,n.~ Economic Development Institute 9J~-r of The World Bank Financia l Instituti ons in Djstress: Causes and · Remedie s Paul A. Popiel EDI WORKING PAPERS · FINANCE, INDUSTRY AND ENERGY DIVISION Fina ncia l Insti tutio ns in Distr ess: Cau ses and Rem edie s Paul A. Popiel Prepare d for the Asian Seminar on Financi al Structur e and Policy Bombay , Februar y 9-20, 1987 Abstract This paper examines the phenomeno n of financial distress that has taken on worldwide dimensions in the late 1970s and in the 1980s. It traces the causes back to external and internal shocks that affected developing countries during that period and to manageme nt problems. It further outltnes various options and steps leading to a restructuri ng of distressed financial institutions . The macroeconomic and sectoral prerequisit es conducive to financial restructur- ing are also examined. The author is Senior Financial Economist at the Economic Development Institute of the World Bank. EDI Working Papers are intended to provide an informal means for the preliminary disseminati on of ideas within the World Bank and among EDI's partner institutions and others interested in developmen t issues. Copies are available from Edith A Pena. The Economic Developm ent Institute of The World Bank Septembe r 1988 EDI Catalog No. 340/024 The findings, interpretations, and conclusions expressed in this document are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organiza- tions, or the members of its Board of Executive Directors or the countries they represent. Copyright © 1988 by the International Bank for Reconstruction and Development The World Bank enjoys copyright under protocol 2 of the Universal Copyright Convention, This material may nonetheless be copied for research, educational, or scholarly purposes only in the member colDltrieS of The World B8!11c. Material in this series is subject to revision. The views·and interpretations in this document are those of the author(s) and should not be attributed to the EDI or to The World Bank. H this is reproduced or translated, EDI would appreciate a copy. i Abstract This paper examines the phenomenon of financial distress that has taken on worldwide dimensions in the late 1970s and in the 1980s. It traces the causes back to external and internal shocks that affected developing countries during that period and to management problems. It further outlines various options and steps leadinq to a restructuring of distressed financial institutions. The macroeconomic and sectoral prerequisites conducive to financial restructuring are also examined. The author is Senior Financial Economist at the Economic Development Institute of the World Bank. The author is grateful for the comments and assistance of Mr. Aristobulo de Juan, Senior Financial Advisor, financial Policy and Systems Division of the World Bank. This paper was presented at the Asian Seminar on Financial Structure and Policies that was held in Bombay in February, 1987. ii Introduction 1 causes of Financial Distress Among Institutions . . . . . 1 Macroeconomi c . . . . . . . . 1 Sectoral . . . . . . . . . . . . . . 4 Institutiona l . . . . . . . . . . 5 The Choice: To Liquidate or Restructure . . . . . • • . . 8 Resistance to Bankruptcy . . . . . . . . . . 9 The Nature of the Problem . . . . . . . . . . . • . • 10 Early Warning Signals . . . . . . . . . • . . 11 The Case for Government Intervention . . . . . • 11 Restructurin g Financial Institutions 12 Role of the Public Sector . . . . . . . • . • • . 13 · Flow of Funds Solutions . . . . . . . . . . . 13 Liquidity Measures . . . . . . . 13 Direct Liquidity Measures . • • . . • . 13 Indirect Liquidity Measures . . . . • . • • 13 Profitabilit y .·Measures . . . . . . . . . 14 Direct Profitabilit y Measures . . • . • 14 Indirect Profitability Measures 15 Stock Solutions 15 Market Response . . . . . . . • . . . . 15 Recapitaliza tion . . . . . . . . . 15 Involvement of Public Institutions . . . . 17 Degrees of Government Control . . . . . . . 17 Role of the Private Sector . . . . . . . . . . . . . . 17 Financial Restructurin g . . . . . . . . . 18 Table 1: Financial Restructurin g Options (18) Increasing the Equity Base . . . . . . . . . 18 Liability Management . . • . . . . . . . . 20 Asset Management • . . . . . . . . . . . 22 Direct Asset Management . . . . . . . . 22 Indirect Asset Management . • . • . 22 Risk Management . . . . . . . . . . . . 23 Table 2: A Classificatio n of Innovations by Risk Management Function (24) Restructurin g Real Assets . . . . . . . . 25 Restructurin g Intangible Assets . ~ . . . . . . . 25 Management . • . . . . . . . . . . . . . 25 Organization • . . . . . . . . . . . . . . . 25 Operational Efficiency . . . . . . . . . 26 The Merger Option . . . . . 26 The Macro Context of Restructurin g 26 Macroeconomi c Stabilizatio n 27 Capital Markets Development 28 Banking Regulation . . . . 28 iii Supervision . . . . . . . . . . . . . . . . . . . 29 Deposit Insurance Schemes . . . . . . . . . . . . 30 Restructuring and Allocation of Losses . . . . . . . 31 Alternative Patterns of Allocations of Losses 31 Guiding Policy Factors to Restructuring . . . . . 33 1 FINANCIAL INSTITUT IONS IN DISTRES S: CAUSES AND REMEDIES Introdu ction Financi al distress among financia l institut ions be'Came a sectorw ide phenome non in the last decade. Financi al distress has always been a feature of the financia l scene, but most of the time it was associat ed with sectora l problem s (such as those affectin g industri es in transiti on), or institut ional problem s (managem ent problem s, for example ). Today, the number of insolven t financia l institut ions is without precede nt in this century. In Latin America , almost all economi es have been affected . In Chile, Argentin a, and Bolivia , financia l distress took sectorw ide proport ions. In Colombi a, Ecuador , and Brazil, a signific ant number of individu al financia l ·institut ions became distress ed. In Asia, the governm ents of' the Philippi nes and the Republic of Korea had to rescue or restruct ure a number of private and state-ow ned institut ions. Banks and other financia l institut ions in Europe, the Middle East, and North Africa have had .serious troubles . In the United States, the situatio n is worrisom e. While in 1981, 10 U.S. banks failed, by 1986 the number of failures had reached a postdep ression high of 138, and one out of five savings and loan institut ions was insolven t or close to insolven cy. The causes of financia l distress can be found at the macroeco nomic level, at the sectora l level, and at the institut ional level. Hitherto , little has been publishe d about financia l distres s. This paper summari zes some of the features of the World Bank's experien ce in this field. To that end it draws. on interna l Bank literatu re on this topic, includin g Determi nation of Bank Managem ent as a Major Element in Bank Crises and From Good Banks to Bank Banks, both by Aristobu lo