FINANCE E Q U I TA B L E G R O W T H , F I N A N C E & I N S T I T U T I O N S N OT E S How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Examples of components can include, but are not limited to, tables, figures, or images. All queries on rights and licenses should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; e-mail: pubrights@worldbank.org. Cover design and layout: Diego Catto / www.diegocatto.com This paper was prepared by Antonia Menezes, Sergio Muro (Finance & Competitiveness (FCI) Global Practice, World Bank Group), and Clara Martins Pereira (University of Oxford), under the supervision and guidance of Mahesh Uttamchandani (Practice Manager, FCI, World Bank Group). The paper was based on a literature review undertaken by Clara Martins Pereira and Associate Professor Kristin van Zwieten (University of Oxford). Our thanks are extended to the peer reviewers, Kristin van Zwieten (University of Oxford), Miquel Dijkman (World Bank Group), and Pietro Calice (World Bank Group), as well as to the FCI Global Insolvency & Debt Resolution Team members for their inputs. This work is a product of the staff of the World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent. High non-performing loan (NPL) levels can threaten financial stability and also have a significant negative impact on credit, inflation, and real GDP. As such, efforts are commonly undertaken to contain the growth of NPLs and to help resolve them when they reach problematic levels. Insolvency and creditor/debtor rights (ICR) regimes are one of the complementary tools in the policy maker’s arsenal for these purposes. This note reviews the empirical literature on the impact that effective ICR regimes can have on NPLs. Specifically, it highlights the potential impact of (i) effective ICR on increasing loan repayment probability; (ii) effective enforcement mechanisms on lowering banks’ cumulative losses from NPLs; (iii) efficient pre-insolvency mechanisms and (iv) stronger insolvency frameworks on adjusting NPL levels faster; and (v) targeted NPL reform —including ICR reform — on fostering economic growth. >>> Introduction Non-performing loans (NPLs) erode the profitability and can resolution strategy. For instance, some of the main tools of threaten the solvency of banks, and when a sufficiently large NPL resolution include (i) debt restructuring; (ii) write-offs; (iii) volume of loans is affected, they can potentially threaten direct sales; (iv) securitization; (v) asset protection schemes; financial sector stability. Efficient legal regimes that promote and (vi) centralized asset management companies (Baudino effective insolvency and creditor/debtor rights (ICR) are and Yun 2017; World Bank FinSAC 2016). As pillar (i) conveys, important tools that facilitate debt recovery, reduce the cost strengthening ICR regimes is an integral component of this of credit, increase access to finance and, as a result, help broader NPL resolution strategy, even with the challenges of improve NPL levels. legal reform during a time of systemic crisis (Baudino and Yun 2017). This Policy Note examines the relationship between effective ICR systems and NPL levels. In particular, it identifies relevant It is also important to note that the impact of NPL levels empirical studies that illustrate how effective ICR systems is only one positive outcome of improved ICR systems. can help mitigate the rise in NPLs and resolve existing NPLs, Strengthening a country’s ICR system has also been shown potentially strengthening overall financial sector stability and to have effects associated with a lower cost of credit; an limiting credit misallocation. The scope of this note is limited increased availability of credit; increased returns to creditors; to the relationship between ICR regimes and NPL levels, job preservation through reorganization frameworks; and although it is important to note that ICR regimes are only one promotion of entrepreneurship. These other benefits of a possible set of complementary tools for dealing with bank NPL sound ICR system have been explored in more detail in earlier problems and that broader institutional, regulatory, and legal publications (World Bank 2014a). reform are likely to be needed for a more comprehensive NPL Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 5 >>> High Levels of NPLs Can Impact Financial Sector Stability In modern economies, banks are typically the primary financial (Inaba et al. 2005), as more income is channeled into debt intermediaries and are fundamental to a stable financial servicing (Aiyar et al. 2015a; European Banking Coordination system, one that is “capable of efficiently allocating resources, “Vienna” Initiative 2012, Section 2). Increases in NPL levels assessing and managing financial risks, maintaining are accordingly associated with a significant negative impact employment levels close to the economy’s natural rate, and on credit, inflation, and real GDP (Klein 2013, Section IV). eliminating price movements of real or financial assets that will affect monetary stability or employment levels” (World Bank When NPL levels rise, banks are required to raise provisions 