Different Models of Bad DebtRestructuring

Remarks based on experiences with bad debt problemsin developed economies and Central European transition economies

ByStefan Kawalec

Vice-President of the Management Board, Commercial Union Polska

Presentation for the International Seminar onComparative Experiences in Confronting Banking Sector Problems

in Central/ Eastern Europe and Central Asia

Organized bythe World Bank, the International Monetary Fund, the European Bank for

Reconstruction and Development, and the National Bank of Poland

April 22-24, 2002Warsaw, Poland

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Contents of the presentation*/• What is a bad debt problem? ........................................................................................................................3• What are the causes of bad debt problems? ................................................................................................. 5• What are the causes of bad debt problems? - The case of transition economies ......................................... 7• Why bad debts are dangerous? - Stock and flow problem ...........................................................................8• How bad debt problems affect bank activity and new lending practices? ...................................................9

– Hiding the problem ......................................................................................................................... 10– Looking for quick profits to compensate for bad debt losses ......................................................... 11– Wait and see .................................................................................................................................... 12– What are the possible results? ........................................................................................................ 13

• Impact of banking problems on the whole economy .................................................................................. 14• How to deal with banking crisis? .................................................................................................................15• Recapitalization

– By whom? ....................................................................................................................................... 16– How much and in what form? ......................................................................................................... 17

• Why separate bad debts and bad borrowers from the bank? ....................................................................... 18• Separation of bad debts

– Two main approaches ..................................................................................................................... 19– USA Spain model: carving-out ....................................................................................................... 20– Reasons for looking for an alternative solution .............................................................................. 21– The Polish model: decentralized work-out ..................................................................................... 22

• Experience of three Central European countries– Table ................................................................................................................................................ 24– Summary ......................................................................................................................................... 25

• The USA- Spain model versus the Polish model– Comparison ..................................................................................................................................... 26– Conclusions ..................................................................................................................................... 27

• Bibliography .................................................................................................................................................28

*/ The presentation is based on Kawalec and Stypulkowski (2001) – see Bibliography

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What is a bad debt problem?• Bad debts are a phenomenon unknown in a traditional

socialist economy.• Bad debts appear in a market economy where enterprises are

exposed to market forces and face the demand barrier• In a market economy a bank has to anticipate that a certain

percentage of loans may be lost. Prices should be set at sucha level as to assure that proceeds from performing loans willprovide a cushion to cover losses on expected non-performing loans.

• When losses on non-performing loans are significantlyhigher than anticipated, the bank loses its capital.

• In case of a significant bad debt problem in a bank, creditlosses may endanger the bank’s capital adequacy or evensolvency.

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What is a bad debt problem? (2)

• A significant bad debt problem on a country level existswhen a high share of non-performing assets threatensthe liquidity and solvency of a substantial part of thebanking sector.

• It was estimated that between 1980 and 1996 out of 181member countries of the International Monetary Fund133 i.e. 73% experienced serious banking problems.

• Among those undergoing significant problems were– well established and developed market economies such as: USA,

Japan, Sweden, Norway, Finland, France, Spain, as well as– dynamic emerging economies such as: Chile, Israel, Argentina,

Mexico, South Korea, Turkey

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What are the causes of bad debt problems?

• Dramatic changes of macroeconomic conditions such as:– recession– change in asset price (stock market or real estate price bubble)– unexpected change of interest rate environment– dramatic change of value of the domestic currency

and/or• Major liberalization of financial sector such as:

– deregulation of interest rates– exchange rate liberalization– liberalization of capital flows– removal of credit limits– opening banking market to new entrants and foreign competition

Serious banking problems on a country level in developedeconomies usually follow or coincide with:

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What are the causes of bad debt problems? (2)

However ...

Each individual case of significant bad debt problems in a bankresults from bad management practices and identified flawsin credit policies.

Very often political interference in bank credit decisions has asignificant contribution in creating and prolonging bad debtproblems.

