic elements are thought
through before significant actions are taken in any one area. Conversely, failure to develop an
explicit, comprehensive strategy likely results in actions and decisions that undermine future
degrees of freedom, lead to partial and false solutions, and result in higher long-run costs.
Principal Elements of a Comprehensive Strategy
Like in the private sector, the public sector approach to defining strategy involves tasks
such as gaining agreement on what must be achieved, setting concrete goals, defining basic
principles to govem actions, gathering and analyzing information, and ensuring that the strategy is
consistent with the team's capacity to execute.
A first step in defining strategy is to obtain from senior political authorities clearly defined
objectives for the crisis management team.51 The strategic objectives set out in box 6 could be
adapted and elaborated based on country-specific circumstances.
Box 6: Objectives of a Comprehensive Strategy for Crisis Resolution
Restore the confidence offinancial institution depositors, creditors, and investors.
Restoring confidence is necessary to stabilize financial sector liquidity and to tap international
and domestic private equity capital and debt finance.
Restore the solvency, profitability, and liquidity of the financial system and build
institutional capacity. The economy requires the services of a sound and well-developed
financial system, including better governance over firms.
Restore the solvency, profitability, and liquidity offirms. The financial system cannot be
restored to health unless the corporate sector is restored to health. Efforts to fix banks while their
debtors are unable to service their debts will not be durable and will prove costly.
Strengthen financial sector structure and the regulatory framework. Government action
in resolving the crisis will significantly affect the structure of the financial system (institutions
and markets) and can be used to correct long-standing structural and regulatory weaknesses. In
financing crisis resolution, the government can create a range of liquid government debt
instruments, which can encourage capital market development. Regulatory changes can be used
to drive improved governance and greater market discipline.
51. Depending on the nature of the institutional arrangements (see chapter 2), the relevant senior political authorities
may well be conformed as the governing body for the crisis management teamL



79
Minimize losses. The stock of losses will continue to grow unless action is taken to
prevent it. Although some losses will be borne by the private sector (shareholders, creditors),
many may accrue to the government, with significant fiscal consequences. Attempts to limit up-
front fiscal outlays can lead to higher losses and long-run costs. Large up-front outlays may be
required to achieve a definitive resolution. A portion of those outlays can be recovered over time.
Getting the economy back on track quickly also will help to reduce the long-run costs.
Finance the losses. The government will have to ensure that adequate financing is
available and that adequate instruments and markets exist.
As a complement to these overarching objectives, the crisis management team needs to
agree on a long-run vision of the desired nature of finance and financial relationships in the
economy. This also should be agreed with the senior political and financial authorities. The vision
would give shape to the post-crisis financial system and serve as the long-run target of decisions
that the team will have to take in resolving the crisis.
Armed with clear objectives and a basic vision of the future, the crisis management team
then defines concrete goals for the period of their work, typically three to five years. These goals
relate both to financial problems (insolvency or illiquidity among banks and debtors) and to
structural problems (weaknesses that led to the problems or that will impede resolving them). The
goals are shared with and ratified by the senior political authorities. The crisis management team
then defines near-term objectives consistent with the goals.
A comprehensive strategy involves defining specific operating principles to guide the
actions of the teamn. They are designed to promote transparency, to ensure fairness and burden
sharing, to minimize waste, looting, and bailouts, and to use public support for banks to maximum
effect. They define the basic parameters for determining who is eligible to benefit from public
support. It is important to ensure that senior political authorities ratify these principles.
The strategy should be based on a realistic assessment of the dimensions of the problems.
Underestimating the scope of the problems would undermine the utility of a comprehensive
strategy. The lesson of experience is that problems often are worse than initially imagined.
Therefore, the team's strategy should accommodate a worst-case scenario. It needs to be flexible,
since it likely will need to be revised and enhanced as the work proceeds. The strategy must have
sufficient flexibility to acconiniodate unexpected events and the discovery of more severe