de Juan, Financi al Crises in Develop ing Countri es, a draft paper by Manuel Hinds, Crisis in the Financi al Sector, by Millard Long, and Managing Financi al Adjustm ent in Middle- Income Countri es, by Alan Roe and Paul A. Popiel. causes of Financi al Distress Among Institut ions Macroec onomic In contras t to the stabilit y that prevaile d in the 1960s and the early part of the 1970s, the late 1970s and the 1980s were a period of instabi lity for financia l systems . Until 1973, internat ional commod ities 'prices, domestic prices, interes t rates, and exchange rates were relative ly 2 stable in most countries. In that context, low inflation and positive real rates of interest (negative real rates ·an deposits were a problem only in a minority of countries with high inflation) made the holding of financial assets attractive. As a result, in developing countries, domestic resources financed a large share of domestic investment: during 1965-1973, national savings on average accounted for about 80 percent of total investment. From 1974 onward, a number of macroeconomic developments led to financial instability in many developing and developed countries, first in a context of international expansion, and later in a context of international contraction. Between 1974 and 1980--a period of international expansion--non oil commodity prices on the whole stayed high, which benefited many countries' terms of trade. International bank lending increased sharply as oil resources were recycled, but at the same time inflation became widespread. In that context, rampant financial repression in many developing countries stalled financial deepening and contributed to a perverse set of incentives that encouraged external borrowing. With the mobilization of domestic financial resources constrained by negative real deposit rates and the easy availability of . external loans, countries with expansionist policies borrowed abroad to maintain growth, finance their trade deficit, and increase investment. Quite often this borrowing, mainly at commercial rather than concessional terms and at variable interest rates, was made even more attractive by overvalued exchange rates. Furthermore, in many countries, only part o'f the external borrowing went to finance investment. Another part was recycled back into the international financial system through capital outflows resulting from financial asset holders' lack of confidence in domestic policies and from insufficient incentives to hold domestic assets. The second oil price increase in 1979 and the subsequent recession in the developed countries triggered a period of international contraction. For non oil producing, developing countries, terms of trade fell drastically. Real interest rates rose in international capital markets, sharply increasing many countries' debt service. Growth sagged. International banks began to reduce their lending on a voluntary basis. As a result, an increasing number of countries became unable to meet their debt service obligations and were obliged to seek rescheduling. Most affected were countries with large amounts ·o·f short-term · .v ariable debt. In this adverse context, many developing countries were forced to undertake radical stabilization programs. These program~ included most of the time sharp 3 devaluations (for a sample of 35 developing countries, the average rate was 24 percent per year during 1981-1983), substantially higher domestic interest rates, and stringent credit controls. Another macroeconomic cause of financial distress was the existence, in many developing countries, of inward- oriented policies reflected in high tariff and nontariff protection to local industries. These policies prevented the development of efficient manufacturing industries in general and export industries in particular, and made local production dependent upon imported raw materials and intermediate goods. They caused large current account deficits when the rate of expansion of domestic demand exceeded the rate of growth of export revenues, either because of excessively expansionary policies and/or downturns in terms of trade. To sum up, the major macroeconomic causes of financial distress were: o the use of expansionary policies to maintain growth in the late 1970s and the early 1980s; o the use of external credit to finance the deficits caused by these expansionist policies; 0 the resulting inflation; o the overvaluation of domestic currencies; o the existence of inward-oriented policies. These macroeconomic. and sectoral developments distorted relative prices and diverted credit flows toward consumption, production for the domestic market, and real estate speculation. They also had devastating effects on the income flows and financial structures of economic agents, enterprises, and financial institutions. Financial institutions were hit twice: indirectly, through the deterioration of the financial situation in the corporate sector, their main customer, and directly, through the impact of these developments on their own incomes and their financial structures. While financial instability became widespread in the 1980s, the intensity of its impact varied markedly across the developing world. Most affected were economies of Latin America, the Middle East, and North Africa. In the 1970s, many of these economies became overheated with high inflation _ and low or negative real interest rates. This situation constrained the countries' ability to mbbilize domestic 4 financial resources and increased their dependency upon foreign borrowing to finance their deficits. When foreign funds became scarce and expensive, they were obliged to take dr~stic adjustment measures to reduce the deficits. Many of the· economies in Sub-Saharan Africa followed a similar pattern. Countries in Asia were on the whole less affected. For several of them, external trade accounts form only a small part of the gross domestic product, and their external borrowing at commercial terms was low. Hence, they suffered less from external shocks. Others with important external trade and foreign borrowing did not let their economies get overheated and made relatively rapid adjustment to external shocks. Finally, structural and sectoral adjustment--in particular the trade and financial liberalization that is taking place in a growing number of countries--tends to destabilize ·portfolios, even if temporarily. Lowering of protection, deregulation of interest rates, adjustment of prices and exchange rates, and decontrol of credit have all jolted local economies. Lowering of protection translates into lower profits · to protected enterprises on which financial institutions may have substantial claims, since these enterprises were generally profitable prior to the trade liberalization. Interest rate deregulation may cause a widening of the lending spread, that is, lower deposit rates and higher lending rates, or it may push interest rates up because of distress deposit