2016a). When banks are not able to recover the money lent, and hold more regulatory capital, impairing their balance the financial system and the economy at large may suffer.1 sheets (Miglionico 2019). The balance sheet impact is often aggravated by the associated private sector debt overhang Despite standardization efforts by international standard- problem, as weak demand for credit also contributes to setting bodies (Basel Committee on Banking Supervision shrinking bank profits (Council of the European Union 2017), NPLs are still defined in various ways.2 In most 2017, Chapter 2). These compounded effects often lead to jurisdictions, NPLs are defined as bank loans that have bank failures (Lu and Whidbee 2013), and can represent a been delinquent for more than a specified number of days, significant threat to the stability of the financial sector (Bottazzi, usually more than 90, or which are deemed unlikely to be paid De Sanctis, and Vanni 2010). according to predefined criteria -known as “unlikely to pay” or “UTP” criteria- (Basel Committee on Banking Supervision It is therefore important to adequately understand all forces 2017).3 NPL levels — calculated as the ratio between NPLs affecting NPL levels and what measures can be put in place and total bank loans — are largely driven by macroeconomic to decrease them once they rise. The importance of this conditions (Ari, Chen, and Ratnovski 2019), but they can understanding is heightened at a time when the COVID-19 themselves have significant impact on the economy through pandemic threatens to trigger liquidity and solvency crises strong feedback effects (Klein 2013, Section IV; Beck, around the globe (Adrian and Natalucci 2020; Ari, Chen, Jakubik, and Piloiu 2013). In particular, high NPL levels and Ratnovski 2020a), particularly as NPL levels were seen undermine bank lending and, more generally, the supply of to sharply increase during previous crises (Ari, Chen, and credit, with disproportionately negative effects for small and Ratnovski 2019). The rest of this note focuses on the role medium-sized companies (Klein 2014; Cucinelli 2015). High that ICR systems have in mitigating the rise of NPLs and in NPL levels also hamper investment by overleveraged firms facilitating their resolution. 1. Deterioration in asset quality is not the only channel of potential financial instability. Importantly, others relate to the liability side of banks’ balance sheets (for instance, when liquidity problems morph into solvency issues). We thank Pietro Calice for this comment. 2. Moreover, the rigor of actual enforcement shows important differences, even between jurisdictions with similar regulatory definitions. The authors thank Miquel Dijkman for suggesting this addition. 3. Again, these criteria vary across countries and institutions. As such, the IMF states that loans may be classified as NPLs when (unspecified) “evidence exists to reclassify them as nonperforming even in the absence of a 90-day past due payment, such as when the debtor files for bankruptcy” (see International Monetary Fund 2019, 192). Similarly, the European Central Bank also includes in its NPL definition loans for which “the debtor is assessed as unlikely to pay its credit obligations in full without reali- zation of collateral, regardless of the existence of any past-due amount or of the number of days past due” — without specifying how that “unlikeliness” is to be evaluated and noting, instead, that it is for banks to have clearly defined internal criteria to identify indicators of unlikeliness to pay (UTP). See European Central Bank 2017, 50. Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 6 >>> Effective ICR Regimes Facilitate Debt Recovery and Affect NPLs In this note, ICR is broadly defined as the set of prerogatives of insolvent entities in a collective manner,”4 while trying to that supply “efficient, transparent, and reliable methods for accommodate a balance between creditor recovery and recovering debt, including the seizure and sale of immovable debtor protection (La Porta et al. 1998). and movable assets and sale or collection of intangible assets” (World Bank Group 2016b). Debt recovery methods include ICR regimes have an impact on both the likelihood of a bilateral debt enforcement processes — both in and out of borrower defaulting as well as on the tools that banks can use court — as well as the insolvency system. The latter include to maximize creditor recovery when a borrower does default. tools ranging from informal out-of-court workouts and pre- Data shows that increased creditor recovery is positively insolvency proceedings to formal proceedings and provide associated with higher levels of credit to the private sector for an “orderly process for the reorganization or liquidation (Figure 1). > > > F I G U R E 1 - Recovery Rate and Domestic Credit to Private Sector 100- Recovery rate (cents on the dollar) 75- 50- 25- Correlation = 0.6179 R2 = 0.3818 0- - - - - - 0 50 100 150 200 D O M E S T I C C R E D I T T O P R I VAT E S E C T O R ( % O F G D P ) East Asia and the Pacific Latin America and the Caribbean OECD Sub-Saharan Africa Europe and Central Asia Middle East and North Africa South Asia Source: World Bank Group Indicators and Doing Business 2020 4. See Menezes 2014, the previous World Bank Group Viewpoint on debt resolution and business exit, describing, among other things, the positive association between more effective ICR regimes and wider access to credit and the negative relationship of the former with the cost of credit. Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 7 Additional analysis on strong ICR regimes’ positive seen as the enhanced protection of creditors’ security effects on private sector development, particularly credit, interests), borrowers tend to diversify acquisitions, invest in entrepreneurship, and growth have been set out in related high recovery assets, reduce cash-flow risk, and deleverage notes (World Bank Group 2014a). Moreover, other World Bank their balance sheets (Acharya, Amihud, and Litov 2011). publications describe specifically the benefits of ICR systems in Moreover, the adoption of effective ICR measures reduces crisis situations, including to address debt overhang, facilitate default rates, resulting — at least in the short-term — in lower restructurings, preserve employment, and ensure micro and NPL occurrence (Padilla and Requejo 2000). For instance, small businesses are able to effectively exit the market (World India established Debt Recovery Tribunals (“DRT”) — quasi- Bank Group 2020a, 2020b, 2018, 2017). legal institutions introduced by the government in 1993 to improve the speed of debt resolution and creditor recovery in The World Bank Principles for Effective Insolvency and the country — that have been associated with reductions in Creditor/Debtor Regimes (the “Principles”) and the UNCITRAL loan delinquency. Indeed, a 2009 study analyzing long-term Legislative Guide on Insolvency Law (the “Legislative Guide”) loan data from a large Indian bank found that the introduction have been recognized by the Financial Stability Board as of DRTs led to an increase of up to 11 percent in the likelihood representing the international consensus on best practices that loans were repaid within 180 days (Visaria 2009, 59). for evaluating and developing national insolvency regimes, including enhancing creditor rights. The Principles provide best The evidence suggests that, all other conditions remaining practice benchmarks for ensuring ICR regimes can facilitate the same, reforming ICR systems could help decrease NPL the survival of viable but distressed firms, help reduce the risk occurrence. This evidence is supported by a study on NPL associated with lending to such firms, and ease the exit of determinants in 36 Middle East and African (MENA) banks nonviable, insolvent firms (World Bank Group 2016b). finding that stronger legal rights (as measured by the legal rights index of the World Bank’s Doing Business) are associated with Policy makers are increasingly reaching consensus regarding lower NPL levels (Boudriga, Taktak, and Jellouli 2010).8 It is the positive influence of effective ICR regimes on addressing worth noting, though, that increases in ICR effectiveness have NPL levels (Council of the European Union 2017, Chapter 4; also been found to widen access to credit and to prevent the European Banking Authority 2016, 34), and this note focuses exclusion of lower-grade borrowers from the market (Jappelli, narrowly on examining this issue.5 The evidence supporting Pagano, and Bianco 2005; Haselmann, Pistor, and Vig 2009; ICR regimes’ effects on both the likelihood of loan repayment Houston et al. 2010; Vig 2013). As these effects are associated and the frequency and magnitude6 with which bank loans with riskier lending, the aggregate effect of ICR frameworks on become nonperforming (“NPL occurrence”) is examined in NPL occurrence might be described as ambiguous. section I below. Sections II through V review the extent to which ICR regimes facilitate the effective management or resolution of nonperforming loans (“NPL resolution”).7 II. Effective and faster enforcement mechanisms reduce cumulative I. Effective ICR regimes can losses suffered by banks and are improve the likelihood of loan associated with lower NPL levels. repayment, resulting in lower NPL occurrence. Effective ICR frameworks, which are often found in more developed credit markets, protect creditors by minimizing the time required for them to enforce their rights against defaulting Strong ICR regimes have been found to improve loan borrowers (Dam 2006). By contrast, legal environments where repayment and decrease borrowers’ risk-taking behavior. contract enforcement — including enforcement of debt contracts Particularly when faced with stronger creditor rights (generally — is slower, curtails creditors’ ability to recover their loans. 5. Other World Bank Group publications address some of the legal challenges affecting NPL resolution. See, for example, Cerruti et al. 2019, Chapter 2. 6. The expected loss to banks from their loan portfolios is calculated based on both the probability of the loans defaulting and the magnitude of the losses experienced, if and to the extent that such loans default (see Heitz and Narayanamoorthly 2020). 