80
problems. Even where the strategy has been formulated to accommodate a worst-case scenario, it
should be validated and updated periodically by the crisis management team. In some cases, this
may require modified political agreements.
Implicit in the foregoing is that both the senior political authorities and the crisis
management team have distinct roles to play in developing and executing a comprehensive
strategy. The senior political authorities (particularly the president or prime minister, the finance
minister, and legislative leaders) need to orchestrate political consensus around matters such as
overall objectives, financial sector visioIn, medium-term goals, and operating principles. The crisis
management team handles the details of the strategy based on explicit, politically agreed guidance
on these matters. It then develops strategy, establishes priorities, and defines and executes the
specific work of crisis resolution. Providing explicit guidance allows the political authorities to
hold the crisis management team accountable for execution and to deflect at least some of the
pressure from constituencies.
Executing a Comprehensive Strategy
Putting a comprehensive strategy in place lays the groundwork for defining the work
program of the crisis management team and their plan for executing the strategy, which will
involve simultaneous action on many fronts. The work program defines the actions required to
move from widespread bank and debtor insolvency through to the final sale of all banks, problem
loans, repossessed assets, and company shares the government will come to own in the process.
Also involved are the unwinding of any extraordinary government guarantee of bank liabilities
and reconfiguration of the financial system in accordance with the agreed vision. The work
program should be concrete, specifying what actions will be taken, by whom, and when. At the
same time, the work program needs to be revised and updated constantly as the work unfolds.
A key task of the crisis management team is to maintain political consensus on the
principal elements of a comprehensive strategy. This is not a one-time event. This is an important
task in the context of challenges likely to confront the team, such as the discovery of more serious
problems than were originally contemplated, organized lobbying by vested interests, and negative
reaction to the sale of banks or firms to foreign investors.



81
Similarly, maintaining media and public support for the strategy needs to be part of the
work program. Stakeholder groups tend to have unrealistic expectations about the speed with
which problems can be solved and to anticipate misuse or unfair use of public support. The crisis
management team has to have an ongoing communications program that incorporates information
about the (realistic) timing of the team's work, especially key actions and decisions. To build and
maintain public support, the communications program needs to demonstrate and emphasize the
team's application of the principle of fairness in its decisions (highlighting the importance of
having that principle agreed at the political level). Building strong public support also can be
critical in keeping the prograrm on track in the event of changes in the political leadership.
CHAPTER 10. LINKING BANK AND CORPORATE DEBT RESTRUCTURING
Government almost certainly will have to provide substantial financial support to banks in
order to salvage the banking system from a systemic crisis. The process of crisis management is
largely a process of maximizing the impact of support to banks. This "impact" cannot be limited
to banks only; it also needs to affect corporate debts to the extent that they undermine the finances
of banks.
The Korean, Thai, and Indonesian governments left debt restructuring decisions largely to
bankers and debtors. The governments played a limited role and, with minor exceptions, did not
explicitly link the provision of financial support to banks with the outcomes of debt restructuring.
Bankers-either managers of private banks or managers contracted to run nationalized banks-
were responsible for pursuing corporate debt restructuring. See table 2 for the principal features of
this approach.



82
Table 2: Features of Governments' Approach to Debt Restructuring
Government role                   Benefits                    Risks
Create enabling environment        Minimizes          Defers losses via
(accounting, regulatory, and tax   government         cosmetic restructuring,
treatment), encourage formation of  involvement and   does not strengthen
voluntary creditors' committees,  reduces the         banks, and raises costs
provide regulatory (forbearance) and  potential for
tax incentives, upgrade creditor-  political
debtor legal framework, and provide  interference
oversight via bank supervision
process
This chapter suggests a means by which government can link the provision of financial
support to banks more closely with actual outcomes of corporate debt restructuring. It describes a
means for leveraging the financial support that government provides to banks so as to improve the
incentives for debt restructuring to occur.52 From a banker's perspective, the improved incentives
derive principally from the fact that govermment provides the capital necessary to absorb the
losses inherent in debt restructuring and promotes the bank's survival. From a debtor's
perspective, the government provides the means to obtain needed cash flow, and perhaps debt
relief, and signals the anticipated long-run viability of the bank. This can improve the debtor's
incentive to engage in debt restructuring, which can preserve the bank relationship and restore
access to new credit.
Underlying this approach is recognition of the fact that there is an inherent financial
interdependency between restructuring debt and granting support to a bank that will be salvaged:
the amount of support should be based (in large part) on the losses the bank likely will incur in
constructively restructuring debts, while constructive debt restructuring is unlikely to proceed
without adequate capital support. A key challenge for government is to make transparent the
losses inherent in debt restructuring as a means of determining the amount of support required by
banks. There are essentially two ways to make the losses transparent: either sell the debts or
restructure them. The tendency is for governments to sell debts to government-owned asset
management companies in order to facilitate bank resolutions, but this creates its own set of
52 For additional information see Scott 2000a.



