metadata: authors: 0: author: Dado, Marinela E.
1: author: Klingebiel, Daniela
docna: 0: docna: Decentralized credtor-led corporate
            restructuring - cross-country experience
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Legal Institutions of the Market Economy,Banks & Banking Reform,Intergovernmental Fiscal Relations and
            Local Finance Management,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Countries that have experienced banking
            crises have adopted one of two distinct approaches toward
            the resolution of non-performing assets-a centralized or a
            decentralized solution. A centralized approach entails
            setting up a government agency-an asset management
            company-with the full responsibility for acquiring,
            restructuring, and selling of the assets. A decentralized
            approach relies on banks and other creditors to manage and
            resolve non-performing assets. The authors study banking
            crises where governments adopted a decentralized,
            creditor-led workout strategy following systemic crises.
            They use a case study approach and analyze seven banking
            crises in which governments mainly relied on banks to
            resolve non-performing assets. The study suggests that out
            of the seven cases, only Chile, Norway, and Poland
            successfully restructured their corporate sectors with
            companies attaining viable financial structures. The
            analysis underscores that as in the case of a centralized
            strategy the prerequisites for a successful decentralized
            restructuring strategy are manifold. The successful
            countries significantly improved the banking system's
            capital position, enabling banks to write down loan losses;
            banks as well as corporations had adequate incentives to
            engage in corporate restructuring; and ownership links
            between banks and corporations were limited or severed
            during crises.
repnme: repnme: Decentralized credtor-led corporate
            restructuring - cross-country experience
display_title: Decentralized credtor-led corporate
            restructuring - cross-country experience
listing_relative_url: /research/2002/10/2032623/decentralized-credtor-led-corporate-restructuring-cross-country-experience
topicv3: Commercial Banking m1326069 1236,State Owned Enterprises m1326323 721,Bank Capital Adequacy m1326723 1241,Financial Institutions m1505015 3797,Asset Management m1586418 877
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Financial Sector Practice (FSP)
no_of_pages: 60
model_extractions: | POLICY RESEARCH WORKING PAPER 2901

# Abstract

Countries that have experienced banking crises have adopted one of two distinct approaches toward the resolution of nonperforming assets-a centralized or a decentralized solution. A centralized approach entails setting up a government agency-an asset management company-with the full responsibility for acquiring, restructuring, and selling of the assets. A decentralized approach relies on banks and other creditors to manage and resolve nonperforming assets.

Dado and Klingebiel study banking crises where governments adopted a decentralized, creditor-led workout strategy following systemic crises. They use a case study approach and analyze seven banking crises in which governments mainly relied on banks to resolve nonperforming assets. The study suggests that out of the seven cases, only Chile, Norway, and Poland successfully restructured their corporate sectors with companies attaining viable financial structures. The analysis underscores that as in the case of a centralized strategy the prerequisites for a successful decentralized restructuring strategy are manifold. The successful countries significantly improved the banking system's capital position, enabling banks to write down loan losses; banks as well as corporations had adequate incentives to engage in corporate restructuring; and ownership links between banks and corporations were limited or severed during crises.

This paper-a product of the Financial Sector Operations and Policy Department-is part of a larger effort in the department to examine the resolution of financial crises. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room MC9-624, telephone 202-473-3722, fax 202-5222031, email address hvol@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at mdado@worldbank.org or dklingebiel@worldbank.org. October 2002. _(53_ pages) _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about developnment issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

## Produced by the Research Advisory Staff
# **Decentralized Creditor-Led**<sup>**Corporate Restructuring**</sup>

# **Cross-Country Experience**

## By

## Marinela E. Dado and Daniela<sup>Klingebiel</sup>

## **JEL classification codes:** G20,<sup>G28, G34,G38</sup>

Keywords: Financial institutions<sup>andservices,bankandcorporaterestructuring,emerging</sup> market economies We would like to thpnk Ying Lin<sup>for very useful researchassistance.The authorsthank GerardCaprio andStijn</sup> Claessens for helpful cornzments.
# I. **Introduction**

In recent decades, many countries<sup>haveexperiencedbanking problems reflected</sup> in high levels of non-performing loans<sup>thatrequiredamajor andexpensiveoverhaulof</sup> their banking systems. By one count, 112<sup>episodesof systemic bankingcrisesoccurred</sup> in 93 countries since the late 1970s<sup>(Caprio and Klingebiel2002).</sup> The proper management and disposition of impaired<sup>assetsis oneof themostcriticalandcomplex</sup> tasks of successful and speedy financial<sup>restructuring. Successfulassetmanagement</sup> policies can facilitate bank restructuring<sup>byacceleratingtheresolutionofnon-</sup> performing assets and can promote<sup>corporaterestructuringby providing theright</sup> incentives for voluntary debt restructuring.

The two alternatives for asset management<sup>strategiesinclude settingupa</sup> government agency with the full responsibility<sup>foracquiring,restructuring,andselling</sup> of the assets (the centralized approach) or<sup>letting banksandother creditorsmanage their</sup> own non-perfonning assets (the decentralized<sup>approach).Empiricalstudiesand/or cross</sup> country analyses on the usefulness and<sup>success of either strategyremainsparse.Whilea</sup> companion paper evaluated experiences<sup>withcentralized assetmanagementcompanies</sup> (AMCs) (Klingebiel 2000), this paper<sup>willfocusonexperienceswithbankingcrises</sup> where the responsibility for the workout<sup>of bad debt was mainly left with the banks.</sup> We apply a case study approach and<sup>analyzesevenbanking crisesduringwhich</sup> governments mainly relied on banks<sup>toresolve non-performing assets.</sup> Our study suggests that out of the seven cases,<sup>onlyChile,NorwayandPolandsuccessfully</sup> restructured their corporate sectors with<sup>companiesattainingviable financialstructures.</sup> The analysis underscores that the<sup>prerequisitesforasuccessfuldecentralized</sup> restructuring strategy are manifold. The<sup>successfulcountriessignificantly improvedthe</sup> banking system's capital position enabling<sup>themtowrite downloanlosses;banksas</sup> well as corporations had adequate incentives<sup>toengageincorporaterestructuring;and</sup> ownership links between banks and companies<sup>werelimitedorseveredduringthe</sup> crises.

The remainder of the paper is organized<sup>asfollows.SectionIIillustratesthe two</sup> altemative approaches to financial restructuring. Section Im presents the analysis of seven country cases in which governments<sup>mainlyreliedondecentralizedcreditor</sup> restructuring to deal with debt resulting<sup>from bankingcrises.Section IV concludes.</sup>

# **II. Approaches to Corporate Restructuring**

Two approaches to financial corporate<sup>restructuringcanbe distinguished (Sheng</sup> 1996). Countries can use either (i) a centralized<sup>government-ledapproachviaasset</sup> management companies; or (ii) a decentralized<sup>creditor-led restructuringstrategy.</sup> Under a _centralized, government-led_<sup>approach,assetrecoveryiscentralizedin</sup> one public agency (asset management company,<sup>AMC).A specialized agencymay be</sup>
2 required because the task, of dealing with non-performing loans is fundamentally different from that of making loans. Transferring assets to a centralized asset management company may also increase leverage over debtors and break perverse ownership links between banks and corporations allowing for better collections on loans. Notwithstanding these advantages, recent country experience shows that it is difficult to insulate an asset management company holding a large share of corporate claims against political pressures. Moreover, a transfer of the loans breaks the links between banks and corporations-relationships made valuable by banks' access to corporate information. And if an asset management company fails to actively manage the assets it holds, it can undermine credit discipline in the entire system. The evidence on how successful AMCs have been is mixed (Klingebiel 2000).

Box 1: The Use of Asset Management Companies in the Resolution of Banking Crises - **Cross Country Experience**

**In** the past, asset management companies (AMCs) have been employed to address the overhang of bad debt in the financial system. Two main types of AMCs can be distinguished: AMCs set up to help and expedite corporate restructuring and AMCs established as rapid asset disposition vehicles. A review of seven cases reveals that AMCs have a mixed record. In two out of three cases, corporate restructuring AMCs did not achieve their narrow goals of expediting bank and/or corporate restructuring. These experiences suggest that AMCs are rarely good tools to expedite corporate restructuring. Only the Swedish AMC successfully managed its portfolio, acting in some instances as lead agent in the restructuring process. It was helped by some special circumstances, however: the assets acquired were mostly real estate related, not manufacturing (that are harder to restructure), and were a small fraction of the banking system (which made it easier for the **AMC** to maintain its independence from political pressures and to sell assets back to the private sector). Rapid asset disposition vehicles fared somewhat better with two out of four agencies, namely Spain and the US, achieving their objectives. The successful experiences suggest that AMCs can be effectively used, but only for narrowly defined purposes of resolving insolvent and unviable financial institutions and selling of their assets. But even achieving these objectiyes required many ingredients: a type of asset that is easily liquifiable (real estate), mostly professional management, political independence, a skilled resource base, appropriate funding, adequate bankruptcy and foreclosure laws, good information and management systems, and transparency in operations and processes. In the Philippines and Mexico, the success of the AMCs was doomed from the start as the governments transferred politically motivated loans and/or fraudulent assets to the<sup>AMCs</sup> which are difficult to be resolved or to be sold off by a govermnent agency susceptible to political pressure and lacking independence. Both of these agencies did not succeed in achieving their narrow objectives.

Source: Klingebiel, 2000.

The _decentralized, creditor-led work-out._ approach relies on banks and other creditors to resolve non-performing loans. Since banks have the institutional knowledge of the borrower, and since their own survival depends on asset recovery, they may be better able and willing to maximize recovery value and avoid future losses. Furthermore, banks can provide new loans in debt restructuring.
3 <!-- Start of picture text --> Box 2: Advantages and Disadvantages of Decentralized Creditor led Approach to Financial<br>Restructuring<br>Advantages<br>* Ensures that the informational capital that banks have accumulated on their borrowers is preserved.<br>* Leaving loans in banks may provide better incentives for recovery and for avoiding future losses by<br>inproving loan approval and monitoring procedures.<br>* Leaving loans in banks avoids the general deterioration of payment discipline that can occur if assets<br>are transferred to an AMC which fails to properly manage them.<br>* Banks can provide additional financing which may be necessary in the restructuring process.<br>* Political considerations in restructuring decisions are limited as the actual restructuring is left to the<br>private sector and not transferred to a public agency which may be prone to political pressure.<br>Disadvantages<br>* Economies of scale - i. e. consolidation of scarce work out skills and resources - are not achieved.<br>* Ownership links between banks and corporations are not dealt with and may thus imnpede corporate<br>restructuring.<br>* May prove a distraction for banks' core business of '"making loans".<br>* Banks typically are not good at restructuring which requires different types of skis.<br><!-- End of picture text --> The remainder of the<sup>paperlooksattheexperienceofbankingcriseswherethe</sup> responsibility for the debt<sup>workoutswas mainly left with the banks.</sup>

# **HI. Cross Country Experience**<sup>**withDecentralized-CreditorLedRestructuring**</sup>

# **A. Methodology**

**_Sample selection._** We adopted a two step<sup>approachinselecting country casesforour</sup> detailed analysis. First,<sup>onthe basisof asurvey of pastbankingcrises(CaprioandKlingebiel</sup> 2002), we identify twelve<sup>casesin which governmentslargelyadopted decentralizedcreditor-led</sup> strategies. These are seven emerging<sup>market economies (Argentina,Brazil,Chile,Colombia,</sup> Thailand, Turkey, Venezuela),<sup>twoindustrializedcountries(JapanandNorway)andthree</sup> transition economies (Hungary,<sup>PolandandSlovenia).Second,weconductanextensive</sup> investigation of the availability<sup>of detailedinformationanddataonthe resolutionprocess.In</sup> five out of the 12 cases,<sup>we haveinsufficientdetailed informationtoundertakeathorough</sup> analysis as we do not have<sup>completeinformationoncorporaterestructuringstrategiesincluding</sup> the scope of corporate distress,<sup>appliedwork-outmechanism,andfinancial dataon the corporate</sup> sector and banking sector. These country cases are<sup>Brazil, Colombia,Slovenia,Turkeyand</sup> Venezuela. We therefore<sup>analyze sevencountry cases whichinclude two industrializedcountries</sup> [Japan (1991-present)<sup>andNorway(1987-93)],threeemergingmarketeconomies[Argentina</sup> (1980-82), Chile (1981-86),<sup>andThailand(1997-present)]'</sup> and two transition countries [Hungary (1991-95)<sup>and Poland(1992-95].</sup>

l It is important to point<sup>out here thattheanalysisof theThaicase hastoa prelirninaryevaluationasthe crisis</sup> started in 1997, and the latest<sup>corporatedatawe haveforThailand dates from mid-2001.</sup>
4

**_Information sources._** Our analysis relies on published reports and World Bank internal documents. We supplement these sources with extensive interviews with country experts familiar with the details of the individual country cases.

> **_Case studies._** We use a case study approach and carry out an analysis that is aimed at

> characterizing the incentive structure under which banks and firms operated - or initial conditions - at the onset of the crisis and five years after the crisis started. While institutional

> changes are not always easy to implement, especially when they need parliamentary approval-

> as in the case of bankruptcy regimes-this period should provide governments in those countries where the incentive framework is not conducive to corporate restructuring with sufficient time to improve the framework.

We proceed by first summarizing the main characteristics of the specific banking crisis - type of distress, size of the nonperforming loans at the peak of the banking crisis and scope of corporate distress to get a better understanding of the type and severity of the banking crises in the sample countries. We continue by analyzing the incentive framework that banks and corporations are subject to at the beginning of the crisis and then examine the changes governments made to the framework five years after the start of the crisis. We focus particularly on four components of the incentive framework that have been found in the literature to be important to encourage banks and corporations to engage in meaningful corporate restructuring: (i) banks' capital positions and therefore their ability to withstand losses; (ii) the accounting and (iii) legal framework in which banks and corporations are operating as it indicates to what extent banks and corporations have (correct) incentives to come to the negotiating table and reach solutions that result in sustainable corporate financing patterns; and (iv) existing ownership links between banks and corporations (Claessens, Klingebiel and Djankov 1999). Extensive ownership links between banks and corporations would weaken either incentives to engage in meaningful corporate restructuring.

**_Evaluating outcomes._** The aim of corporate restructuring is to attain viable financial structures within a reasonable timeframe. Therefore we judge the success or failure of a decentralized restructuring strategy on the financial health of the corporate sector and evaluate to what extent the restructuring has led to financially viable corporate sectors five years after the onset of the crisis.

# B. **Main Characteristics of Banking Crises**

> Figure 1 and Table 1 (below) provide information on the type and scope of distress in the seven country cases. All countries in the sample experienced systemic financial crises, that is, a major part of the banking system of each sample country was affected and its aggregate capital base was exhausted.

The scope of distress in the corporate sector is partly reflected in the share of nonperforming loans (NPLs) at the peak of the crises (Figure 1). The level of non-performing loans can therefore be used as a rough proxy for the extent of corporate distress. Figure 2 indicates that levels of NPLs were significant in all sample countries at the height of the crisis - exceeding 30 percent of banking system assets - with the exception of Norway and Hungary. Argentina's
5 financial sector appears to have<sup>beenhitthehardestamongthesamplecountries withNPLs</sup> amounting to over 50 percent of<sup>bankingsystem assets (Caprio and Klingebiel2002).</sup>

**Figure 1. Peak Level of Nonperforming**<sup>**Loans (NPLs)asPercent**</sup> **of Total Banking System Loans**

<!-- Start of picture text --> Thandk (198) _<br>Pobnd (1M3)<br>Norway (1r1<br>Japan (1998)<br>Hunguy (1994)<br>Chdie (19_6)<br>Argoftina (9I9 S1) _4<br>0 10 20 30 40 50 60<br><!-- End of picture text --> Note: * denotes NPLs as percent of<sup>totalbanking assets.</sup> Source: Caprio and Klingebiel 2002:<sup>IntemationalMonetary Fund,International FinancialStatistics</sup> The increase in the number of bankruptcies<sup>(Table1)alsoreflectsthe extentof corporate</sup> distress. Among the countries<sup>forwhichdatawereavailable,themostsignificantincreasein</sup> bankruptcies was recorded in Argentina,<sup>where bankruptciesrose by 76%in thefirstyear of the</sup> financial crisis (Balino 1991).<sup>In Hungaryand Poland,over 50 percentof the bankingsystem's</sup> non-perforning loans were owed by<sup>loss-making state enterprisesthat madeup over half of the</sup> enterprise sector and were related<sup>tothe transitionfromcentralplanning toamarketeconomy</sup> (World Bank 1996).
6 Table 1. Characteristics of Banking Crises

|Countrv|T_Reofdistress|Corporatesectordistress|
|---|---|---|
|Argentina<br>(1980-82)|Privatesectordebt|Thepeakrateofincreaseofbusinessfailureswas76%<br>in1980,thefirstyearofthecrisis(Balino1991).|
|Chile<br>(1981-86)|Private sector debt|Estimatedincreaseinnumberofbankruptcies from81<br>in1975to810 in1982(Velasco1991).|
|Hungary<br>(1991-95)|Debtsowedbystate-owned<br>enterprises,mainly,tostate-<br>ownedbanks.|Gross enterpriselosses increasedfromlessthan1%of<br>GDPin1988to14%in1992.By1993,50%of70,000<br>enterprises (mainlyinindustry)were lossmakers.The<br>largestloss-makers accountedfor60%oftotal<br>enterpriselossesand50%ofoverduebankdebt(World<br>Bank1997a).|
|Japan<br>(1991-ongoing)|Privatesectordebt|Corporatebalancesheets deterioratedoverthe1990s<br>andROEsdroppedfrom7.5%inlate1980stoan<br>averageof2.8%inthe1990s(InternationalMonetary<br>Fund2000).|
|Norway<br>(1987-93)|Privatesectordebt(corporate<br>andhousehold)|Bankruptcyratesroseby40%ayear during1986-89.<br>Banklossesconcentratedinprimarysectors(14%),<br>mining&export-orientedmanufacturing (15%)and<br>realestate(13%)(Norway'sRoyalMinistryof<br>FinanceandCustoms1992).|
|Poland<br>(1992-95)|Debtsowedby state-owned<br>enterprises,mainly,tostate-<br>ownedbanks.|In1992, 67%ofenterprises remaininginstatehands<br>werelossmakers,mostlyinheavyindustry(World<br>Bank1993).|
|Thailand<br>(1997-ongoing)<br>Source:Compilationbya|Privatesectordebt (realestate)<br>uthors.|In1997,32.6%ofcorporationscouldnotservicetheir<br>debts(Claessens, Djankov, Klingebiel1999).|

# C. Assessment of the Incentive Framework at the Onset of the Crisis

We analyze the incentive framework at the onset of the crisis by evaluating (i) banks' capital positions; (ii) accounting framework and (iii) legal framework; and then (iv) existing ownership links between banks and corporations.

