Chapter

2 A Framework for Analysis and Assessment

Editor(s):
William Alexander, Jeffrey Davis, Liam Ebrill, and Carl-Johan Lindgren
Published Date:
August 1997
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Author(s)
Gillian Garcia

The goal of systemic bank restructuring is to restore or create a sound banking system that can provide efficient banking services to the economy on a sustainable basis. Although this goal is expressed in terms of the system as a whole, its accomplishment requires a wide array of microeconomic, institutional, and regulatory measures, some of which must be geared to the circumstances of individual banks. This Chapter provides a framework for assessing restructuring strategies and instruments by linking these to the framework for sound banking developed in Bank Soundness and Macroeconomic Policy (Lindgren, Garcia, and Saal, 1996). The determinants of a sound banking system developed in that volume are strong internal governance by bank managers and owners, external governance by markets and supervisors, and a generally stable economy. It follows then, that a program to restructure a banking system must resolve problems at the level of the individual banks, the banking system, and the macroeconomy.

At the level of individual banks, a restructuring program must address both the financial condition of each bank and its operations. Improvements in both will usually be required to place the bank on a sound footing so that internal governance can then be relied upon. Because financial and operational restructuring are intended only as a prelude to turning over the bank to its owners and managers, the instruments used in the restructuring must be designed to create proper incentives for the principals to maintain the soundness of the bank in the future.

At the level of the system, the restructuring program must address the configuration of the banking sector and the legal and institutional structure that forms its operating environment. It is at this level that conditions for market discipline are created, for example, through competition and the establishment of a system in which no bank is “too big to fail.” It is also at this level that the regulatory and supervisory framework is put into place.

Finally, it is important that the macroeconomic framework be supportive of business and banking activity. At the same time, the strategy for dealing with banking system problems must be consistent with sound macroeconomic management and the restoration of confidence in the economy and in the banking system.

Financial and Operational Restructuring of Banks

The core of any systemic restructuring strategy typically includes a set of specific measures aimed at restoring the solvency and profitability of individual banks thought to be viable, that is, solving the “stock” and the “flow” problems that these banks face. The former centers on the stock of nonperforming loans or other bad assets being carried on the balance sheet. This problem is usually addressed through financial restructuring. Although improving the balance sheet will generally improve the flow of income by replacing nonperforming assets with earning assets, a lasting improvement on the flow side must come from operational restructuring to eliminate the sources of losses.

The country cases in Chapter 3 show that more countries have been able to restructure their banking systems financially than operationally. Four years after the onset of bank restructuring, almost three-fourths of the countries surveyed had addressed the stock problem, whereas only half had resolved the flow problem. This suggests that additional attention to operational restructuring in the overall strategy is required, but also that the instruments used for financial restructuring need to be chosen in such a way as to create incentives for owners and managers to pursue operational restructuring.43

Criteria for Restructuring Instruments

The needs of each situation will vary, but to the extent that the goal of creating a sound and self-sustaining banking system is shared, certain characteristics for restructuring instruments are desirable.

  • Cost effectiveness. Financial resources are always limited; the need to minimize total as well as fiscal costs is obvious. However, lowest cost is not the sole criterion, particularly if defined only over the short term; short-term cost cutting can result in higher costs over the longer term.
  • Ease of implementation. The key issue here is feasibility, given existing constraints on skills and institutional resources. Ease of implementation may also encompass the degree to which political consensus can be achieved. As with costs, however, the easiest path in the short term may result in more difficulties later.
  • Equitable distribution of losses. Financial restructuring distributes the bulk of the existing stock of losses. Operational restructuring can also have the effect of distributing losses, particularly where staffing cuts or higher fees to bank customers are used to generate earnings for recapitalization. Thus, the instruments chosen for restructuring should reflect the policy decisions made about how losses should be distributed.
  • Minimization of cost to the public sector. Sound fiscal management dictates that concern be focused not only on the government budget but also on the broader public sector expenditure and debt profiles.
  • Fostering strong internal governance. Restructuring instruments must provide an incentive structure that encourages responsible ownership and sound management, which will be the first lines of defense against banking problems in the future. Holding owners and managers responsible for the performance (and losses) of their bank is critical; instruments that bail them out would fail in this regard.
  • Consistency with sound macroeconomic policy. A bank-restructuring program that impairs macroeconomic balance, for example, by creating too great a fiscal burden, or by failing to rebuild confidence and stem disintermediation, will deprive the economy of the stability required not only for growth and development but also as a foundation for sound banking.

Note that these criteria will be met by a given instrument to different degrees in different circumstances. For example, a merger may be relatively cost-effective and a simple measure in one country, but not in another. Replacing managers could improve internal governance, but only in situations in which the new managers will actually be permitted to manage the bank without political interference. Furthermore, it may be necessary to make trade-offs, and the degree to which these will be feasible will vary across countries. For example, for a country with little public sector debt, taking on a greater public sector burden could ease implementation and still be consistent with sound macroeconomic management, while possibly diminishing incentives for good bank management. The analysis that follows provides some indication regarding how various instruments will meet these criteria, but the particular circumstances of each systemic bank restructuring must be assessed individually.

Financial Restructuring

Financial restructuring of those banks deemed viable is essential because a bank that is not financially sound will not have the financial capacity to provide banking services, will not inspire confidence on the part of the public, and will not create the appropriate incentives for owners and managers to operate the bank properly. Failure to provide sufficient resources to appropriately restructure banks will jeopardize the sustainability of the system; this was a contributing factor to the emergence of the second rounds of problems in Argentina in 1989–90, Hungary in the 1990s, and Tanzania since the 1980s. On the other hand, an overly generous program could result in significant fiscal costs and induce moral hazard on the part of owners, who are not forced to pursue operational restructuring with sufficient vigor. The financial resources of recapitalized banks must include an appropriate level of owners’ capital, both to provide a financial buffer against unexpected shocks and to create an incentive for the owners to operate the bank in a safe manner (so as not to lose their investment).

Financial restructuring measures need to be bank-specific, depending on the condition of each institution. Broadly speaking, the objective is for all banks to reach minimum prudential capital adequacy ratios as soon as possible and to become profitable. Measures to accomplish this fall into two categories: improving the balance sheet and improving income.

Instruments for Improving the Balance Sheet

A stylized bank balance sheet is shown in Table 7. By definition, total assets equal total liabilities. A bank has a negative net worth when the value of liabilities net of capital exceed the value of assets, that is, when capital is negative. Balance sheet improvements can be made by either raising additional capital, reducing other liabilities, or boosting the value of the existing assets.

Table 7.A Stylized Bank Balance Sheet
AssetsLiabilities
CashDeposits
Financial assetsOther debts
Performing
Nonperforming
Real properlyEquity (tier 1 capital)
Subordinated debt (tier 2 capital)

Raising Capital

In raising bank capital, three issues must be addressed: what form does the capital increase take, how is it provided, and what level of capital is necessary.

Modalities of Raising Capital

Some restructuring instruments increase equity capital and the regulatory capital ratios (i.e., both tier 1 and tier 2 capital); some merely raise regulatory ratios. A range of financial restructuring instruments, and their effects on capital and the balance sheet as well as liquidity and income, are summarized in Table 8.

