By Stefan Kawalec. Vice-President of the Management Board, Commercial Union Polska. Presentation for the International Seminar on.

Transcription

1 Different Models of Bad Debt Restructuring Remarks based on experiences with bad debt problems in developed economies and Central European transition economies By Stefan Kawalec Vice-President of the Management Board, Commercial Union Polska Presentation for the International Seminar on Comparative Experiences in Confronting Banking Sector Problems in Central/ Eastern Europe and Central Asia Organized by the World Bank, the International Monetary Fund, the European Bank for Reconstruction and Development, and the National Bank of Poland April 22-24, 2002 Warsaw, Poland

2 2 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 Looking for quick profits to compensate for bad debt losses Wait and see What are the possible results? Impact of banking problems on the whole economy How to deal with banking crisis?...15 Recapitalization By whom? How much and in what form? Why separate bad debts and bad borrowers from the bank?...18 Separation of bad debts Two main approaches USA Spain model: carving-out Reasons for looking for an alternative solution The Polish model: decentralized work-out Experience of three Central European countries Table Summary The USA- Spain model versus the Polish model Comparison Conclusions Bibliography...28 */ The presentation is based on Kawalec and Stypulkowski (2001) see Bibliography

3 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 such a level as to assure that proceeds from performing loans will provide a cushion to cover losses on expected nonperforming loans. When losses on non-performing loans are significantly higher than anticipated, the bank loses its capital. In case of a significant bad debt problem in a bank, credit losses may endanger the bank s capital adequacy or even solvency. 3

4 What is a bad debt problem? (2) A significant bad debt problem on a country level exists when a high share of non-performing assets threatens the liquidity and solvency of a substantial part of the banking sector. It was estimated that between 1980 and 1996 out of 181 member countries of the International Monetary Fund 133 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 4

5 5 What are the causes of bad debt problems? Serious banking problems on a country level in developed economies usually follow or coincide with: 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

6 What are the causes of bad debt problems? (2) However... Each individual case of significant bad debt problems in a bank results from bad management practices and identified flaws in credit policies. Very often political interference in bank credit decisions has a significant contribution in creating and prolonging bad debt problems. Connected lending (lending to companies owned by the bank or its major shareholders or mangers or directors) is a major cause of bank failures. Lack of effective banking supervision is an important factor contributing to the emergence of significant bad debt problem. 6

7 What are the causes of bad debt problems? (3) The case of transition economies All these phenomena that usually precede or coincide with banking problems appeared in the early 1990s in the former socialist economies, which started the transformation to a market 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 from political pressure or connected lending. banking supervision was in the early stage of organization and gaining experience. Thus it is not a surprise that all transition economies underwent or are still undergoing serious bad debt problems 7

8 Why bad debts are dangerous? - Stock and flow problem Bad debts constitute a stock and flow problem for the bank. A stock problem appears when loans are classified as nonperforming and are provisioned or written off thereby diminishing bank capital (shareholders equity). But this one-off loss is not an end. Non-performing loans continue to affect the banks through the flow problem. The flow problem is reflected in the fact that non-performing assets do not produce interest income, while the bank has to pay interest on its liabilities and pay operating costs. If the portion of non-performing loans is significant and this income gap is not counterbalanced by income from performing loans and other sources, the bank is incurring losses and capital loss increases. 8

9 9 How bad debt problems affect bank activity and new lending practices? Typical management behavior patterns in case of significant bad debt problems in a bank: Hide the problem Look for quick profits to compensate for bad debt losses Wait and see

10 10 How bad debt problems affect bank activity and 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 chance that 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 to continue operation and avoid a situation in which the customer s bankruptcy is triggered by other creditors. In evergreening, the bad debt problem may be unseen for some time in the bank s books while in reality it is growing and getting increasingly dangerous to the bank s solvency.