7. At times, countries report NPL ratios that may to some extent distort the underlying economic realities. While this problem is especially relevant in the context of cross-country analysis, the papers reported in this policy note deploy a battery of econometrical tests to attempt to control for these distortions. 8. Based on data collected from 36 commercial banks located across 12 MENA countries for the period 2002–2006 and information from the “legal rights index” of the World Bank Doing Business Report, the paper found that countries with more effective legal rights have lower NPL levels, a result that is highly statistically significant. Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 8 Few investigations have been made into the impact of on their effects, particularly on NPL levels. The formal nature alternative enforcement mechanisms on NPL levels. What of pre-insolvency tools, in turn, has permitted an incipient evidence is available, however, suggests that out-of-court accumulation of research on their effects on NPL ratios. mechanisms for the enforcement of creditor rights might help reduce bank losses from NPLs. A 2014 article investigated the NPL data from EU Member States for the period 2007–2012 impact of regulatory and enforcement changes on mortgage was analyzed in a 2015 paper in light of the level of pre- lending and risk in India, where the introduction of the Securitisation insolvency efficiency in the different Member States, as and Reconstruction of Financial Assets and Enforcement of measured according to 12 indicators (Carcea 2015).11 These indicators were designed to assess the ease with which firms Security Interest Act 2002 (SARFAESI) strengthened out-of- in each jurisdiction can restructure debt before insolvency court enforcement rights. Specifically, following the reform, arises and reflect, in particular, four composite dimensions of financial institutions and asset reconstruction companies may pre-insolvency efficiency: (i) easiness/availability of preventive take enforcement actions without court intervention where a measures; (ii) efforts to facilitate continuation of debtors’ nonperforming asset is secured, is over minimum threshold operations; (iii) direct and indirect costs of the measures; and amount (Rs.100,000), and accounts for more than 20 percent of (iv) debt sustainability. The results show that more efficient pre- the borrower’s outstanding debt. By looking into loan-level data insolvency mechanisms increase the rate at which NPL levels from a large Indian mortgage provider and analyzing expected decline and return to normal in the aftermath of macroeconomic losses following short-term loan delinquency before and after shock. In particular, countries in the upper tercile of restructuring the introduction of SARFAESI, the authors found a negative efficiency — which includes early-warning procedures, better association between improvement in out-of-court enforcement majority decision options, and better debt discharge possibilities rights for banks and losses from NPLs. The effect appears — increased the adjustment speed of the NPL rate by almost to be concentrated on the worst cases of delinquent debtors 14 percentage points relative to those in the lower tercile. (Campbell, Ramadorai, and Ranish 2015).9 Faster court enforcement also links to NPL levels. After controlling IV. Effective insolvency regimes for macroeconomic and bank-specific variables, a recent paper can facilitate NPL resolution. on the determinants of NPL levels in 140 large European banks found that the number of days required to enforce contracts in each jurisdiction can have a statistically significant impact on NPL The role of effective insolvency regimes in strengthening levels. More specifically, a reduction of 30 days in the average creditor recovery has been clearly established in the literature. time required to enforce a contract (as measured by the World Insolvency regimes provide a range of tools facilitating firm Bank’s Doing Business)10 is associated with a mean decline of restructuring and liquidation with the overall objective of the NPL ratio of 0.24 percentage points (Cerulli et al. 2017). maximizing creditor recovery and allocating risk among stakeholders in a predictable, equitable, and transparent manner (White 1994). Effective insolvency regimes can also III. Efficient pre-insolvency play a positive role in facilitating NPL resolution. mechanisms can increase the A recent paper studied the link between insolvency frameworks adjustment speed of NPL levels. and NPL resolution in EU and OECD countries between 2003 and 2016 (Consolo, Malfa, and Pierluigi 2018). The study constructed an insolvency framework index based on World Pre-insolvency tools include various legal mechanisms Bank Doing Business data from three separate indicators that facilitate restructuring at a stage before a firm is legally (Getting Credit, Enforcing Contracts, and Resolving Insolvency). insolvent and enters formal insolvency procedures. These The findings suggest that jurisdictions with stronger insolvency mechanisms complement out-of-court workouts and core frameworks are able to adjust NPL levels faster. Moreover, insolvency regimes (see section IV). While out-of-court stronger insolvency frameworks are associated with faster private workouts have come into wide use to facilitate NPL resolution sector deleveraging, both for households and for nonfinancial during financial crises (Claessens 2005), their confidential corporations. These results highlight the potential of insolvency nature has limited the development of an empirical literature frameworks to facilitate economic recovery (Carcea et al. 2015). 