Table 8.Instruments for Financial Restructuring
InstrumentsCorresponding Asset/LiabilityBalance Sheet EffectLiquidity EffectIncome EffectCountry Examples
New private actions
Issue equityAssets/equity riseGrowsImprovesIncreasesUnited States (1990s), Mauritania (1993)
Issue-subordinated debtAssets/debt riseGrowsImprovesIncreasesUnited States (1990s)
Issue other debtAssets/debt riseGrowsIncreasesPassim
Provide real assetsAssets/equity riseGrowsImproves if soldMaybeUnited States (thrifts, 1980s)
Revalue assetsEquity risesGrowsNoneNoneJapan, United States
Government actions
Provide cashAssets/tier 1 equity riseGrowsImprovesIncreaseEgypt (1991), Finland (1991–94), Mauritania (1993), Philippines (1986), Sweden (1991)
Provide negotiable bondsAssets/equity riseGrowsImprovesShould increasePoland (1993–94), Chile (1982–83), Ghana (1990), Hungary (1993–94)
Provide non negotiable bondsAssets/equity riseGrowsImproves1Should increaseLatvia (1993), Mauritania (1993)
Purchase equityAssets/equity riseGrowsImprovesShould increaseEgypt (1991), Finland (1991–94), Mauritania (1993), Philippines (1980), Sweden (1991)
Swap bad assets for negotiable bondsAsset substitutionConstant2Improves 1Should increaseAlgeria (1996) Hungary (1993–94), Poland (1993–94)
Swap for nonnegotiable bondsAsset substitutionConstant2ImprovesShould increaseGhana (1990), Lao People’s Democratic Republic (1993) Sri Lanka (1993)
Write down claimsLiabilities fallShrinksImprovesCosts failArgentina (1994–95), Chile (1982–84), Côte d’Ivoire (1991), Estonia (1992), Philippines (1986)
Swap deposits for equityDebt falls/equity risesConstantImprovesCosts fallKenya (public deposits, 1986–89), Malaysia (private deposits, 1986–88
Swap deposits for bondsLiability substitutionConstantImprovesCosts fallArgentina (1989–90)
Make long-term loansTier 2 capital increasesGrowsImprovesIncreasesArgentina (1994–95), Azerbaijan (1995), Finland (1991), Hungary (1994), Mexico (1995)
Make shorter-term loansAssets/debt riseGrowsImprovesRisesArgentina (1994–95), Chile (1982–83), Latvia (1993), Mauritania (1993), Philippines (1936)
Assume liabilitiesWrite off bad assetsShrinksImprovesIncreasesArgentina (1995), Chile (1983), Finland (1991), Latvia (1995), Mauritania (1986), Philippines (1986)
Place depositsAssets/deposits riseGrowsImprovesDependsLithuania (1995)
Aid public or private borrowers, sometimes with guaranteesAsset (value) risesQualityImprovesIncreasesAzerbaijan (1995), Hungary (1987), Mexico (1995), Moldova (1994), Philippines (1986), Turkey (1994)
Source: IMF start

The extent of the liquidity improvement will depend on the terms of the debt: the bank does not have the option of liquidating the debt if needed.

If the asset is impaired and not fully provisioned, assets, equity, and the balance sheet appear to grow.

Source: IMF start

The extent of the liquidity improvement will depend on the terms of the debt: the bank does not have the option of liquidating the debt if needed.

If the asset is impaired and not fully provisioned, assets, equity, and the balance sheet appear to grow.

An increase in paid-in equity capital is the preferred form of recapitalization. This requires the existing owners to provide cash to the bank, or sell equity positions to new owners.44 On the liability side of the balance sheet, equity increases. On the asset side, cash increases; thus assets increase more than liabilities net of capital. The cash then serves as a financial resource for the bank–s operations and for the acquisition of new earning assets {e.g., loans). Another potential source of equity is conversion of other claims, such as those of subordinated debtors or even depositors, into equity. This does not inject additional cash but reconfigures the bank’s liabilities, reducing debt-service and liquidity obligations. The conversion of subordinated debt to equity in a case of default is generally consistent with the terms of such debt instruments. Conversion of deposits to equity or to long-term debt is more problematic; it may represent a breach of contract, be politically contentious and difficult to administer, and raise questions of fairness and future governance. However, to the extent that depositors benefited from interest payments or other services provided by a bank that could not afford to do so, they might now be expected to bear some of the costs. Converting deposits or other claims into equity or longer-term obligations is most feasible when the liabilities are held by a limited number of large creditors, who may have an interest in, and are qualified to exercise ownership and strong governance over the bank.

Alternatively, the owners might issue subordinated, long-term debt. This qualifies as tier 2 capital under Basle rules and would increase regulatory capital {hut not equity capital) and provide additional funds to allow the bank to acquire new earning assets. Subordinated debt is inferior to equity because borrowing does not increase net worth; if the negative net worth of the bank is significant, this form of capital would not be sufficient to put the bank on a sound footing. Raising equity is also more cost effective from the bank’s perspective; it improves the bank’s capital as well as income by reducing its debt burden. Subordinated debt carries a regular debt-service obligation that equity does not carry. In addition, under the Basle capital accord, tier 2 capital must always remain a fraction of tier 1 capital. Consequently, long-term borrowing alone cannot restore insolvent banks to solvency nor enable them to meet their regulatory capital ratios. Nevertheless, funds borrowed long term to replace short term obligations can improve liquidity. They may also increase confidence in the bank’s ability to meet its obligations and thereby improve access to additional, lower-cost funds and reduce the risk premium the bank must pay.

Contributions to a bank in the form of unrequited transfers of government bonds will add capital and may improve liquidity if the instruments are negotiable.45 The improvement in capital and liquidity may prove illusory, however, if the debt does not bear a market rate of return or the government does not service the debt on a timely basis. As shown in Table 9, some governments have provided batiks with negotiable debt, while others have offered nonnegotiable securities. Each has pros and cons. On the one hand, negotiable debt is subject to market risk if held in a bank’s trading portfolio and marked to market, which could reduce the bank’s potential liquidity.46 On the other hand, nonnegotiable debt constrains the bank’s loan expansion, but that may be desirable if the bank is still operating inefficiently. Sometimes owners attempt to recapitalize their bank by revaluing fixed assets or transferring real property. Such a recapitalization is likely to be more cosmetic than real, especially when the assets are nonearning (and so do not improve income) or nonnegotiable (and so do not improve liquidity). Thus a limit should be placed on the amount of bank capital that can be raised in this form.47

Table 9.Modalities of Government Debt Recapitalization Instruments
CountryYearAmount Issued (In percent of GDP)Maturity (In years)Interest (In percent a years)Negotiability
Algeria1993232010 (fixed)n.a.
1996120Money market rateNegotiable
Bangladesh1991215n.a.Nonnegotiable
Chile1982n.a.10No interest paidNonnegotiable
1984n.a.7 (real)n.a.
Côte d’Ivoire19915.6153 (well below the market rate)n.a.
Hungary1993–949.120Market rateNegotiable
Lao People’s Dem. Rep.19931.2n.a.n.a.Nonnegotiable
Latvia19932.3720 (for the first year, thereafter, a real rate of 1.5 percent)Nonnegotiable
Mauritania19935.6Six-month and 1-year renewable bills.11.0 per year (equal to central bank rediscount rate).Nonnegotiable
Poland1993–942.215National Bank of Poland rediscount rate, but only 5 percent minimum fixed is paid, the rest is capitalized.Partly negotiable: first three years, only with National Bank of Poland consent. Thereafter negotiable for domestic financial institutions.
Spain19851.51213.5 (fixed).n.a.
Tanzania1992102011 (fixed).n.a.
Source: IMF staff.Note: n.a. denotes not available.
Source: IMF staff.Note: n.a. denotes not available.