11 How bad debt problems affect bank activity and new 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 risk management skills this usually results in further significant losses. Boosting credit expansion to dilute bad debts High credit expansion without proper credit risk management is likely to increase credit losses. Increase interest rate on new loans Leads to adverse selection: good customers are likely to be discouraged by high interest rates and loans may be taken by customers who desperately need money but will be unable to pay it back in future. 11

12 How bad debt problems affect bank activity and new lending practices? (4) Wait and see A passive strategy that is more likely to be adopted by stateowned 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 responsible for, or because the management is new in the bank) The management thinks that the government as the owner should resolve the bad debt problem and recapitalize the bank. The management explains to the government that without capital injection the bank cannot be profitable: We continue day to day activity but do not expect that we may have profits Management becomes accountable for nothing. 12

13 How bad debt problems affect bank activity and new lending practices? (5) What are the possible results? If a bank operates in distress because of a significant bad debt problem, management actions are very likely to deteriorate 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 to bankrupt customers instead of financing productive activities. Bank losses may grow with geometrical progression and become several times higher than the bank nominal capital. 13

14 14 Impact of banking problems on the whole economy A banking crisis affects the economy in various ways. It undermines overall confidence in the economy and causes misallocation of resources. It may result in a major banking destabilization when major banks lose liquidity and/or there is a bank panic resulting in downsizing of the banking sector'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 declined cumulatively by 18% over 1996 and Even if a one-off destabilization is avoided, an unresolved banking crisis undermining confidence in banks and threatening their liquidity may contribute to the systematic erosion of banking balance sheets (as happened in Romania in 1990s). A prolonged banking crisis, even if it neither destabilizes nor erodes the banking sector, is likely to ultimately have a deep negative impact on economic growth as in the Czech Rep. and Japan in 1990s.

15 15 How to deal with banking crisis? If a banking crisis is dealt with both decisively and in a way that inspires confidence, the disruptive impact on economic growth may be minimized. It requires: Recapitalization Separation of bad debts Management change and privatization of troubled banks Creation of an effective banking supervision

16 Recapitalization (1) By whom? If the bank has negative capital and the government does not want 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 a strong, fit and proper strategic investor ready to inject new capital and restructure the institution. However, this solution is often unfeasible. There may be no acceptable buyers willing to inject money into an insolvent bank or the government may not be ready to accept their terms. Trying to sell quickly in this type of situation without previous restructuring may in fact result in delaying both restructuring and privatization. Thus the recapitalization by the government is often the most practical option 16

17 Recapitalization (2) How much and in what form? Size and form of recapitalization of troubled banks should be such 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 sources of income to compensate for the loss of income resulting from nonperformance of bad loan portfolio. Recapitalization could be in the form of cash or interest bearing government 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. 17

18 18 Why separate bad debts and bad borrowers from 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 new loans to allow the debtor to continue operations. =The bank may act under political pressure and/or hope that this new money increases the chance to recover past loans. However, good money going after bad money usually just increases bank losses. Management preoccupied with old debts can not adequately focus on current business and may be unable to introduce sound standards for new credit operations.

19 19 Separation of bad debts Two main approaches Carving-out bad debts and transferring them into a specially created restructuring agency (USA-Spain model) Internal separation of bad debt portfolio under the management of the work-out department separated from the credit department (Polish model)

20 Separation of bad debts USA-Spain model: carving-out Applied during banking crises in USA and Spain in the 1980s and in a number of countries in the 1990s (including Czech Republic, 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 in which an unhealthy part of the body is extracted. The outcome of the operation may be successful if the rest of the organism is healthy or may be cured. 20

21 Separation of bad debts Reasons 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 replacement of bad asset with government securities and establishment of new management may provide substantial cure to the troubled institutions. Less suitable in former socialist countries where it was not sufficient to replace bad assets and management. It was essential to change the whole corporate culture and standards 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 assessing credit risk in the market environment. Painless removal of the bad debt burden from the banks 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 and effectively recover bad debts. It would not be possible to quickly create a strong institution with high quality staff. Nor would it be possible to devise an incentive system that would ensure the institution s active approach toward indebted enterprises. It would be difficult to make such an institution resistant to political pressure. 21