bidding by the worse-off intermediaries. In contrast, a rise in real rates may result in many firms becoming insolvent, which in ·turn affects financial institutions' portfolios. The experiences of countries like Chile, Uruguay, Jamaica, Portugal, Turkey, and Korea are illustrations of the short-run financial and economic imbalances that may follow adjustment and · liberalization measures. Sectoral Several sectoral problems compounded the macroeconomic ones. In most developing countries during the 1970s, financial systems were repressed with financial prices--interest rates and foreign exchange rates--distorted and maintained arbitrarily below inflation rates. Concurrently, abetted by inflation, governments were extracting a substantial seigniorage from the financial systems. As a result, the real value of financial assets was eroded, and their holders opted out, preferring to hold external financial assets or real assets instead. This led to disintermediation and to the shrinkage of financial systems. . It also reduced the availability of . domestic loanable funds, forcing economies to borrow in the external markets. In many developing countries, -governments also 5 regulated all or part of the credit allocation, giving .. priority to activities with perceived high social returns (but often with quite low economic and financial returns), or to public over private enterprises. Many of these directed credits ended up as nonperforming loans. A third sectoral problem in several developing countries was credit concentration. It was particularly severe when caused by conglomeration, that is, by common ownership of banks and firms. There are several incentives to common ownership for both bank and firm owners. Such ownership ensures the availability of credit, internalizes profits, and finances new acquisitions and speculation. These incentives usually lead to the emergence of conglomerates. The incentives are enhanced when one of the parties to the conglomerate has access to subsidized--that is, below market rates--credit. One way for a bank to have access to subsidized credit is to buy the enterprise that benefits from it. Conglomerates were strongly hit in many countries when the international contraction came in the 1980s, accompanied by . a liquidity squeeze. Excessive concentration of credit as well . as many other injudicious operations were facilitated in countries where the regulation of the financial system was inadequate and/or the supervision insufficient. In many developing countries, financial systems regulation tends to be patchy and to lack coherence because regulations have been expanded piecemeal to specific problems. Regulations also tend to concentrate on the deposit banks as a group and to neglect the other financial intermediaries. In many countries supervisory agencies tend to emphasize "passive supervision," that is, verification of the conformity of banks' procedures with the prevailing regulations, at the expense of "active supervision," which can be defined broadly as an in-depth assessment of the quality of management, of the risk factor, and of the institution's portfolio. In times of financial instability, passive supervision is usually insufficient to signal deterioration in an institution's financial situation early enough. Also, many supervisory agencies lack the expertise to monitor complex financial operations, such as risk exposure in foreign exchange operations. Institutional Problems at the institutional level included excessive loan concentration and conglomeration that have been discussed already, but others, the majority, can be related .directly or indirectly to instit~tional · m~nagement. 6 The deteriora tion of financial institutio ns is a product of many factors. Two major factors are economic condition s and managemen t. In several cases the former leads to the latter. Financial institutio ns headed by weak managemen t are usually the first ones to fell prey to deteriora ting economic condition s because an adequate managemen t is more adept at dealing with changing economic condition s. · Data on financial institutio ns in distress in several countries indicate that specific managemen t weaknesse s, particula rly in the lending area, are a frequent initial cause of financial distress. For many ins ti tut ions the process of deteriora tion begins with poor lending practices . Manageme nt's lack of attention to the details of the loan function opens the door to credit weaknesse s and leaves the banks vulnerabl e to economic change. · If not dealt with in a timely and adequate way, nonperform ing loans and associated problems tend to accumulat e rapidly. Deteriora tion of the managemen t culture is one of the consequen ces of not resolving problems as well as the cause of long-lasti ng problems (see papers by Aristobul o de Juan cited in the introduct ion). The attitude and behavior of top managemen t permeate middle managemen t and other organizat ional layers. A bad managemen t culture is very difficult to change, and the change for the better may take as long as the change for the worse, unless several layer~ of managemen t are changed at once. This is one of the reasons why experts often advocate mergers a~ a solution to · crises that originate d in managemen t shortcomi ngs. Deteriora tion in the managemen t culture is usually a process that takes place in four principal stages, namely: o . technical mismanage ment, o cosmetic managemen t, o desperate managemen t, and o fraud. Technical mismanage ment involves inadequat e policies, procedure s, and practices , for example overexten sion, poor lending procedure s or practices , or poor planning. Overexten sion arises from (a) establish ing lending policies that lead to an expansion of loans out of proportio n to the bank's capital; (b) diversify ing operation s into geographi cal areas or sectors of economic activity unfamilia r to the bank; and (c) marketing financial products and services in which the promoting bank has neither the competiti ve edge nor the requisite experti~e. 7 Poor lending arises from such activities as, f9r instance, undue concentration on a single borrower or sector, or connected !endings. The best and most common example of mismanagement of assets and liabilities is mismatching maturities and prices. The classic situation is the granting of long-term fixed rate loans funded from variable rate short-term deposits. If sectorwide rigidities in term transformation mechanisms exist, then illiquidity or disintermediation crises may occur. This has happened to financial institutions ranging from United States saving and loans institutions, to Colombian financieras, to housing-finance institutions in countries such as Brazil, Chile, and Jamaica. Lack of internal controls involves, for instance, inappropriate credit reviews and/or end procedures, insufficient information systems, failure to detect arrears in a timely fashion, inadequate internal audits, and increased