Who Provides the Capital?

Where banking problems are widespread, and particularly where they are linked to macroeconomic or enterprise difficulties that raise the risk and jeopardize the profitability of banking activities in general, private owners are unlikely to be willing to inject capital into insolvent or marginally solvent banks. Similarly, other creditors are unlikely to voluntarily convert their claims on weak banks into equity. Conversion of private creditors’ claims on banks into equity imposes no costs on the government, although writing down government deposits has an immediate cost. Sophisticated depositors and other creditors who received unusually high rates of return on their funds before a writedown perhaps should not be surprised by the penalty they incur, because they should have perceived the risk they were undertaking.48 Converting deposits to longer-term debt may provide bad incentives to bank owners in that they do not give up any control over their bank, although they do retain an obligation to repay that debt in the long run. However, even where deposits are converted to equity and the owners’ stake is diluted, bank governance may remain ineffective if the new shareholders are diverse and inexperienced.

The government may try moral suasion to induce current owners to provide additional capital and offer forbearance on capital and other regulatory requirements, but such forbearance should be temporary, governed by memorandums of understanding (MOUs) and strictly monitored by supervisors.49 In addition, the government might consider requiring future owners to contribute additional capital by making the granting of any new charters conditional on the new owners’ legally enforceable agreement to make new capital contributions as needed to meet regulatory capital standards, However, systems of double or unlimited liability discourage investment in banks, especially when other industries do not face the same obligation. Further, while this approach might be useful for the future, it does not address the current need for recapitalization, since the provisions of most existing bank charters do not stipulate unlimited liability.

Thus, private capital may not be available in sufficient amounts for the banking system to be recapitalized, and it is usually necessary for the government to provide resources to recapitalize banks. However, there are differences in the degree to which private and government capital meet the criteria outlined above. In particular, private capital has no direct or indirect fiscal costs, unless accompanied by forbearance or tax preferences. It is equitable and promotes internal governance by placing the initial responsibility on bank owners to recapitalize their bank. If they are unable or unwilling to do so, owners should forgo all or part of their stake in the bank.

Government contributions to capital, on the other hand, have direct fiscal implications. Cash contributions in the form of a grant or equity purchase will affect the fiscal balance, although an equity position could potentially be sold in the future.50 Unrequited government assistance is inequitable when the government was not responsible for the bank’s problems. The fact that distress is widespread, however, suggests that the government may be at least partially responsible through bad macroeconomic management, interference in bank activities, or lax supervision. Thus, it may be equitable to provide some assistance. However, any assistance that benefits those responsible for the bank’s problems may foster expectations of future bailouts and encourage poor management in the future. Matching public with private contributions to the recapitalization may help both to reduce the fiscal costs of financial restructuring and improve incentives.51

The fiscal cost and public debt burden of government provision of capital have clear macroeconomic implications, which can be reduced by minimizing government contributions. However, it must be recognized that private recapitalization also has implications for macroeconomic management. That investment in the banking sector is worthwhile is of little doubt. Nevertheless, allocation of capital resources to the banking sector means forgoing other investments or increasing the stock of capital available (e.g., through foreign capital inflows). The amount of resources that may be diverted to the banking sector over the short term may determine the rate at which acceptable capital adequacy standards can be reached.

Level of Recapitalization

The level to which banks are to be recapitalized can also have important effects on competition and incentives. While the United States maintains a principle that the Federal Deposit Insurance Corporation (FDIC) brings a failed bank’s equity to zero and private parties must raise the remaining funds to meet the bank’s capital requirement, adhering to such a cost-minimizing, incentive-compatible principle is usually impractical when distress is systemic. Recapitalizing some problem banks to higher levels than others (including those not receiving support) confers an unfair competitive advantage on those receiving the greatest support and argues for recapitalizing rehabilitated banks to a uniform capital ratio—but one that does not exceed the (average) level that prevails at other solvent banks. The appropriate level of this target ratio remains an issue, however. A ratio is too high if it reduces incentives for banks to recover problem loans and slows down the rationalization of operations, but is too low if the market perceives that banks with lower ratios are at risk and withholds funds at a reasonable price from them.

Reducing Other Liabilities

Writing down the value of certain liabilities or converting debt into equity can increase a bank’s net worth, lower its interest expenses, and increase its net income. Liabilities may be reduced voluntarily, under existing formal legal mechanisms (such as the bankruptcy code), by government fiat, or indirectly by inflation, especially when interest rates are fixed and interest payments are delayed.52 The scope for writing down or converting private sector claims on problem banks is often limited by political resistance, legal obligations that protect depositors’ claims under deposit insurance or other guarantees, and administrative complexity (including difficulties in reconciling creditor interests and deciding what to do with deposits that may have been taken outside the banks’ books). A number of countries, including Argentina, Brazil, Chile, Côte d’Ivoire, Estonia, Latvia, Malaysia, and Thailand (see Chapter 3), have tolerated a partial default on deposit and other claims on problem banks. On the other hand, several countries (Finland, Japan, Kuwait, Mexico, Sweden, and Turkey) have granted blanket guarantees of deposits during recent periods of distress or crisis.

The substitution of certain classes of assets for others (e.g., floating-rate or indexed assets for fixed-rate instruments), or the replacement of certain classes of liabilities by others (e.g., long-term, fixed-rate liabilities for floating-rate, short-term, or indexed liabilities), may reduce the bank’s risk exposure, improve liquidity, and increase viability. It does not increase equity, however, unless there is an element of subsidy in the exchange. Replacement of liabilities denominated in foreign exchange for others expressed in domestic currency and the replacement of domestic currency assets by assets denominated in foreign exchange may reduce banks’ foreign exchange risk. In such cases, the party (usually the government or the central bank) that facilitates the swap absorbs the cost and assumes the risk.

These instruments for reducing liabilities are cost effective, in that no new funds are required and can help to minimize the public sector burden of restoring banks’ balance sheets. In practice, they are likely to be perceived as inequitable, and to be difficult to implement. They will, however, create additional incentives for market discipline by depositors and other creditors in the future, and thus foster improved external governance. The macroeconomic impact will depend chiefly on the wealth and income effects of the write-off on the creditors, especially depositors. Furthermore, if depositors do not perceive that the banking system has been permanently strengthened, confidence may be impaired, reducing intermediation and possibly monetization of the economy.

Managing Assets

The balance sheet relationships imply that raising the value of assets will increase net worth. For an insolvent bank, scope to improve the existing assets may be limited, but maximizing their value will at lease forestall further losses and could permit the reversal of some loan-loss provisions, increasing capital. Thus efforts must be made to assert control over problem loans, collateral, and the other assets of distressed or failed banks and maximize the value that can be recovered. This will not only reduce net restructuring costs, but also send a message to borrowers that they need to fulfill their contractual obligations. Bad assets can be managed in a decentralized manner by a workout unit within each bank, by asset-management companies (AMCs) outside the banks, or by a centralized AMC. Usually the use of AMCs external to the banks implies government involvement, although, strictly speaking, this need not be the case, as an AMC could in principle be privately organized and funded (e.g., by a consortium of banks or a private deposit insurer).