22 22 Separation of bad debts The Polish model: decentralized work-out (1) Recapitalization of troubled banks with interest bearing government 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 minimum regulatory level. Internal separation of the Bad Loan Portfolio (BLP) within the bank Creation of work-out department separated from the credit department to manage the BLP Deadline to complete the restructuring of the BLP within one year

23 23 Separation of bad debts The 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 one year 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 of them and/or convert them into equity of the firm, to enable implementation of the financial 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 of which has been placed in the BLP, unless such credit was given a furtherance of a conciliatory agreement.

24 24 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 Bank restructuring methods applied in technically insolvent USA-Spain model Bank privatization Partial privatization in 1992 but the Contribution of banking supervision in containing bad debt problem Results 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 Mixed approach: partial carvingout and three consecutive recapitalizations which did not changed banking culture Government ultimately decided to ensure proper governance through strategic investors. Most banks sold to strategic investors in Polish model Weak Moderate Significant 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 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 Recapitalized banks were taken over by strategic investors in (5-7 years after recapitalization). 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.

25 Experience of three Central European Countries Summary The Czech Republic bank rehabilitation programs following USA-Spain model approach did not result in a change in bank behavior and bank/ enterprise relations. Banks in these countries, freed from old bad loans, remained under state control, were subjected to political influence in their lending policies and were extending new bad loans. In Hungary, the mixed bank rehabilitation program was costly and did not change bank culture. The deep change of bank behavior occurred afterwards as a result of the sale of controlling stakes to foreign strategic investors. In Poland, the program of banks and enterprises financial restructuring as well as the prospect of bank privatization contained moral hazard and changed the behavior of banks, although privatization itself was implemented slowly. 25

26 26 The USA Spain model versus Polish model Comparison USA Spain model Polish model Easier to manage Banks are quickly freed of old problem and may concentrate on current business Does not change bank culture Bad debts are more likely to reappear unless the bank is quickly sold to a decent strategic investor Enables quick privatization and finding a strategic investor More difficult to manage Restructuring takes time Strongly affects bank culture Diminishes the danger of reappearance of bad debt problem. Privatization should be delayed until restructuring of bad loan portfolio is completed

27 The USA Spain model versus Polish model Conclusions 27 If the government is committed to privatizing troubled banks and selling them to strategic investors as soon as possible, then the USA Spain model seems superior as it facilitates quick privatization and finding a strategic investor. A decent bank as a strategic investor seems to be the best means to change corporate culture and avoid the reappearance of the bad debt problem. However, if the troubled bank is to be privatized without a strategic investor, or privatization will be delayed, then the Polish model has important advantages as it contributes to the change of corporate culture and diminishes the danger of reappearance of the bad debt problem.

28 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 4 th Annual Bank Conf. on Development in Latin America and the Caribbean", "Banks and Cap. Markets: Sound Fin. Systems for the 21 st. Century", San Salvador, El Salvador, June Kawalec, Stefan (1999), Banking Sector Systemic Risk in Selected Central European Countries: Review of Bulgaria, Czech Republic, Hungary, Poland, Romania and Slovakia, CASE - Center for Social and Economic Research (CASE Reports No 23), Warsaw. Kawalec, Stefan, Slawomir Sikora and Piotr Rymaszewski (1995), Polish Program of Bank and Enterprise Restructuring Design and Implementation 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 transition economies, Presentation for Institute of International Finance Risk Management Workshop sponsored by Bank of China 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, Central and East European Privatization Center, Ljubljana, Slovenia. Sundararajan V., and Tomas J.T. Balino (1991) editors, Banking Crises: Causes and Issues, International Monetary Fund, Washington, D.C.. 28