Woo: Nonperforming assets tie up resources when resource allocation is a precondition for economic recovery. Nonperforming assets can also weaken financial institutions whose financial intermediary role is critical for economic recovery.
Most banking crises are triggered by an explosion of nonperforming assets, followed by a deterioration in credit quality and credit discipline. Typically, when we speak of bank restructuring, we talk about recapitalizing banks, strengthening prudential regulation, and improving profitability. Less attention is paid to how to deal with nonperforming assets, despite the fact that these are often the underlying cause of the banking crisis. Resolution of nonperforming assets is a much more difficult issue to tackle, and it takes much longer.
Woo: What is distinctive about the Asian crisis is the incredible magnitude of nonperforming assets and the weakness of the legal systems. Asia’s legal system, which was underdeveloped in many ways to begin with, simply could not deal with the volume of nonperforming assets. This is why governments, and even the private sector, in the Asian countries began to turn to extra-legal frameworks to deal with nonperforming assets. This gave rise to the use of asset management companies and out-of-court corporate debt restructuring.
Woo: Asset management companies are still a very controversial subject, and I have tried to deal with them as such in my paper. We have very little evidence about how well they work, so it is too early to label them a panacea. The underlying rationale behind asset management companies is an economies-of-scale argument. If a country has limited expertise in asset management, it makes sense to pool those limited resources to maximize asset recovery.
Also, financial crises may reflect serious problems with credit discipline. Let’s say I’ve been borrowing from you for a long time and have developed a special credit relationship. When I’m not paying back, you may give me additional loans to help pay off the earlier loan. Asset management companies can remove those loans from credit managers to ensure that the borrowers are treated objectively.
Asset management companies can make it easier to assign value to distressed financial institutions. If a bank wants to go to the market to raise capital, it is often very difficult to value nonperforming assets in the middle of a banking crisis. If the bank wants to raise capital or the government is trying to privatize a bank that it has taken over, taking the nonperforming assets off the balance sheet makes it easier for new shareholders or buyers to assign a value to these banks.
Asset management companies have also been used to facilitate privatization for the resolution of closed banks. In some cases, the final objective may not be maximizing the recovery of assets. For example, a foreign bank may be willing to buy an undercapitalized domestic bank but simply not want to touch the nonperforming assets. In that case, the government actually removes the nonperforming assets before privatizing the bank—as France did with the resolution of Crédit Lyonnais. The repository of the nonperforming assets then becomes an asset management company charged with managing those nonperforming assets.
Asset management companies may also be given tremendous special legal power to deal with delinquent debtors, as was done in Malaysia. In that instance, the banks simply did not have the power to act under existing law.
But I do want to stress that asset management companies should not be viewed as a standard instrument for use in noncrisis times. And even during crises, I would caution countries to think very carefully about the formation of such companies. There are a lot of potential drawbacks, and no hard and fast rules. Although all of the Asian crisis countries created asset management companies, each company was very different. Thailand, for example, created private rather than public asset management companies. The government sold several banks but, as part of the contract, required the buyers to manage the nonperforming assets on behalf of the government. This is because the government lacked the expertise to manage nonperforming assets but tapped private sector expertise to do so.
Out-of-court corporate debt workouts are also something you wouldn’t want to do in normal circumstances. You do it in crisis mode because the courts are not working and you don’t have the time to wait. In a country like Thailand, where so many loans were nonperforming, if the banks had cut off all credit lines, the economic impact would have been very severe. The government had to find a quick way to resolve nonperforming loans and restore the health of the economy. The underlying rationale for a workout is not only to help creditors and debtors but also to limit the social repercussions of nonperforming assets.
A government-coordinated centralized workout may be advisable in situations where a workout led completely by the private sector would not be feasible. If you have one or two very large creditors, they can take the lead and bring others into the fold. But where there is no single large creditor, everyone tends to sit on the sideline with a wait-and-see attitude. In this situation, government may have no choice but to try to catalyze the process itself.
Woo: Obviously, there are a lot of legal issues. In many countries, the asset management company cannot transfer nonperforming assets from the bank without the permission of the debtors. That has slowed the process.
The regulatory framework is also crucial. Consolidated supervision must be in place when asset management companies are introduced, especially when private banks set up their own asset management companies as subsidiaries. Without consolidated supervision, banks setting up such company subsidiaries can simply boost their own capital by transferring assets to the subsidiaries at above-market prices.
