Impact Evaluation of the Romanian Insolvency Reform 1 How do Stronger Insolvency Laws Impact Borrower Decisions? Concept Note

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1 1. Introduction Impact Evaluation of the Romanian Insolvency Reform 1 How do Stronger Insolvency Laws Impact Borrower Decisions? Concept Note Shawn Cole(Harvard Business School and Jameel Poverty Action Lab), Raluca Dragusanu (Harvard Business School), Leora Klapper (World Bank Group) December 2012 Two important goals of a bankruptcy system are to weed out the bad, i.e., unviable businesses, from the good, i.e., viable businesses, and to keep viable businesses in operation. In most cases keeping the business alive is the most efficient outcome as creditors get a chance to recover a larger part of their credit, more employees keep their jobs, and the network of suppliers and customers is preserved. The World Bank Group s Investment Climate Department in collaboration with the Development Research Group at the World Bank Group is carrying out an impact evaluation in Romania to determine whether increased awareness on out of court workout practices affects: 1) Improved loan repayment rates, and 2) New loans granted to those clients that become eligible The impact evaluation will assess the impact of new out-of-court debt restructuring guidelines, The Corporate Debt Restructuring Guidelines (CDRGs) introduced in Romania in September This is not a change to the bankruptcy law or to court proceedings, but rather a set of principles to guide an out-of court settlement before insolvency proceedings are initiated in court. The debtor and the creditor have the option to enter into an agreement regarding mutually agreed upon debt restructuring, as a result of which both parties attempt to come to an agreement to change the terms of the debt repayment in a way that allows the debtor to continue doing business. Out-of court restructuring is perceived as more effective than the court process because in successful cases, the dispute is settled earlier and the debt is recovered more often. As a simpler and cheaper alternative to the courts, the main beneficiaries are small and medium sized firms (SME s). The setting and experimental design have several important advantages, which we describe in detail below. Romania is a growing economy, with a GNI per capita of over US$ 8,000 in 2009 (WB-WDI), and has been a member of the European Union (EU) since January 1, It is the seventh largest country among the 27 current members of the EU with a population of over 21 million. Romania achieved 1 This Impact Evaluation is conducted and funded by the Investment Climate Impact Project, a joint effort of the World Bank Group s Investment Climate Department, IFC s Investment Climate Business Line, and the World Bank s Development Research Group, in collaboration with IFC s Development Impact Department, the Development Impact Evaluation Initiative, the FPD Chief Economist s Office, and the Global Indicators and Analysis Unit. The project is funded by the U.S. Agency for International Development, the U.K. Department for International Development, and the World Bank Group s Investment Climate Department. This concept note has been reviewed by Rita Benitez, CEC Bank, Andres Martinez, Massimiliano Santini, Mahesh Uttamchandani. 1