83
problems and potential costs, as discussed in chapter 8. A key objective of the approach suggested
in this chapter is to speed up the process of bank resolution and debt restructuring without
transferring large volumes of loans to asset management companies.
The chapter first reviews the principal weaknesses of the approach actually taken by the
three Asian governments. It then discusses the nature of the basic goals of a more aggressive
approach to debt restructuring and the means to execute that approach.
Weaknesses in the Approach Taken by Asian Governments
The approaches taken by the Korean, Thai, and Indonesian governments suffered from at
least three general weaknesses. First, they did not sufficiently leverage government's financial
support as a means to change the incentives for bankers to restructure debts.53 Providing financial
support to banks without linking the new capital to explicit restructuring outcomes reduced the
incentives for bankers to engage in debt restructuring, since it allowed them to write down (or
create provisions for) debts without restructuring (reducing) their claim on debtors and their
assets. Although the banks' ba]ance sheets were improved, the debtors may have been left overly
indebted. The financial position of banks appears to have improved, but this might be illusory.
A second weakness was that the governments, in effect, ceded to bank managers the
analyses, decisions, and follow-up that would significantly influence the governments' eventual
cost in salvaging the banks and resolving the crisis. This might have any number of consequences,
including decisions based on insufficient information and analysis, excessive debt forgiveness to
well-connected debtors, and insufficient action to ensure recovery of the remaining debt.
The third weakness was that banks received financial support without sufficient
information regarding the likely extent of losses inherent in constructive debt restructuring. Given
the incentives to underestimate the scope of losses, governments' initial rounds of support were
53. One exception was a program in T'hailand where the government made available additional Tier 2 debt capital
linked directly to the magnitude of the write-downs resulting from debt restructuring and the net increase in private
lending. The program was little used, however. In Korea and Indonesia, an indirect link between debt capital and
write-downs was established by linkling recapitalization to performance contracts that required improved risk
management capacity, including credit workouts and a reduction in nonperforming loans. But capital was provided in
advance of actual performance, and liatle provision was made for monitoring or enforcing contracts.



84
insufficient, making additional rounds of support likely. This undermined the credibility of the
support program and the incentives facing bankers. It delayed bank resolution and debt
restructuring and raised costs.
Goals of Linking Bank and Corporate Debt Restructuring
Taking a more aggressive approach to debt restructuring is intended to promote
constructive debt restructuring (in other words, to avoid both inaction and cosmetic restructuring)
and to control costs to government.
The first goal is to remove the incentives that bankers and debtors may have to either
delay restructuring or engage in cosmetic restructuring and to create incentives for both parties to
engage in constructive debt restructuring. This has two benefits. First, it can make transparent the
losses inherent in debt restructuring more quickly so that governments can ascertain the need to
recapitalize banks and provide support that will restore the cash-based profitability of banks.
Second, accelerating the debt restructuring process can result in more prompt restoration of the
creditworthiness of firms. Restoring banks to health and making firms creditworthy lay the
groundwork for a resumption of lending under market-based terms and conditions, reducing
uncertainty, boosting output, reducing costs, and improving government's ability to finance those
costs.
The second goal is to ensure the prudent use of the financial support that government will
provide and better control the potential moral hazard inherent in providing that support.
Government especially needs to avoid a situation where it.has only limited information on the
activities of bankers, while being forced to provide multiple rounds of financial support to them.
By contractually linking support to the outcomes and performance of debt restructuring,
govermments can hold bankers responsible for their restructuring efforts and create better
incentives for them to engage in constructive debt restructuring. It is possible to reduce not only
the cost of delay but also the risk that bankers will engage in excessive debt forgiveness.
Design and Execution of the Approach
The key distinguishing features of this approach are (a) that financial support to banks
would be contingent, by contract and perhaps also by law, on bankers' performance in