> _a. Banks_ **_'_** _capital positions._ To engage in meaningful corporate restructuring banks need to be adequately capitalized as they need capital to write down loans. To determine the level of capitalization in our sample crises countries, or in other words, the incentives of banks at the

> initial stage of the crisis to engage in any meaningful corporate restructuring, we classify the

> crises countries into four categories according to the risk adjusted capital level of their financial institutions. Since the level of non-performing loans in the banking system is highly correlated

> with the level of capital, we also use the level of non-performing loans (NPLs) if information on capital adequacy is not available. We classify financial institutions' capital base as follows. A

> four indicates that banks are well capitalized as their capital adequacy ratio is beyond eight percent and non-performing loans in the banking system are beyond five percent of total banking system loan. At the other end of the spectrum a one denotes a system in which banks are clearly
7 insolvent as their reported capital level is below two percent of risk adjusted capital or total banking system NPLs exceed 25 percent. In four (Argentina, Chile, Hungary, Poland and Thailand) out of the sample of seven countries, individual banks were severely undercapitalized and mostly insolvent with an adjusted capital adequacy ratio of minus two percent.

To illustrate this rating with a few numbers, the Chilean banking system had a negative net worth of 12.2 billion pesos in the first year of the crisis while it faced losses of 70 billion pesos by the second year of the crisis (Sheng 1996c). The shortfall in the capital of the seven banks in Poland participating in the restructuring program accounted for 18 percent of their assets at the start of the crisis (World Bank 1993). The collapse of the real estate and stock mnarkets in Thailand rendered substantial shares of bank portfolios as nonperforming and as banking problems reached crisis proportions, the capital positions of banks weakened. According to 1998 market estimates of capital shortfalls for Thai banks, the latter would need US$30 billion to weather the crisis (World Bank 2000b). Japan's banks appeared to be better offin the mid-1990s with most of them reporting a risk adjusted capital adequacy ratio of between minus two to plus two percent (Kanaya and Woo 2000). But their capital positions did not improve significantly through the remainder of the decade (International Monetary Fund 1998). Out of the seven crises, countries Norway's banks appeared to be the best positioned in the initial phase of the crisis to deal with corporate distress. Their risk adjusted capital adequacy ratios were between two and eight percent.

Figure 2. Banks' Capital Positions Prior to Recapitalization <!-- Start of picture text --> 3.5-<br>3 -~~~~~~~~~j<br>0<br>2E 5 - -<br>0<br>06<br>B~.1.5<br>r- g 0. 1- 1-E~ -- X _ t .5 -<br><!-- End of picture text --> _Notes:_ We group countries into four categories with regards to the capital adequacy position of their banks and or the level of non-performing loans in the banking sector. A four indicates that all banks in the system are well capitalized and that the adjusted capital adequacy ratio (CAR) of the banks exceeds eight percent or the minimum legal requirement whatever is higher and non-performing loams (NPLs) of the banking system are below 5 percent. A three indicates that banks are slightly undercapitalized with their CAR ranging between two and eight percent and overall banking sector NPLs are between 6 and 10 percent. A two indicates that banks are significantly undercapitalized with their CAR ranging from minus two to plus two percent and banking sector NPLs are between 10 and 25 percenL A one denotes a system in which banks are severely undercapitalized and insolvent with a CAR below minus two percent and NPLs exceed 25 percent _Sources:_ Balino 1991; Bbrish, Ding and Noel 1996; Claessens 2001; Claessens, Djankov and Klingebiel 1999b; Kanaya and Woo 2000; Sheng 1996c; World Bank 1993; World Bank 2000b.
8

**Table 2. Accounting Framework**

|Comp|arisonoftheaccoun<br>and|ting frameworkatth<br> during thecrisis|eonsetofthe|crisis|
|---|---|---|---|---|
|Countrv|Loan<br>classification|Loan<br>provisionin,|Interest<br>accrual|Average|
|Argentina|||||
|Onset|I|1|1|1.0|
|During|I|I|1|1.0|
|Chile|||||
|Onset|3|2to3|2|2.5|
|During|4|3|4|3.7|
|Hungary|||||
|Onset|3|2to3|2|2.5|
|During|4|3|3|3.3|
|Japan|||||
|Onset|2|2|2|2.0|
|During|2|2|2|2.0|
|Norway|||||
|Onset|3|4|4|3.7|
|During|4|4|4|4.0|
|Poland|||||
|Onset|3|2to3|4|3.2|
|During|3|3|4|3.3|
|Thailand|||||
|Onset|1|1|1|1.0|
|During|3|3|2|2.7|

_Note:_ Countries are scored on a scale from I to 4 for each<sup>indicatorwith 4 indicating best practiceandI indicating furthest awayfromn best</sup> practice.

Loan classification Specific loan loss provisioning: Interest Accrual I = loan past due more than 360 days I = 0%/o substandard; 50% doubtful; **1000%6** loss. I = up to 6 months, no clawback. 2 = loan past due more than 180 days 2 = 10- 15% substandard; 50% doubtful; 1000/o loss. 2 = up to 3 months, no clawback. 3 = loan past due more than 90 days 3 = 20% substandard; 75% doubtful; 100%/o loss. 3 = up to 6 months, with clawback. 4 = repayment capacity of boTTower/forward 4 = present value of future cash flow or fair value of 4 = up to 3 months, with clawback looking collateral.

**_Sources:_** Argentina: Balino 1991; Chile: Barandiaran and Luders 2000,<sup>Larrain, M.1989, Sanhueza 2000b;Hungary:Borish, Ding and Noel</sup> 1996, World Bank Various years(b); Japan: Kanaya and Woo<sup>2000, Intemational Monetary Fund 2000;Norway: Karlsen2000;Poland:</sup> Borish, Ding and Noel 1996, World Bank Various years(a); Thailand:<sup>Claessens, Djankov and Klingebiel1999b</sup>

**_b. Accounting framework for banks._** Financial institutions incentives to engage in corporate restructuring is also influenced by the accounting<sup>frameworkunderwhichthey</sup> operate. Here loan classification and loan loss provisioning rules<sup>forbanksdetermine towhat</sup> extent banks can carry non-performing loans on their books without<sup>classifying them assuch and</sup> can accrue uncollected interest. As a result, capital and income<sup>will beoverstatedandbanks</sup> have limited incentives to engage in corporate restructuring<sup>sincetheycansimplyhide losses.</sup> The sample countries were scored according to how<sup>accounting rulescomparedwith</sup> intemational best practice defined as follows: (i) loan classification<sup>accordingtotherepayment</sup> capacity of borrower; (ii) loan provisioning based on the<sup>present value of futurecash flow or fair</sup> value of collateral; and (iii) interest accrual rule requiring<sup>therecognitionof overbookingof</sup> interest income when a delinquent loan is declared nonperforming<sup>(upto90 days)(Claessens,</sup> Djankov and Klingebiel 1999b). Table 2 indicates that those rules were poor and trailed
9 international best practice significantly<sup>infive(Argentina,Chile,Hungary,Japan and Thailand)</sup> out of seven country cases. Banks<sup>in Argentinaand Thailand operatedundera weak accounting</sup> framework that allowed them to<sup>postponetherecognitionofloan losses andoverstate their</sup> capital positions. Banks in Thailand<sup>hadtoclassifyaloanasnon-performingonlyafterit had</sup> not been serviced for 360 days.<sup>Atthesametime,theywere allowedtoaccrueuncollected</sup> interest income for up to twelve<sup>months (Alba,HemandezandKlingebiel1999).Incontrast,</sup> Norway's and Poland's accounting<sup>frameworkwas significantlybetterin theinitialphaseof the</sup> cnsis.

**_c Legal framework._** The bankruptcy system is crucial<sup>indisciplining borrowersand</sup> forcing them to come to the negotiating<sup>table withgood restructuringproposals.</sup> Table 3 compares important features of<sup>the bankruptcyframework-so-called creditor rights -across the</sup> sample countries. As shown in<sup>Table3,thelegalframeworkin fiveof thesample countries</sup> contains two out of four creditor<sup>rights.Argentinaonly hasonecreditor rightinitslawsand</sup> Thailand affords creditors a relatively<sup>highprotection-on paper,atleast -by having three out</sup> of four creditor rights in its laws.

**Table 3. Legal Framework and the**<sup>**Existenceof Ownership Links**</sup>

|Count|Restrictions for<br>goinginto<br>reorganizations|No<br>automatic<br>stayon<br>assets|Secured<br>creditor<br>paidfirst|Manager does<br>notstayin<br>reoreanization|. Sumof<br>creditor<br>rightsindex|Efficiency<br>ofjudicial<br>system<br>index|Enforcement<br>ofcreditor<br>nigts|Ownership<br>structures|
|---|---|---|---|---|---|---|---|---|
|Argentina|0|0|1|0|1|6.0<br>|0.6<br>|2<br>|
|Chile|1|0|1|0|2|7.2|1.4<br>|1<br>|
|Hungary|I|1|0|0|2|3.0<br>|0.6<br>|1<br>|
|Japan|0|0|1|1|2|8.0|1.6<br>|3<br>|
|Norway|1|0|1|0|2|10.0<br>|2.0<br>|3<br>|
|Poland|1|0|1|0|2|.3.0|0.6<br>|1<br>|
|Thailand|I|I|0|1|3|3.2|0.9|1|

# _Notes:_

_Legalframework._ The score for<sup>thelegalframework is measured as the</sup><sup>_sum_of four indicatorsof creditor rights:(i)restrictionson organizations;</sup> (ii) no automatic stay on assets;<sup>(iii) securedcreditors paidfirst; and (iv) managementdoes notstay inreorganization.AnindicatorisscoredasI</sup> if the particular creditor right is<sup>providedinthecountry'sconmmerciallaws;otherwise,it is scored as zero.Attheoutsetof theirtransition,</sup> Hungary and Poland had to develop<sup>(i)legalframeworksthatwerecompatiblewithlaws inmarket economies;and(ii) judicialinstitutions to</sup> enforce the new laws. Efficiency of<sup>judicialsystem index assessestheefficiency andintegrity of thelegalenvironmentas it affectsbusinesses,</sup> particularly foreign firms. (The<sup>scoringrangesfromIto10.)The enforcementof creditor rightsis calculatedas the productof the creditor rights</sup> and judicial efficiency indices<sup>divided by10.</sup> _Ownership structure_ (Based<sup>on methodologydevelopedby LaPorta, Lopez-de-Silanes,and Shlcifer1999).</sup> 4 = Widely dispersed ownership<sup>(firms do not have any shareholders withvoting rights exceeding20 percent)</sup> 3 - Widely dispersed ownership<sup>andcross-shareholdingsallowed (firms are allowed toownsharesincorporations thatbelong toits chainof</sup> control) 2 - Controlling shareholder<sup>(corporationsinwhichshareholders'voting rightsexceed20 percent)andno cross-shareholdingsin publiclyheld</sup> corporate shareholder I = Controlling shareholder and<sup>at least one publicly tradedcompanyin the chainof control</sup> _Sources:_ La Porta, Lopez-de-Silanes,<sup>andShleifer1998and1999;Claessens,Djankovand Nenova2000; WorldBank1985;Barandiaranand</sup> Luders 2000, Sanhueza 2000b;<sup>Kopanyi2000b;Intemational MonetaryFund1999b; Karlsen2000 and Norway'sMinistry of Finance;authors'</sup> estimates.
10 But for an insolvency system to be effective, creditors need to be able to rely on the judicial system to have these laws enforced. Therefore, Table 3 also provides information on judicial efficiency which assesses the efficiency and integrity of the legal framework on a scale from 1 to 10 with 10 indicating the highest degree of efficiency. As Table 3 indicates, among the crisis countries, Norway has the most efficient legal system. Japan's judicial system also ranked well followed by that of Chile and Argentina. Thailand trails the sample countries significantly indicating that enforcement of creditor rights faces serious impediments and limits creditor's ability to use the bankruptcy system as disciplining mechanism.<sup>2</sup> Hungary and Poland did not only have to carry out a fundamental transformation of their legal frameworks to make them compatible with laws in market economies, a process that was almost completed by the late 1990s but they also had to develop modem and efficient judicial institutions to be able to enforce them (World Bank 1996; Borish, Ding and Noel 1996a). Therefore, enforcement capacity was relatively weak during these countries' financial crises.

_de Ownership structures._ The effectiveness of decentralized work-outs may also be hampered by ownership links between banks and corporations as the same party would be both debtor and creditor (Claessens, Djankov, Klingebiel 1999). Using a methodology developed by La Porta, Lopez-de-Silanes, and Shleifer (La Porta, Lopez-de-Silanes, and Shleifer 2002) we score countries on their prevailing ownership structure at the onset of the crisis on a scale from 1 to four with one indicating that one controlling shareholder and at least one publicly traded company is in the chain of control (for further detail see Table 3) and ownership links are pervasive. The results of the analysis reflected in Table 3 show that ownership of the corporate sector was relatively concentrated and significant direct ownership links between financial institutions and companies existed in four out of six countries for which information was available. These countries were Chile, Hungary, Poland and Thailand.

In Thailand, ownership of both financial and corporate institutions is concentrated in a limited number of families (World Bank 2000b). Chilean banks and companies enjoyed significant ownership links in the form of "grupos" or financial and manufacturing conglomerates which had acquired nearly all the largest manufacturing and banking firms in the mid 1970s (Velasco 1991). In the case of the transition countries - Hungary and Poland - the large shares of non-performing loans held by state-owned banks were largely the result of lending practices to state-owned enterprises (World Bank 1996). The ownership structure in which the government was the main shareholder in both banks and enterprises continued during the early part of the transition. Also, that period was marked by continued lending on the part of state banks to loss-making state-owned enterprises even as the banking crises had emerged (World Bank 1996). The practice prevailed initially at least not only due to banks' limited capacity to assess credit risk but also to occasional interventions by their major shareholder - the government - to support socially sensitive state enterprises (Borish, Ding and Noel 1996a).

**2** Thailand has complemented its framework for corporate reorganization and asset resolution for large corporation with out-of-court, extra-judicial systems, the Corporate Debt Restructuring Advisory Committee. This committee and associated restructuring processes generally rely on the so-called London rules-principles for corporate reorganization first enunciated in the United Kingdom in the early 1990s. Since the London rules were not designed for systemic corporate distress, Thailand tried to tighten them in various ways to make those rules conducive to outof-court restructuring (For greater detail, see Claessens, Djankov and Klingebiel 1 999b).

**'** That is, credit under socialism was extended primarily on the basis of the government's assessment of a state enterprise's importance in the economy, rather than its profitability and ability to service its loans.
**11**

While direct ownership links are<sup>limitedinJapan,itstraditional</sup><sup>_keiretsu_structure fosters</sup> not only long held ties among<sup>Japanesecorporationsbelongingtothe sameindustrialgroupbut</sup> also close connections with<sup>particular financialinstitutions(International Monetary Fund1999b).</sup> In Norway, direct and indirect<sup>ownershiplinks betweenbanksand corporationswerelimitedat</sup> the onset of the crisis, therefore<sup>limiting disincentives for corporate restructuring.</sup>

**_Overall conduciveness_** _of_ **_the_**<sup>**_incentiveframeworkforcorporaterestructuring._**Toshow</sup> the overall conduciveness of<sup>theincentiveframeworkfor corporaterestructuringweconstructa</sup> overall incentive framework index.<sup>Thisindexreflectstheunweightedaverageofthescores</sup> sample countries received<sup>on thefourcomponentsof therestructuring frameworkattheinitial</sup> phase of the crises. These<sup>four indicatorsare again:(i)the bankingsystem'scapital position;(ii)</sup> the accounting framework;<sup>(iii) thelegalframework;and(iv)existing ownership links between</sup> banks and corporations. Table 4 shows that, except<sup>forNorway, the samplecountries' banks</sup> and corporations operated<sup>withinaweakoverallincentiveframeworkthatwasnotparticularly</sup> conducive for corporate restructuring<sup>at the onset of the crisis.</sup>

**Table 4. The Overall Incentive**<sup>**Framework at the Onset of the Crisis**</sup>

|Cqumr|Bank<br>capital<br>positions|Accounting<br>framework|Legal<br>fiamework|Ownership<br>structure|OverallFramework<br>IncentiveIndex|
|---|---|---|---|---|---|
|Argentina<br>(1980-82)<br>|1.0|1.0|0.6|2.0|1.2|
|Chile<br>|||||15|
|(1981-86)<br>|1.0|2.5|0.7|1.0|.|
|Hungary<br>(1991-95)<br>|1.0|2.5|0.6|1.0|1.3|
|Japan||||||
|(1991-<br>ongoing)<br>|2.0|2.0|1.6|3.0|2.2|
|Norway<br>(1987-93)<br>Poland<br>|3.0<br>|3.7<br>|2.0<br>|3.0<br>|2.9<br>|
|(1992-95)<br>|1.0|3.2|0.6|1.0|1.5|
|Thailand<br>(1997-<br>ongoing)|1.0|1.0|0.9|1.0|1.0|

_Source:_ Tables I - 3 and<sup>Figure1.</sup>

# **D. Government Efforts to Upgrade**<sup>**the IncentiveFramework**</sup>

The previous section indicated<sup>thattheframework fordecentralizedrestructuringshowed</sup> significant weaknesses in most<sup>of oursamplecountriesin theinitialphaseof the crisis.In this</sup> section, we evaluate to what<sup>extent countriesimprovedthe overall incentiveframeworkto make</sup> it more conducive to and<sup>acceleratecorporaterestructuring.</sup> As mentioned earlier, in<sup>this</sup>
12 analysis we will only consider changes made within a period of five year after the crisis began. While institutional changes are not always easy to implement, especially when they need parliamentary approval-as in the case of bankruptcy regimes-this period should provide governments with sufficient time to adjust the incentive framework for corporate restructuring. We focus our attention on the question to what extent governments strengthened the major components of the overall incentive framework, Annex tables 1, 2 and 3 provide a more detailed summary of govermnents' efforts or measures, to support financial and corporate restructuring.