probability of lending to uncreditworthy borrowers. When technical -" mismanagement causes losses or cuts in dividends, it frequently leads to cosmetic management. This entails hiding losses so as to buy time and remain in control and typically leads to manipulation. Management may resort to reducing the level of undistributed profits to maintain a predetermined level of dividends, thereby undermining the capital base. When further reduction of undistributed profits is not possible, net profits may be manipulated. Another quite frequent method· i .s to provision less for losses than required. This is done via 11 evergreenin9" procedures, artificial forms of collateralization that are either. economically insufficient to cover the debt or impossible to foreclose on. Evergreening involves the automatic ·rescheduling and rollover of loans. This method allows manage~ent not to classify the unpaid loans as overdue, or even not to write them off as a loss, but rather to hide them in the current portfolio and accrue uncollectible interest as income. The most serious loan problems are almost always to be found in the portfolio that banks have labelled current. The transfer of resources to borrowers that may have negative equity, current losses, or negative cashflows has adverse effects on the allocation of resources and delays economic development by creating a vicious circle. The transfer of additional resources to borrowers may have devastating effects. It delays economic development by misallocating resources and depricing more creditworthy companies of these resources, and adversely affects investment. A shortage of investment funding for new and creditworthy enterprises and .projects is one of the most perverse effects. of financial distress. 8 Other means of m·anipulating net profits are, for instance, reevaluation of fixed and intangible assets or advance accrual of income, concurrent with the postponing of acc~ual of expenditure. When management faces the prospects of "having to declare" a capital loss or to pay fewer or no dividends, then, besides engaging in cosmetic management, it may resort to practices that could boost liquidity or provide a quick injection of income. Such practices include paying rates above market levels--as many ailing thrift institutions have done in the United States--or increasing borrowing r ·a tes to levels that only attract distressed borrowers--t hat is, the class of debtors that is least likely to repay--as many banks did in Bolivia in 1985--or, finally, purchasing real estate or speculative stock in times of inflation. When management is faced with illiquidity or insolvency, it may resort to fraudulent practices, for instance, trans~erring remaining assets by lending to companies in which the banker has an interest. The Choice: To Liquidate or Restructure If as a result of adverse macroeconomi c or microeco~omic developments a financial institution finds itself in a situation where its equity is persistently eroded, corrective measures are called for. At that point, if the management or the supervisory authority do not react constructive ly, the institution will most likely start on the slippery slope from technical mismanagemen t. ~o desperate mismanag~ment. Hence, it is never too soon to react to a deterioratin g financial situation. The first and usually the most difficult step for management, boards of directors, monetary authorities, and governments alike is to recognize the deterioratin g situation and the existing or future losses. Indeed, this recognition may bring into the open wrong · macrosectora l/microecono mic policies or shortcomings in the decision-mak ing process, or reveal restrictive monetary and financial policies. Also the recognition of losses can adversely affect the public's confidence in the banking system, accelerate capital flight, and worsen the already existing financial distress. Once this "losses recognition" bridge is crossed, then, as a policy, the sooner corrective measures are taken, the better it is for depositors, borrowers, the institution, the financial sector, and the economy in general. Postponing-- a constant temptation-- is never a good policy. Hoping for improvement has usually proved ' wishful thinking. 9 Acting fast is of the essence, since the situation may spread to other institutions and ultimately to the whole sector. Reliance on market forces is one way to deal with an in~blvency problem. The market will evaluate whether the institution is worth more dead or alive. In the absence of a traded price, this evaluation of the financial value of the institution would reflect a combination of adjusted book value and of net present value of estimated future cashflows. In most of the cases the market resolves, or would resolve, such problems through bankruptcy, allocating the losses to the economic agents that suffered them. According to banking regulations in most countries, in the case of insolvency the institution's shareholders must restore the institution's equity through the purchase of additional shares. Otherwise the institution is liquidated or sold to new investors, a move that forces the initial shareholders and other holders of the liabilities of the failed institution to absorb the losses. Although the bankruptcy solution may be the first best solution in.a majority of insolvency cases, it is not the easiest one to implement. Resistance to Bankruptcy Resistance to bankruptcy is inherent in many aspects of the economic system. Firms accommodate one another's delinquencies, banks tolerate delinquencies on loans, depositors insured by deposit insurance or reassured by the presence of an interventionist central bank have confidence in financial institutions. Similarly, bankruptcy codes tend to protect debtors rather than creditors, an~ politicians will be reluctant to allow the demise of prominent financial managers. This aversion to bankruptcy, together with the tendency to provide bailout programs, distorts the risk- reward balance associated with investment in financial institutions. The provision of a financial safety net limits the downside risk. This is akin to granting an option to shareholders and creditors of financial institutions with the premium paid by the taxpayers. In essence, the general tendency is to socialize losses and privatize profits. But an opportunity cost is associated with funds used to restructure insolvent financial institutions. Bailouts may amount to a misallocation of resources, especially in cases of financial institutions that are not viable on an economic return basis, but only on a financial return basis due to market imperfections or subsidies. In these cases, bailouts merely postpone the inevitable real adjustment while risking an even greater collapse due to an overextended financial system. Moreover, · a certain incidence of financial failures, even of banks, must occur, as well as private losses of economic agents who have adopted imprudent