85
restructuring debts and achieving debt restructuring outcomes and (b) that the crisis management
team would play an active role in monitoring and ratifying debt restructuring decisions taken by
the managers of banks receiving public support. See table 3 for a summary of the basic features of
this approach.
Table 3: Features of Linking Bank Support to Debt Restructuring Outcomes
Government role                Benefits               Risks
Provide financial support to banks Leverages financial  Requires substantial
under contractual terms and   support to promote prompt  institutional capacity
conditions that promote debt  debt restructuring, reduces  to implement
restructuring, ratify analyses and  the potential for cosmetic  effectively
decisions relating to restructuring  debt restructuring, makes
of large credits, evaluate bankers' transparent the outcomes of Potential for
debt restructuring performance  debt restructuring, and ties  political
with contractual remedies for  managers' future       interference.
poor performance, including   employment to debt
cessation of support, and perhaps  restructuring outcomes.
establish a special supporting
legal regime.
Support to banks would be available only under contracts linking the amount and timing
of financial support to debt restructuring outcomes and performance (as well as a range of other
performance standards not dealt with here). The contract would provide for new capital based on
the actual losses incurred in appropriately restructuring debts. To strengthen the incentives facing
bankers and to control potential moral hazard, the agreed support would be disbursed in tranches
based on performance.
The crisis management team would be responsible for and closely oversee the negotiation
and enforcement of contracts. A key activity would be to monitor debt restructuring performance
(coverage of the portfolio, policies applied, and procedures used) and outcomes (veracity of
restructured financial terms ancl the associated terms and conditions for debtor operational
restructuring). Large debtor relationships would be monitored case by case. Small loans would be
monitored on a portfolio basis. The team will have to have the ability to judge the performance of



86
bankers in using the support provided and to insist on managerial changes where support has not
be used effectively.
Support should be provided to banks only under this program. To avoid the moral hazard
that might arise in granting support, in principle support should be restricted to banks that engage
in constructive debt restructuring (involving concessions and loss sharing by both parties).
Similarly, debt relief to firms that is enabled by government support to banks should be available
only to firms that engage in constructive debt restructuring. All steps taken should avoid allowing
beneficiaries of support to believe that they can obtain more support in the future. The contract for
support must be seen as a one-time opportunity.
The institutional capacity necessary to design and execute such an approach to crisis
resolution is formidable. On the one hand, such institutional capacity is beyond what can be
realistically expected of many governments. On the other hand, the international financial
community has a great deal of expertise in applying the basic elements of this approach. These are
the same elements used by private sector investors. The principal constraint may be the lack of
political will to take a hard-nosed approach to the provision of support to banks and to put in
place the necessary institutional arrangements, in particular insulating the crisis management team
from inappropriate political interference (see chapter 2). If political will exists, the principal
challenge is to assemble a crisis management team with the skills and leadership capacity to
design, organize, and implement this approach.