The IMF is concerned about the pricing of assets, particularly in cases where these are essentially taken over by government-owned institutions. The Korean Asset Management Company bought nonperforming assets from all banks, including ongoing private banks. The IMF was very concerned that the government bought these assets at above-market prices to bail out the financial institutions. If that were the case, the transfer would be, in effect, a subsidy from the government. We felt strongly that if subsidies were needed—if the bank were, let’s say, insolvent—direct recapitalization by the government (which gives the government more leverage in the bank) would be superior to transferring assets at above-market value. In Mexico, where assets were essentially bought at a book value that was significantly higher than their real underlying value, the government incurred an implicit cost in owning assets that weren’t worth very much.
It is easy to understand the temptation that asset pricing offers governments. Direct recapitalization, which the public may see as giving money away to highly paid bankers, is sometimes politically very difficult. The public is much less likely to scrutinize the price at which assets are bought from these banks, but this is the wrong way to go. Asset management companies should be free of political intervention; political interference can really undermine the effectiveness of these companies.
Another important aspect of asset management companies is the timing of asset disposition. A crucial lesson is that the warehousing of assets may not prevent prices from tumbling, since the future supply of assets will likely be discounted in current prices. However, the need to catalyze activities in stagnant asset markets may lead government-owned asset management companies to dispose of some assets rapidly, even though by postponing the disposition they may obtain better prices.
Woo: The Asian debt workout approach differed from the consensus-oriented London approach in that it allowed the majority of the creditors to decide the fate of the debtors. Although, strictly speaking, debt workouts are outside the legal system, they require much heavy handed intervention on the part of the government to enforce ground rules. A lot of people did not like the direct government intervention, but it was probably the first-best option under the circumstances.
In terms of best practices, I believe it is critical that banks be at least partially restructured before they embark on a comprehensive workout of impaired assets. Weak banks pushed into this process may not have the incentive to do the right things. Weak banks may also be reluctant to make necessary concessions (because of the immediate impact of the concessions on their balance sheets) or they may make too many concessions when pressured by the government.
You also want strong banks in order to enforce credit discipline. In Thailand, for example, when the number of nonperforming loans grew, borrowers capable of servicing their loans also defaulted. A heavy volume of nonperforming loans makes it difficult for creditors to chase after all of them, and when banks begin to offer big concessions to troubled borrowers, good borrowers say, “well, I’m going to default too.” Banks have to be strong, so that the incentives of the borrowers and the banks are optimally aligned.
Also, provision and classification rules are crucial. If the provision rules for restructured loans are too weak, banks will restructure loans only to improve their book capital ratios. This is because if they can classify the restructured loans immediately as performing, they can cut back on their provisioning. If a bank is weak and afraid it might be closed if it falls below the minimal capital ratios, it may restructure loans too eagerly if loan classification and restructuring requirements are too weak.
Asset management companies can also play an important role in out-of-court workouts. In countries such as Korea where individual banks may not have the clout to bargain with large enterprises, asset management companies can consolidate the exposure of banks to particular enterprises and be in a position to negotiate with the debtors more effectively. The threat of bankruptcy must be reasonably credible to ensure that parties come to the table. Although these workouts occur out of court, they are heavily reliant on an effective legal framework to make nonperforming asset resolution meaningful and efficient.
Woo: That’s why many asset management companies need to have a limited lifetime. Since often the asset management company is itself in liquidation, its board must make certain that staff do not have incentives to prolong the life of the company unnecessarily. Where, of course, the asset management company is part of a deposit insurance agency—as it is in the U.S. Federal Deposit Insurance Corporation—a more permanent arrangement is appropriate. Those who create an asset management company should also ensure that the staff has legal protection to execute their responsibilities in good faith. Otherwise, the staff may be hesitant to take the necessary steps for fear of lawsuits.
For debt workouts, especially in Asia, the danger was in reinvolving the government in a major way when many of the original problems resulted from government-directed lending to certain sectors. There was concern that the government might resume its past role of deciding who gets saved and who doesn’t.
I’d like to stress again that both asset management companies and out-of-court debt workouts have definite drawbacks. But in a crisis of systemic proportions, they may be a necessary evil.
Effective asset management essentially has four prerequisites: an effective legal system, a sound financial regulatory and supervisory framework, a neutral tax framework, and a stable macroeconomic environment. If all these are in place, the asset management process should not need to rely on the creation of an asset management company or on an out-of-court corporate debt workout.
Copies of IMF Working Paper No. 00/33, Two Approaches to Resolving Nonperforming Assets During Financial Crises, by David Woo, are available for $7.00 each from IMF Publications Services. See page 109 for ordering details.