Loan workout by the banks themselves has the advantage of building banks’ capacity in this function, which will always be necessary to some degree. Banks should be better placed than a new AMC, since they already have the loan files and some institutional knowledge of the borrower. Particularly in the case of small and medium-sized borrowers, where banks tend to be the primary creditors, banks should have sufficient leverage and information to conduct a workout. Leaving the problem assets on the bank’s own balance sheet increases its incentives to maximize the value recovered and to avoid future losses by improving loan approval procedures. It also minimizes public sector involvement.

It may prove difficult for a bank to manage a large quantity of bad assets because asset recovery demands skills that differ from traditional banking. Asset management by the bank may be difficult to implement, may not be cost effective if appropriate staff and resources are not available, and may divert management from its primary focus. It may then be appropriate to set up a separate AMC for that bank. Handling the assets and recovering value from them via an AMC involves several steps. First, the AMC must be capitalized. Second, competent staff must be hired to gain control over the assets and track their acquisition, location, maintenance, and sale. This is a difficult exercise involving careful record keeping and accounting, especially where there are a large number of assets of disparate types that are distributed over a wide geographical area. Moreover, careful account must be made of funds expended and recovered. To encourage effective operations, it is preferable to undertake a one-time capitalization of the AMC, so the AMC will have incentive to become self-funding out of recoveries.

AMCs should be set up as separately capitalized units that are operated under profit-maximizing criteria. For example, a bank may be divided into two segments, a “good bank” that concentrates on the bank’s core business and a “bad bank” that focuses on maximizing recoveries from the bad assets. Alternatively, the bank might create a wholly owned subsidiary AMC to which the problem assets are transferred in exchange for shares in the subsidiary. Regardless of the specific corporate structure, in these examples the net financial responsibility stays with the bank but the task of conducting the workout is separated from the day-to-day operations of the bank, so as to allow management and staff of the bank and the AMC to concentrate on their respective tasks. In many cases, however, the combination of banks’ lack of skills and managerial resources and the need to recapitalize the banks has led to the establishment of government-capitalized AMCs.

Where banks’ capacity is too constrained, or management too unreliable, to set up bank-owned AMCs, it may be necessary for the government, deposit insurer, or restructuring agency to take over the problem assets. In some cases, there is the additional concern that multiple AMCs may be difficult to staff, or that several AMCs independently trying to liquidate assets at the same time may drive asset prices down very rapidly. A centralized AMC may be able to internalize the costs of holding some assets longer, offsetting these costs against future gains. This approach may also facilitate coordination with enterprise restructuring and privatization. This not only requires centralization, but also adequate capitalization to fund the asset inventory.

These considerations have led many countries to establish government-funded centralized AMCs, which usually manage the problem assets of all the banks being restructured.53 Depending on the country’s circumstances, this approach can be more cost-effective than the decentralized approach, although it is likely to result in a greater public sector burden, depending on how the AMC is financed, and may alter incentives for the banks.

The use of a government-funded AMC usually involves an exchange of government bonds for problem loans on the banks’ balance sheets. This can occur directly, or by capitalizing the AMC with government bonds and then having the AMC and the banks swap bonds for loans. Such swaps are probably the most common form of government-funded recapitalization, occurring, for example, in Algeria (1995), Hungary (1993–94), Ghana (1990), Poland (1993–94), the Lao People’s Democratic Republic (1993), and Sri Lanka (1993). Usually, nonperforming assets are purchased at face value.54 When bad assets are bought at face (book) value, or at any value above the fully provisioned market value, an element of subsidy is involved, and the transaction increases the recipient bank’s equity and risk-weighted capital ratios.55 Therefore, banks prefer to transfer problem assets at as high a price as possible, whereas AMCs are better served by using lower asset values. This difference in incentives should be used to establish proper transfer prices. Transfers from the banks should ideally be done only once, in order to create incentives for the banks to manage their remaining assets and issue only carefully assessed loans, without the expectation of being able to dump more bad loans on the AMC at a later date.56

The choice between public, private, or joint management of problem assets should depend on who is likely to be more efficient in handling the assets, which will vary from country to country. In either case, specialized personnel are required to run the operation on strictly commercial criteria under an incentive structure that rewards efficiency. The incentive problems presented by state-owned enterprises and politically powerful debtors are particularly onerous in many developing and transition economies. Use of a government-funded AMC may not ultimately improve recoveries, but at least it removes the burden from the banking system and places it squarely where it belongs. Where asset recoveries from the private sector are significant, government ownership of the AMC allows the public sector to recoup some of the expenses involved in bank restructuring.

AMCs can effectively manage only claims on enterprises that have some prospect of viability or are eligible for bankruptcy. Banks in developing and transition economies often have claims on public enterprises or claims that represent disguised quasi-fiscal transfers to public institutions or other borrowers who often have no intention of repaying. Since political factors may inhibit the seizure of collateral or the enforcement of bankruptcy, such claims should not be considered loans or transferred to the AMC; instead they should be handed to the government for disposition.

Aiding bank borrowers can also improve banks’ asset quality. Direct government support of borrowers, writing off or writing down their obligations, reducing their interest or exchange rate risks by swaps and hedges, and even restructuring borrowers’ financial obligations to the bank on terms more favorable to the borrower can strengthen banks’ balance sheets where they increase the net present value of banks’ expected recoveries.57 However, if the budget constraints facing borrowers are eased in the process, any improvement in debt servicing may prove temporary and the enhancement in the quality of bank loans illusory, particularly if the subsidy element of debtor-aid programs distorts the borrower’s true financial condition. These pretenses can adversely affect bank credit assessment, loan classification, and provisioning, and distort the evaluation of the financial condition of individual banks.

Officially sponsored support programs can be costly. In addition, they can be inequitable because they are typically made available to specified classes of borrowers and not tailored to individual borrower circumstances so that they may support nonviable debtors whose collateral should be seized and their loans written off; or grant potentially viable debtors with insufficient relief to reestablish their debt-servicing capacity; or aid sound debtors with support they do not need. For example, the authorities in Argentina, Mexico, and Turkey have aided borrowers who had loans indexed to foreign. currency values but had no sources of foreign income. Finally, official support for bank debtors increases moral hazard and distorts credit allocation, and creates poor incentives with respect to future lending and borrowing.

Instruments for Improving Income

A stylized bank income statement is presented in Table 10. The recapitalization and asset-management strategies discussed above should improve income by reducing interest costs, loan provisions or write-offs, and raise revenues from loan recoveries and interest earned when the new capital is put into earning assets. In most cases, significant improvements can be made by reducing operating expenses, discussed below. There is also some scope for the use of public financial instruments, particularly control over interest and tax rates, to improve bank income. Improvements in income ultimately will help to generate retained earnings, and thus reduce the need for capital injections by owners or other contributors.58

Table 10.A Stylized Bank Income Statement
IncomeExpense
OperatingOperating
Interest earnedInterest paid
FeesWages, salaries, etc. Loan-loss provisions
NonoperatingNonoperating
Capital gainsCapital losses
Recoveries from lost loansLoans written off Taxes

Wherever interest rates have been regulated, they can be liberalized to allow banks to increase lending rates and reduce deposit rates. The central bank can also reduce banks’ cost of funds, for example, through reduced discount rates on central bank lending. These policies can allow banks to widen their interest spreads and increase operating income, although they may come at the cost of the loss of interest rate management as monetary policy tool. In addition, if the need for recapitalization is large, the reduction in deposit rates may discourage savings and intermediation while the increase in lending rates would have an adverse effect on growth and could encourage adverse selection of borrowers.