87
PART 3. PREPAIRING TO MITIGATE THE RISK OF CRISIS
Part 1 reviewed the principal actions taken by governments in the three crisis countries,
assessed those experiences, and suggested general guidelines and principles that support crisis
resolution. Part 2 developed the conceptual underpinnings for two fundamental improvements in
crisis management practices. F'art 3 draws on the experiences in the three countries and elsewhere
to identify key steps that regulatory authorities can take to mitigate the risk of crisis and be better
prepared to deal with shocks should they occur. The objective is to reduce the potential that
shocks lead unnecessarily to systemic problems or even full-scale financial crises. T he steps
reviewed in part 3 can be taken today by supervisory agencies, central banks, deposit protection
agencies, and financial institutions.
Shocks might involve isolated events, such as the sudden withdrawal of deposits from a
bank or the bankruptcy of a large debtor. They also might be of a more systemic nature, such as
major changes in public policy, significant movements in interest rates, devaluation of the
exchange rate, or the collapse of real estate or equity market prices. Two relevant facts in this
regard are that many shocks of this nature can be expected to occur in most markets sooner or
later and that some banks will weather them, while others will not. Government can promote the
ability of official agencies, financial institutions, and, most important, financial markets to deal
with shocks such as these and to reduce the potential that damage will spread unnecessarily.
Part 3 advocates the use of contingency planning as a tool to improve preparedness to deal
with shocks. Undertaking formal contingency planning prior to a shock will help the authorities or
financial institutions to identify the types of actions that may have to be taken in such a situation,
as well as the skills, policies, and processes required to support those actions. Contingency
planning can lead to prompt and comprehensive action to mitigate the risks that shocks will cause
unnecessary damage. The use of contingency planning is discussed in the context of the two key
points of interest in dealing with shocks: liquidity management and the intervention in weak
banks.



88
CHAPTER 11. BANK LIQUIDITY MANAGEMENT
Governments can mitigate the riskc of crisis by ensuring that supervisory authorities have
carefully evaluated regulations, supervisory policies, and practices applicable to the management
of liquidity shocks incurred by banks. A shock involves a sudden increase in demand for liquidity
by banks. Shaken depositor confidence might lead to deposit outflows. The inter-bank market
might be sharply curtailed as well, limiting the role of the system itself in recycling liquidity to
needy banks. Bankers need to be well prepared to weather such liquidity shocks. Their failure to
be prepared can exacerbate a shock and trigger a systemic financial crisis.
Supervisors should routinely ensure that bankers and bank boards of directors adopt
adequate policies and practices for liquidity management. Relevant bank policies include defining
how liquidity is to be measure and limited, setting minimum monitoring and reporting standards,
and determining how exceptions to limits are to be authorized. Relevant practices should include
routine measurement of current and prospective liquidity under a range of possible market
conditions and continuous management of overall bank (and, where appropriate, financial group)
liquidity.
In addition to applying the standards of basic risk management to the policies and
practices of bank liquidity management, supervisors should require bankers to prepare detailed
contingency funding plans that define the manner in which they will maintain bank liquidity in
the event of distress. The plan should set out the specific steps that bank managers intend to take
to weather a severe liquidity shock. Although borrowing from the central bank should be seen as a
last resort, bankers should be required to ensure that the assets and documentation required to
support collateralized borrowing from the central bank are in proper order. Government should
ensure that supervisors routinely evaluate banks' adherence to these standards as part of the
supervisory process.
Supervisors themselves need to be prepared to respond to liquidity problems in banks.
They need to be prepared to send staff and auditors into banks experiencing liquidity problems,
and these persons need to be prepared to evaluate the bank's funding situation and to detect
potential looting or other misuse of liquidity by bank insiders. Supervisors should be prepared to
solicit from the bank detailed liquidity reports depicting its funding situation, likely on a daily