**_a. Strengthening the loss absorption capacity of banks._** In six out of the seven sample countries, (Argentina, being the exception) the authorities attempted to shore up banks' capital position by providing public funds. In all cases, governments used ex-ante upfront schemes rather than employing a recapitalization strategy with an ex-post recapitalization mechanism that links banks' recapitalization to corporate restructuring. Ex-ante recapitalization may be implemented quickly and can signal to the market that problems are being resolved. Provided that it is accompanied by substantive improvements in corporate govemance and bank operations and is well monitored, it can be an up-front investment that leads ultimately to lower costs. But ex-ante recapitalizations also carry large risks. Governments routinely respond to such systemic bank solvency problems by injecting capital into insolvent banks, without requiring changes in governance and bank operations and the recapitalizations turn out to be futile. Banks will have better capacity to work out loans and to take losses, when recapitalized but they may still delay restructuring and roll over non-perform-ing loans since they are able to attract new funds anyhow. And likewise, corporations may have little incentive to undertake necessary operational restructuring, if they have access to new funds anyway (Claessens 1998). Therefore, the success of these recapitalization schemes depend on the following three factors: (i) the size of the recapitalization scheme; (ii) the timeliness of the provision of capital; and (iii) the conditionality attached to the recapitalization schemes.

_Size of the recapitalization schemes and repeated recapitalizations._ In three out of seven cases - Chile, Hungary and Japan - the government failed to provide recapitalization schemes of sufficient size, making additional injections of capital necessary. Insufficient capital injections do not only reduce the loss absorption capacity of financial institutions but they also limit these institutions' incentives to engage in corporate restructuring as they await the next bail-out. In Chile, repeated loan purchases reinforced the perception by both debtors and creditors alike of the government's readiness to keep providing additional support (Barandiaran and Hemandez 1999; Brock 1999; Larrain, M. 1989; Sheng 1996c; Velasco 1991). Similarly, after three recapitalizations in Hungary, banks remained too poorly capitalized to be able to engage in earnest restructuring (World Bank 1999a; 1999b). Japan only provided public support to their banks seven years into the crisis. To date, Japan has implemented two rounds of recapitalizations - in 1998 and in 1999. Yet according to market observers, the Japanese banks continue to remain severely undercapitalized (Goldman Sachs 2002c).

_Timing of the recapitalization schemes._ As important as the size of the schemes is their timeliness. In five out of six cases - Chile, Hungary, Norway, Poland and Thailand-capital infusions took place within three years of the onset of their crises (Barandiaran and Hernandez 1999; Brock 1999; Larrain, M. 1989; Sheng 1996c; Karlsen 1994; Norway's Royal Ministry of Finance and Customs 1992; Velasco 1991; World Bank 1993; 1994; 1999a; 2000a). In contrast,
13

> Japan relied on economic growth to restore bank solvency for a seven year period (International Monetary Fund 1999a). During that time, Japanese banks were expected to recapitalize via

> increased earnings over time and-this was to be made possible by govemment macroeconomic programs to stimulate growth, implicit forbearance and low interest rates. This approach did not

> result in stronger balance sheets for banks and enhanced their ability to take losses. The

> authorities took a more forceful approach to restructuring in the eighth year of the crisis that included government injection of capital into the banking system (Kanaya and Woo 2000).

_Conditionality._ Govemrnent can attach two types of conditionality to the disbursement of public funds. Governments can either link disbursements to a repayment schedule (with penalties for non-compliance) andlor to financial and operational restructuring criteria that banks have to meet to be eligible for receiving funds. Except for Hungary, all of the public recapitalization schemes attached some conditionality to the disbursement of funds. The public recapitalization programs in Chile and Poland required time-bound repayments by the banks to the government. In Chile, the government recapitalized banks through repeated direct purchases of substandard loans with zero coupon notes under a ten year repurchase agreement. The banks in turn had to commit to repurchasing all loans sold to the central bank. Banks had to redeem _5_ percent of the recapitalization bonds every six months. Under Poland's enterprise and bank restructuring program, seven commercial banks received new capital in the form of fifteen year government restructuring bonds that had to be repaid every six months. Banks were, however, allowed to sell the bonds after three years. In both cases, banks' inability or failure to service their obligations would have resulted in government sanctions. For example, conciliation agreements under Poland's program carried penalties for non-compliance and the authorities required the supervisory boards of the participating banks to establish incentive compensation schemes that linked managers' bonuses to banks' profits (van Wijnbergen, 1994).

In Norway and Thailand, public funds were injected into banks only after the write down of shareholder capital, thereby resulting in a (potential) severe dilution of ownership. In addition, the capital injections of banks in Norway were also made contingent upon operational restructuring. For example, banks participating in the recapitalization programs had to substantially reduce the number of branches and the level of operating costs so as to raise bank profitability and thereby help the banks sustain their capital adequacy. Thailand's program included the option for the govemment to require changes in bank management. In Japan, the long delayed government recapitalization required banks to meet two criteria to qualify for public funds - positive net worth and the ability to generate long-term profits (Kanaya and Woo 2000).

> _Results of the public recapitalization efforts._ Public recapitalization schemes appeared to have been successfiul, i. e. resulting in sustainable financial structures in banks in three out of the

> six countries (second column of Table 5). These are Chile, Norway and Poland. Despite

> initially underestimating the extent of the crisis and engaging in several rounds of recapitalization, the Chilean government considerably strengthened the capital base of the banks

> enhancing their ability to withstand losses (Brock 1999; Velasco 1991). Five years into the

> crisis, the banking system moved from a capital shortfall to an equity surplus and banks reached capital levels between two and eight percent (Skarmeta 1999).
14 In Norway, the government injected public funds into one large commercial bank and three large savings banks as well as a number of smaller savings banks. Capital levels in banking institutions improved with risk adjusted capital adequacy ratios reaching beyond eight percent and system wide NPLs dropping significantly. The commercial banking system's risk adjusted capital adequacy ratio rose from 7 percent during 1981-85 to 10.58 percent in 1993. The share of commercial banks' after-tax profits in total assets improved from -0.3 percent in 1987 to 1.2 percent in 1994. Commercial bank losses as a share of total loans fell from its peak of 5.2 percent in 1991 to 0.2 percent by 1994.

The capital provision in Poland led to adequate capital levels (the risk adjusted capital adequacy ratios in these banks ranging from 2 to 6 percent) in the seven banks participating in the restructuring program and allowed them to write off a significant portion of unrecoverable debts (World Bank 1997b; 2000a). The public recapitalization program allowed the seven banks to achieve a capital adequacy ratio of 12 percent by 1995, i.e., three years after the crisis began. For the banking system as a whole, the share of NPLs to total loans declined from 28 percent in 1992 to 10 percent in 1997, i.e., five years after the onset of the crisis. By 1998, all seven banks were sold to foreign investors.

The public schemes were less successful in the other three sample countries that provided public funds for recapitalizations. Three capital injections (1991-93) in Hungary continued to leave banks undercapitalized and their overall capital positions did not improve (compare Table 5). The recapitalization programs were neither conditioned on operational restructuring of the banks or changes in bank management nor did they provide sufficient incentives to banks to address corporate distress. While the third scheme required banks to sign consolidation agreements, the latter did not include specific quantitative performance criteria nor specific remedial measures that, not surprisingly, rendered the agreements ineffective. In 1995, i.e., four years after the onset of the crisis, a new Hungarian government moved towards a strategy of bank privatization, largely through sales to foreigners, to improve banks' capacity to sustain losses. The government also made great strides in privatizing the enterprise sector. Nevertheless, Hungarian banks reached adequate capital levels towards in 1998-despite repeated recapitalizations-seven years after the onset of the crisis and only after 60 percent of the banking system had been sold to foreigners (World Bank 1999a; 1999b).

In Japan, the government's strategy to engage in capital forbearance left banks severely undercapitalized five years after the onset of the crisis, the timeframe of this study. Public recap schemes initiated in 1998 and 1999 continued to leave banks severely undercapitalized and while the second round of recapitalizations was conditioned on improvernents in the operating environment of the financial institutions, it did not result in these institutions undertaking serious corporate restructuring efforts (Goldman Sachs 2002c). At the beginning of 2002, the market estimate of non-performing loans in the Japanese banking system stood at 35 percent of outstanding loans (Goldman Sachs 2002c). Therefore, even today, eleven years after the onset of the crisis, banks remain significantly undercapitalized.

Thailand's commercial banks were reluctant to take advantage of government recapitalization because of the resulting dilution of ownership and the requirement for change of management. The recapitalization program offered banks Tier 1 capital support conditioned on
15 these banks adhering to stringent conditions including<sup>meeting strictloanlossprovisioning</sup> standards and changing bank management. This market based approach ensured that public funds would have only been provided when shareholders<sup>had been wiped out.Notwithstanding,</sup> banks that needed fresh capital could delay the application<sup>forsuchassistancesincetheywere</sup> allowed to recapitalize on a flow basis and comply<sup>withmorestringentcapitaladequacy</sup> requirements at a later point in time. As a result,<sup>onlytwonon-intervenedprivatebankshave</sup> accessed public funds. Instead, banks have raised expensive capital on<sup>their own.Stillinthe</sup> end they remain substantially undercapitalized because of<sup>high levelsof non-performingloans.</sup> By 2002, system wide NPLs stood at one-third of<sup>totalloans(StandardandPoors 2002).</sup> _Additional mechanism for debt relief_ In addition to capital infusions,<sup>governmentshave</sup> employed schemes to bail out specific groups of private debtors which<sup>areessentially equivalent</sup> to bank recapitalization. However, such efforts create disincentives for<sup>borrowerstomake</sup> earnest efforts to repay their debts.<sup>4</sup> The loan reprogramming programs in Chile led to moral hazard problems as borrowers expected more generous debt relief<sup>tobeforthcoming</sup> (Barandiaran and Hemandez 1999; Brock 1999; Sheng 1996c).<sup>Repeated refinancing schemesin</sup> Argentina in 1982 did not help avert the deterioration<sup>inbank solvencythatcontributedtothe</sup> second financial crisis that began in 1989 (Giorgio and Sagari 1996;<sup>Velasco1991).</sup> _b. Correcting deficiencies in the accounting framework._ The third<sup>column inTable5</sup> indicates that the accounting framework improved in five out of seven<sup>countries.The adoption</sup> and enforcement of forward-looking loan classification soon<sup>afterthecrisisbeganbrought</sup> Norway's framework fully to international best practice. Norway was also<sup>one of two countries</sup> (the other being Poland) that applied "best practice"<sup>provisioningrulesforrestructureddebt,</sup> wherein the restructured loan is reclassified as perforning and the specific<sup>provisionsarelifted</sup> after a period of regular debt servicing (Karlsen 2000).<sup>At theotherextreme,accountingrules</sup> remained unchanged in Argentina by the end of the crisis of the<sup>early1980sanditsframework</sup> remained farthest from best practice throughout the crisis period (Balino<sup>1991).Japanalsoleft</sup> its accounting framework unchanged five years into the crisis. Only<sup>in1998,sevenyearsafter</sup> the onset of the crisis, did Japan introduced forward looking loan classification<sup>rules makingitin</sup> principle more difficult for institutions to hide<sup>their losses.</sup> Improvements to the regulatory regimes of Chile, Hungary, Poland, and Thailand,<sup>in that</sup> order, brought their frameworks closer to best practice although<sup>some rulesstilltrailed behind</sup> best practice. Chile's bank regulations and the new banking law of 1986<sup>whichemphasized</sup> market information dismantled the 1982-84 practices of explicit regulatory<sup>forbearancetoease</sup> the crisis (Sheng 1996c). Hence, Chile's framework improved<sup>significantlyfiveyearsafterthe</sup> crisis began. Hungary's amendment to the banking<sup>lawin1994,thefourthyearof thecrisis,</sup> 4 Argentina and Chile provided public debt relief to private debtors<sup>throughrepeated programsof across-the-board</sup> debt restructunings or debt reduction. These included exchange rate guarantee<sup>schemes,de-dollarizationof debts(in</sup> which the government assumes foreign exchange losses of dollar denominated<sup>loans), or restructuringof loan terms</sup> for firms that meet certain eligibility criteria. In some instances, debt relief<sup>was extendedtoconsumer and mortgage</sup> loans by rescheduling interest and repayment terms. In the case of Argentina, the authorities relied on a merger/liquidation strategy for bank restructuring and alleviation of indebtedness<sup>ofthe privatesector(through</sup> across-the-board refinancing programs) to avert further bank failures. The<sup>programs entailedrefinancingbythe</sup> central bank of the loans of private borrowers, that is, extending loan maturities<sup>atfavorableinterestrates.While</sup> the government did not recapitalizd banks, it helped them by bailing out private<sup>borrowers.</sup>
16 resulted in a major upgrading of its accounting framework,<sup>includingtheintroductionof</sup> forward-looking loan classification and provisioning norms. Thailand<sup>significantly upgradedits</sup> classification and provisioning requirements and somewhat<sup>tightenedinterestaccrualrulesin</sup> 1999 bringing the overall accounting framework much closer<sup>to international best practice.Yet,</sup> immediate loan reclassification for restructured debt was<sup>allowed,freeingup previously made</sup> provisions after a debt workout (World Bank 2000b).

**Table 5. Comparison of the Restructuring Framework for**<sup>**Banks**</sup> **and of the** Financial **Results for the Corporate Sector** (at the onset of the crisis (in brackets) and five years into the crisis)

|||Frame|work fordecen|tralizedrestru|cturing||Result|
|---|---|---|---|---|---|---|---|
|Country|Bank<br>capital<br>positions|Accounting<br>framework|Efficiency<br>and<br>enforcement|Ownership<br>structure|Overall<br>index|Improvement<br>inoverall<br>index|Financial<br>conditionof<br>corporate sector|
|Argentina<br>(1980-82)|(1)1|(1.0)1.0|(0.6)0.6|(2)2|(1.2)1.2|+0.0|(1)1|
|Chile<br>(1981-86)|(1) 3|(2.5) 3.7|(0.7)0.7|(1) 3|(1.5)2.8|+1.3|(2)3|
|Hungary<br>(1991-95)|(1) 1|(2.5)3.0|(0.6)0.7|(1) 3|(1.3)1.9|+0.6|(1)2|
|Japan<br>(1991-<br>ongoing)|(2) 2|(2.0)2.0|(1.6)1.6|(3)3|(2.2) 2.2|+0.0|(2)2|
|Norway<br>(1987-93)|(3)4|(3.7)4.0|(2.0)2.0|(3) 3|(2.9)3.3|+0.4|(3)4|
|Poland<br>(1992-95)|(1)3|(3.2) 3.3|(0.6)0.7|(1)3|(1.5)2.5|+1.0|(1) 3|
|Thailand<br>(1997-|(1)2|(1.0)2.7|(0.9)0.9<br>|(1) 1<br> <br>|(1.0)1.7<br>|+0.7<br>|(2)2<br>|
|ongoing)<br> <br>**_So_**<br>for|_<br>__<br>_<br>**_urce:_**Tables2-4;<br>Reconstructionan|_<br> Borish,Dingand <br>dDevelopment19|I<br>Noel 1996;Claessens<br>98;KanayaandWoo|_<br> <br> <sup>2001;Claessaens, </sup><br> 2000;<sup>Karlsen2000</sup>|_I<br><sup>Djankovand Klin</sup><br><sup>;Sheng1996c;</sup>|_<br>-_I_<br><sup>gebiel1999a and1999</sup><br> <sup>WorldBank1985;W </sup>|I<br><sup>b;European Bank</sup><br><sup>orldBank2000b.</sup>|

**_c Improving the legal framework._** None of the countries in our<sup>samplemadesignificant</sup> changes to their formal balnkruptcy regime and therefore a number of weaknesses<sup>in theformal</sup> bankruptcy law were not eliminated (see fourth column Table 5).