Connected lending (lending to companies owned by the bankor its major shareholders or mangers or directors) is a majorcause of bank failures.

Lack of effective banking supervision is an important factorcontributing to the emergence of significant bad debt problem.

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What are the causes of bad debt problems? (3)The case of transition economies

All these phenomena that usually precede or coincide withbanking problems appeared in the early 1990s in the formersocialist economies, which started the transformation to amarket system:• dramatic changes of macroeconomic conditions• major financial sector liberalization• bad management practices resulting from lack of experience

in operating in market conditions and sometimes also frompolitical pressure or connected lending.

• banking supervision was in the early stage of organizationand gaining experience.

Thus it is not a surprise that all transition economies underwentor are still undergoing serious bad debt problems

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Why bad debts are dangerous? - Stock andflow problem

Bad debts constitute a stock and flow problem for the bank.A stock problem appears when loans are classified as non-performing and are provisioned or written off therebydiminishing bank capital (shareholders equity).But this one-off loss is not an end. Non-performing loanscontinue to affect the banks through the flow problem.The flow problem is reflected in the fact that non-performingassets do not produce interest income, while the bank has topay interest on its liabilities and pay operating costs.If the portion of non-performing loans is significant and thisincome gap is not counterbalanced by income from performingloans and other sources, the bank is incurring losses and capitalloss increases.

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How bad debt problems affect bank activityand new lending practices?

• Hide the problem

• Look for quick profits to compensate for bad debtlosses

• Wait and see

Typical management behavior patterns in case ofsignificant bad debt problems in a bank:

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How bad debt problems affect bank activityand new lending practices? (2)

Hiding the problem"Evergreening" - the most common method

�Bad debts are not classified.�Interest and capital payments are refinanced and bad loans are presented in the bank’s

books as performing

Practicing "evergreening" and pretending that a bad loan is good:�The bank does not take any steps to diminish the loss through active recovery and

seizing collateral. The longer an active recovery is postponed the lower the chancethat the bank will be able to recover anything once it decides to do so.

�The bank may be forced to give real new cash to the customer in order to allow it tocontinue operation and avoid a situation in which the customer’s bankruptcy istriggered by other creditors.

In “evergreening”, the bad debt problem may be unseen for sometime in the bank’s books while in reality it is growing and gettingincreasingly dangerous to the bank’s solvency.

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How bad debt problems affect bank activity andnew lending practices? (3)

Looking for quick profits to compensate for bad debt losses

• Entering new and more risky activities looking for higher return Done in despair without proper expertise, experience and riskmanagement skills this usually results in further significant losses.

• Boosting credit expansion to dilute bad debts High credit expansion without proper credit risk management islikely to increase credit losses.

• Increase interest rate on new loans Leads to adverse selection: good customers are likely to bediscouraged by high interest rates and loans may be taken bycustomers who desperately need money but will be unable to payit back in future.

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How bad debt problems affect bank activityand new lending practices? (4)

Wait and seeA passive strategy that is more likely to be adopted by state-owned banks

– The management does not feel responsible for bad loans (Since they regard bad loans to be a result of changes in macroecon.

conditions that the government macroeconomic policy is responsiblefor, or because the management is new in the bank)

– The management thinks that the government as the owner shouldresolve the bad debt problem and recapitalize the bank.

– The management explains to the government that without capitalinjection the bank cannot be profitable: “We continue day to dayactivity but do not expect that we may have profits”

Management becomes accountable for nothing.

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How bad debt problems affect bank activityand new lending practices? (5)

What are the possible results? If a bank operates in distress because of a significant baddebt problem, management actions are very likely todeteriorate the situation.

Management is likely:– to be paralyzed– not to undertake active recovery steps to recover loans– to try to hide the problem– to undertake desperate and risky actions trying to generate

quick profits in order to compensate for losses.As a result, more and more bank resources are allocated tobankrupt customers instead of financing productive activities.Bank losses may grow with geometrical progression andbecome several times higher than the bank nominal capital.