Relying on banks to recapitalize over time from increased profits derived from wider interest spreads has no fiscal cost, but it presupposes that banks have the market power to do so. This is not usually the case in developed financial markets, and the income earned from this approach will be constrained by the interest elasticities of the supply of deposits and the demand for loans. In particular, the ability to increase spreads by reducing deposit rates is limited when depositors have access to alternative liquid instruments (at home or abroad) and demand a premium for placing their funds in risky domestic banks. Lower bank deposit rates may also be inequitable in placing the burden of financial restructuring on new depositors. Unless a low interest rate environment is consistent with the overall macroeconomic environment, it could interfere with monetary management. Nevertheless, some economists in the United States believe that monetary policy in that country was designed to keep deposit rates low early in the 1990s to help the banking system, which was suffering from widespread capital inadequacy.

Banks may have more opportunity to increase spreads by raising lending rates because many bank borrowers do not have ready access to credit from other banks or nonbank sources, domestic or foreign. In addition, only the strongest borrowers are likely to be able to borrow abroad, which leaves the weaker cadre for domestic banks. Furthermore, only the riskiest borrowers may be prepared to pay high borrowing rates resulting in an adverse selection problem for banks. Responding to this dilemma, prudently managed domestic banks can be expected to tighten credit standards during the restructuring and will not want to take the risks associated with expanding their loan portfolios or expend the time and resources to evaluate the creditworthiness of a potential customer. Instead they may stop attracting deposits and shift their assets to safe havens. Thus, while increasing banks’ spreads has no direct fiscal cost, it unfairly penalizes good borrowers and depositors, distorts saving and investment behavior, creates a credit crunch, encourages adverse selection, and could impede monetary policy.

To avoid such problems, the central bank may reduce reserve requirements to increase bank’s net income and increase bank liquidity. Argentina, Hungary, Spain, and Venezuela reduced reserve requirements during periods of banking distress, and in Lithuania noncompliance was tolerated. This action has a quasi-fiscal cost, however. Further, the liquidity released by reducing reserve ratios may also complicate monetary management. Profits and other taxes on banks may be reduced, especially where the rates applied to banks exceed those for other businesses. Where loan-loss provisions are not tax deductible they can be made so.59

Inflation is sometimes mistakenly seen as an instrument to raise bank income and reduce the real value of impaired loans in banks’ portfolios. It was, for example, used as an instrument by Yugoslavia during the 1980s and has more recently effectively reduced the size of the balance sheet problems in real terms in many transition economies. Indeed, inflation may create temporary profits from float and foreign exchange speculation, but when the economy stabilizes, these profits are eliminated and banks typically have difficulty in adjusting. In addition, inflation typically reduces the quality of loans and management’s ability to evaluate credit risk by distorting enterprises’ balance sheets and reducing the accuracy of macroeconomic and sectoral forecasts. These distortions lead banks to overestimate the creditworthiness of bank customers, under provision for losses, and report artificially inflated profits that, if taxed, lead to a gradual decapitalization of banks.60 Finally, the negative interest rates that typically prevail under high inflation discourage deposit growth. Negative rates also cause disintermediation. Moreover, the redistribution of wealth by inflation is often inequitable. Thus, as an instrument for bank financial restructuring, inflation does not measure up to the criteria outlined above.

Table 11 summarizes the financial restructuring instruments that could be used to improve bank income. These are often popular because they have a negligible or nontransparent fiscal impact in the short run and can reduce the amount of explicit government recapitalization required. Imposing some costs on bank customers and depositors can be considered equitable, as well as an appropriate way to reduce costs to the public sector. Furthermore, removal of existing interest rate or tax distortions would be consistent with sound macroeconomic management. However, active encouragement of wider spreads through restrictions on interest rate, capital movements, or competition would convey poor incentives to bankers and to debtors and can have adverse effects on the macroeconomy and its management. Improvements in income solely through financial approaches are unlikely to be sufficient to turn around profitability and recapitalize a bank in a reasonable period of time. Better results in terms of improving the income statement can usually be achieved through operational restructuring, to which we now turn.

Table 11.Financial Instruments to Improve Bank Income
InstrumentEffect
Reduce deposit ratesReduces interest costs.
Raise loan ratesIncreases interest income.
Reduce reserve requirementsIncreases earnings.
Reduce excessive bank taxesLowers costs and improves incentives for proper loan classification and provisioning.
InflationEncourages indebtedness, speculative profits, and poor credit management; may reduce economic growth.

Operational Restructuring

To return banks that are being restructured to profitability and prevent additional losses from occurring, it is necessary to improve their internal governance and operations. Measures to restructure operations often involve changes of ownership and management and reengineering or rationalization of operations, including changes in a bank’s business strategy, product mix and pricing, improved loan recovery procedures, the closure of branches, reductions in staff and increased use of automation. Where government ownership, oligopolistic market structures, or vertical integration with industrial groups has contributed to poor internal governance of banks, operational restructuring must be closely linked to systemic configuration issues, discussed below. The key tasks typically facing owners and managers of problem banks are summarized in Box 5.

Whether publicly or privately owned, banks need to be well managed in order to cut costs, strengthen internal controls, increase efficiency, and eliminate the flow losses so as to achieve a sustainable level of profitability. Public policy’s role in this process is to force the replacement of failed owners and bad managers, remove barriers that impede new management’s ability to exercise good governance, such as directed lending, restrictive labor laws, or requirements that banks operate particular branches or provide unprofitable services, and monitor the process to make sure that steady progress is made. When owners and managers tail to make necessary improvements in bank operations, supervisors may negotiate or impose a contractually binding MOU on the bank, change its management, or place it in conservatorship. A bank that is undercapitalized, is being considered for public assistance, or has been taken over by the government, should be required to formulate and submit a business plan for approval. When the supervisor has approved the plan, its terms may be formulated in an MOU to encompass all of the improvements that are needed and specify phased targets for accomplishing them, and in particular for cutting costs and reaching capital adequacy targets. The bank supervisor can then monitor the bank’s progress in meeting these goals; penalties or other corrective actions may be imposed for failure to meet targets.61

Box 5.Key Elements of Operational Restructuring

  • Formulating a business plan that focuses on core products and competencies.
  • Reducing operating costs by cutting staff and eliminating branches where appropriate, ceasing unprofitable activities, and disposing of unproductive assets.
  • Implementing new technology and improving systems of accounting, asset valuation, and internal controls and audit.
  • Establishing and enforcing internal procedures for risk pricing, credit assessment and approval, monitoring the condition of borrowers, ensuring payment of interest and principal, and active loan recovery.
  • Creating internal incentive structures to align the interests of directors, managers, and staff with those of the owners.