However, four out of seven countries complemented their<sup>formalframeworkfor</sup> reorganization and debt workouts with out-of-court extra-judicial procedures<sup>toaccelerate</sup> restructuring. In the 1980s, Chile used private arbitration to resolve liquidations<sup>and</sup> bankruptcies as an altemative to the outdated and slow judiciary<sup>system(Barandiaranand Luders</sup> 2000). In the absence of fully developed liquidation and<sup>bankruptcylegislationaswellasa</sup> skilled and efficient court system, Poland launched its well<sup>knownprogramofbankand</sup>
17 enterprise conciliation in 1993 that allowed enterprises<sup>toenter intotime-bound, out-of-court,</sup> bank-led conciliation agreements aimed at restructuring<sup>and/or assetresolution. Atthesame</sup> time, the governnent required banks to initiate<sup>bankruptcyorliquidationproceduresifthey</sup> failed to reach agreemnent with their nonperforming<sup>enterprise borrowers(World Bank1993).</sup> Out-of-court programs in Hungary and Thailand<sup>appearedtohavebeenlesssuccessful.</sup> Hungary tried to circumvent an overburdened court<sup>systemwithaconciliationprogrambutit</sup> failed due to a lack of transparent rules and penalties<sup>fornon-compliance.</sup> This resulted in persistent interventions by competing government<sup>ministries whichcompletely underminedthe</sup> out-of-court process (Kopanyi 2000a; World Bank<sup>1997a).Aweakstructure andinadequate</sup> enforcement of the out-of-court framework adopted<sup>inThailandhavenotfacilitated</sup> restructuring. At the end of 1999, thirteen percent<sup>oftherestructuredcases revertedtonon-</sup> performing status in just a few months (Claessens,<sup>DjankovandKlingebiel1999b).Thailand</sup> also established a separate bankruptcy court that was<sup>intendedtoincreasetheefficiencyof</sup> judicial procedures in bankruptcy cases to address the<sup>mainweaknessinitsformalbankruptcy</sup> regime in early 1999. Following the establishment of<sup>thecourt,thenumberof bankruptciesin</sup> Thailand still remained low, however, and fraught with<sup>difficulties(Foley 2000).</sup>

**Table 6. Features of Out-of-court Corporate**<sup>**Restructuring**</sup>

||Allormost banks<br>signedontoaccord<br>|Accord providesfor<br>formalarbitrationwith<br>deadlines<br>|Accordimposes<br>penaltiesfor<br>nonconpliance<br>|
|---|---|---|---|
|Argentina<br>|No<br>|No<br>|No|
|Chile<br>|No<br>|Yes<br>|n.a.<br>|
|Hungary<br>|Yes<br>|No<br>|No<br>|
|Japan<br>|No<br>|No<br>|No<br>|
|.<br>Norway<br>|No<br>|No<br>|No<br>|
|Poland<br>|Yes<br>|Yes<br>|Yes<br>|
|Thailand|Yes|Yes|Yes|

_Note:_ In Chile, private agents were allowed to resolve<sup>bankruptciesby hiring specialized privateconsultingfirns.</sup> _Sources:_ Barandiaran and Luders 2000; Kopanyi<sup>2000a;WorldBank1997a; WorldBank1993;Claessens,DjankovandKlingebiel</sup> 1999b

**_d. Severance of ownership links._** As the fifth column of Table **_5_** suggests, in Chile, Hungary and Poland where direct ownership links were<sup>significant impedimentsto restructuring,</sup> the introduction of new regulations, public recapitalizations<sup>and foreignentryintothefinancial</sup> system effectively severed or at least significantly reduced<sup>ownershiplinks. Inthesecrisis</sup> countries the government used the crisis as an opportunity<sup>tochangeownership structuresand</sup> sever ownership links that can hamper corporate restructuring.<sup>Afterthecrisisemerged, Chile</sup> began to tighten limits on cross-ownership between<sup>financialinstitutionsandcorporationsbut</sup> more importantly, started to enforce them (Sheng 1996c).<sup>5</sup> Moreover, foreign entry into the banking system further severed ownership links between<sup>corporationsandbanks(WorldBank</sup> 1997c; 1999b). Recapitalization programs in Hungary<sup>effectivelynationalized banksandwiped</sup>

5 Banks were required to reduce loans to related companies<sup>tonomorethan</sup><sup>_5_percentof theirtotal portfolios.By</sup> the last year of the crisis, a new banking law attempted<sup>to eliminate the practiceof related lendingand definedmore</sup> precisely the concept of "client".
18 out the equity of state-owned enterprises that were also the banks' main borrowers, thus breaking the ownership links between the two entities (Abel and Szakadat 1997; Borish, Ding and Noel 1996a). The Polish govermment prohibited the seven bank participants of the recapitalization program from making new loans to non-performing borrowers (i.e., state-owned enterprises) (World Bank 1993). All seven banks were sold to foreign investors within five<sup>yearsofthe</sup> launch of the conciliation program. The subsequent privatization of the banks in Hungary to foreign investors had a more profound impact ultimately than the repeated public injections of capital (World Bank 1997c; 1999b). To the contrary, in Thailand bank and corporate restructuring continued to be hampered by direct ownership links. And while direct ownership links are limited in Japan, indirect links or the _keiretsu_ structure remained intact and continued to hamper bank and corporate restructuring.

**_Overall conduciveness_** _of_ **_the incentiveframeworkfor corporate restructuring._** Column 6 in Table 5 summarizes the overall conduciveness of the incentive framework for<sup>corporate</sup> restructuring in the sample countries five years after the onset of the crises. As the table illustrates, only Chile and Poland upgraded its incentive framework significantly to<sup>reach2.8 and</sup> 2.5 respectively on a scale from one to four with four signaling a highly conducive<sup>environment</sup> for corporate restructuring. Norway, which started out with a relatively conducive regime, as indicated by its score of 2.8, improved its framework to 3.3 thereby nudging it closer<sup>to</sup> international best practice. The remaining four countries made only limited improvements to their framework leaving impediments to corporate restructuring largely unaddressed. Out of these four countries Argentina's framework remained furthest away from international best practice with a score of 1.2, followed by Thailand (1.7), Hungary (1.9), and Japan (2.2).

# E. **Results of the Restructuring Efforts**

The aim of corporate restructuring is to attain viable corporate financial structures in a reasonable amount of time. Therefore, we determine that a country's decentralized restructuring approach was successful if it has led to viable financial structures of corporations<sup>withina five</sup> year time frame. We assess on a scale from one to four the financial situation of the corporate sector. The decentralized restructuring strategy is then judged to be successful if the overall sector either scores a three or a four meaning that the weighted average interest coverage ratio of corporations exceeded three and that the share of companies with an interest coverage ratio of below one is less than 20 percent.

Figure 4 illustrates that the corporate sectors in only three out of the seven sample countries attained viable financial structures within a five year timeframe. In Chile, Norway and Poland corporate distress was significantly reduced during the crisis period and corporations were put on a sounder financial footing. The remaining four countries-Argentina, Hungary, Japan and Thailand-were less successful in encouraging creditor led workouts and therefore the finns in these countries still exhibited substantial distress five years after the onset of their respective crises.

While Chile started out with a weak overall incentive framework for corporate restructuring, the country updated several components of the framework significantly by
19 strengthening the capital base of<sup>the bankingsystem,upgradingtheaccountingframeworkand</sup> severing ownership links between<sup>banksand corporations.After underestimatingtheextentof</sup> the crisis initially, the Chilean<sup>governmentlaunched successiveandmassiveprogramsto</sup> recapitalize the banks and to<sup>bailoutborrowersinorder toresolve thecrisis. However,Chile's</sup> experience also showed that the<sup>government'slack of a realistic assessmentof corporate distress</sup> proved very costly since repeated<sup>recapitalizationand debt relief schemes served to reinforcethe</sup> perception by creditors and<sup>borrowers thatthegovernmentwould continueto provide additional</sup> assistance (Barandiaran and Luders<sup>2000).Theprogramsforbailingoutborrowerscreateda</sup> serious moral hazard problem<sup>that initially deterredrapidcorporaterestructuring.</sup> Following several across-the-board rescheduling<sup>programsin1984-85,the corporatesector startedto show</sup> signs of profitability and improved<sup>financialconditions (BarandiaranandHemandez1999).The</sup> quick pace of the economic<sup>recoverywas similarlyareinforcingfactor for corporate</sup> restructuring.

Figure 4. The **FinazcialW** Health<sup>of the Corporate</sup><sup>**Sector**</sup> <!-- Start of picture text --> 4.5 -<br>4<br>3.5<br>2.5 '- DAt io~~~~~~~~~~~~~~- the onset of the cisis<br>2.5 =Five - years after the start of the nsis<br>1.5 ' ^ _ _ * || ___ | _ |<br>°. F--5;1- 2 ll<br><!-- End of picture text -->

_Note:_ We rate the financial health<sup>of the corporatesectoraccordingtotwo factors.One,the sector weighted</sup> interest coverage ratio and second,<sup>the shareof companieswithaninterest coverage ratioof lessthan one.</sup> We assess the financial situation<sup>of the corporate sectoron a scalefromoneto four based on data availability</sup> for either of the two factors and<sup>therefore weclassifycorporationsintofourcategories.Aonedenotesa</sup> situation in which the weighted<sup>averageinterest coverageratio of all firmsisbelowoneand/or theshareof</sup> companies with an interest coverage<sup>ratioof oneor less ishigherthan30 percent.A two denotesasituation</sup> in which the weighted average<sup>interest coverageratioof allfirmsis betweenthree andoneand/orthe share</sup> of companies with an interest<sup>coverageratioof oneor lessis between21and30 percent.A threedenotesa</sup> situation in which the weighted<sup>averageinterest coverage ratioof allfirmsis betweenfiveandthreeand/or</sup> the share of cornpanies with an<sup>interestcoverageratioof oneorlessis between11and 20 percent.Afour</sup> denotes a situation in which<sup>the weighted averageinterest coverageratioof allfirms exceedsfiveand/or the</sup> share of cornpanies with an interest<sup>coverageratioofoneorlessis lessthantenpercent.</sup> _Sources:_ Argentina: World Bank 1985; Chile:<sup>World Bank1987; Hungary and Poland:Pohl, Anderson,Claessensand</sup> Djankov, 1997; Japan: Goldman<sup>Sachs2002a; Norway:staff calculationsusing Bloombergdata;Thailand:</sup> Claessens 2001.
20

> The absence of ownership links and the existence of a well functioning legal framework in Norway were favorable initial conditions for restructuring - as evident in its overall incentive structure's score of 2.9 (see Table 4). Adequately capitalized banks as well as the improvements in banks' operations and in the accounting framework during the crisis period provided creditors and borrowers with the incentives to engage in restructuring. Among the seven countries, Norway's framework - which scored the highest of the country cases (3.3) -was the best placed for applying the decentralized approach. While it is difficult to separate the effects of proper incentives from the economic recovery that began in the last year of the crisis, the financial positions of both banks and corporations quickly turned around.

While the incentive framework was relatively weak in Poland at the start of the crisis (compare Table 5), the government enhanced the framework by significantly augmenting bank capital positions and accounting regulations and severing ownership links between banks and corporations. Moreover, the bank and enterprise restructuring program included conditions on bank recapitalization and time-bound limits on debt workouts. Poland succeeded to reduce the bad debt problems of the seven participating banks and managed to encourage some operational restructuring by enterprises during the period of the program. The restructuring program led to improved quality of borrowers, increase in bank equity, improved bank lending and strict prudential rules (International Monetary Fund 1999c). Nevertheless, two Bank studies have concluded that operational restructuring as a result of the debt workouts occurred at a much slower pace than expected (Gray and Holle, 1996a; World Bank 1997b). In the end, the quick resumption of growth in Poland, as GDP rose at an average 6 percent per year in 1993-96, helped accelerate enterprise restructuring (World Bank 1997c; 2000a; Barbone 2000).

The decentralized corporate restructuring strategies that governments adopted in Argentina, Hungary, Japan and Thailand were and in some cases are still severely hampered by an inadequate incentive framework. In these countries, corporate debt levels continued to be high and companies' financial structures remained weak, five years into the crisis.

Argentina's overall incentive framework was barely strengthened such that the framework was still not conducive for corporate restructuring five years after the onset of the crisis. The government aggressively implemented a costly strategy of bailing out insolvent borrowers. Along with such strategy, the authorities relied on liquidations or forced mergers of financial institutions to resolve the crisis. Despite these efforts, the corporate sector was persistently in financial distress (World Bank 1985) and the government failed to address weaknesses in the capital position of banks, accounting rules and legal framework amidst a fragile macroeconomic environment.

With a weak incentive framework (a score of 1) at the outset (compare Table 5), Hungary relied heavily on public injections of capital to strengthen the incentives for restructuring. However, repeated public recapitalizations - without strengthening bank incentives and supervision nor empowering the out-of-court system - did achieve little progress in enterprise restructuring. Five years later, Hungary's banking problems continued to remain unresolved and the financial position of the corporate sector continued to be weak. The situation improved markedly only after the authorities changed course four years after the crisis began and opted not only for bank privatization but also for a comprehensive reform of the regulatory framework and
21 serious macroeconomic adjustment<sup>(WorldBank1997a).</sup> Following the wide-reaching<sup>and</sup> aggressive privatization program<sup>ofthe Hungarianeconomy,aWorldBankcountrystudy</sup> concluded that, towards the<sup>endof thedecade:(i) mostfirmshave restructuredtheir operations</sup> although those that remained<sup>state-ownedhaverestructuredtheleast; and(ii)foreigndirect</sup> investment has been the key<sup>to the paceandscope of enterpriserestructuringin Hungary (World</sup> Bank 1999b).

Weakly capitalized banks, inadequate<sup>accountingframeworkandindirect ownership links</sup> persisted in Japan, encumbering<sup>thedecentralizedapproach.Forsevenyearsafterthecrisis</sup> began, the authorities relied on<sup>growth to restore the health of the corporateand financial sectors.</sup> The authorities largely pursued<sup>accommodatingfiscal and monetary policies tostimulate growth</sup> hoping that such a strategy<sup>wouldresolvetheproblems inthecorporate andbanikingsectors.</sup> Undercapitalized banks were<sup>allowed tolanguishforquiteanextendedperiod.This strategy</sup> only delayed the much-needed<sup>restructuring.</sup> For most of the crisis period,<sup>theincentive</sup> framework for corporate restructuring<sup>hardly improvedasit scored2.2 at the onset and fiveyears</sup> hence. Only in 1998 the government<sup>beganto takeamoreaggressiveapproachandstartedto</sup> strengthen the framework for<sup>restructuringinearnestwithapublicrecapitalizationprogram.</sup> This was followed by improvements<sup>in the accounting rulesand their enforcement.Nevertheless</sup> the corporate sector continues<sup>tobe weakandnon-performingloansinthe banking sectorare</sup> again on the rise (Goldman Sachs<sup>2002c).</sup> Thailand's overall incentive framework<sup>showedsomeimprovementasthe crisis ensuedas</sup> the score for the overall index<sup>changedfrom1.0 to1.7.While the government wasquick to offer</sup> the injection of public funds<sup>intothe bankingsystem,banks were slowto takethisupasthe</sup> government also allowed them<sup>torecapitalizeona flow basisviaretainedearningsand because</sup> the acceptance of public funds<sup>wouldhave resultedin the dilutionof ownershipandorin a</sup> change in management. The<sup>capital inadequacyof banks is compoundedby impedimentscaused</sup> by accounting rules that trail<sup>behindbestpractice,aweakenforcementof thelegalframework</sup> and continued, although slightly<sup>reducedownershipconcentrationandownership linksbetween</sup> banks and corporates. Progress with<sup>corporaterestructuringhasbeenlimitedand,forthe most</sup> part, banks have been willing to engage<sup>only incosmeticrestructuringof assets that are"easyto</sup> restructure". While the level of corporate<sup>distressimproved significantlyin Thailandcompared</sup> to the onset of the crisis, a large<sup>shareof companiescontinuetohaveweak financialstructures</sup> and more than 24 percent of companies<sup>didnothave enoughcash toservicetheirinterest</sup> (Claessens 2001), in the middle<sup>of 2001,four yearsinto the crisis.</sup>

# **IV. Conclusions**

The scatter plot in Figure 5 indicates<sup>thatthe decentralized restructuringstrategy resulted</sup> in viable financial structures of<sup>thecorporatesectorin thosecountrycaseswheretheincentive</sup> framework was conducive for bank-and<sup>corporaterestructuring,i.e.countriesscoredrelatively</sup> high on the incentive framework<sup>index. Firmsinonlythree countries-Norway,Chile, and</sup> Poland attained viable financial<sup>structures through decentralizedrestructuring.Theexperience</sup> of Chile and Poland also suggests<sup>thatweakincentivesframeworksat theonsetof a crises does</sup> not necessarily need to be a severe<sup>impedimenttoresolving corporatedistressif governments</sup>
22 upgrade the incentive framework significantly in a timely manner making it more conducive to corporate restructuring. As Figure 5 suggests the financial health of corporations in Argentina, Thailand, Hungary, and Japan did not improve significantly amidst an environment characterized by weak incentives for corporate restructuring.

> The results of the country case studies point to the manifold prerequisites for the success of decentralized strategies. They require: (i) adequately-capitalized banks; (ii) proper incentives for banks and borrowers; and (iii) limited or no ownership links between banks and corporations (as otherwise the sarne party would be both debtor and creditor). The results also indicate that the

> speed with which governments improve the incentive framework for corporate restructuring is important to achieve sustainable financial structures of corporations and to accelerate corporate restructuring.

**Figure 5. Success of Decentralized Corporate Restructuring Strategies**

<!-- Start of picture text --> 4<br>3.5 Norw ay<br>t 3 -Iifle, PIand<br>* 2.5<br>2 -j* * *Japan<br>2i 1.5 ThaDand HIngary<br>1.5<br>I 1 * Argentina<br>0.5-<br>0<br>0 0.5 1 1.5 2 2.5 3 3.5<br>Incentive Frarrework<br><!-- End of picture text --> Financial institutions need to be adequately capitalized to have the loss absorption capacity to engage in sustainable corporate restructuring. If governments allow banks to recapitalize via increased earnings over a longer time horizon, either through implicit or explicit forbearance, banks' ability to engage in meaningful corporate restructuring is limited. Forbearance does not create stronger balance sheets necessary for the absorption of losses. Marginally capitalized banks often tend to engage in cosmetic restructuring such as maturity extension or interest rate reduction which may not lead to sustainable corporate financial structures. And, cross country experience shows that forbearance dilutes financial institutions' incentives to negotiate more forcefully with the controlling shareholder of distressed corporations.

Thus, decentralized strategies often require governnents to help strengthen banks' capital position, if financial institutions deemed viable cannot obtain capital exclusively from private
23 sources. One option governments can consider for strengthening banks' capital position is expost rather than ex-ante recapitalization. Experience, including that of Hungary, Japan, and Thailand has shown that recapitalizing banks ex-ante does not necessarily ensure that restructuring will take place, and may create considerable moral hazard. Ex-post recapitalization links government support to a financial institution's progress in debt restructuring. The most explicit form of ex-post recapitalization would be to implement a loss sharing rule by which the government would cover a certain percentage of the loss arising from corporate restructuring deals.

To put bite into the incentive framework for restructuring, governments need to tighten provisioning and classification rules for bank loans if these rules are not in line with international best practice and also adjust rules for corporations. It often also means requiring financial institutions to apply those rules uniformly to standard, restructured, or rescheduled loans and to ensure that classification is based on a borrower's demonstrated ability to repay.

Implementing tougher accounting requirements often present a trade-off for governments. Requiring financial institutions to more realistically mark their assets to market and to provision restructured debt properly has short-term repercussions on financial institutions' capital positions and often increase their capital needs. Yet, international experience shows that meeting these upfront costs early on improves banks' incentives for loan recovery and proper restructuring and may thus yield significantly lower fiscal costs ultimately (Honohan and Klingebiel 2000).

Effective insolvency systems facilitate the rehabilitation of enterprises and also provide an efficient mechanism for the liquidation of those enterprises that cannot be rehabilitated. In addition, rehabilitation procedures may help overcome coordination problems of different creditors if they allow courts to impose restructuring agreements over the objections of creditors. Moreover, in economies undergoing transition, making state-owned enterprises subject to insolvency laws sends a clear signal that there is a limit to the amount of public financial support the firms can count on.