or 10 injudicio us practices . To instill financial disciplin e and accountab ility, some financial institutio ns must fail and some risk-pron e depositor s lose their claims. The Nature of the Problem The nature of the problem will very much shape the correctiv e actions to be taken. Basically , the problem may be ' one of illiquidi ty or of insolvenc y. A firm that is having difficult ies meeting its current obligatio ns out of its cashflow is illiquid. This condition may be temporary , and given time a firm that is technical ly illiquid may be able to raise cash, pay its obligatio ns, and survive. That is, the firm may not have structura l problems with cash flow, profits, assets, and the compositi on of liabilitie s. As far as the financial institutio n is concerned , the causes of illiquidi ty may be internal or external. For instance, illiquidi ty .may be due to managemen t problems, in which case the cause i~ internal. But financial institutio ns may become illiquid because of their debtors' illiquidi ty problems, . which result in loan delinquen cies or even defaults. In this latter case, the cause is obviously external. Corporati ons may encounter illiquidi ty problems for many reasons: high inflation , high nominal interest rates, insuffici ent cash flows, insufficie nt assets, and so on. Insolvenc y, however, is a situation that indicates a chronic l ·e vel of over indebtedn ess. Insolvent firms may be illiquid, but their difficult ies are of a far more serious nature, reflecting a fundament al imbalance in the financial structure . A firm is insolvent when its liabilitie s exceed the fair and realizabl e value of its assets. This results iri a deficit equity. Whereas nonfinanc ial institutio ns may experienc e illiquidi ty despite underlyin g solvency, a peculiari ty of financial institutio ns is that most of the time insolvenc y precedes illiquidi ty. A financial institutio n may have lost its capital several times and still be liquid, provided that its net cashflow remains positive. The dimension of the portfolio , the leverage that financial institutio ns operate with, and their ability to raise money from depositor s, provided that there is no panic, allow them to operate for long periods even with negative equity capital. This has been, for instance, the case of many financial institutio ns in Bolivia after the very sharp adjustmen t of the economy in 1985. The ability to survive a state of inso~vency is one of the key differenc es between financial and nonfinanc ial firms. 11 It highlights the urgency of taking rapid preventive action when the financial situation of a financial institution seems about to deteriorate. It also highlights the importance of wat.c hing for early warning signals, and of adequate regulation and supervision, as the delayed consequences of a financial crisis heighten the risk and cost to the entire economy. ' Early Warning Signals To prevent sudden occurrence of a financial crisis a system is needed that is applied internally by management and externally by the supervisory authority. Internally, management should analyze the assets and liabilities structure on a continuous basis, regardless of whether a problem emerges or not. This is an essential part of the process of assets and liabilities management. All loans past due should be scrutinized. Externally, bank supervisors should look at early warning signs of illiquidity, including a pattern of poor- quality loans; rapid expansion in lending activity without a healthy, stable deposit base; mismatch in maturity structure; dependency on subsidized sources of funding; a protected customer base that lacks other borrowing avenues; a drop in dividends; and · poor management. The popular model for supervision of financial institutions is the CAMEL model used by the FDIC and FSLIC in the United States. CAMEL stands for o Capital adequacy, o Asset quality, o Management competence, o Earning strength, o Liquidity sufficiency. On a systematic basis, bank supervisors can apply predictive models, stich as multiple discriminant analysis, to detect the onset of financial problems. This statistical technique, similar to regression analysis, uses a variety of financial ratios to detect any significant deterioratio n in profitabilit y and liquidity. These include the current ratio, the debt-to-asse ts ratio, the quick ratio, and the average collection period. The Case for Government Intervention Once an institution is insolvent, correction measures are needed, but the market solution may be difficult to implement for the various reasons already mentioned. This is particularly true when the whole banking system is in distress and total equity is not sufficient to absorb losses, 12 as was the case in the first part of the 1900s. Moreove r, the failure of some banks could undermin e confiden ce in the banking system as a whole and lead to a run on deposit s. The financia l system' s capacity to mobilize resource s would be im~~ired and would affect adverse ly economi c activity and growth, with the result that losses to the economy and the general public could exceed the cost of the transfe r of resource s associa ted with the restruct uring of the insolve nt institut ions. Liquida tions are not only financi ally costly, but socially costly as well. In bankrup tcy proceed ings real and financia l resource s are consumed in litigati on, investm ent in human capital is lost togethe r with the institut ion's value as a going concern , includin g any intangib le assets such as good will. Finally , as the assets of the financia l institut ions are often liquidat ed at substan tial discoun ts, the buyers of these assets experien ce a windfal l gain at the expense of credito rs, and ultimat ely of savers. · Restruc turing Financi al 'Institu tions The restruct uring of financia l institut ions general ly involve s a governm ent entity, such as the superint endency of banks, or the central bank as monetary authori ty and lender of last resort, or an FDIC equival ent. Increasi ngly often, the process also includes a program establis hed by an outside special ist team. Such a program typicall y entails: o Verific ation of the bank's financia l situatio n, which often proves more serious than suspecte d. o A detailed busines s stateme nt program ing restruct uring of the bank through surgica l measure s, such as the sale of unneces sary assets and adminis trative streaml ining; reshuff ling of middle · managem ent; staff and overhead cuts; loan recovery ; loan securing ; liquidat ion of non-perf orming assets; revamped marketin g plans; new financia l services and product s; interes t-rate strategy ; and, in cases of fraud, institut ion of crimina l proceed ings. o Identifi cation of the financia l package for rehabil itation. This could include a recapit alizatio n by existing shareho lders, credit on deposit ors, outside investo rs, or a public agency; a program for dealing with custome rs' arrears; a