Replacing owners and managers and screening their replacements to see that they are “fit and proper” not only improves the bank’s prospects for viability, but also sends a message to others that incompetence and illegality will be punished, reinforcing appropriate incentives for the future. There are circumstances, however, where it would be inequitable or infeasible to replace management. If the bank’s difficulties have occurred as a result of an unforeseeable natural disaster or massive error in public policy, it may be inappropriate to punish management for the failure. Where there is a national shortage of management skills, the pros and cons of replacing all managers may have to be carefully evaluated, especially in the case of small banks. If existing management is allowed to continue, it must be placed under a revamped incentive structure and its actions closely supervised. Where management has acted fraudulently or knowingly violated laws or regulations, the case for replacement is unassailable, even where talent is scarce. Serious deficiencies or persistent failure to meet restructuring targets should result in conservatorship or closure of the bank.

Operational restructuring is difficult and time consuming, but it is the only way to ensure that banks become profitable and will not end up in renewed trouble in the future. Thus, no restructuring strategy can be considered cost effective if it does not address a bank’s internal operations. Failure to undertake adequate operational restructuring was the reason for successive rounds of financial restructuring in several countries. For example, the dominant state-owned bank in Tanzania was recapitalized in 1992 with an injection of government bonds in exchange for nonperforming loans. However, bank practices and management were not adequately reformed at that time. The bank continued to make losses, and a new restructuring and recapitalization program was required within a few years. In Sweden, on the other hand, two large failed banks were merged and restructured, and the resulting bank emerged as one of the most profitable in the system, carrying a high market (privatization) value.62 It should be noted, however, that in a country undergoing an economic transition, where enterprise restructuring has not been completed, ensuring that bank restructuring is a one-time occurrence will be difficult.

Systemic Aspects of Restructuring

While problems in the management of individual banks are the most common causes of bank failure, when a significant portion of a banking system becomes distressed, there are usually broader problems in the sector or in the environment in which banks are operating. Thus, in addition to instruments for financially and operationally restructuring banks, a systemic restructuring strategy must include measures to redress any deficiencies in the configuration of the banking system and in the operating environment.

Banking System Configuration

The industrial structure of the banking system is important because of the effect it has on the profitability and efficiency of individual banks. Entry and exit, competition, and active market discipline tend to result in a more resilient banking system. To the extent that the sector is being restructured, measures can be taken to foster the emergence of such a system. The closure of nonviable banks and downsizing of others will improve prospects for the remaining banks. On the other hand, high concentration can lead to inefficiency and to situations in which certain banks are deemed ‘too big to fail,’ and the existence of regional or functional monopolies could result in underprovision of key services, particularly to less economically powerful customers. Dominance by state-owned banks, which often focus on implementing fiscal policy rather than commercial banking, may impair competition and the efficiency of financial intermediation. Ownership by industrial or individual interests could also result in a weak banking system beset by problems of insider lending, credit concentration, and other market distortions.

General Considerations

In addressing these issues, entry and exit policies will be critical. Ideally, with adequate screening of owners for fitness and propriety, prompt corrective action for undercapitalized banks, and measures to speed the smooth exit of problem banks, market forces should be able to determine the ultimate configuration of the system, including the scale and scope of its constituent institutions. In many cases of systemic restructuring, however, the banking sector is not large enough and, especially where credit discipline has generally broken down, is not sufficiently attractive to domestic or foreign capital to support the changes in the banking market required to arrive at an efficiently configured system. In addition, existing institutions may be so large that failure of an individual bank would result in serious disruptions. In such cases, the authorities may have to take a more active role in determining the microstructure of the market. This is often facilitated by the fact that the government becomes the de facto owner of a large portion of the system when it, or one of its agencies, takes over failed banks.

In formulating a structural plan for the sector, the authorities must be mindful of the need to see not only that services are provided to the different sectors of the economy, but also that the banks supplying these services are able to do so profitably, and can in the long run compete effectively both with alternative domestic financial services providers and with foreign firms.63 Recapitalizing banks that cannot become competitive is pointless and expensive, and care should be taken not to hobble relatively healthy institutions by forced mergers with weak banks. As part of the restructuring program, the authorities may foment mergers, divestitures, and other reconfigurations of existing institutions. It is desirable, however, to reduce over time both this type of sectoral management as well as state ownership stakes in financial institutions.64 When the government does enter into the business of running banks it must minimize its expenditure by operating the banks on commercial terms and employing the best available management; this would also establish a performance record conducive to eventual privatization.

There are elements of “central planning” here, as indeed there must be in any systemic restructuring program following massive market failure. Refusing to countenance some amount of central planning is not an option.65 Taking a system of ten insolvent banks and restructuring it to create a system often rehabilitated banks implicitly makes certain decisions regarding the configuration of the system. Restructurers have both an opportunity and an obligation to explicitly reconsider the configuration of the banking system. Restructuring a system without attempting to ensure that it is efficient, competitive, and resilient will in the long run be neither cost effective, equitable, nor consistent with minimizing the long-term public sector burden, fostering strong internal governance of banks, and maintaining a stable market-oriented macroeconomy.

Number of Banks and Distribution of Banking Assets

Consolidation of banking activities in a fragmented system can enable banks to diversify, achieve economies of scale, and economize on scarce management skills. Consolidation involves closing and liquidating insolvent or critically undercapitalized banks, salvaging potentially profitable parts of banks in liquidation, and merging viable banks where the resulting institution will be adequately capitalized and well managed. Supervisors should have the legal authority to force failing banks to recapitalize, find a merger partner, or close, and should do so based on the viability analysis conducted as part of the initial assessment.

A highly concentrated banking system, on the other hand, can be made more competitive by splitting large failed banks into parts, selling the viable pieces, and liquidating the rest. Large troubled banks can also be downsized gradually by restricting asset growth and risk taking, including lending to problem debtors. This approach was adopted in Nicaragua, Peru, and Tanzania to stem losses at problem banks, while at the same time opening the playing field for the entry and growth of sound competitors.

Country experiences illustrate a range of approaches. Closure and mergers were used in most of the more successful restructuring cases; splitting of banks was less common. Banks accounting for a significant portion of the system were closed or merged in Argentina (early 1980s), Estonia, Latvia, and Venezuela; thousands of banks and thrifts were closed or merged in the United States.66 Tanzania adopted a strategy of allowing entry, including by joint-venture and foreign banks. Most transition economies began the process of restructuring their banking systems by breaking up monobanks but then allowed entry almost indiscriminately. Indiscriminate entry also proved costly in Spain and the United States in the 1980s.

Entry and Exit

The terms of entry of new owners or new banks should be part of the restructuring strategy; licensing policy for banks is thus an important systemic restructuring instrument. Allowing the entry of sound new banks into the economy is essential for an efficient banking system; however, during restructuring, temporary restrictions on the establishment of new banks may be necessary to conserve supervisory resources, raise the franchise values, and facilitate the sale of troubled banks to new owners. While caution in licensing new institutions is warranted, it should not be used as an excuse to prop up troubled banks, prevent the entry of top-quality banks, or give domestic banks excessive market power.