A question, however, here is whether indeed rehabilitation can be achieved most effectively through the application of a formal procedure. In a systemic crisis in particular, many countries rely on liquidation proceedings as the principal mechanism for rehabilitating enterprises. The very existence of liquidation proceedings create incentives for an out-of court restructuring and because an enterprise can be sold as a going concern liquidation can provide an effective vehicle for rehabilitation (Hagan 2000; International Monetary Fund 1999).

If bankruptcy procedures are lengthy and weak, debtors have incentives to ride out the economic downturn without diluting ownership which may inhibit deeper restructuring. Well functioning legal procedures and good access to courts are therefore crucial. Even if an adequate bankruptcy law exists, cross-country experience shows that effective implementation of the framework is even more important. In particular, given the complexity and the urgency of insolvency proceedings, effective implementation requires judges and administrators who are efficient, ethical and adequately trained in commercial and financial matters (Hagan 2000; International Monetary Fund 1999).
24 Finally, ownership links between debtors<sup>and borrowersalsohampertheeffectivenessof</sup> decentralized work-out strategies.<sup>Extensive ownership linkscanleadtoa deadlockof claims</sup> that may be difficult to break as<sup>the same party is both debtor and creditor.</sup>
25

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31 . 1997b. "Poland: Enterprise and Financial Sector Adjustment Loan Project." _Implementation Completion Report._ June. Washington. D.C.

_1 997c. "Poland - Country Economic Memorandum: _Reform and Growth on the Road to the EU " Economic Report._ July. Washington, D.C.

. 1998. _East Asia: The Road to Recovery._ Washington, D.C.

1 999a. "Hungary: Enterprise and Financial Sector Adjustment Loan Project." _Implementation Completion Report._ June. Washington, D.C.

1999b. _Hungary: On The Road to the European Union._ Washington, D.C.

. 2000a. "Poland: Enterprise and Financial Sector Adjustment Loan Project" _Project Performance Audit Report._ March. Washington, D.C.

. 2000b. "Thailand - Social and Structural Review-beyond the Crisis: Structural Reform for Stable Growth." _Economic Report._ January. Washington, D.C.

. Various years(a). Poland: Enterprise and Financial Sector Adjustment Loan Project Files.

. Various years(b). Hungary: Enterprise and Financial Sector Adjustrnent Loan Project Files.
32

# Annex Table 1. Government Policies to Resolving Bank and Corporate Distress

|Country|Typeof<br>distress<br>(publicor<br>privatedebt)|Scope<br>(Peaklevelo<br>of financia<br>Financial Sector<br>(levelofNPLs<br>atpeakas%of<br>banking system)|ofdistress<br>fNPLsaspercent<br>lsystemassets)<br>CorporateSector|Provisionof<br>liquidity<br>support|Closureof<br>financial<br>institutions|Governmentre<br>Publicrecapitaliza<br>Publicfundsfor<br>recapitalization(conditions<br>andtypeofprogram)|solutionstrategy<br>tionprogram<br>Takeup|Privateinjectionof<br>capital|Publicdebtrelief<br>program|
|---|---|---|---|---|---|---|---|---|---|
|Argentina<br>(198042)|*<br>Private<br>sectordebt|Estimated at<br>50%<br>(1979-81)|Peakrealrateof<br>increaseofbusiness<br>failureswas 76%in<br>1980,thefirstyearof<br>the crisis. (Measured<br>asliabilitiesoffirms<br>declaredbankrupt<br>deflatedbyWPI.)|No|Yes.<br>83institutions<br>closedbyend<br>1982.|No|Not applicable|Notapplicable|Yes.<br>(i)Repeated<br>refinancing<br>programs for<br>private debtin<br>1981-82; (ii)<br>government<br>assunmpionof<br>privateforeigndebt<br>liabilitiesin1981-<br>82andaportion of<br>thedebtwas<br>exchangedfor pesos<br>atbelow-market<br>exchangerate.a|

Prinmay resolution mechanism was liquidabon of financial institutons. Fiscal cost of refinancing amounted to 7% of GDP.
33

|Country<br>Chile|Typeof<br>distress<br>(publicor<br>privatedebt)<br>*<br>Pi|Scope<br>(Peaklevelof<br>offinancial<br>FinancialSector<br>(levelofNPLs<br>atpeakas%of<br>bankingsystem)<br>|ofdistress<br> NPLsaspercent<br> systemassets)<br>CorporateSector<br>|Provisionof<br>liquidity<br>support<br>|Closureof<br>financial<br>institutions<br>|
|---|---|---|---|---|---|
|<br>(1981-86)|<br>rvate<br>sectordebt|35.4%ofloans<br>(1986)<br>USS5.5 billion|Estimatedincreasein<br>numberof<br>bankruptciesfrom81<br>in1975to810in<br>1982.|Yes.<br>Errergency<br>loans<br>extended to<br>banksatthe<br>startofthe<br>crisis.|Yes.<br>3ofIIfinancial<br>institutions<br>intervenedin<br>1981-82 were<br>liquidatedin<br>1983.'|

|Governmentre|solutionstrategy|||
|---|---|---|---|
|Public recapitaliza<br>Pbli fd f|tion program<br>|Private injectionof<br>capital|Public debtrelief<br>program|
|uc uns or<br>recapitalization(conditions<br>andtypeofprogram)<br>Yes.|Takeup<br>25of42institutions|Y||
|<br>Feb1984loanpurchase<br>programstonon-<br>intervenedbanks butno<br>conditionsonbank<br>restructuringwere<br>required.Thecentralbank<br>purchasedloansuto|<br>sold badloanstothe<br>centralbank<br>amountingto20/of<br>thetotalloansinthe<br>bankingsystem.<br>Loanpurchase<br>idthl|es.<br>'Yapitalismo<br>Popular"program<br>forprivatizationof<br>4intervenedbanks<br>tosmallindividual<br>investorsinjected<br>|Yes.<br>Repeatedprograms:<br>(i) variousacross-<br>the-boarddebt<br>rescheduling<br>programs(suchas<br>debtsof"productive<br>"|
|p <br>150%oofcapital and<br>reserves andthe banksin<br>tumpurchased interest-<br>bearingcentralbank<br>promissory notesat<br>favorableterms.Bank<br>shareholders wererequired<br>tocommitalldividendsto<br>therepurchase untilthe<br>purchaseobligation was<br>completed.Administration<br>ofthepurchasedloan<br>portfolio,however,<br>remainedin eachbank.|mproveesovency<br>ofnon-intervened<br>banksandaccelerated<br>the recognitionof<br>requiredprovisions.<br>.|newcapitalintothe<br>banksaccompanied<br>bysubsidies.|debtors,medium-<br>sized businesses,<br>transport<br>companies,<br>mortgage&<br>consumerloans);<br>(ii)preferential<br>exchangerate<br>scheme; (iii)<br>govemment's<br>assumptionof<br>foreign exchange<br>losses throughde-<br>dollarizationof<br>foreign loans.I<br>Also, smallerdebt<br>reliefprogramsfor<br>mortgageand<br>consumer loansand<br>debtsofmedium-<br>sized businesses,<br>transport<br>comnpanies.|

> Cumulative cost of liquidations amounted to **11%** of GDP (Barandiaran and Hemnandez 1999). The fiscal coats toGDP oftheprograms were2.7%, 14.7% and 6.1%ofGDP.
34

|Country|Typeof<br>distress<br>(publicor<br>privatedebt)|Scope <br>(Peaklevelof<br>offinancial<br>Financial Sector|ofdistress<br> NPLsaspercent<br> system assets)<br>CorporateSector|Provisionof|Closureof|Governmentre<br>Pbliili|solutionstrategy<br>|||
|---|---|---|---|---|---|---|---|---|---|
|Hungary<br>|*<br>Debts owed<br>|(levelofNPIs<br>atpeakas%of<br>bankingsystem)<br>26%ofloans<br>|<br>Gross enterprise|<br>liquidity<br>support<br>Yes|<br>financial<br>institutions<br>Yes.|ucrecaptazat<br>Publicfundsfor<br>recapitalization(conditions<br>andtypeofprogram)<br>Yes|onprogran<br>Takeup<br>14bk|Privateinjectionof<br>capital<br>|Publicdebt relief<br>program<br>|
|(1991-95)|bystate-<br>owned<br>enterprises,<br>mainly,to<br>state-owned<br>banks.|(1994)|<br>losses increased from<br>lessthan1%ofGDP<br>in1988to14%in<br>1992. In1993,onthe<br>basis ofAMOF<br>survey,_50%_of<br>70,000enterprises<br>(mainlyinindustry)<br>wereloss makers.<br>Thelargestloss-<br>makingfirms(about<br>500)accounted for<br>60% oftotal<br>enterpriselossesand<br>50%ofoverduebank<br>debt.I||<br>Butnotuntil<br>1986.<br>Onebank was<br>liquidatedand<br>onespecialized<br>banksurrendered<br>banklicense.|.<br>Three recapitalization<br>programsofoneperyear<br>during1991-93without<br>subjectingthebankstoany<br>seriousconditions,Inthe<br>1992-1993programs,the<br>governmentcarvedout<br>90°hofthefaceva!ueof<br>the NPLportfolioin<br>exchangeforgovernment<br>bonds,whilethebanks<br>assumed_lO!Yo_<br>oftheface<br>valueoflosses.The1993<br>schemerequiredbanksto<br>signa consolidation<br>agreementwiththe<br>governmenttoensuretheir<br>operationaland financial<br>restructuring;inpractice.<br>theseagreernentdidnot<br>specifyquantitative<br>performancecriteriaand<br>targeTsnorspecify<br> <br>remedialrnasures."<br>|ans (including<br>the5largcststate-<br>ownedconunercial<br>banks)and60savings<br>cooperatives<br>pasticipatedinthe<br>1992scheme.Butin<br>1993,8banks,<br>including3ofthe<br>largestbanks,and<br>manycooperatives<br>werefoundtobe<br>significantly capital-<br>deficient.The1993<br>schemeentailedan<br>initialrecapitalization<br>oftheinsolventbanks<br>toK0CAR**and**two<br>subsequent<br>recapitalizations to<br>bringthebanksto4%<br>and8%CAR.<br>Cunulative<br>recapitalizationwas<br>US$3.5billion or8%<br>of1994GDP.|Yes.<br>Govemment<br>adopted new<br>strategyafterthe<br>1991-93<br>recapitalizations<br>thatfocusedsolely<br>onbank<br>privatizationfrom<br>1994onward.|No|

**'G** Private Gross enterprise banks consisted losses of rose small cooperative banks catering from 1% of GDP in 1988 to 14% to the financing needs in 1992 (World Bank of pivate 1997a). fannerm and rural households. Borish, Ding and Noel 1996a.

- **2** Also, thcre were no sanctions for nonr-conpliance.
35

|Country<br>|Typeof<br>distress<br>(publicor<br>**privatedebt)**<br> <br>|Scope <br>(Peaklevelof<br>offinancial<br>FinancialSector<br>(levelofNPLs<br>atpeakas%of<br>bankingsystem)<br>|ofdistress<br> NPLsaspercent<br>systemassets)<br>CorporateSector<br>|Provisionof<br>liquidity<br>support<br>|Closureof<br>financial<br>institutions<br>|Governmentre<br>Publicrecapitaliza<br>Public fundsfor<br>recapitalization(conditions<br>andMyeofprogmam)|solutionstrategy<br>tionprogram<br>Takeup|Privateinjectionof<br>capital|Publicdebt relief<br>program|
|---|---|---|---|---|---|---|---|---|---|
|Japan<br>(1991-<br>ongoing)<br>|*<br>Private<br>sectordebt<br>|30%ofloans<br>(1998)<br>|Corporatebalance<br>sheetsdeteriorated<br>overthe1990sand<br>ROEsdroppedfrom<br>7.5%inlate1980s to<br>anaverage of 2.8%in<br>the1990s.<br>|Yes.<br>Forthefirst<br>sevenyearsof<br>thecrisis,<br>authorities<br>attemptedto<br>keepbanking<br>systemafloat<br>byproviding<br>liquidity<br>loans.|Yes.<br>Uptolate1997,<br>government<br>relied<br>on<br>'convoy" system<br>inwhich strong<br>banks<br>were<br>called<br>uponto<br>support<br>weaker<br>banks.<br>Closure<br>of<br>7<br>housing<br>companies<br>(usen) downin<br>1995.<br>Twomajor banks<br>nationalizedin<br>1998|Yes.<br>Government<br>recapitalizationschemeput<br>inplacein1998and again<br>in1999;ex-ante<br>recapitalization;<br>Bankshadto meettwo<br>criteriatoqualify for<br>public funds<br>*<br>positivenetworth<br>and<br>*<br>abilitytogenerate<br>long-termprofits.<br>Second time around,<br>conditionalitywasmore<br>strictlyadheredto.|In1998,18najorand<br>threeregionalbanks<br>receivedYen1.8<br>trillioninpublicfunds.<br>Thegovermmenteither<br>purchasedpreferred<br>sharesorsubordinated<br>debt. Thus,allmajor<br>banks exceptfor one<br>receivedpublicfunds.<br>InMarch1999,15<br>banksreceivedYen<br>7.5trillion80%of<br>which wasin theform<br>convertiblepreferred<br>stock.||No|
|Norway<br>(1987-93)|*<br>Private<br>sectordebt<br>(Corporate,<br>mostly,and<br>household)|4%ofassets<br>(1991)|Bankruptcyratesrose<br>by40%ayearduring<br>1986-89.1<br>Bank losses<br>concentratedin<br>primarysectors<br>(14%),mining&<br>export-oriented<br>manufacturing(15%)<br>andrealestate(13%).|Yes.<br>"Specialterr"<br>loans<br>extended in<br>1991-92by<br>thecentral<br>banktothe<br>banking<br>systemat<br>interestrates<br>lower than<br>othercentral<br>bankloans.|No|Yes.<br>Injectionofequitytoone<br>largecommnercialbank<br>(besidesthethreelargest<br>thatwerenationalized)and<br>**to**3largesavingsbanks<br>andothersavings banks.|Directcapital<br>injectionsduring1989-<br>92:NOKIbillion<br>(US$155million)to<br>onecomnmercialbank;<br>NOK3billion(USS<br>465million)tothe<br>savings banks.|No|No|

> I Finance companies were the first to show the effects of the emerging crisis in 1986-87 with losses nainly from property investments exceeding 5% of loans and many companies went out of business and were

> restructured. In 1987, three medium-sized banks recorded heavy losses that wiped out their equity capital. Then, in 1990, the largest banks encountered problems due to heavy loss provisions. In contrast to the first phase of the crisis in 1987-89 when newly established firmns faced problemn, well-etablished companies especially in trade, hotels and restaurants and real estate, defaulted on their loans.
36

|Country|Typeof<br>distress<br>(publicor<br>**privatedebt)**|Scopeo<br>(Peaklevelof <br>offinancial<br>FinancialSector<br>(levelofNPLs<br>at peakas%of<br>banking system)|fdistress<br>NPLsaspercent<br>systemassets)<br>Corporate Sector|Provisionof<br>liquidity<br>support|Closureof<br>financial<br>institutions|Government res<br>Publicrecapitalizati<br>Publicfundsfor<br>recapitalization(conditions<br>andtypeofprogram)|olutionstrategy<br>onprogram<br> <br> <br>Takeup<br>|Privateinjectionof<br>capital<br>|Publicdebtrelief<br>program<br>|
|---|---|---|---|---|---|---|---|---|---|
||*|357%fl|67%fntrri|Yes|No|Yes|Upfront|No|No|
|Poland<br>(1992-95)|- Debtsowed<br>bystate-<br>owned<br>enterprises<br>(SOEs),<br>mainly,to<br>state-owned<br>banks.**14**|.ooans<br>(1993)|oeepses<br>remainingin state<br>bandswereloss<br>makers,mostlyin<br>heavy industry(1,992)<br>Is<br>|<br>|<br>|.<br>Tobeeligiblefor<br>recapitalization,banks<br>wererequiredtohave<br>independentaudits and<br>portfolioreviews,<br>assignment ofNPLsto<br>sepamteworkoutunitsand<br>strategicplansubmittedto<br>MOFtodealwithtroubled<br>assets.<br>|<br>recapitalizationofUS$ 750million in1993of<br>sevencommercial<br>banks(18%ofthetotal<br>assetsofthosebanks).<br>Recapitalization<br>permittedthesebanks<br>towriteoffa<br>significant portionof<br>unrecoverabledebts.<br>||N|
|Thailand<br>(1997-<br>ongoing)|*<br>Private<br>sectordebt<br>problem.|32%ofloans<br>(1998)|32.6%ofcorporations<br>(1997)couldnot<br>servicetheir debts|Yes.<br>Substantial<br>(20%ofGDP)|Yes.<br>57of91finance<br>companies;<br>Iof15domestic<br>banks|Yes<br>InplacesinceAugust<br>1998;Ex-ante<br>recapitalization through<br>tier2;aweaklinkto<br>corporaterecapitalization<br>existsthroughtier2<br>capital.<br>Currentshareholdercapital<br>expected tobewritten<br>downtozerobefore<br>infusionandgovemment<br>canchangenmanagement;<br>howeverweaksticksin<br>placetomakeprogram<br>credible.|Govemmentinjected<br>$8.9billioninto<br>private banksand<br>$11.7billion into<br>publicbanks||o|

**''** Private banks consisted of small<sup>coopeativebanks catering to the financing needsof private farmersand ruralhouseholds.</sup>

" Loss-making SOEs not servicing<sup>their debts numbered 2000and accountedfor40% of the totalloan portfolio of ninestate ownedcommecialbanks. As of September1992,some 3000non-commercialized</sup> enterprises remained in state hands.
37

# Annex Table 2. Incentive Framework at Onset of Crisis

|Country|_Framework_<br>Banksallowed<br>toownnon-<br>financial firms|Ownershipli<br>Non-financial<br>companies<br>allowedtoown<br>financialfirms|nks betweenbanks<br>Significant<br>ownershiplinks<br>betweenbanksand<br>corporations|andcorporations<br>_Pracice_<br>Significantlinks<br>betweennon-<br>banksand<br>corporations|<br>Financialand<br>non-financial<br>companies linked<br>throughfamily<br>owncrship|Banks'andnon-<br>rmancials'capital<br>adequacypositions|A<br>(Countries <br>eachvariab<br>and1indic<br>practice.)<br>Loan<br>classification|ccountingfram<br>arescoredona<br>lewith4indica<br>atingfurthesta<br>Loan loss<br>provisioning|ework**16**<br>scalefrom <br>tingbestpr<br>wayfromb<br>Interest<br>accrual|1to4for<br>actice<br>est<br>Average|
|---|---|---|---|---|---|---|---|---|---|---|
|Argentina<br>(1980-82)|Limnited.|Pernittedbut<br>subjecttoprior<br>approvalof<br>authorities.|No.Butthe<br>interfirm market<br>developedahighly<br>interconnected<br>infrastructurethat<br>allowed participants<br>tovoidreserve<br>requirementsand<br>regulationson<br>relatedIending,<br>portfolio<br>concentrationand<br>minimumcapital.|Yes.<br>Ifany,through the<br>interfirrnnarket.|No|Oneofthelargestprivate<br>banks,threeotherbanks<br>andanumberofnon-<br>bankinstitutions,allof<br>whichexpandedquickly<br>wereconsidered insolvent<br>andwereclosedor<br>intervenedin1980.The<br>onlyinstitutionsthat<br>appearedsolventwere<br>thosebackedbythe<br>governmentorthose<br>privatebankswith well-<br>establishedreputation.<br>By1983,manynon-bank<br>institutionswere<br>liquidatedandtherest<br>wereeithemergedor<br>transformedwithbanks.|I||||

> 1 Note: Countries are scored on a scale from I to 4 for each indicator with 4 indicating best practice and I indicating furthest away from best practice.