2 impressive rates of growth and poverty reduction during , although its income per capita was still only around 44% that of the EU. While the prospect of becoming an EU member motivated significant reforms in many areas, important vulnerabilities in the economy remain, and the reform agenda and the need for structural transformation remain a priority as is the case in many other middle-income and transition economies. We believe that our results can be generalized and of value to policymakers, researchers, and practitioners in a wide range of countries. This project also represents the first randomized experiment to study the impact of an insolvency reform. The study will provide training to a sample of SME borrowers on the Corporate Debt Restructuring Guidelines to determine whether this training has any consequence on loan repayment rates and requests for loans. This training will provide SME borrowers with an explanation of the CDRGs through a combination of e-learning course training, a printed pamphlet, and instructor-led workshops. Furthermore, by using bank data rather than surveys, we are able to track the impact of this reform over time at a very reasonable cost. The results will be of academic interest, but can immediately impact practice both within the Romanian bank participating in our project and at other local financial institutions. This project serves as an important first step in a broader research agenda of understanding the impact of business environment reforms on credit, new investment, job creation and growth. 2. Contribution to the Literature Earlier studies on the impact of efforts to speed up the resolution of debt recovery claims find that reforms increased the probability of timely repayments, reduced the cost of debt/ interest rates, and increased the aggregate level of credit. For instance, Visaria (2009) uses a loan-level dataset to study the impact of new debt recovery tribunals in India that quickened the pace of debt recovery claims and allow lenders to seize increased collateral on defaulting loans. Similarly, in Brazil, a broad 2005 bankruptcy reform established a higher level of creditor protection which brought a reduction in the cost of debt and an increase in the aggregated level of credit (Funchal 2008). Yet studies on the impact of new mechanisms to encourage debt restructuring/ reorganization (and lower liquidation rates) have focused almost exclusively on firm survival. For instance, a 1997 bankruptcy law in Belgium introduced mechanisms to encourage corporate rehabilitation as an alternative to liquidation. The reforms increased creditor protection for companies that are granted reorganization protection and reduced SME liquidation type bankruptcies (Dewaelheyns and Van Hulle, 2006). Colombian Law 550 (1999) introduced a new reorganization code that streamlined the reorganization process, specifically establishing shorter statutory deadlines for reorganization plans and reducing opportunities for appeal by debtors. Giné and Love (2006) find that the reform improved the selection of viable firms into reorganization and significantly lowered the duration of reorganization. To our knowledge, this study is an opportunity to conduct the first randomized evaluation of the introduction of a new debt restructuring process in any country. There are several randomized evaluations that study borrower behavior, such as Pande and Field (2008) who study repayment frequency and default; Karlan and Zinman (2008) who look at how interest rates and loan maturity affect demand for credit; Bertrand et. al(2010) who study the effect of advertising content on credit demand in direct mail field experiment; and Cole et. al (2010) who look at the role and relative importance of financial literacy and prices in determining the demand for banking services. However, no 2

3 randomized evaluation has been carried out to study the effects of insolvency reform on firm borrowing and investment behavior. We view our contributions to the literature as the following: 1) answering a broad set of questions on how borrowers make borrowing and repayment decisions; 2) measuring the impact of out-of-court debt restructuring on payment rates, and 3) the very first randomized experiment to test the casual impact of out-of-court debt restructuring on new loan (and investment) decisions.. 3. Research Design 3.1 Hypotheses We plan to provide training to a sample of SME borrowers (relative to the control group) on the new out-of-court debt restructuring principles in order to test the following hypotheses: H1: Out-of-court debt restructuring has a causal impact on borrower loan repayment rates; H2: Out-of-court debt restructuring has a causal impact on new borrower loan requests. 3.2 Experiment: Randomly offering borrowers training on the new law To carry out this impact evaluation, the World Bank Group has partnered with CeC Bank in Romania, who will provide it with access to 1,000 SMEs being in distress and not meeting their payment obligations for 30 days past due. But that the legal action has not started. This sample will be randomly divided into two groups, based on individual characteristics such as, industry, geographical location, loan-size, and payment history. Group A the Control group - will consist of 500 SMEs, and will receive no training. We cannot rule out that individuals in Group A will learn about the new law through the media or colleagues, but this contamination would work against us finding robust results. Loan officers responsible for inviting participants from the treatment group will not be required to sign a confidentiality agreement on the project. CeC Bank already trains its borrowers on basic out of court workout principles, and these may make reference to the CDRGs. As mentioned above, it is possible that participants from the treatment group may interact with participants from the control group; however this cannot be controlled. One possibility is introducing a pre-study contamination survey to get a sense of how familiar the control group was with the CDRGs and loan default consequences prior to the intervention. Group B the Treatment group will consist of the remaining 500 participants who will receive trainings on the Corporate Debt Restructuring Guidelines, including the workshop training, an e-learning course, and a supporting pamphlet. The trainings, which will be taught by a local lawyer, will include a presentation and handouts reviewing in simple terms of the design of the CDRGs, how banks can use the principles in the case of delinquent loans, and the specific implications of the law for SME borrowers. The e-learning course will be an interactive CD-based session about the new guidelines, in easy to understand language. 3