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Impact of banking problems on the whole economyA banking crisis affects the economy in various ways.

– It undermines overall confidence in the economy and causes misallocation ofresources.

– It may result in a major banking destabilization when major banks loseliquidity and/or there is a bank panic resulting in downsizing of the bankingsector's balance sheet.

Such destabilization is likely to be connected with a drop in GDP. In Bulgaria in 1996,a banking panic triggered a deep macroeconomic crisis and real GDP declinedcumulatively by 18% over 1996 and 1997.

– Even if a one-off destabilization is avoided, an unresolved banking crisisundermining confidence in banks and threatening their liquidity maycontribute to the systematic erosion of banking balance sheets (as happenedin Romania in 1990s).

– A prolonged banking crisis, even if it neither destabilizes nor erodes thebanking sector, is likely to ultimately have a deep negative impact oneconomic growth as in the Czech Rep. and Japan in 1990s.

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How to deal with banking crisis?

If a banking crisis is dealt with both decisively and in away that inspires confidence, the disruptive impact oneconomic growth may be minimized. It requires:

• Recapitalization

• Separation of bad debts

• Management change and privatization of troubled banks

• Creation of an effective banking supervision

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Recapitalization (1)By whom?

• If the bank has negative capital and the government does notwant its liquidation the bank should be recapitalized

either by the government or by new private owners.

• It would be good if a troubled bank could be quickly sold to astrong, fit and proper strategic investor ready to inject newcapital and restructure the institution. However, this solution isoften unfeasible. There may be no acceptable buyers willing toinject money into an insolvent bank or the government may notbe ready to accept their terms. Trying to sell quickly in thistype of situation without previous restructuring may in factresult in delaying both restructuring and privatization.

• Thus the recapitalization by the government is often themost practical option

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Recapitalization (2) How much and in what form?

• Size and form of recapitalization of troubled banks should besuch as to resolve stock and flow problems�Resolving the stock problem means restoring the capital base:

- allow the bank to create adequate provisions against bad exposures and- assure that after creating the necessary provisions the bank would reach

capital adequacy with a safe cushion above the minimum regulatory level.

�Resolving the flow problem requires providing additional sourcesof income to compensate for the loss of income resulting fromnonperformance of bad loan portfolio.

• Recapitalization could be in the form of cash or interest bearinggovernment bonds. Instruments like shares in companies, real estate, zero-coupon

bonds are not appropriate as they do not resolve the flow problem.• Recapitalization should preferably be one time and up-front.

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Why separate bad debts and bad borrowersfrom the bank?

Financial ties between a bank and bad debtors are dangerous• A banks with significant exposure to a company in a difficult

financial situation is likely to be under pressure to provide newloans to allow the debtor to continue operations.=The bank may act under political pressure and/or hope that this newmoney increases the chance to recover past loans. However, “goodmoney” going after “bad money” usually just increases bank losses.

• Management preoccupied with old debts can not adequately focuson current business and may be unable to introduce soundstandards for new credit operations.

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Separation of bad debtsTwo main approaches

• Carving-out bad debts and transferring them into aspecially created restructuring agency (USA-Spainmodel)

• Internal separation of bad debt portfolio under themanagement of the work-out department separatedfrom the credit department (Polish model)

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Separation of bad debtsUSA-Spain model: carving-out

• Applied during banking crises in USA and Spain in the 1980sand in a number of countries in the 1990s (including CzechRepublic, Slovakia, Slovenia).

• Assumes:� Recapitalization of troubled banks with interest bearing government bonds� Carving out bad debts and transferring them into specially created national

restructuring agency• Advantages: Quick separation of bad debts and bad borrowers

from bank’s healthy operations which:� Diminishes danger that the bank will finance old insolvent borrowers� Allows the management to concentrate on new business

This approach could be compared to a surgical operation inwhich an unhealthy part of the body is extracted. The outcomeof the operation may be successful if the rest of the organism ishealthy or may be cured.