write- off of bad loans and a partial absorpti on by the governm ent of the remainin g debt; a diversi fication of funding sources ; and risk managem ent. Financi al projecti ons would need to be undertak en. 13 Role of the Public Sector The following sections will examine the role of goyernment entities in the restructuring process in the context of solutions, which imply a once and for all adjustment--either in the form of recapitalization or loss absorption--and of flow of funds solutions. ' Flow of Funds Solutions Flow of funds solutions involve the granting of direct credit subsidies to improve liquidity and indirect subsidies to increase or achieve profitability. Liquidity Measures Liquidity measures can be undertaken either directly or indirectly, as explained in the following paragraphs. Direct Liquidity Measures. The bank could be forced to waive the distribution of dividends, thereby retaining profits to offset bad.. debts. This would cause shareholders to participate in the loss allocation process. The bank of Thailand requested this move from Siam City Bank in January 1987. The central bank could extend credit to the ailing institution in the form of soft loans, revolving lines of credit, and rediscount facilities, primarily for working capital purpose. This would be a means of liability management. · Indirect Liquidity Measures. The government could facilitate access to new sources of credit . by providing a guarantee or backup facility, such as a standby letter of credit. For example, in 1986 the Hong Kong Government guaranteed the repayment of a $128M emergency credit issued to Ka Wah Bank by Hong Kong and Shanghai Banking Corporation and the Bank of China. · Resources could be transferred to delinquent corporate debtors of the ailing bank. This could take the form of subsidized credit lines financed with central bank's rediscounts and the establishment of preferential exchange rates for the repayment of loans denominated in foreign currencies. The assistance could enable repaym·e nts to be made on loans to the ailing bank. However, such assistance should only be given to illiquid corporate debtors with long- term financial viability. Insolvent corporate debtors should be dealt with according to the market. This is a solution implemented in Malaysia, where, as a second stage in a 14 financial restructuring program, the Central Bank set up a restructuring fund for delinquent (and viable) enterprises. Profitability Measures Like liquidity measures, profitability measures can be effectuated either directly or indirectly, as explained in the following paragraphs. Direct Profitability Measures. There are three main ways to finance subsidies aimed at increasing profitability: inflation, high spreads, and taxes. Inflation simultaneously reduces the real value of assets and liabilities. It is politically the easiest course of action and has been the most common process used to alleviate, or cover up, financial distress. Latin American countries, including Argentina and Brazil (as encompassed in the institution of "concordata"), have often let inflation rule. It is no. coincidence that the region suffers the greatest financial in.s tability. The disadvantages of this method are: (a) Financial discipline is avoided as no write-offs are needed--debts are inflated away. (b) The shareholders are bailed out, while most of the burderi ·of the adjustment falls upon depositors. This is due to negative real deposit interest rates resulting · in a transfer of corporate wealth to shareholders. (c) The burden of the subsidy is distributed in an uneven and unpredictable manner. This causes demonetization through· ·the loss in real value of deposits and currency. (d) Distortion of interest rates causes a serious misallocation of resources. (e) The eventual need to reduce inflation requires drastic and prolonged contractionary policies that result in yet more financial crises· that further undermine economic development. Higher spreads can be obtained through either reducing rates paid on deposits or increasing those paid on loans, or both. If deposit rates are lowered, the ~apital markets would suffer, as would the process of financial deepening because of disinterrnediation. Higher lending rates also have their costs: they worsen the financial situation 15 of debtors. As with inflation, this method also results in substantial misallocatio n of resources. Taxes can be levied and the proceeds used to subsidize the ailing institutions to write off their non- performing assets and to operate with lower gearing ratios. The advantages are: ' (a) The subsidy is transparent, and costs can be ascertained. (b) · Taxes can be selective in terms of distributing their burden to specific target sectors of the general public. (c) It is the only flow solution that can apply specifically to the ailing institution without providing windfall gains to shareholders of other financial institutions . However, taxes. are always politically unpalatable and difficult to apply in . an emergency situation (such as a run on the banking system) because the imposition of taxes and the granting of subsidies requires the enactment of specific legislation, a time- consuming process. Other means of artificially increasing profit levels include reducing legal reserve requirements (with possible detrim.ental long-term consequences ) and purchasing low- yielding forced investments from the ailing bank. Indirect Profitability Measures. These are subsidies, including special tariff protection and the localization of foreign borrowing. An example is Ecuador's securitizatio n program, which can be given to the corporate debtors of an ailing bank. Stock Solutions Stock solutions can take the form of market response or recapitaliza tion, as explained below. Market Response. The government may allow the bankruptcy of an insolvent financial institution. In such a case, there would be a reduction in stocks, with losses being allocated to the holders of the failed institution' s liabilities. Recaoitaliza tion. · Banks can be recapitalized in a number of ways including increasing the level of paid-up capital (share capital) and having the 'gc:>vernment absorb losses. 