In all cases, new owners must be fit and proper and approved by the supervisory authority. Reputable foreign banks can contribute to the restructuring process if they are permitted to acquire and recapitalize existing banks (especially weak banks) either as sole owners or in joint ventures with domestic banks. In most cases of systemic restructuring, however, the banking sector will not be attractive to new investors until some degree of normalcy and confidence has returned.

Exit policy is as important as entry policies. Competitive forces and market discipline, made orderly under supervisory direction, should be permitted to hold sway, without central bank or other support for insolvent banks. This policy may not be applicable until the restructuring is complete but should be articulated along with the restructuring strategy so as to create the appropriate incentives for new owners and managers.

Ownership

The ownership structure of the banking system may need to be changed to improve decision-making, risk management, cost containment, and profitability. Laws governing bank ownership by a dominant group and the regulation and supervision of insider and related-party lending can be strengthened to ensure that banks are not owned by those seeking to loot them. Viable banks can be sold to new owners, and a separation of banking from ownership by industrial or commercial interests may be sought. Cross-holding of equity among banks should be discouraged, as it reduces market transparency and weakens banks’ ability to raise capital. Publicly owned banks, including those taken over during restructuring, can be gradually privatized once the public perceives that financial restructuring has been successfully completed. Most of the sample countries with significant public bank sectors that made progress used privatization as a tool of bank restructuring. However, in the absence of fit-and-proper new owners, continued conservatorship or government ownership is preferable.

Foreign ownership can increase competition and bring new capital, skills, and technology into the system. Reputable foreign banks should be permitted to enter the market, but may need to be encouraged to provide a full range of banking services.

Permissible Banking Activities

There is no consensus about the best configuration of bank powers. While this paper will not discuss the relative merits of universal and commercial banking, it is possible that a country may choose to modify the system it had previously adopted. For example, banks that were specialized in housing and industrial development might be allowed to extend the range of their activities and customers in order to enhance their opportunities for diversification and profit. However, a wider array of banking activities will require more sophisticated systems of internal control, disclosure, market discipline, and supervision.

Operating Environment

The operating environment comprises the political, legal, and administrative arrangements that guide economic and financial transactions and shape the financial markets and the system of payment and settlement in which banks operate. The political environment is crucial for systemic bank restructuring. The best restructuring options, which may involve quick action and substantial allocation of losses to the private sector, tend to be the most difficult ones politically. Incentives therefore exist to delay corrective action and instead keep the system functioning through regulatory forebearance and LOLR support to nonviable banks. Explicit deposit guarantees may calm the system and appease politically powerful interests. However, the end result may well be a scenario under which the government finds itself financially responsible for most of the losses in the banking system. To the extent feasible, a political consensus should be developed regarding the actions to be taken.

In most cases of systemic banking problems, the legal and administrative infrastructure is also deficient. Thus any strategy to address the problems must include policies to create an appropriate legal framework, including adequate corporate, bankruptcy, contract, accounting and private property laws, to provide a basis for the economy’s incentive structure, for internal governance of banks, for market discipline by private sector shareholders and creditors, and for loan recovery. The strategy must also include measures to establish or improve bank regulation and supervision and enforce compliance with prudential standards. The financial infrastructure is also important. For example, a well-designed payment system limits spillover when a bank fails, a well-developed capital market can provide additional sources of liquidity, and a well-capitalized insurance industry buffers the banking system against natural disasters.

The challenge in providing an appropriate environment for banks is to apply public policy to improve microeconomic conditions, including laws, regulations, the payments system, and the political environment. New legislation with respect to banking, bank supervision, and the business framework is often required. Improved accounting, asset-valuation, loan-classification, loss-provisioning, and disclosure rules can be effective instruments to encourage market discipline. Strong, independent supervision is needed to secure compliance with regulations. Removal of excessive or poorly designed taxes is necessary in some cases. Finally, reliable courts, strict enforcement of property rights and criminal laws, and the elimination of political interference will create an environment deterring fraud and malfeasance.

Restoring Stability and Confidence

No strategy will be sustainable if it is not consistent with sound macroeconomic management and supportive of public confidence. These are interrelated: confidence is fundamental to the sustainability of the restructured banking system and the public must have confidence not only in the stability of the financial system, but also in the fact that sound macroeconomic management will create the basis for future stability. A restructuring strategy commands confidence if it is timely, comprises a comprehensive and consistent package of measures that clearly demonstrates the authorities’ commitment and ability to address and resolve the problems in the system, avoids asset-price deflation, and is combined with credible and supportive macroeconomic policies.

Macroeconomic Stability

Some aspects of the general condition of the economy may be beyond the control of the authorities; nevertheless, macroeconomic recovery and stabilization aid recovery in the banking system. Where necessary, a program of macroeconomic stabilization therefore should be instituted in tandem with bank restructuring. Important linkages in this area will be the choice of the macroeconomic policy stance and the fiscal and monetary aspects of the restructuring strategy itself. In particular, controlling the cost of the restructuring program will contribute to, or at least minimize disruptions to, any stabilization program. As the case studies in Chapter 3 show, bank restructuring is not incompatible with economic recovery or rapid economic growth; indeed it may even be a prerequisite. For example, in most of the sample countries, inflation was reduced following bank-restructuring programs.

Chapter 1 has pointed out that a key consideration from the perspective of designing the restructuring strategy and choosing appropriate instruments is to minimize the fiscal and debt burdens created. This may require an iterative process of assessing the fiscal implications of instrument packages and loss-sharing arrangements and then revising the strategy or choice of instruments.

As noted above, inflation is not an appropriate tool to financially restructure banks; over the longer term, price stability will make a much greater contribution to the development of the banking sector. Fully addressing the monetary policy implications of bank unsoundness in the short term will usually be beyond the scope of a restructuring strategy, which in any event will seek to restore the banking system as a stable fulcrum for monetary policy as soon as possible. Restoring external balance is an important concern in many countries experiencing banking system distress or crisis. The restoration of confidence in the banking system will be critical to the repatriation of flight capital and the resumption of foreign capital inflows.

Confidence in the Banking System

If the banking system does not have the confidence of the public, disintermediation, capital outflows, and potential liquidity and exchange rate crises will occur. The early introduction and announcement of a comprehensive restructuring strategy for the entire system helps to rebuild confidence and eliminate the need to react case by case to successive waves of bank failures.67 A comprehensive strategy can help avoid the extension of blanket guarantees to depositors and creditors of problem banks68 If accompanied by credible measures to restructure the system, an allocation of losses to owners and creditors of closed banks is not likely to significantly affect confidence in the remaining banks, which will be seen to be viable.

In contrast, delay or failure to introduce a comprehensive strategy is likely to result in continuing losses and possibly in a rapid weakening of the financial condition of problem banks, as owners and managers gamble for recovery or loot their banks69 Allowing problem banks to continue operating leads to bank runs, contagion, and loss of confidence, which can turn into runs on the entire banking system and flights from the currency. In such a setting, policies for dealing with problem banks on a case-by-case basis become ad hoc and erratic, and the authorities may contribute to the escalation of problems through supervisory forebearance and the provision of liquidity. Eventually they may be forced to issue blanket guarantees to depositors and creditors to calm the situation, reducing the scope for an appropriate distribution of losses and the crafting of a restructuring strategy consistent with macroeconomic stability.