89
basis. These reports can be designed in advance, and bank managers can be familiarized with their
content and use. Supervisors should be prepared to impose enforcement actions rapidly and to
monitor compliance, if necessary, to stem the potential misuse of liquidity. Defined procedures
for these supervisory steps can be set out in advance.
Finally, the relevant authorities (supervisory authorities, the central bank, and the deposit
protection agency) each will need to be prepared to play their respective roles in promptly
resolving a bank experiencing liquidity problems. A key objective is to avoid a situation where
the central bank is forced to provide liquidity to a bank due to the authorities' inability to
implement a resolution mechanism, such as those discussed in chapter 5. The authorities' roles
include, for example, determining the condition of the bank, choosing appropriate resolution
mechanisms, and promptly implementing those decisions. To mitigate the risk of crisis and
enhance crisis preparedness, government should ensure that the official institutions are well
prepared to play their given role in the bank resolution process.
CHAPTER 12. RESOLVING WEAK BANKS
Weak banks are like a cancer in the system. They often are irrational competitors that
skew the pricing of risks and undermine systemic profitability and stability. The existence of such
banks increases the potential for a shock to lead to crisis. Perhaps the most important step
government can take to mitigate the risk of crisis and promote the performance and stability of the
banking system is to ensure that the responsible authorities have and use the capacity to, in effect,
weed out weak banks. This means ensuring that the legal, regulatory, and supervisory regimes
promote the identification and r esolution of weak and failing banks. The objective is to ensure
that bank failures are handled in the normal course of business without disrupting the system
unnecessarily.
Law and Regulation
In the context of resolviing weak banks, the most relevant elements of the legal and
regulatory framework are prudential regulations relating to capital and the powers of supervisors



90
and other relevant authorities in the event of bank illiquidity or insolvency.54 Laws and
regulations applicable to foreign ownership of banks and taxes also are relevant.
Governient needs to ensure that the regulatory framework for prudential capital standards
is sufficie\ntly conservative so as to enable supervisors to take action before banks are severely
insolvent. \This framework encompasses prudential rules applicable to capital adequacy, asset
classification, and asset provisioning, along with related regulatory accounting standards.
Intemationally agreed standards and principles provide a good point of reference. Taking action to
strengthen the local regime can help to mitigate the potential consequences of shocks.
Laws granting powers to supervisors and other relevant authorities in the event of bank
illiquidity or insolvency were deficient in each of the crisis countries addressed in this paper. A
significant, yet common, weakness was the inability to suspend or terminate the ownership rights
of shareholders of banks judged to be insolvent. Government can evaluate the adequacy of such
powers either through actual use (trial and error) or by engaging in contingency planning. Both
methods are discussed later in this chapter.
As discussed in chapter 2, the permanent institutions of government may not provide a
sufficient response to a crisis, and the formation of a special, temporary crisis management team
might be advisable. The powers of the team might supersede those of the legal authorities of the
country's permanent official institutions. Special legislation might be required to vest the team
with those powers. Getting such legislation in place in the midst of a crisis can be time-consuming
and contentious. Govemment can avoid this eventuality by making provisions in existing law for
the establishment of some form of crisis management team in the event of a systemic shock.
Foreign investors are one potentially important source of new capital for banks. At the
outset of the crises, all three countries had in place legal restrictions on foreign investment in
banks, reducing the potential supply of new capital to banks. Taking steps to remove legal and
other impediments to foreign investment in banks can increase the potential for existing
shareholders to raise new capital in the event of a shock or otherwise.
54. The judicial system, of course, can be equally important but is not addressed here.



91
Government can act to ensure that tax laws facilitate the investment of new capital in
troubled banks. Tax-loss carry- forward provisions are a key feature of such laws. Generous carry-
forward provisions can increase the return on new invested capital and serve as a useful
inducement to new investment.
Supervisory Processes
As emphasized in chapter 5, shareholders and managers bear primary responsibility for
ensuring the financial soundness of a bank, and supervisors must hold them accountable for
resolving the bank's problems, including by injecting additional capital where required. Given the
pivotal role played by capital in weathering shocks, routine bank supervision should assess not
only the adequacy of bank's capital but also the bank manager's capital planning process. The
capital planning process should involve a contingency planning process that assesses how bank
management and shareholders wvould raise additional capital or reduce risks in the event of a
shock.
Chapter 5 indicated that shareholders of weak banks or those that have experienced a
shock are reluctant to put up more capital or to dilute their ownership interest by raising
additional capital from new investors. Supervisors should have in place adequate processes that
provide as much motivation as possible for existing shareholders to recapitalize their bank, should
that be required. The capacity of supervisors to motivate recapitalization has four basic
components. The first is diagnostic capacity, as described in chapter 4, to assess accurately and
demonstrably the condition of the bank. The second is a supervisory enforcement process that
progressively raises the stakes f,or managers and shareholders who fail to raise adequate capital
within a reasonable period of time. The third is a prompt and effective process of failure
resolution, as described later in this chapter, that managers and shareholders believe is likely to be
triggered should the bank become insolvent or not viable. The fourth component is a referral
process that subrmits any suspected improper or illegal activities for review and possible
prosecution by law enforcement and judicial authorities. Government should ensure that
supervisors' capacity is evaluated and that all four components are in place.
In the event of a shock, the supervisors will have to decide whether to grant forbearance to
banks not meeting prudential staundards. Government can encourage supervisors to develop their