16 In the case of share capital, the government can mandate shareholders to restore the ailing bank's equity capital through the purchase of newly issued shares. Pressure can also be brought to bear upon internationa l bank shareholders to participate in the share capital increase. In Chile, the Central Bank has forced a number of banks to raise new capital and to show their real assets and losses. A Eore recent example concerns Siam City bonds. The Bank of Thailand has ordered this ailing bank to increase its capital by 1.5 bn baht in fresh funds through a share issue. The stock was offered to shareholders by means of a rights issue. The incentive for existing shareholders to subscribe was that, if they didn't, shares at the drastically reduced par value would be offered to outsiders, thereby diluting the ownership stake of the original shareholders . The other method of recapitaliza tion, absorbing loan losses, can be induced in two ways, direct and indirect. Direct loan absorption occurs when banks are forced to write off non-performi ng loans and remove bad debts that they may have been carrying as :assets on the balance sheet. This can be done by a reduction in the level of registered capital, thereby reducing the par value of stock. This forces the bank's shareholders to bear their share of losses. The Bank of Thailand ordered Siam City Bank to reduce its registered capital by 95 percent; par value was reduced from 100 baht to 5 baht. The central bank will sometimes purchase the non- performing portfolio of the ailing baJ;lk. Payment can be made in the form of central bank papers that produce a yield higher than the cost of deposits. This form of bailout absolves shareholders from responsibili ty. An alternative, as was done in Chile, is to provide shareholders with a risk- free _ l oan to recapitalize their bank . . In Chile, shareholders were obligated to service the loan and shoulder the liability. At ~he same time, the ailing bank's bad portfolios were sold to the central bank at a discount to reflect their questionable value (with a repurchase schedule). Alternately, a central bank can provide funds or absorb bad loans in exchange for claims on the institution' s future income. Indirect absorption of loan losses occurs if demand deposits or deposits from small savers are in danger. Then a deposit insurance scheme provides a needed financial safety net. However, a consequence is that depositors become unconcerned with the quality of the institutions . 17 A financial institution in distress can be assisted indirectly if the central bank transfers resources to the delinquent corporate debtors, thereby improving the quality of existing loans. Involvement of Public Institutions. Deposit insurance corporations for the superintendency of banks are the most effective agencies to handle restructurings of financial institutions. They can take over failing banks, recapitalize them, and sell them back to the pr,ivate sector without nationalizing them in the process. Continental Illinois Bank, for example, is still under the control of the FDIC; many Spanish banks were taken over in the 1970s by the Deposit Guarantee Fund and sold back to the private se_c tor following restructuring; five Chilean Banks have been sold to private entrepreneurs after the Superintendency of banks managed them for almost five years. In the United States, there is lobbying to enact emergency regulatory powers for federal agencies to allow them to take control of a failing bank before it actually becomes insolvent. Degrees of Government Control. A last but important extreme measure deployed by governments to avert financial failure is the assumption of ownership control. The collapse of the banking systems of Chile and Uruguay led to such state intervention, even under basically liberal economic policies. But actual nationalization should · be avoided as it would diminish confidence in the banking system, spur capital flight, and deter capital inflows, including international commercial bank lending. An alternative would be for the government to take control--but not ownership--of the failed institution. The Banco Central do Brazil has the right to change the management of an ailing bank if previous measures of rehabilitation have not been not successful. A special government fund could be established to support these financial institutions, during which time they would be restructured and then transferred back to the private sector. Role of the Private Sector Specialist workout teams will increasingly be utilized to restructure ailing financial institutions. They will follow the trend that is occurring in the United States with investment banks, consulting companies, and specialized firms offering these services individually or combined and within a package. The process will encompass financial restructuring, restructuring of real and intangible assets, and the merger option. 18 Financial Restructuring This aspect will normally be undertaken in close cooperation with the government. Financial restructuring deats with the problems of illiquidity and insolvency by strengthening the bank's liquidity position and/or capital structure through improved availability and terms of finance, and a reduction or rollover of debt. Typically, the bank would get a portion of its debt, and/or deposits, converted into other instruments (such as quasi-equities), another portion would be rescheduled, and the remainder would be left as short-term debt. The resulting composition of the balance sheet is designed to provide financial stability to the bank. A classification· of a sampling of financial restructuring options and the appropriateness of their application to the problems of illiquidity and insolvency are shown in Table 1. Table 1: Financial Restructuring Options Type of Restructuring Illiquidity Insolvency Recapitalization in form of: 1) New equity capital x x 2) Write offs of bad loans x 3) Absorption by government of bad . loans x x Settlement of arrears x x More credit x Rescheduling of existing debt x Lower interest rates x x Financial restructuring can be segmented into four main categories: increasing the equity base, liability management, asset management, and risk management. Increasing the Equity Base Equity finance is the most vital component of restructuring finance. It is needed to absorb write-offs of bad loans while restoring the bank to a reasonable level -of leverage.. 19 When losses are moderate and the bank has a positive net equity, these losses can be absorbed through capitalizing normal profits for a short period of time. This flow sol.ution places the burden of restructuring on existing sha.r eholders by diminishing the equity base and omitting dividends. The next option is to seek a straight equity increase. This is generally not an easy task, at least in terms acceptable to the existing shareholders. Incentives include such things as shares offered at a substantial discount .from book value (e.g., as adopted in the restructuring by IFC of surinvest Casa Bancaria of Uruguay in 1986) or a two-for-one rights issue (e.g., as offered in 1986 by United Asian Bank of Malaysia) . Government can force shareholders to participate, as described earlier. Alternatively, new shareholders can be attracted to participation in a banking institution at an attractive . price. For foreign banks, it may be good public relations and provide a "back door" means of entry to the protected domestic banking sector. Some debt generally has to be exchanged for equity to reduce fixed charges. Alternatively, to prevent a run on deposits and the liquidity crisis which this would create, some deposit funds may be converted into equity or various forms of