9. Notably, a larger impact was caused by a change in the regulatory classification of NPLs (from 180 days delinquent to 90 days delinquent). 10. World Bank Group “Doing Business — Enforcing Contracts” data is available at https://www.doingbusiness.org/en/data/exploretopics/enforcing-contracts. 11. NPL data derives from the IMF Financial Soundness Indicators for the period 2007–2012. The IMF Financial Soundness Indicators can be found at https://data.imf. org/?sk=51B096FA-2CD2-40C2-8D09-0699CC1764DA. Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 9 V. Targeted NPL reform fosters the NPL ratios in a particular country fell by at least seven percentage points) and the responses associated with them. economic growth. These NPL reduction episodes were then divided into two categories: (i) reduction episodes in which countries had adopted targeted measures for the active reduction in their In light of the evidence that high NPL levels have a negative stock of NPLs (including encouraging the move of NPLs into impact on the economy and may, in certain cases, pose a asset management companies, facilitating the restructuring threat to financial stability, it is not uncommon for policy makers of NPLs, and reforming insolvency laws); and (ii) reduction to seek measures to reduce NPL levels — but, as discussed episodes in which countries enjoyed or engineered a growth in above, more than one policy approach can contribute to a new loans. A control group was also compiled from countries comprehensive NPL strategy. Since NPL levels reflect the that had experienced NPL ratios in excess of 7 percent for ratio between NPLs and total loans, policy makers can combat three years in a row but no action was taken to address them high NPL levels by specifically targeting defaulted bank loans and, simultaneously, credit failed to grow (Balgova, Nies, — in particular by strengthening ICR regimes (“targeted NPL and Plekhanov 2016, 3). The study found that countries that reform”) — or by fostering total loan growth. actively attempted to reduce NPLs during the sample period (category (i)) achieved more economic growth than countries A 2016 paper surveying a sample of 100 countries during the (in the control group) that failed to take any action to combat period between 1997 and 2014 sought to measure the relative their NPL levels; the differences revealed were as much as impact of these two approaches to banks’ NPL problem. More a 3 to 4 percentage point increase in GDP growth and a 13 specifically, a cross-country dataset was built containing 73 percentage point increase in investment growth.12 NPL reduction episodes (defined as events during which 12. These results were on par with those of countries that reduced NPL levels following a growth in new loans. Equitable Growth, Finance & Institutions Notes | How Insolvency and Creditor/Debtor Regimes Can Help Address Nonperforming Loans <<< 10 >>> Conclusion NPLs have significant negative impact on the financial system effective insolvency frameworks are all associated with a and the economy as a whole. In addition to affecting economic statistically significant positive impact on reducing NPL levels development through various supply channels — curtailing or accelerating the speed with which these levels are reduced access to credit, discouraging investment, and aggravating — countries that take an active stance against NPL levels unemployment rates — high NPL ratios also represent a experience more growth than countries that fail to adopt any significant threat to financial stability, with important systemic measures to combat these loans. consequences. The lessons described above might be especially relevant as The evidence described in this Policy Note suggests that ICR the world learns how to deal with the economic effects of the reform can be a powerful tool for combating the NPL problem. COVID-19 pandemic, which is expected to lead to a sharp Indeed, a growing number of studies suggest that effective ICR increase in NPL levels in numerous jurisdictions (Laeven and regimes, particularly those promoting strong creditors’ rights, Laryea 2009, 3; Jassaud and Kang 2015, Part III). Facilitating have the effect of decreasing the frequency and magnitude with a faster and stronger economic recovery will require policy which loans become nonperforming. Evidence also shows that makers to mobilize the full range of tools available to them for more effective ICR regimes can further contribute to improving addressing NPL levels, and in this context, the importance of NPL resolution. 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