> Loan classification loan loss provisioning:

Specific loan loss provisioning: Interest Accrual

- I = loan past due = loan past due loan past due past due due more than than 360 days days 2 = loan = loan loan past due more due more than 180 days days 3 = loan past due more = loan past due more past due more due more more than 90 days days

- I = loan past due = loan past due loan past due past due due more than than 360 days days I = 0%/o substandard; 50%0 doubtful; 100%/o loss. I = up to 6 months, no clawback. 2 = loan = loan loan past due more due more than 180 days days 2 = 10 - 15% substandard; 50% doubtful; 100% loss. 2 = up to 3 months, no clawback. 3 = loan past due more = loan past due more past due more due more more than 90 days days 3 = 20% substandard; 75% doubtful; 1 00%/6 loss. 3 = up to 6 months, with clawbackL 4 = repayment capacity of borrower/forward 4 = present value of future cash flow or fair value of 4 = up to 3 months, with clawback looking collateral.
38

# **Country**

**Ownership links between banks and corporations**

|**Country**|_Framework_<br>Banksallowed<br>toownnon-<br>financialfirms|**Ownershiplin**<br>Non-financial<br>companies<br>allowedto own<br>financialfirms|**ksbetweenbanks**<br> <br>Significant<br>ownershiplinks<br>betweenbanksand<br>corporations|**andcorporations**<br>_Practiee_<br>Significantlinks<br>betweennon-<br>banksand<br>corporations|<br>Financial and<br>non-financial<br>companieslinked<br>throughfamily<br>ownership|**Banks'andnon-**<br>**financials'capital**<br>**adequacy positions**|**A**<br>**(Countriesa **<br>**eachvariabl**<br>**and1 indica**<br>**practice.)**<br>Loan<br>classification|**ccountingframe**<br>**rescoredona s**<br>**ew/ith4 Indicati**<br>**tingfurthestaw**<br>Loanloss<br>provisioning|56<br>**work'**<br>**calefrom**<br>**ng bestpr**<br>**ayfromb**<br>Interest<br>accrual|**1to4 for**<br>**actice**<br>**est**<br>Average|
|---|---|---|---|---|---|---|---|---|---|---|
|Chile<br>(1981-86)<br>|In1980,limit<br>onbank<br>investmentin<br>agiven<br>enterprises'<br>shares was<br>raisedfrom<br>100/hto20%<br>ofbank'spaid<br>capital and<br>reserves.<br>|In1978,the<br>maximum<br>individual<br>holdingsof<br>banksharesof<br>3%by<br>companies<br>allowedunder<br>the1974law<br>wasabolished<br>becauseitwas<br>difficultto<br>enforce.<br>In1980,a limit<br>of5%for<br>unsecured<br>creditsand25%<br>forsecured<br>credits was<br>introducedand<br>halvedinthe<br>caseof<br>borowers<br>linkedtothe<br>bank.<br>|Yes.Through<br>"grupos"or<br>financialand<br>manufacturing<br>conglomerates.<br>Afterliberalization<br>(inthemid-1970sa,<br>gruposacquired<br>nearlyallthelargest<br>andmanufacturing<br>andbankingfitn$s."<br>Grupos oftenused<br>bank creditto<br>purchaseshares in<br>the banksbeing<br>acquired, withthe<br>stockthemselvesas<br>loancollateral.By<br>1982,related<br>lendingaccounted<br>for14%oftotal<br>loans and21%of<br>theloansofthefive<br>largestprivate<br>banks.<br>|Yes.Alsothrougb<br>grupos.|No|Bytheendof1983,<br>bankingsystem'snet<br>worthstoodat-12.2<br>billionpesosasitfaced<br>lossesof70billion<br>pesos.'(OrNPLto<br>equityraiorose from<br>22.4%in1981to158.1%<br>in1985.)|3.|Between2and<br>3"9|2|2.5|
|Hungary<br>(1991-95)|Permitted|Permtitted|Whenthebanking<br>sectorwas<br>organizedin1987,<br>SOEscouldown<br>sharesofstate-<br>owned banks.The<br>bigdebtorswerethe<br>shareholders.|Links,ifany,were<br>throughstate<br>ownership.|No|Despitethe1991-92<br>rewapitalizabionsofthe<br>bankingsystem,eight<br>largebanks(andsome<br>cooperatives)werestill<br>technicallyinsolventas<br>of1993.|3|Betwccn2and<br>320|221|_2.5_|

**7** Velasco 1991.

" Sheng 1996.

> **"** Specific provisions of 100% of past due loans (Sanhueza 2000b).

> 200% substandard; 500/o doubtful; 100% loss

> 21 1993 Banking Actanmendment (effecdve 1994) introduced mandatory 100% provision forpast due but unpaid interest although interest suspension was not provided (Borish, Ding and Noel 1996a).
39 Country Ownership **links** between banks and corporations

|Country|_Framework_<br>Banksallowed<br>toownnon-<br>financial firms|Ownership**lin**<br>Non-financial<br>companies<br>allowedtoown<br>financial firms|**ks**betweenbanks<br>Significant<br>ownership links<br>betweenbanksard<br>corporations|andcorporations<br>_Practice_<br>Significantlinks<br>between non-<br>banks and<br>corporations|<br>Financialand<br>non-financial<br>companies linked<br>throughfamily<br>ownership|Banks'andnon-<br>financials'capital<br>adequacypositions|A<br>(Countriesa<br>eachvariabl<br>and1indica<br>practice.)<br>Loan<br>classification|ccountingfram<br>rescoredonas<br>ewith4indicati<br>tingfurthestaw<br>Loanloss<br>provisioning|ework**16**<br>calefrom<br>ngbestp<br>ayfromb<br>Interest<br>accrual|1to4for<br>ractice<br>est<br>Averagc|
|---|---|---|---|---|---|---|---|---|---|---|
|Japan<br>(1991-<br>ongoing)|Limited to<br>holding5%<br>interest.|Permitted,<br>providedtotal<br>investnentdoes<br>notexceed<br>investingfirm's<br>capital ornet<br>assets.|Banksandfirmsare<br>linkedthrough<br>extensivewebof<br>relationships<br>betweencore<br>shareholdersand<br>maincustomers||15largest<br>families own7%<br>ofbanks,16%of<br>corporations,and<br>13%ofnon-<br>banks.|Thecollapseofthereal<br>estatemarketandequity<br>pricesturnedmanyloans<br>non-performningand<br>considerablyreduced<br>banks'capitalposition.<br>Jusencompaniesand<br>smallerbankswere<br>|2|2|2|2|
|Norway<br>(1987- 93)|Investmentsof<br>up to490/%in<br>single<br>companies;<br>only4%of<br>totalbank<br>assets<br>permitted to<br>beinvestedin<br>shares.|Generally,there<br>isamaximum<br>ownershiplimit<br>of10%ofany<br>singleownerof<br>afinancial<br>institution;<br>some<br>exceptions.|No|No|No|affected theworst.<br>Bankswere poorly<br>capritalizedandhadlittle<br>tocushionthemselves<br>againstloanlosses.<br>BaningLawof1972<br>requiredeachbankto<br>maintain 6.5% CAR<br>when theprevailingratio<br>priorto1972was8%.|3|4|423|3.7|
|Poland<br>(1992-95)|Permittedup<br>to25%ofthe<br>bank'scapital.<br>**24.**|Permitted|Links,ifany,were<br>through state<br>ownership.|Links,ifany,were<br>throughstate<br>ownership.|No|1991portfolioreviewsof<br>thesevenstate-owned<br>commercial banks<br>showedthemtobe<br>insolventinthe<br>aggregate.Thecapital<br>shortfalloftheseseven<br>bankswas significantand<br>estimratedatUS$750<br>million.21|3 2|Between2and<br>327|42|3.2|

- 22 Bank holding companies and their subsidiaries are allowed to bold in the aggregate up to 15% of the total shares of non-financial companies.

**22** 1987 banldng regulations stipulated that banks could not enter as income any unpaid interest on NPLs (Karlsen 2000).

**24** The central bank may grant exceptions to the limitation. Non-financial assets acquired by banks during bank conciliation or restructuring agreements were encouraged to be sold within 2-3 years. 25 Agricultural bank and the housing bank.

'6 Substandard loans include those past due between 7 and 90 days.

**27** 20% substandard; 50%/d **o** ubtful; I100% loss

> **2'** Interest due but not received was not taxable. Provisions for losses can be made before tax as in the case of loans classified as doubtful or loss.
40 <!-- Start of picture text --> Country Ownership links between banks and corporations Banks' and non- Accounting framework 16<br>financials' capital (Countries are scored on a scale from 1 to 4 for<br>adequacy positions each variable with 4 Indicating best practice<br>and 1 indicating furthest away from best<br>Framework Practice practice.)<br>Banks allowed Non-financial Significant Significant links Financial and<br>to own non- companies ownership links between non- non-fnancial Loan Loan loss Interest Averge<br>financial finns allowed to own between banks and banks and companies linked classification provisioning accrual<br>financial firmns corporations corporations through family<br>ownership<br>Thailand Yes Yes; statutory No. No. Yes 29 Many weakpublic and I 1 l<br>(1997- linit 5%; private conumercial<br>ongoing) banks.<br><!-- End of picture text -->

**29** It hasbeen estimnated, forexarrple, thatthetop 10 famniliescontrolled46.2percentofthenuarketcapitalization of listed fimisasofend-1996,ofwhichholdings in financial institutions accounted for 18.3 percent of their wealth and in corporations for the rest (World Bank 2000b).
41

# Changes in Incentive Framework During Crisis

Country

|Country|_Changesin _<br>|_framework_<br>|Ownershiplinks<br>|betweenban<br>_C_|ksandcorpor<br>_hanges inown_|ations<br>_ershipstructure_|||Banks' andnon-<br>financials' capital<br>adequacypositions|
|---|---|---|---|---|---|---|---|---|---|
||Banksallowedto<br>own non-financials|Non-financials<br>allowedto own<br>financials|Nationalization<br>(shareof assetsheld<br>bystate-owned)|Privatization|Saleto<br>foreigners|Concentrationof<br>ownership<br>controlamong<br>top15families<br>|Assets<br>carved out<br>|Assetsheldby<br>stateasshalmof<br>GDP<br>||
|Argentina<br>(1980-82)<br>||||||Notapplicable|Not<br>applicable|Notapplicable|Analysisofbankscovering<br>1982-86showedcontinuous<br>declineinROE and<br>weakeningofloan<br>portfolios.By1986,banks<br>representing26%oftotal<br>bankassets hadlostatleast<br>50%oftheirequitywhile<br>institutionsaccountingfor<br>41%hadnegativerealreturn<br>on equity30|
|Chile<br>(1981-86)|Notpermitted.|Pernittedupto<br>1O<sup>0</sup>/oof bank's<br>sharesand<br>Superintendent's<br>priorapproval.<br>(Loans torelated<br>companieswereto<br>bereducedtono<br>morethan5%ofthe<br>total portfolioby<br>end1990.)|In1981/2,11<br>institutions were<br>intervenedofwhich<br>9finance<br>companieswere<br>liquidated.Two<br>largebankswere<br>latersoldto<br>foreigners.<br>In1983,the<br>government<br>intervenedin7<br>banks(&Ifinance<br>company)though3<br>institutionswere<br>liquidated.|Thefive<br>intervened<br>banks that<br>were not<br>liquidated<br>were<br>privatizedby<br>1986.|Twobanks<br>intervenedin<br>1981/82<br>weresoldto<br>foreigners.<br>Ofthebanks<br>intervenedin<br>1983,those<br>thatwere<br>restructured<br>weresold<br>mainlyto<br>domestic<br>investors<br>through<br>capitalismo<br>popularfor<br>individual<br>investorsand<br>salesto<br>groupsof<br>domestic<br>private<br>investors.|Notapplicable|Not<br>applicable|Notapplicable|.<br>Loanpurchase programsin<br>general gavethe banksthe<br>possibilityofwritingoffbad<br>loansovera10-yearperiod.<br>Privatizationof4intervened<br>banksallowedthemtobe<br>fullycapitalizedby1986.|

> 30 World Bank 1998.
42

|Country|_Changesinf _<br>|_ramework_<br>|Ownership**links** <br>|betweenbank<br>_Ch_<br>|sandcorpor<br>_angesinown_<br>l|ations<br>_ershipstructure_<br>Cif|A|Athldb|Banks'andnon-<br>financials'capital<br>adequacypositions|
|---|---|---|---|---|---|---|---|---|---|
||Banks allowedto<br>ownnon-financials|Non-financials<br>allowedtoown<br>financials|Nationalization<br>(shlmeofassets held<br>bystate-owned)|Privatization|Saeto<br>foreigners|oncentratono<br>ownership<br>controlamong<br>top15fanmilies|ssets<br>carvedout|ssesey<br>stateasshareof<br>GDP||
|Hungary<br>(1991-95)|Nochanges|No changes|Recapitalizationin<br>1991-94through<br>exchangeofbonds<br>forNPLs resultedin<br>nationalizationsuch<br>that outof44banks<br>inoperationin<br>1995,17were<br>majoritystate-<br>ownedand5had<br>minority state<br>ownerhip.**3'**<br>Previously, bank<br>shareholders<br>included state-<br>ownedenterprises.|Government<br>implemented<br>bank<br>privatization<br>ineamest<br>startingin<br>1995.Byyear<br>end,about<br>threefourths<br>ofthebanks<br>weremajority<br>private.|Majority<br>stakein held<br>byforeign<br>investorsin7<br>largest<br>commercial<br>banksasof<br>1999.|Notapplicable|Not<br>applicable|Asof1998,state<br>heldminority<br>stakesin2 banks<br>and100%<br>ownershipofI<br>bank(due to<br>recapitalization<br>in1997-98),<br>equivalentto<br>0.3%ofGDP.|AverageCARsofthelarge<br>mostlyprivatized banks<br>improvedto13% in1998.<br>Averageinmedium private<br>(denovo)bankswas17%in<br>1998.**"**|
|Norway<br>(1987-93)|Nochanges|Nochanges|By1991,<br>recapitalization<br>resultedinthe<br>government'ssole<br>ownershipor<br>rajority<br>shareholdingofthe<br>threelargest<br>commercialbanks<br>whichaccounted for<br>85%ofall<br>commercial bank<br>assets.Inthemid-<br>1990s,the<br>government<br>expressed its<br>intentionto reduce<br>itsshareholdingto<br>50%/**o** fthetwo<br>largestbanksbyfall<br>1997and toatleast<br>onethirdthereafter.|In1995,two<br>yearsafter<br>resolutionof<br>thecrisis,the<br>govenment<br>soldthethird<br>largestbank.|Thesaleof<br>thethird<br>largestbank<br>wasmostly<br>toforeign<br>investors.|Notapplicable|Not<br>applicable|Asof1998, the<br>statemaintained<br>61%and51%<br>stakeinthetwo<br>largestbanksthat<br>accounted for<br>40%and 30%/**o** f<br>total commercial<br>banklending.3|AverageCARsof<br>commercialbanksincreased<br>from7%in1981-85to<br>10.6%in1993.Bymid-<br>1990,banks'capital<br>positionswere considered<br>healthyandsufficientto<br>absorblosses.|

"Recapitalization effectively renationalized the banks with the MOF receiving 75% of shares of the banidng system<sup>(Borish,Ding and Noel1996a)</sup> **32** World Bank 1999b.