4 The project will determine the effects of the training on borrower behavior by comparing the financial decisions of the treatment and the control group following the intervention. As a randomized study, the project will ensure that the treatment and control group are similar. CeC Bank will select 1,000 borrowers located in any of the following cities: Bucharest, Constanta,, Ploieşti, Sibiu, Timişoara. Once selected, they will provide the lead researchers on the project, Leora Klapper, Shawn Cole and Raluca Dragusanu, with baseline data containing the following information for each borrower: Loan characteristics (duration, purpose, size in terms of value, collateral/ guarantees, interest rate, and outstanding balance), Repayment characteristics (dates) Firm information (Revenue, expenditure, total assets, number of employees, and more). Randomizing Participant Information In order to respect CEC Bank s confidentiality requirement to borrowers, each participant s name and address will be removed and replaced with a unique identifier. Following the anonymization process, CEC will send the baseline borrower data to the lead researchers (Cole, Dragusanu, Klapper). The lead researchers will then proceed to divide the sample into the two groups, using a randomized procedure. A standard statistical software, such as Stata, will be used to carry out the randomization. After carrying out the randomization, the project leaders will provide CeC Bank with the list of borrower identifiers participating in the treatment group. The CEC Bank team will then send invitations for training to only those clients whose identifiers were assigned to the treatment group. The baseline data must be submitted at least one month in advance of the workshops to give project leaders enough time to carry out the randomization. This should allow CeC Bank sufficient time to notify the treatment group of the planned training workshops. Collecting Data after Training Following the workshops, data from participants accounts (treatment and control) must be submitted to the World Bank Group by CEC Bank on a quarterly basis. The data to be provided by CeC Bank following the training intervention will include the following: Loan characteristics, Repayment characteristics, including the dates and amount of each repayment, whether the client has approached bank to enter an out-of-court workout agreement, and details of any loan restructuring and/or new repayment schedule, Any new loan requests (including amount requested), and Firm information (provided on an annual basis). The study will use a difference-in-difference approach, controlling for borrower risk characteristics, such as the age of firm, sector, and previous repayment history. This study can shed light on the casual correlation of new debt restructuring options with borrower behavior. 4. Project Status and Deliverables The implementation of this project depends on the cooperation of the local bank, CeC Bank, to confidentially share loan file information with the project team. 4

5 The non-experimental data collection will begin immediately following an agreement with the Bank. The training intervention will be implemented as quickly as possible (currently planned for March 2013). Once the training workshops have been held, data is to be provided by CeC Bank on an ongoing basis over a period of 8 quarters (2 years). The project leaders will be in charge of carrying out the data analysis and delivering a first draft of results in September The study s conclusion should be available by the end of the summer of As stated above, a very attractive feature of this project is that it relies only on data that the bank collects in the normal practice of business, therefore eliminating delays due to data entry, problems with surveys, etc.in addition, the authors (and IFC staff) will author a ViewPoint note summarizing the key policy findings for the study. Subject to available funding, the authors will also disseminate the main findings to the local banking community in a venue to be determined at a later date. 5. Conclusion Providing individuals with access to capital represents one of the most promising methods of fueling economic growth and reducing poverty. Lenders are more willing to lend to smaller, riskier borrowers if their expected payoff is higher. One way to increase a lender s return is by simplifying and strengthening the insolvency process in the case of default. Our proposal to test the causal effect of a new out-of-court debt restructuring guidelines in Romania is an opportunity to measure the real impact of such guidelines on the SME sector. 5

6 6. Timeline and next steps Task Sign the cooperation agreement Mission to Bucharest Deliver of baseline(s) data Who Approximate Days Due date - Raluca, Massi 5 days December 2012 Finalize the IE design and workshop agenda, Massi, Najy, Andres 5 days January 2013 Randomize the data 1 day January 2013, Massi, Send out the invitation letter to debtors CEC Bank 3 days January 2013 Design pre-workshop contamination survey, Massi, Najy, Andres 3 days January 2013 Organize workshops, including finalize e- learning course, web-hosting, print brochure, coordination with events management firm and local consultant - Local STC, Ioan Chipper, Raluca, Massi 5 days February 2013 Hold workshops in 4 cities - Local STC, Ioan Chipper 4 days March 2013 Deliver 1 st Annual data CEC Bank June 2013 Deliver 1 st Quarterly data CEC Bank July 2013 Deliver 2 nd Quarterly data CEC Bank November 2013 Deliver 3 rd Quarterly data CEC Bank March 2014 Deliver 2 nd Annual data CEC Bank June