An important element of confidence building is transparency, which is necessary for public acceptance of the restructuring strategy. An information campaign should be considered a key element of a restructuring strategy. Information about burden sharing and the rules of operation for remaining banks are particularly important. Secrecy may be required at certain stages when the strategy is being formulated to avoid provoking a crisis and to prevent insider fraud. However, no significant banking problem can remain undisclosed for long; to the extent that there is a potential for crisis the response should be to move quickly to institute a restructuring program rather than to try keep the situation secret. For example, the experiences of successful bank-restructuring exercises, like those in Sweden, Peru, and Côte d’Ivoire, show that transparency is crucial to an efficient process and to public confidence. Public confidence ultimately depends on the public’s ability to observe consistent and efficient implementation of the announced strategy and the smooth functioning of the banking system over time.

In addition, it should be recognized that sustaining asset values by successfully managing the real and financial property of failed banks is important, not only to minimize the losses the banks experience (and the cost to the public sector) but also to maintain asset values, credit discipline, and confidence in the financial system and the broader economy. Mass liquidation of the assets of a large number of failed banks is not an option when it would cause an excessive deflation of asset prices and trigger the collapse of banks not previously affected. Balance must be sought between asset disposals to reestablish a market with realistic values, which may require a drop in prices, and excessive deflation, which could contribute to or exacerbate an economic downturn.

A well-designed safety net of LOLR facilities, depositor protection, and strengthened supervision should be available to support remaining viable banks. Remaining banks may also benefit from a temporary full guarantee for depositors and other creditors, including domestic and foreign interbank depositors. Once the public can trust remaining banks to be sound and liquid, their interest in withdrawing funds will be reduced.

Finally, the role of complementary macroeconomic policies is essential for confidence. It is virtually impossible to restore domestic or international confidence in a situation where the government ends up assuming an overwhelming debt burden and there is a simultaneous foreign exchange crisis; this is the case in some transition countries.

Implementation Issues

Assessing problems and diagnosing causes will determine the appropriate strategy responses, but in all cases, systemic bank restructuring involves an extraordinary range of microeconomic measures that can easily overwhelm the authorities’ implementation capacity. It is therefore important to begin planning and execution quickly, to keep the strategy as simple and flexible as possible, and to take steps to identify and resolve critical constraints.

Planning

Successful bank restructuring requires broad political commitment at a high level, while the details of implementation are best determined at the technical level.70 But the broad principles of the restructuring, in particular those regarding the distribution of losses, involve key political considerations. Parliament will need to be involved, where there is a need to approve expenditures and enact new legislation to facilitate and expedite the process. For example, legislation may be needed to establish special agencies, provide temporary guarantees or emergency powers, or remove particular legal or judicial obstacles. Although the banking supervisor is responsible for identifying banking problems and alerting the monetary and budget authorities, ideally the government, typically represented by the ministry of finance, would assume the primary responsibility for formulating the restructuring strategy because of the budgetary and broader macroeconomic implications. However, government staff generally have limited banking skills and knowledge, so there are cases where the central bank may be the only agency capable of doing the job.

Regardless of institutional arrangements, planning needs to be done in close consultation with the monetary and supervisory authorities (both of which may reside in the central bank), particularly when the necessary skills and banking knowledge reside in those areas. In general, the supervisor’s role at the planning stage is to provide data and technical support and to ensure that the strategy being developed is consistent with prudential rules and the reemergence of sound banks. The central bank’s role is to ensure that the restructuring strategy and instruments are consistent with monetary policy and to establish plans to handle an existing or potential liquidity or foreign exchange crisis.

As shown in Chapter 3, countries that implemented effective restructuring strategies designated or created special agencies or working groups to coordinate and implement the technical aspects of the strategy. In Sweden, a new agency was formed. In Spain, the deposit insurance agency assumed the responsibility for dealing with failed banks. In the United States, the deposit insurance agency also dealt with failed banks, although a special agency was required to deal with the larger problem of failed thrifts.71

Execution

Systemic bank restructuring is a labor intensive and complex process requiring special skills; it is not a supervisory function. A special technical group should be created to implement the systemic restructuring strategy in order not to detract the budgetary, monetary, and supervisory authorities from their regular tasks. The technical group could be a special agency established for this purpose, or a unit within the ministry of finance, or the central bank. Public confidence and efficient implementation will require a clear understanding that only one lead authority will be assigned to interpret the strategy and issue any public statements. The establishment of a temporary special agency for this purpose has the advantages of creating the scope to quickly assemble the necessary expertise unhampered by existing bureaucratic structures, the ability to function at arm’s length from the government and parliament, and of providing a clear signal that the restructuring will be a one-time effort not to be repeated.

Implementation of a systemic bank-restructuring program often demands speedy decisions and actions, particularly where market reactions are a concern. Special administrative procedures may be required. For example, bank closures are often effected by supervisory withdrawal of the license, rather than through the standard bankruptcy process. This is because closing an insolvent bank must be done expeditiously to avoid providing insiders with opportunities to strip assets.

Experience has taught that bank restructuring is not a task for bank supervisors. Instead, supervisors have an important supportive role to play in the monitoring of banks that are being restructured, especially their compliance with specific restructuring commitments (often included in memorandums of understanding) and normal prudential rules, and in setting new rules and criteria where needed. However, supervisors’ direct involvement in restructuring would introduce conflicts of interest and potentially diminish the supervisory authority’s ability to carry out its primary role over the longer term. As discussed above, proper management and disposal of loans, collateral, and other assets of failed or restructured banks is also an essential part of the restructuring process, and may be best accomplished by a specialized unit or agency.

Identifying Critical Constraints

As the strategy is being formulated and as it is being implemented, it will be important to identify the critical path of tasks at various levels and take steps to ensure that any constraints are resolved. At the early stages, reaching political consensus is often a roadblock. Later in the process, skill shortages and the lack of an adequate legal framework have often been factors, particularly in developing and transition economies.

Bank restructuring requires a variety of technical skills in addition to banking, such as business analysis, accounting, audit, law, property and corporate management, loan collection, and asset liquidation. Personal integrity is also essential, because the scope for fraud and corruption is unusually large. Since assembling a group with the requisite skills from within the country may be difficult, participation of foreign experts may be necessary. This may be subject to political constraints, especially as such skills typically are expensive. But the cost of such skills is dwarfed by the costs of permitting a banking crisis to deepen; country experiences confirm that money for top-notch technical skills is well spent.

Legal issues may also delay or stop bank restructuring. Early identification of obstacles to declaring a bank insolvent, closing an insolvent bank or taking control away from owners, downsizing bank branches and staff, transferring loans and collateral, and forcing bankruptcy and liquidation of borrowers will facilitate an early start on corrective action in the relevant legal or administrative areas.

Applying the Framework

There is no single appropriate strategy for all countries facing the need to restructure their banking systems. The fact that such a need has occurred in industrial, transition, and developing economies means that the specific problems of the system, the institutional structure of the economy, the critical constraints, and the available financial and human resources vary tremendously across the range of countries that have experienced, or are experiencing, widespread banking system distress. Nevertheless, the analysis provided here, by linking specific elements of a restructuring strategy with the creation of a framework for sound banking, suggests that certain issues must be addressed in all cases if the strategy is to be successful. Indeed, the survey of country experiences in Chapter 3 confirms that there are best practices consistent with this approach that appear to be robust across countries.

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