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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
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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 such
a level as to assure that proceeds from performing loans will
provide a cushion to cover losses on expected non-
performing 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.
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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,
J apan, 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 developed
economies 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 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.
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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 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
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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 non-
performing 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.
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How bad debt problems affect bank activity
and new lending practices?
• Hide the problem
• Look for quick profits to compensate for bad debt
losses
• Wait and see
Typical management behavior patterns in case of
significant bad debt problems in a bank:
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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.
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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.
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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 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 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.
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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.
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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 1997.
– 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.
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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
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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
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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.
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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.
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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)
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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.
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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.
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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
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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.
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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 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.
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The USA – Spain model versus Polish model
Comparison
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 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.
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