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Separation of bad debtsReasons for looking for an alternative solution

•USA- Spain model� Suitable in established market economies where some banks encountered problems

due to bad management and unfavorable macroeconomic trends. Thus the replacementof bad asset with government securities and establishment of new management mayprovide substantial cure to the troubled institutions.

� Less suitable in former socialist countries where it was not sufficient to replace badassets and management. It was essential to change the whole corporate culture andstandards of banking activities.

•Polish decision makers:� Believed that the carving out of bad debts would not address the cause of the problem,

which lay primarily in the lack of experience and expertise of the banks in assessingcredit risk in the market environment. Painless removal of the bad debt burden from thebanks creates the danger that the bad loan portfolio will reemerge in the near future.

� Did not believe that a centralized, government sponsored agency could vigorously andeffectively recover bad debts. It would not be possible to quickly create a stronginstitution with high quality staff. Nor would it be possible to devise an incentivesystem that would ensure the institution’s active approach toward indebted enterprises.It would be difficult to make such an institution resistant to political pressure.

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Separation of bad debtsThe Polish model: decentralized work-out (1)

• Recapitalization of troubled banks with interest bearinggovernment bonds to such a level as to:� allow the banks to create adequate provisions against bad debts and� assure that after creating the necessary provisions the bank would

reach capital adequacy with a safe cushion above the minimumregulatory level.

• Internal separation of the Bad Loan Portfolio (BLP)within the bank

• Creation of work-out department separated from thecredit department to manage the BLP

• Deadline to complete the restructuring of the BLPwithin one year

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Separation of bad debtsThe Polish model: decentralized work-out (2)

• Specification of eligible methods for the BLP restructuring program.The law obliged the recapitalized banks to ensure that before the oneyear deadline elapses one of the following events had taken place:� the loan was recovered in its entirety� the debtor regained its credit worthiness which was proven by at least a three

month record of servicing the debt� a conciliatory agreement was reached between the debtor and creditors - under

such agreement creditors could agree on rescheduling claims, write of part ofthem and/or convert them into equity of the firm, to enable implementation of thefinancial and business restructuring plan of the indebted company

� the debtor was declared bankrupt by the court� liquidation of the debtor was initiated� the loan was sold by the bank on the open market .

• Formal ban on providing new credit to an enterprise, the debt ofwhich has been placed in the BLP, unless such credit was given afurtherance of a conciliatory agreement.

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Experience of three Central European Countries Czech Republic Hungary Poland Starting conditions In early 1990s 30-70% of loans in state-owned banks were non-performing and many major banks became

technically insolvent Bank restructuring methods applied in 1991-1994

USA-Spain model

Mixed approach: partial carving-out and three consecutive recapitalizations which did not changed banking culture

Polish model

Bank privatization Partial privatization in 1992 but the government retained control. In 1997 in face of persistent bad debts problems the government decided to sell controlling stakes to strategic investors which happened in 2000-01.

Government ultimately decided to ensure proper governance through strategic investors. Most banks sold to strategic investors in 1994-1997

Recapitalized banks were taken over by strategic investors in 1998-2000 (5-7 years after recapitalization).

Contribution of banking supervision in containing bad debt problem

Weak Moderate Significant

Results Room created by carving out old bad debts was soon filled by new ones. Share of bad loans in bank credit was above 30% in 1999. The government had to recapitalize major banks again in 2000 before their sale to strategic investors.

The most healthy banking sector in Central Europe. Share of bad loans in bank credit was about 3% in 1999.

Banks originally covered by the program regained capital adequacy and were ultimately sold to strategic investors at relatively high prices. Banking sector regarded as healthy though share of bad debts increased to 13% in 1999 after going down to 10% in 1997.

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Experience of three Central European CountriesSummary

• The Czech Republic bank rehabilitation programs followingUSA-Spain model approach did not result in a change in bankbehavior and bank/ enterprise relations. Banks in thesecountries, freed from old bad loans, remained under statecontrol, were subjected to political influence in their lendingpolicies and were extending new bad loans.