3 As of 1998, GDP = NOK 1100 billion and deposit money bank assets = NOK<sup>1030</sup> billion;<sup>government's holdingsof the two largest banks=NOK 9195 million.</sup>
43

**Country**

|**Country**|_Changesin_<br>|_framework_|Ownership**links**|betweenbank<br>_Ch_|s and corpor<br>_angesinown_|ations<br>_ershipstructure_|||Banks' andnon-<br>financials'capital<br>adequacypositions|
|---|---|---|---|---|---|---|---|---|---|
||Bklld|Nfiil||||||||
||ansaoweto<br>ownnon-financials<br>|on-nancas<br>allowedtoown<br>financials<br>|Nationalization<br>(shareofassetsheld<br>bystate-owned)<br>|Privatization<br>|Saleto<br>foreigners|Concentrationof<br>ownership<br>controlamnong<br>top15famnilies|Assets<br>carvedout|Assetsheldby<br>stateas shareof<br>GDP||
|Poland<br>(1992-95)|Nochanges'|Nochanges|Sevenof9state<br>owned connnercial<br>banksreceived<br>governmentbonds<br>toraisetheircapital<br>adequacy.|Authorities<br>ainwdat<br>privatization<br>ofall nine<br>state-owned<br>commercial<br>banks.Asof<br>end1995,4<br>bankswith<br>13%oftotal<br>banking assets<br>were<br>privatized.By<br>1998,only<br>twostate-<br>ownedbanks<br>remained.|Saleoffour<br>banks<br>resultedin<br>foreign<br>ownership<br>sharesinthe<br>rangeof25-<br>56%.<br>Initially,<br>bank<br>privatization<br>faced<br>political<br>resistanceto<br>foreign<br>investment,<br>"|Notapplicable|Not<br>applicable|38%ofbanking<br>systemequity36<br>(1995)|Recapitalization allowed7<br>bankstoachieve12%CAR.<br>Buttwospecializedbanks<br>(26%oftotalbankassets,<br>1995)areinneedof<br>restructuing.Butmnany<br>privatebanks createdin the<br>early1990swithloose<br>licensingstandardswould<br>face capital shortfallsunder<br>existingrequirements.<br>Thus,overallCARforthe<br>entire bankingsystemstood<br>at6%in1995.'<br>In1996,if<br>loanclassificationstandards<br>hadbeenstrictlyapplied,the<br>specializedbanksandnmany-<br>small bankswouldhave<br>beenoutofcompliance.3<sup>'</sup>|
|Tbailand<br>(1997-<br>ongoing)|Nochanges|Nochanges|4institutions;<br>43 percent(1999)|Intendedfor<br>public<br>institutions|2banks sold<br>toforeigners;<br>4pending<br>(1999)|53.5percent|2percent<br>(finance<br>companies,<br>1999)|127percent<br>(1999)|No.Mainprivateandlarge<br>publicbankscontinuetobe<br>weaklycapitalized.|

74 Unclear about the position of equity holdings swapped for bad debts in 5 commercial banks (imnplications for managenment and banks' regulatory conmpliance) (World Bank 1994).

" Following the first bank privatization, the banks' shares were put on the market and the subsequent price jumnp led to criticismn of the MOF for having undervalued the shares before going public. This prompted the authorities to be more cautious in selecting investment advisors and caused a slowdown in the process. _'6_ As of 1995, total bank assets stood at 42% of GDP. State held _55%_ of bank assets.

" World Bank 1997c.

" World Bank 1997c.
44

|Country|Taxor other<br>impedimentsto<br>revelationoflosses|Loancl|assificationand<br>frame<br>(Same**framew**|loanlossprovis<br>work<br>**ork**asabove)|ioning|Trouble|dDebt Restructuring|Framework|
|---|---|---|---|---|---|---|---|---|
|||Loan<br>classification|Loanloss<br>provisioning:|Interest<br>accrual|Average|Classification<br>guidelinesof<br>reclassifiedloans|Debt/EquitySwap|Mergersand<br>Acquisitions|
|Argentina<br>(1980-82)|*****<br>Long traditionofthe<br>banking<br>superintendencyof<br>overlookinganalysis<br>ofloanportfolio<br>qualityand operating<br>efficiencyofbanks.|I|1|I|1.0|Noseparate<br>framework.|Not applicable|Not applicable|
|Chile<br>(1981-86)<br>Changesto<br>prudential<br>regulations<br>weremadein<br>1985-86.|*****<br>Taxdeductibilityof<br>specificprovisionswas<br>allowed.<br>*****<br>Untilthetax reformof<br>1984,thetaxrateon<br>dividendsexceeded<br>thatofinterestincome|4|3 39|4|3.7|Notimmnediate.<br>Requiredpermission<br>ofthe<br>Superintendency.|Nodebt-equity swaps<br>under loanpurchase<br>andrescheduling<br>programs. Swapswere<br>used mainlybynon-<br>intervenedbanks,<br>especiallywithforeign<br>debt||
|Hungary<br>(1991-95)|*****<br>Authoritiesannounced<br>theirintentiontoadopt<br>regulationson<br>accounting, reporting<br>andvaluationof<br>restructureddebtin<br>1996-97.AsofJune<br>1999,such regulations<br>hadnotbeen<br>introduced.|4|34|3|3.3|Noseparate<br>framework."|Underthe<br>recapitalizationtloan<br>consolidation program<br>in1992,itwasunclear<br>whetherdebtequity<br>swapswerelegalor<br>illegal.||
|Japan<br>(1991-<br>ongoing)<br>Changesto<br>framework<br>weremadein<br>1998|*****<br>Bankswerenot<br>allowedtodeductfrom<br>taxableincome losses<br>incurredas<br>consequenceofout-of<br>court restructuring.<br>Thiswas corrected<br>onlyinJuneof1998.<br>Also,provisionsand<br>debtforgivenesshave<br>notbeentax<br>deductible.|2|2|2<br>*****<br>*****|2.0<br> <br>Still<br>inadequate<br>recognition<br>and under<br>provisioning<br>ofloans.<br> <br>Thebook<br>valueisstill<br>usedfor<br>valuing<br>securities.|Noseparate<br>framework|||

39 Under 1982 law: 20% substandard, **400O/** doubtful, 100%/o loss (Sanhueza 2000b).

**'°** 1993 Banking Act amendment (effective 1994) introduced the use of forecasts of potential losses in classification and provisioning (Borish, Ding and Noel 1996a). 4' As of June 1999, troubled debt restructuring regulations had not been adopted.
45 Country Tax or other Loan classification and loan loss provisioning Troubled Debt Restructuring Framework impediments to framework revelation of losses (Same framework as above) Loan Loan loss Interest Average Classification Debt/Equity Swap Mergers and classification provisioning: accrual guidelines of Acquisitions reclassified loans Norway (1987 -93) * Specific provisions loan were loss fuilly 4 4 4 4.0 Reclassification allowed only after Equity mrarket was value valued or at None. tax deductible. regular servicing. present value, whichever was lower. Provisioning made if the value of the equity was lower than the original debt exposure. Poland 3 3 4 3.3 Reclassification only Unfavorable tax (1992 - 95) - 95) 95) after 3 months of debt treatment of equity servicing, swaps. Thailand 3 3 2 2.7 Innediate (1997reclassification possible.

Poland 3 3 4 3.3 (1992 - 95) - 95) 95) Thailand 3 3 2 2.7 (1997ongoing)
46

|||||Legal<br>|Framewo<br>|rk<sup>4 2</sup><br>||fl|Ci|Sifi Idit|
|---|---|---|---|---|---|---|---|---|---|---|
|Country|Restrictions for<br>goinginto<br>reorganizations|Noautomatic<br>stayonassets|Secured<br>creditorpaid<br>first|Managerdoes<br>notstayin<br>reorganizations|Sumof<br>creditor<br>rights|Efficiencyof<br>judicialsystem<br>index|Enforcement<br>ofcreditor<br>rightsindex<sup>43</sup>|Ruleoaw<br>index|oupton<br>index|pecc mpemens|
|Argentina<br>(198042)|0|0|1|0|1<br>|6.0<br>|0.6<br>|5.35<br>|6.02<br>||
|Chile<br>(1981-86)|1|0|1|0|2<br>|7.2<br>|1.4<br>|7.02|5.30||
|Hungary"<br>(1991-95)||1|0|0|2|3.0|0.6|n.a.|n.a.|Thelackofrmodemand<br>efficient institutionsand<br>judicialcapacityisevident<br>inthehugecourtbacklog<br>forliquidationprocedures<br>during1992-96.|
|Japan<br>(1991-ongoing)|0|0|1|1|2|8.0|1.6|8.98|8.52||
|Norway<br>(1987- 93)|1|0|1|0|2|10.0|2.0|10.0|10.0|None|
|Poland<br>(1992- 95)|1|0|1|0|2|3.0|0.6|n.a.|n.a.|Shortageoftrainedjudges;<br>weakenforcementofcourt<br>judgments;highcourt<br>costsforcasefiling;weak<br>administrationofcourts;<br>outdated/inefficient<br>registries forproperty<br>rights,entryandexit.|
|Thailand<br>(1997-ongoing)|I|t|0|1|3|3.2|0.9|6.25|5.18||

12 Sources for indices of creditor rights, efficiency of judicial<sup>system, ruleof law and corruption:La PortaLopez-de-Silanes, and Shleifer1998,Claessens,Djankov andNenova 2000;WorldBank1985;</sup> Barandiaran and Luders 2000, Sanhueza 2000b; Kopanyi<sup>2000b; IntemationalMonetary Fund1999b;Karlsen2000and Norway'sMinistry of Finance;authors'esdmates.</sup> '3 Computed as the product of the creditor rights and efficiency of<sup>judicialsystemindices divided by 10.</sup> " 1993/94 bank and debtor conciliation program was unsuccessful.<sup>Onlyt4% of the eligible enterprisesapplied to the program.Banks wereless willingto write offdebtsand preferredto sellassetspledgedas</sup> collateral. The negotiations were frequently interrupted by<sup>interventions fromthe StateProperty Agency;the selectionprocessof enterpriseswas based on non-financialconsiderations;theagreementsfailedto</sup> specify quantitative performance criteria and targets and to<sup>impose penaltiesfor non-compliance(Kopanyi 2000a).</sup>
47

# **Annex Table 3. Characteristics of Financial Restructuring Approach Adopted and Results**

**Country**

|**Country**||**Gov**|**ernmentResolutionAppr**|**oach**||
|---|---|---|---|---|---|
|Argentina|AMC mechanismused<br>None|DecentralizedMechanisms<br>_Cilii _|Growth<br>|OtherImpedimentstoCorporate<br>Restructuring<br>|Results|
|<br>(1980-82)||_aprapostonofbanks_<br>*<br>nTegovernment'sstrategyofbankmnergers<br>andtransformationwasnot sufficientto<br>attain acapitalbasethatcouldsupporttosses<br>whenloanportfoliosbegantodeteriorate<br>again,<br>_Accountingframework_<br>*<br>Centralbanktighteneditssupervisory<br>function.Butdespiteinmprovedsupervision<br>andacomprchensive_setof_prudential<br>regulations, recognitionofloanlossesstill<br>sufferedfrom(amongothers)thelackofan<br>apprpriatesysternforclassifying loan<br>portfolioaccordingtoriskandtolerationby<br>theauthoritiesofbanks'ownadhoc<br>accountingpracticestowardsloss-<br>provisioning.<br>|Unsoundandpoorly managed<br>publicfinances coupledwitha<br>tightmonetarypolicyledto<br>highinterestratesand<br>hyperinflation.|UnmiteduseofApril1981refinancing<br>schemedue to:(i)announcementofan<br>upconmingmoregenerous scheme;(ii)<br>widespreadperceptionthatmuchofdebt<br>reliefwasconvenedtoforeignexchange<br>thatsubsequentlyleftthecountry.|n<br>Thesecond schemeprecluded<br>enterprises withfiscalobligations<br>inarrearsorhaddistributed<br>dividendsaboveacertain amount<br>inthepastorwereconsidered<br>alreadybankrupt.Ahigherthan<br>expectednumber_of_enterprisesdid<br>notmeettheeligibilitycriteria.As<br>ofend1981,on)yabout 4%ofthe<br>debtestimated eligiblefor<br>restructuringhadbeen refinanced.<br>*<br>Debtdistressrecurredafter1982<br>andreachedcrisis proportionsin<br>1989.|
|||_Legalframnework_<br>*<br>Noout-of-courtmechanismputinplace<br>(exceptforblanketrestructuringprogram);<br>no changestobankruptcy framework.<br>_OwnershipsSructure_<br>*<br>Nochanges||||
48

|**Country**||**Gov**|**ernmentResolution Appr**|**oach**||
|---|---|---|---|---|---|
||AMCmechanismused|DecentralizedMechanisms|**Growth**|Other**Impediments**toCorporate<br>Restructuring|Results|
|Chile<br>(1981-86)|None|_Capitalpositionofbanks_<br>*<br>Thepublicandprivaterecapitalization<br>programsimprovedthecapitalbaseofbanks<br>toabsorblosses.<br>_Accounrtingframework_<br>BankSuperintendency cracked downon<br>excessiverelatedlendingin198142and<br>imposedloanlimitstosingleenterprises.<br>Such measurescarnetoolate toreversethe<br>deterioatingsituation.Infact,theauthorities<br>mistakenlyperceivedtheproblemnsto be<br>temporaryand allowedaccountingflexibility<br>tobanksinreflectingtheirlosses (e.g.<br>extendingthreholdfordeclaring delinquent<br>loansnon-perfornning).Thesepracticeswere<br>dismantled onlyin1984-85.|Thegovermnentpursuedtight<br>fiscalpolicyintheyears<br>leadingupto andduringthe<br>crisis. Chile alsoexperienced<br>extraordinarilyhighreal<br>interestratesduringthesame<br>period.Beginningin1982,the<br>governientused monetary<br>policyto activelymoderate<br>increasesin interestrates.|Across-the-board restructuringschenmes<br>didnotdistinguish betweenfintswith<br>varyingdegreesofdifficulties.Thelack<br>ofrealistic assessmentoftheconditions<br>oftheschemes erodeditscredibilityin<br>thelongrun.Thus,repeatedschemes<br>reinforcedtheperception heldbyboth<br>debtorsandcreditorsalikeofthe<br>govemment'sreadinesstoprovide<br>additionaldebtreliefandledtoaserious<br>moralhazardproblem."|Thedecentralized approachbailedout<br>borrowersandstrengthenedthecapital<br>positionofbanksatafiscalcost<br>estimatedtoexceed40%ofGDP.Butit<br>helpedtoimprovethecorporatebalance<br>sheet, together with theeconomic<br>recoverybeginningin1985,thereby<br>allowingforthe reductionoflong-term<br>indebtedness. Therestructuring<br>progransprovidedworkingcapitaland<br>financialrelieffor700/oofdebtorsand<br>helpedthemregaintheir<br>creditworthiness.a|
|||_Legalframework_<br>*<br>Bankruptcyframeworkremained outdated<br>andthejudiciarysystemwasslow.Inthe<br>early1980s,privateagents wereallowedto<br>resolvebankruptcycasesbyhiring<br>specializedprivateconsultingfirmsto<br>engageinresolution(insteadofrelyingon<br>thegovernmentagcncy orthe judicial<br>system).<br>_Ownershipstructure_<br>*<br>In1982,theauthoritiesenforcedexisting<br>ownershiplimits.Also, theBanking Actof<br>1986introduced stringentrestrictionson<br>relatedlending.||||

**F** or example, the 1982 loan purchase program was successful because banks were still reluctant to stop rolling over loans because it would force them to start legal action against delinquent debtors, when it was still likely that the govemment would provide additional relief. a As of end 1986, the financial indicators of 100 firms surveyed whose stock is traded on the Santiago stock exchange had improved substantially, a reflection of the corporate sector's improving financial situation. (World Bank 1987)
49 Country

**Government Resolutdon Approach**

||**AMC**mechanismused|DecentralizedMechanisms|Growth|OtherImpedimentsto Corporate<br>Restructuring|Results|
|---|---|---|---|---|---|
|Hungary<br>(1991-95)|None<br>Oneofthe recapitalization<br>programsintendedtotransfer<br>NPLs toacentralentitybut<br>thelatterneverbecame<br>operational.|_Capitalpositionofbanks_<br>*<br>Thenewstrategytakenbythe government<br>thatcameintopowerin1995wasa<br>decentralizedapproachtodebtrestructuring.<br>Itsrelianceoneamestbankprivatization<br>eventuallyledtothestrengthening ofthe<br>banks'capitalbase.Itssuccess contrasts<br>withthefailureofpriorpublic<br>recapitalizationprograms.<br>_Accountingframework_<br>BankingActofDec1991introducedloan<br>classificationandprovisioning rules inline<br>withBISstandards.Buttheresponsibilities<br>ofsupervisionweresplitbetween two<br>agenciesandweakeneditsfunction.The<br>1995programincludedacomprehensive<br>reformof regulationsandbanksupervision<br>powers.<br>_Legalframework_<br>*<br>Atough bankruptcylawtook effectinJan<br>1992andlateramendedin1993.Whilethe<br>lawledtoasubstantialnumberoffilingsfor<br>bankruptcyandliquidation,suchcaseswem<br>subjecttolongdelaysinprocessingand<br>adjudication. The1993bankruptcy<br>aamendmentaimedtoremedycertain<br>deficienciesalsopartlyledto thedeclinein<br>thenumberoffilings.The1995pTogram<br>improvedtheefficiencyofinsolvency<br>proceedings.<br>*<br>1992 and1993recapitalizationpmgrams<br>envisagedatransparentout-of-courtdebt<br>conciliation procedureinthefaceof<br>overburdenedcourtsandliquidators. The<br>1992programwasthwartedby:(i)the<br>absenceofruleson howtosettlestateclaims;<br>(ii) lack ofclarityifdebt-equityswapswere<br>legal orillegal.The1993program became<br>miredinpersistentinterventionsby<br>competing govemmentministriesandmoral<br>hazard concernsthatcontibutedtoits<br>termination.<br>_Ownershipstructure_<br>*<br>Towardstheendofthe1990s,thelargest<br>conunmercialbankshadbeenprivatizedin<br>additiontootherbanks,largelytoforeign<br>investors.|Macroeconomicpolicyinthe<br>early1990s was characterized<br>byastalledfiscalreformanda<br>relaxedrmonetarypolicy.Real<br>interest rates werenegativein<br>1992-93.However, witha<br>newlyelectedgovernmentin<br>1995,areform programwas<br>launchedandincluded<br>structuralmeasures,astrong<br>fiscaladjustmentandsterilized<br>monetaryinterventions.|*<br>Thelackofcapacityinbanksto<br>conducttroubleddebt restructuring<br>andthelackofstrategic skills<br>amongenterprisemanagers<br>discouraged them from<br>participatingintheearlier<br>conciliationscheme.<br>*<br>The repeatedgovernmentfinanced<br>bailoutsof1991-93withoutabank<br>incentive andregulatory framework<br>resultedinfurtherinmprudentrisk<br>takingandadverseselectioninthe<br>corporateandfuancialsectors.|*<br>Despitetherepeated<br>recapitalization,someattemptsto<br>improvetheaccountingand legal<br>framework (includingout-of-court<br>conciliation),corporate<br>restructuringwaslimited.Inabout<br>two-thirdsofthecases that entered<br>intotheconciliationprogram, the<br>creditorsanddebtorsfailedtoreach<br>agreement.Mostclaims weresold<br>through public tendertofactoring<br>companies.<br>The1995pmgramthatemphasized<br>bankprivatmzationand<br>comprehensive regulatoryand<br>incentwveframeworkprovedtobe<br>more effectiveinupgradingcapital<br>basesandencouraging<br>restructuring.Thequality ofbank<br>assetsimprovedwith theshareof<br>loss anddoubtfulloansin thetotal<br>bankingsystem'sloanportfolio<br>declinedsteadily from 25%in1993<br>to3%bythelate1990s.|
_50_