7 Deliver 4 th Quarterly data CEC Bank July 2014 Deliver 5 th Quarterly data CEC Bank November 2014 Deliver 6 th Quarterly data CEC Bank March 2015 Deliver 3 rd Annual data CEC Bank June 2015 Deliver 7 th Quarterly data CEC Bank July 2015 Deliver 8 th Quarterly data Write research paper Write policy note CEC Bank November

8 7. Selected References Dewaelheyns, Nico, Van Hulle, Cynthia, Legal Reform and Aggregate Small and Micro Business Bankruptcy Rates: Evidence from the 1997 Belgian Bankruptcy Code. K.U. Leuven AFI Working Paper No Funchal Bruno, The effects of the 2005 Bankruptcy Reform in Brazil, Economics Letters, No. 101 Giné, Xavier, Love, Inessa, Do Reorganization Costs Matter for Efficiency? Evidence from a Bankruptcy Reform in Colombia (July 1, 2006). World Bank Policy Research Working Paper No Visaria, Sujata, Legal Reform and Loan Repayment: The Microeconomic Impact of Debt Recovery Tribunals in India, American Economic Journal: Applied Economics. Karlan, Dean, Zinman, Jonathan, Credit Elasticities in Less-Developed Economies: Implications for Microfinance American Economic Review, 98(3), June 2008, pp Pande, Rohini, Field, Erica, Repayment Frequency and Default in Micro-Finance: Evidence from India Journal of European Economic Association Papers and Proceedings, April-May 2008, Vol. 6 (2-3): pp Bertrand, Marianne, Karlan, Dean, Mullainathan, Sendhil, Shafir, Eldar. What s Advertising Content Worth? Evidence from a Consumer Credit Marketing Field Experiment Quarterly Journal of Economics, 125(1), February 2010, Cole, Shawn, Thomas Sampson, and Bilal Zia. "Prices or Knowledge? What Drives Demand for Financial Services in Emerging Markets?" Journal of Finance (forthcoming) 8

9 Appendix 1: About the Authors and Selected Publications Shawn Cole is an Assistant Professor of Graduate Business Administration at the Harvard Business School, and a research affiliate of MIT s Poverty Action Lab. He holds a Bachelor s in economics and German literature from Cornell, and a Ph.D. in economics from MIT. His research focuses on finance in emerging markets, examining how frictions affect firm and individual outcomes; and how financial innovation may improve the lives of the poor. He has worked on a wide range of program evaluations, including one of the very first large-scale randomized evaluations in India, involving 12,000 students in two states. Current randomized evaluations include the effect of rainfall insurance on household investment decisions and consumption variability; the utility of futures prices to agricultural investment decisions; and understanding the demand for bank accounts in Indonesia. Shawn has also developed course material on BASIX insurance products. Remedying Education: Evidence from Two Randomized Experiments in India, (with A. Banerjee, E. Duflo, and L. Linden), Quarterly Journal of Economics, August Financial Development, Bank Ownership and Growth. Or, Does Quantity Imply Quality? forthcoming, Review of Economics and Statistics. Raluca Dragusanu is a third-year PhD student in Business Economics at Harvard. She holds a bachelor s in economics and mathematics from St. Lawrence University. Before the Ph.D., she was a research analyst in the US and global economics research teams at Goldman Sachs. Her research areas include international trade, corporate finance and development. Leora Klapper is a Senior Economist in the Finance and Private Sector Research Team of the Development Research Group at the World Bank. Since joining the Bank as a Young Economist in 1998, she has published articles on entrepreneurship, access to finance, corporate governance, and bankruptcy and risk management. She has over 30 publications in academic journals, and is currently a member of the Journal of Comparative Economics editorial board. Her current research focuses on the impact of the financial crisis on entrepreneurship and household finance, and measurements of financial inclusions. Prior to coming to the Bank she worked at the Board of Governors of the Federal Reserve System, the Bank of Israel, and Salomon Smith Barney. She holds a Ph.D. in financial economics from New York University Stern School of Business. Entrepreneurship in Post-Conflict Transition: the Role of Informality and Access to Finance with Asli Demirguc-Kunt and Georgios Panos, Economics of Transition, Forthcoming Bank Competition and Financial Stability with Allen Berger and Rima Turk, Journal of Financial Services Research 35:2, 2009 [lead article] 9