• In Hungary, the mixed bank rehabilitation program was costlyand did not change bank culture. The deep change of bankbehavior occurred afterwards as a result of the sale ofcontrolling stakes to foreign strategic investors.

• In Poland, the program of banks and enterprises financialrestructuring as well as the prospect of bank privatizationcontained moral hazard and changed the behavior of banks,although privatization itself was implemented slowly.

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The USA – Spain model versus Polish modelComparison

USA – Spain model Polish model

Easier to manage More difficult to manage

Banks are quickly freed of old problem and

may concentrate on current business

Restructuring takes time

Does not change bank culture Strongly affects bank culture

Bad debts are more likely to reappear unless the

bank is quickly sold to a decent strategic

investor

Diminishes the danger of reappearance of bad

debt problem.

Enables quick privatization and finding a

strategic investor

Privatization should be delayed until

restructuring of bad loan portfolio is completed

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The USA – Spain model versus Polish model Conclusions

• If the government is committed to privatizing troubledbanks and selling them to strategic investors as soon aspossible, then the USA – Spain model seems superior as itfacilitates quick privatization and finding a strategicinvestor. A decent bank as a strategic investor seems to bethe best means to change corporate culture and avoid thereappearance of the bad debt problem.

• However, if the troubled bank is to be privatized without astrategic investor, or privatization will be delayed, then thePolish model has important advantages as it contributes tothe change of corporate culture and diminishes the dangerof reappearance of the bad debt problem.

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Bibliography• De Juan, Aristobulo, (1991), “From Good Bankers to Bad Bankers: Ineffective Supervision and Management

Deterioration as Major Element of Banking Crises”, The Economic Development Institute of the World Bank.• De Juan, Aristobulo (1998), "Clearing the Decks: Experiences in Banking Crisis Resolution", paper prepared for

“the 4th Annual Bank Conf. on Development in Latin America and the Caribbean", "Banks and Cap. Markets:Sound Fin. Systems for the 21st. Century", San Salvador, El Salvador, June 28-30.

• Kawalec, Stefan (1999), “Banking Sector Systemic Risk in Selected Central European Countries: Review ofBulgaria, Czech Republic, Hungary, Poland, Romania and Slovakia”, CASE - Center for Social and EconomicResearch (CASE Reports No 23), Warsaw .

• Kawalec, Stefan, Slawomir Sikora and Piotr Rymaszewski (1995), “Polish Program of Bank and EnterpriseRestructuring Design and Implementation 1991-1994” in Simoneti, Kawalec (1995).

• Kawalec, Stefan and Cezary Stypulkowski (2001), „New Lending Practices in light of Past Nonperforming Loans:Remarks based on experiences with bad debt problems in developed economies and Central European transitioneconomies”, Presentation for Institute of International Finance Risk Management Workshop sponsored by Bank ofChina and PricewaterhouseCoopers, Shangri-La Hotel, Beijing, China, March 1.

• Lindgren, Carl-Johan, Gillian Garcia, and Matthew I. Saal (1996), “Bank Soundness and Macroeconomic Policy”,International Monetary Fund, Washington D.C.

• Merrill Lynch (1997), ”Czech Banks: Weighted Down by Debt”, (by Denise Vergot Holle and Stephen Pettyfer),February.

• Montes-Negret, Fernando, Luca Papi (1997), “The Polish Experience with Bank and Enterprise Restructuring“,Policy Research Working Paper 1705, The World Bank, Washington, January

• Simoneti, Marco and Stefan Kawalec (1995) editors, “Bank Rehabilitation and Enterprise Restructuring”, Centraland East European Privatization Center, Ljubljana, Slovenia.

• Sundararajan V., and Tomas J.T. Balino (1991) editors, “Banking Crises: Causes and Issues”, InternationalMonetary Fund, Washington, D.C.

• .