92
forbearance policies in advance. Such policies should incorporate criteria for the circumstances
under which forbearance would be granted and tough standards for monitoring and enforcing the
terms and conditions of forbearance. Not having in place policies for explicit forbearance in the
event of a shock may lead supervisors to grant implicit forbearance (for example, by failing to
promptly enforce loan loss provisioning or capital adequacy rules), which can lead to systemic
deterioration and crisis.
Should existing shareholders be unwilling or unable to arrange for recapitalization of the
bank and should forbearance not be warranted, the responsible authorities should initiate
liquidation of the bank or arrange an assisted acquisition (see chapter 5). To promote the
likelihood that these resolution mechanisms will operate as intended, government should ensure
that the supervisors have tested the mechanisms. One means to test them is by actually using
them. For this purpose, government can promote the use of post-mortem exercises subsequent to
bank failures, where effort is made to refine and improve resolution mechanisms. Improvement
might involve changes to law or simply changes to the relevant authorities' policies and practices.
The relevant financial sector authorities, or others, can conduct the post-mortem exercises.
A second means of testing resolution mechanisms is by engaging in formal contingency
planning exercises. Engaging in contingency planning tests the responsible authorities' likely
response to a sudden shock to the solvency or liquidity of a bank and identifies policy or
operational weaknesses before they are exposed in practice. Contingency planning could involve
testing provisions for rapidly assessing the condition of the bank, coordinating action among
relevant public institutions, limiting potential contagion to other institutions within the same
financial group and to unaffiliated banks, keeping senior government officials informed, and
dealing with the media. A key capacity to evaluate is whether the deposit insurance agency or the
government has the policies and procedures in place to repay protected deposits promptly (in the
case of bank liquidation) or to arrange the prompt transfer of deposits from a failing bank to a
more sound institution (in the case of an assisted acquisition). To facilitate the use of assisted
acquisitions, government can ensure that the responsible authorities have designed information
packages and bidding mechanisms, developed the necessary contracts, and prepared step-by-step
procedures for the tasks involved in transferring deposits to another institution.



93
Contingency planning also might contemplate more severe circumstances, such as the
sudden failure of a major bank. This exercise is more complex, since it must contemplate the
possibility of temporary nationadization. The number of responsible authorities engaged in this
exercise will grow, since the finance ministry will have to become more actively involved. In this
contingency planning exercise, govemment can give advance consideration to the circumstances
under which it would use public funds to salvage a bank and the policies attendant to doing so.
Many of the relevant issues are discussed in chapter 5.
The Asian crises showed how lack of access to financing can constrain the ability of the
responsible authorities to resolve banks promptly. The financing might be necessary to repay
protected deposits in a bank placed into liquidation or to transfer the bank's protected deposits to
another institution. Govermment should ensure that the contingency planning assesses the
availability of financing in sufficient quantity. It should contemplate backup sources of financing
and the related procedural arrangements.
Contingency planning should ensure that the relevant authorities have policies and
procedures for making a least-cost determination of altemative failure resolution mechanisms.
Govemment might wish to ratify the procedures and assumptions involved. This should include
ensuring that a full assessment of the potential future costs inherent in government ownership can
be made. Putting these in place in advance should help to mitigate the risk that the relevant
authorities and government will see nationalization as, in effect, the path of least resistance in the
near term; only to find it an expensive mistake in the long run.55
55 For more information on the use of contingency planning by bank supervisors in the context of systemic crises see
Scott 2000b.