**Country**

|**Country**||**Gov**|**ernmentResolutionApp**|**roach**||
|---|---|---|---|---|---|
|J|AMCmechanism used<br>YAhii|Decentralized Mechanisms<br>|Growth<br>|OtherImpedimentstoCorporate<br>Restructuring<br> <br>|Results|
|apan<br>(1991-<br>ongoing)|es.utortessetup three<br>entities.<br>_CooperativeCreditPurchase_<br>_Company_Wassetupin<br>1993asamechanismfor<br>bankstotransfer loansata<br>discount,thus satisfying<br>requirementsinthetaxlaw<br>whileavoidingthe<br>bankruptcyofdebtors(loan<br>lossprovisions are<br>automaticallytaxdeductible<br>onlywhentheyfollow<br>foreclosureofcollateralor<br>saleofloanataloss).Loan.<br>amounttransferredYen15<br>trillion.<br>_HousingLoans_<br>_AdministrationCorporation,_<br>Createdin1996**to**resolve<br>withina10year period the<br>loansofthe7housing<br>companiesthatwereclosedin<br>1995.<br>_TheResolutionand_<br>_CollectionBank_Wascreated<br>_in_1995todealwiththe_assets_<br>offailedcreditcooperatives<br>andhadreceivedloansofface<br>valueofY1.5trillioninthe<br>firsthalfof1998.<br>Allthreeagencieshave been<br>veryslowinsellingthe<br>assets.|_Accountingframework_<br>*****<br>Until1998,theloanclassificationandloan<br>lossprovisioningframeworkclearlyfavored<br>the hidingoflossesratherthanthe<br>recognitionoflosses.Moreover,banks<br>heavily usedamechanismofshiftingtheir<br>lossesoff-balancebycreating related<br>companieswhichwereneithersubsidiaries<br>noraffiliatesandtowhich theynon-<br>performingloansatabovemarketvalue.<br>_Legalfrumework_<br>*****<br>Japan'spresentbankruptcylawis<br>cumbesonmeandemphasizesprotecttonof<br>creditorrightsthroughliquidation and alack<br>ofothermechanismsthat enabledebtorsto<br>engagecreditorsinnegotiations.Whilea<br>varietyofmechanismexistforcoUrt-<br>supervised reorganization,thesehavenot<br>provedtobeeffective tools forcorporate<br>rehabilitationwhichmay have contributedto<br>unnecessaryliquidations. Moreover,thelegal<br>infrastructureinJapanisnotsuitedfor<br>dealingwithrecoveryanddebt restsuctunng<br>in anexpeditiousfashion.Foreclosureand<br>bankruptcyproceduresarecumbersonmeand<br>canbetimeconsuming. Moreover,allloans<br>areextendedon afullrecoursebasis,<br>implying thatforeclosureofoneloanwould<br>threatenthewholecomnpany.<br>*<br>Compoundingthelegalftameworkissuesis<br>thefactthat thecapacityofbankruptcycourtS<br>inJapanislimitedasthereareonlytwo<br>bankruptcycourts,<br>*<br>Beforethecrisis,thelackofeffectiveformal<br>proceduresmightnothave causeda major<br>problem becausebankswerenotfinancially<br>constrainedand thuscould initiate work-outs.<br>*<br>In1999,thegovemmentpresentedlegislation<br>toParliamentattempting**to**facilitatethe<br>formal corporaterestructuringframework.<br>_Ownershipstrciure:_<br>*<br>Limitedchangesinownership structurehave<br>taken<br>placeandthe<br>complex<br>webof<br>relationshipsbetweenbankshareholdersand<br>main customrnsreducedtheincentives for<br>bankstoaddressbaddebtproblem.|Thegovernmentputinplace<br>repeatedfiscalstimulus<br>packagesthatboostedthe<br>budget deficitfrom70percent<br>ofGDPto120percentanda<br>loosemonetary policywith<br>ovemightratesatzero percent<br>which reducedthecostto<br>banksofcarryingNPLs<br>tremiendouslyandthusalso<br>reducedbanks'incentives**to**<br>restnucturetheloans.|*****<br>Withprospectsforloanrecovery<br>limited,bankshadlittleincentiveto<br>liquidate questionable partsoftheir<br>portfolios, asthecostofcarrying<br>badloanswasinsignificant dueto<br>lowinterestrates, and potentialfor<br>upswinginvalueofassetis greater<br>thanthatofafurtherloss.<br>*****<br>Multipleliensattachedtomostreal<br>estateusedascollateralproved<br>difficulttorank, consolidateand<br>cleir.<br>*****<br>Inorderforthegovernmentto<br>forcebankstorestructure balance<br>sheets(disposeoftheloans),the<br>construction industrywouldhave<br>hadtomarkitsassetstomarketas<br>taxregulationsdonotfavorbanks'<br>unilateralactions.Intheprocess,<br>nianyfirmnsintheconstructionand<br>propertyrelatedindustry would<br>likelyhavebeendeclaredinsolvent<br>with adverseimplicationson<br>employment<br>*****<br>Corporaterestructuring hasfaced<br>significant institutional<br>ignedifentssuchasthehighcost<br>to fismsofreducing<br>untrmsploynentCourt<br>n<br>lingg in the<br>late1970smadedismissals<br>cumnbersomTewhichledfirmsto<br>offervoluntryearlyretirement<br>programs.In1999,theauthorities<br>nxovedtointroducemeasuresto<br>facilitate labormobilityandthe<br>serppingofexcesscapaciry.|*****<br>Theauthorities' strategyfor<br>banking sector recoverywas<br>predicated on aresumpbonof<br>growth that wouldrestorebanks<br>and borrowers to financial strength<br>*****<br>Yet,despitelargeandrepeated<br>fiscal stimulus packagesand loose<br>monetarypolicy, sustained growth<br>hasnotoccurred.<br>*****<br>Only recently didtheauthorities<br>takeamoreaggressive approach to<br>strengtheningtheframework for<br>decentralizedrestructuringby<br>strengtheningthebalancesheetsof<br>bankswithpublicmoney,moving<br>towardconsolidatedaccounting<br>and increasing supervisorypressure<br>onbankstorecognizeproblem<br>loans.<br>*****<br>Whilethesemeasureshaveledto<br>anaccelerationofcorporate<br>restructuringin1999,muchstill<br>remainedto bedone.|
51 Country

|Country||Gov|ernmentResolutionAppro|ach||
|---|---|---|---|---|---|
||AMCmechanismused|DecentralizedMechanisms|Growth|OtherInpedimentstoCorporate<br>Restructuring|Results|
|Norway<br>(1987-93)|None|_CapUalpositionofbns_<br>*<br>Public recapitalizationaccompaniedbythe<br>requireffentforbankstoimproveoperating<br>profitsandreducerisk-weightedasses<br>improvedthecapacityofthebanking system<br>tosustainlosses.<br>_Accountingframework_<br>*<br>With increasedcompetition afterthe<br>deregulation,baiksincreasedlendinginthe<br>1980sinrealestateandstocksthereby<br>increasingtheirexposureto*noveoentsin<br>assetprices.<br>*<br>Before 1987,therewerenospecific<br>regulationsonlossprovisions.Regulations<br>wereissuedonlyin1987whichledtoan<br>increasein provisions.In1990,bank<br>supervisionwasstrengthened.|Anexpansionaryfiscalpolicy<br>and considerabletaxrelief<br>(associatedwiththetax<br>reform)prevailedin1992.The<br>floatingoftheNorwegian<br>currency inlate1992ledtoa<br>monetaryand exchangepolicy<br>aimedatthemaintenanceof<br>the exchangerateagainst<br>European currenciesatthe<br>1993level.Money growth<br>slowedthereafter.||Withaproperbankruptcyframework,<br>strengthenedaccountingregulations,the<br>absenceofownershiplinksbetween<br>banksanddebtorsandrecapitalized<br>banks,thedecentralized approachproved<br>successfulasbanksandfitmsbeganto<br>tumaroundinthe last yearofthectisis.|
|||_Legalframework_<br>*<br>Bankscouldfileforbankauptcyoffirmsat<br>any timeduringthecrisis.||||
|||_Ownershipstructure_<br>*<br>Publicinjectionofcapitalresultedinthe<br>transferofthethreelargestprivatebanksinto<br>statehands.||||
52

# **Country**

# **Government Resolution Approach**

|Poland|AMC mechanismused<br>None|DecentralizedMechanisms<br>_Citliti bk_|Growth<br>|Other**tmpedimensts**toCorporate<br>Restructuring<br> <br>|Results|
|---|---|---|---|---|---|
|<br>(1992-95)||_apaposon ofans_<br>*<br>Publicrecapitalization strengthenedthe<br>capital baseofthecommercialbanks that<br>participatedintherestructuringprogran.<br>Two state-ownedspecializedbanks remained<br>problemridden,includingweakcapital<br>positions.In1996,enforcementof<br>accountingstandardswereviewedtolead to<br>someotherbankstobeoutofcompliance<br>with questionablecapacity toabsorblosses.<br>_Accountingframework_<br>*<br>Interestduebut notreceivedwas madenot<br>taxable in1992.Bankregulationswere<br>tightenedjustbeforetheintroductionof_the_<br>restructuringprogram.Troubleddebt<br>restructuringruleswereadoptedduringthe<br>restructuringperiod. Despiteupgraded<br>bankingregulationsin1992-93,problems<br>remainedinthequality andapplicationof<br>adequateaccountingstandardsforsome<br>banksthatwerenotincludedinthe<br>restructuringprogram.<br>_Legalframework_<br>*<br>Govemmentallowedenterprisestoenterinto<br>out-of-courtChapterIItypc procedure,<br>called conciliatoryagreements ledbythe<br>banks.Ifabankparticipatinginthe<br>restructuringprogram failedtoreach<br>agreementwith anonviabledebtor,thebank<br>was requiredtofileforbankruptcyorsellthe<br>badloans.|Theperiod wascharacterized<br>bypnudentmacroecononmic<br>policiesallowingforagradual<br>declinesininflation.The<br>authoritiesexercisedsorme<br>flexibilitywithinterestrates,<br>thoughtheywereniaintainedat<br>positive reallevels,.|*<br>Lack of developedsecondary<br>marketsandproblemswithtax<br>treatmentinitiallydiscouragcddebt<br>salesandswaps.<br>*<br>Taxdeductibilityforloanwrite-<br>offs andassociatedcorporatetax<br>changeswasnotadopteduntil<br>1994.|*<br>AsofMarch1994,thebanks<br>completed debtconciliation<br>procedures withrespecttodebtors<br>whosedebtsamountedto83%of<br>classifiedloans.25%ofthetotal<br>enterprisesthatenteredintobank<br>conciliationswentintobankruptcy<br>orliquidation. Therestregained<br>creditworthinessortheirdebtswere<br>auctionedoffbybanksortheir<br>collateralseized""Banking<br>systemNPLsfellfrom28%oftotal<br>loansin1992to10%in1997.so<br>The ovcrall cvidenceonoperatonal<br>restructuringbyenterprisesin<br>Polandduringtheperiodcovered<br>bytherestructuring programand<br>thereafterpointstoanotably<br>sluggishpace. However,aWorld<br>Bank surveyofsome1000Polish<br>firnmsbetween1992and1995<br>alludestoevidencethatsorne<br>restructuring hastakenplaceas<br>80%ofthose enterprisesshowed<br>irmprovementsintheirdegreeof<br>profitabilityor loss-making.|

|_Ownership structure_<br>v<br>Privatizationofthebankin sstemwasslow|
|---|
|<br> g y <br>withoverWI/**o**fthebankinsstem tilli|
|. gy sn<br>statehandsin1996.|
53

|**Country**||**Gov**|**ernmentResolutionAppr**|**oach**||
|---|---|---|---|---|---|
||AMCmechanismused|Decentralized Mechanisms|Growth|Other Impediments to Corporate<br>Restrucuring|Results|
|Thailand<br>(1997-<br>ongoing)|Onlyusedfor liquidationof<br>assetsofclosed finance<br>companies thataccountedfor<br>2%ofassets.|_Capitalpositionofbanks_<br>*<br>Despite publicand privateinjectionofcapital<br>inbanks,banksremainedcapital constrained<br>andwouldhavebeenatleast severely<br>undercapitalizediftheyhad acknowledged<br>loanlossesproperlyandthuscontinuedto<br>lackthelossabsorptioncapacitytoenpgein<br>anymeaningfulrestructuring.<br>**_Accounllngfraznework_**<br>*<br>Whileloanclassification andloanloss<br>provisioningstrengthened;frameworkstill<br>not inlinewithinternationalbestpractice<br>andstill favorshidingoflosses.<br>Lep] fiwmwork<br>Legalfbameworck<br>*<br>Reformofbankruptcylawbutcreditorsstill<br>lacked tools<br>toforce<br>foreclosure<br>and<br>liquidationandjudicialcapacityrenained<br>limited. Theformalbankruptcy regimewas<br>complementedwith outofcourtframework<br>butithaslimitedsticksandcarrots.|Afterabriefinitialperiodof<br>tightfiscalandmonetary<br>policy,thegovernment<br>implementedfiscalstimulus<br>programs andloweredinterest<br>ratestohistoricallowlevels.||Despitethegovemrnmentseffortsto<br>strengthenthedecentralizedmechanisms<br>forcorporaterestructuring,meaningful<br>progress onthecorporaterestructuring<br>sideremainslimited.Asof2000,not<br>surprisingly,banksrestructuredmostly<br>thoseassetsthatwere"easyto<br>restructure",i. e.wherefinancially<br>sustainablestructures couldbeachieved<br>bysrbetchingmaturitiesor loweringof<br>interestrates. Accordingtoanalysisof<br>companies'balancesheets,the<br>restructuringoftheseNPLslargely<br>requiredhaircuts,debi toequityswaps<br>~~~~~~~~~~~~~~~~~~~~~~~~~~~and<br>liquidation.Yet,bankscontinuedto<br>becapital constrainedandlackedthe<br>toolstoforcedebtors**to**thenegotiating<br>table.Afteralmostthree years,armunt<br>ofNPLs stillstoodat38 percent.In<br>2002,systemwideNPLsamountedto<br>one-thirdoftotalloans.|
|||_Ownershipstrixtures_<br>*<br>Whileconcentationoffamily ownership<br>declinedsonewhatduringcrisis,itcontinues<br>tobe animpediment||||
# **Policy Research Working Paper Series**

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|---|---|---|---|---|
|WPS2881|ReturnstoInvestmentinEducation:<br>AFurther Update|GeorgePsacharopoulos<br>HarryAnthonyPatrinos|September2002|N.Vergara<br>30432|
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|WPS2883|AssessingtheDistributionalImpact<br>ofPublic Policy|B.Essama-Nssah|September 2002|0.Kootzemew<br>35075|
|WPS2884|PrivatizationandLaborForce<br>Restructuringaroundthe World|AlbertoChong<br>FlorencioLopez-de-Silanes|September2002<br>|H.Sladovich<br>37698|
|WPS2885|Poverty,AIDS,andChildren's<br>Schooling:ATargetingDilemma|MarthaAinsworth<br>DeonFilmer|September2002|H.Sladovich<br>37698|
|WPS2886|Examining theFeasibilityof<br>LivestockInsuranceinMongolia|JerryR.Skees<br>AyurzanaEnkh-Amgalan|September2002|E.Laguidao<br>82450|
|WPS2887|TheDemandforCommodity<br>InsurancebyDevelopingCountry<br>AgriculturalProducers:Theoryand<br>anApplicationtoCocoainGhana|AlexanderSarris|September2002|M.Fernandez<br>33766|
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|WPS2889|EnvironmentalPerformanceRating<br>andDisclosure: China'sGreen-<br>WatchProgram|Hua Wang<br>JunBi<br>DavidWheeler<br>JinnanWang<br>DongCao<br>GenfaLu<br>YuanWang|September2002|Y.D'Souza<br>31449|
|WPS2890|Sector Organization, Governance,<br>andtheInefficiencyofAfricanWater<br>Utilities|AntonioEstache<br>EugeneKouassi|September 2002|G.Chenet-Smith<br>36370|
|WPS2890|Sector Organization, Governance,<br>andthe Inefficiencyof AfricanWater<br>Utilities|AntonioEstache<br>EugeneKouassi|September2002|G.Chenet-Smith<br>36370|
|WPS2891|TrendsintheEducationSectorfrom<br>1993-98|NgaNguyet Nguyen|September2002|E.Khine<br>37471|
|WPS2892|ProductivityorEndowments?<br>SectoralEvidenceforHong Kong's<br>AggregateGrowth|Hiau LooiKee|September2002|P.Flewitt<br>32724|
|WPS2893|BankingonForeigners:TheBehavior<br>ofInternationalBankLendingto<br>LatinAmerica,1985-2000|MariaSoledadMartinez<br>Peria<br>AndrewPowell<br>IvannaVladkovaHollar|September2002|A.Yaptenco<br>31823|
|WPS2894|TelecommunicationsSector<br>ReformsinSenegal|Jean-PaulAzam<br>MagueyeDia<br>TchetcheN'Guessan|September2002|P.Sintim-Aboagye<br>38526|
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||**Title**|**Author**|**Date**|**Contact**<br>**forpaper**|
|---|---|---|---|---|
|WPS2895|TelecommunicationsReformin<br>C6ted'lvoire|Jean-JacquesLaffont<br>TchetcheN'Guessan|September 2002|P.Sintim-Aboagye<br>38526|
|WPS2896|The WageLabor Market and<br>InequalityinVietnaminthe1990s|John LukeGallup|September 2002|E.Khine<br>37471|
|WPS2897|GenderDimensionsofChildLabor<br>andStreet ChildreninBrazil|EmilyGustafsson-Wright<br>HninHninPyne|October2002|M.Correia<br>39394|
|WPS2898|RelativeReturnsto PolicyReform:<br>EvidencefromControlledCross-<br>Country Regressions|AlexandreSamydeCastro<br>IanGoldin<br>LuizA.PereiradaSilva|October2002|R.Yazigi<br>37176|
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