94
REFERENCES
The word "processed" describes informally reproduced works that may not be commonly
available through libraries.
De Krivoy, Ruth. 2000. Collapse: The Venezuelan Banking Crisis of '94. Washington, D.C.:
Group of Thirty.
Honohan, Patrick. 2001. "Recapitalizing Banking Systems." Policy Research Working Paper
2540. World Bank, Policy Research Department, Washington, D.C. Processed.
Honohan, Patrick, and Daniela Klingebiel. 2000. "Controlling the Fiscal Costs of Banking
Crises." Policy Research Working Paper 2441. World Bank, Policy Research Department,
Washington, D.C. Processed.
Klingebiel, Daniela. 2000. "The Use of Asset Management Companies in the Resolution of
Banking Crises: Cross-Country Experiences." Policy Research Working Paper 2284.
World Bank, Policy Research Department, Washington, D.C. Processed.
Lindgren, Carl-Johan, and others. 2000. "Financial Sector Crises and Restructuring: Lessons from
Asia." IMF Occasional Paper 188. Washington, D.C.: International Monetary Fund.
Mako, William P. 2001. "Corporate Restructuring Strategies: Recent Lessons." Paper submitted
to Asian Regional Seminar on Financial Reform and Stability, Hyderbad, India, sponsored
by the International Monetary Fund and Reserve Bank of India. Processed.
Scott, David. 2000a. "Governments as Managers of Systemic Financial Crises: Controlling Costs
by Integrating Bank and Corporate Restructuring." In Charles Adams, Robert E. Litan and
Michael Pomerleano, eds., Managing Financial and Corporate Distress. Washington,
D.C.: Brookings Institution Press.
-. 2000b. "Contingency Planning for Financial Crises." Toronto International Leadership
Centre for Financial Sector Supervision, Toronto. Processed



95
Trable B4.1: Balance Sheet of a Sample Bank
Asset or liability             Amount
Asset
Cash                           50
Governrment securities         50
Corporate debt                 50
Loans                         800
Other assets                   50
Total                        1,000
Liability
Inter-bank deposits           750
Short-term debt               100
Other liabilities              50
Total liabilities             900
Equity                         100
Total equity and liabilities  1,000
Non-interest income      22.50
Noni-interest expense     40.00
The principal assumptions in this stylized example are that all interest expense, non-
interest expense, and non-interest income are paid and received in cash. The bank can avoid
negative cash flow only by retaining some portion of the interest earned by depositors. In other
words, to avoid negative cash flow and eventual illiquidity, the bank must continuously increase
deposits, either by retaining interest earned on existing deposits or by raising new deposits or
other funds. As the portion of loans on which interest payments have been suspended rises above
the threshold, the pressure on the bank to increase deposits intensifies. Bankers will raise deposit
interest rates, which in turn will increase carrying costs on the assets on which debt service has
been suspended.



96
Table B4.2: Point at which the Suspension of Debt Service
Can Cause the Bank's Cash Flow to Become Negative
under Different Interest Rate Scenarios
(percentage of total loans)
Liability                            Nonperforming
Asset yield         rate             Spread             loan threshold
10                5                 5                     38
10                7                 3                     16
20                13                7                     33
20                15                5                     22
20                17                3                     11
30                23                7                     24
30                25                5                     17



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with a Small Financial Sector    Alberto R. Musalem                         32720
Dimitri Vittas
WPS2842 Financial Sector Inefficiencies    Pierre-Richard Ag6nor  May 2002           M Gosiengfiao
and the Debt Laffer Curve        Joshua Aizenman                            33363