quasi-equity. Finally, new investors may be attracted by ~his mechanism. In the most extreme cases, when total debt exceeds total assets, creditors must be persuaded to convert debts to equity to avoid bankruptcy. Provided they do not believe that the government will bail them out in this instance, they may be willing to convert on the grounds that an equity claim on the going concern and future income streams is worth more than the proceeds that would be received following the very substantial cost of liquidation. If loans are converted to equity at full book ·value, there is no loss on the long-run economic value of such claims on the enterprise's real wealth. However, in accepting a risk-bearing equity in lieu of a debt, risk-averse creditors usually perceive a loss. To compensate for the assumed risk, creditors often receive options, warrants, or similar incentives that, on a contingent basis, could further dilute the equity stakes of the original shareholders. In the case of Surinvest, IFC and Midland Bank, as creditors, were offered subordinated convertible notes (conversion into common shares)--preferred shares would also be a possibility--at a discount to book value, with subscription to be paid by outstanding loan conversion. Another possibility is to reschedul~ debt by converting short-term debt to longer-term notes with warrants attached. Creditors often receive a substantial, indeed a 20 controlling, equity position in exchange for their sacrifices. This is at the expense of the original shareholders. Mitigating the dilution of the original sh~reholders' ownership position is possible. For example, shares received in a conversion of debt to equity may be a different class of share with different voting rights from those of the original shareholders. The original owners could be given generous stock options that they could exercise if the bank did well in the future. The allocation of the losses can also be apportioned to depositors by converting a portio'n of deposits into equity. Depositors could be induced by subsidies and direct transfer mechanisms. Depositors could be the means by which the government can, in effect, buy the costs associated with recapitalizing the equity base · without taking a direct ownership interest. The form of government subsidy could be in the form of (a) directing the payment .stream on a package of government bonds to depositors ; ( b) issuing shares in profitable state enterprises to depositors; or (c) issuing government securities and using the funds to increase the equity base of the ailing bank. The bank shares would then be swapped for deposits using the deposits to repay the government debt. An incentive for depositors would be either for the government to sell the shares to depositors at a discount or to draw down the level of deposits only as · interest comes due on its government bonds. Hence, depositors would continue to attract interest on the remaining level of deposits, while at the same time accruing the full benefits (and risks) of equity: dividends and capital gains. Debt to equity conversions could also attract outside investors who would be willing to purchase the debt of creditors at a heavy discount and swap these liabilities for an equ~ty position in the ailing financial institution. This mechanism could attract foreign banks as shareholders. Moreover, the government could use this as a vehicle for privatization of its shareholding in the ailing bank. Chile has actively privatized several banks in this fashion. Liability Management The provision of working capital is an immediate . concern to banks facing liquidity problems. Government subsidies of high deposit rates are one way to attract funds, as are government rediscount facilities. One of the conditions for government approval of foreign banks taking an equity participation could be a concomitant commitment to extend short-term revolving· lines of credit or other backup facilities. 21 The refinancing of existing debt with interest rate concessions or lengthened loan maturities--for example, by capitalizing a portion of the inflation premium in the interest rates of long-term loans--would also help the bank to match the maturities of its assets and liabilities. A longer-term approach would include the development of new sources of funds. These would include various debt instruments, quasi-equities, and forms of asset securitizations. The development of a variety of nondepository instruments is vital for financial institutions to be able to diversify their funding sources and hence be less dependent on deposits and government-sourced funds. An interbank market with free interest rates, money market instruments such as certificates of deposit (CDs), commercial paper, short-term financial bonds, and eventuaily debentures with longer-term maturities and variable interest rates should be explored. A flexible interest rate regime is conducive to financial innovation . . In the longer-term, as capital markets develop in CDs, financial institutions will be able to tap long-term securities markets. Financial institutions will have to continue to rely on the monetary sector to roll over essentially short-term debt instruments into longer-term instruments to match their loans. NIFs could be of use here. Debt with equity "kickers," which would allow creditors to participate in future profits and/or capital appreciation, may induce creditors to provide funds to the ailing bank. Perpetual floating rate notes are an instrument used by British banks to provide funds and boost the level of primary capital. Alternatively, new subordinated debt, in the form of secured bonds or debentures, may be sold at below-market interest rates with a convertible feature or attache.d warrants. The lower interest rates alleviate cashflow problems, the subordination of the new debt protects the prior claims of creditors, and the conversion option has the potential to provide new equity capital as conditions improve. The securitization of assets can diminish financial institutions' borrowing costs by using the cashflow income streams of these assets specifically to service the debt. The cost savings are especially significant to an ailing institution whose credit rating as a corporate entity has dropped, and yet has within its portfolio a bundle of relatively homogenous and identifiable financial assets, which in developing countries could include equipment lease receivables, installment credit receivables, and factoring receivables of consumer durable wholesales. The form taken would be as pass-through securities for certain pools of 22 receivables, collateralized notes, or sale of the assets directly to another investor. Asset securitizations would eliminate the interest rate and maturity risks on these assets, raise funds, create additional fee income, and increase the return on equity. Asset Management . The ailing bank can improve its asset portfolio either directly by writing off or trading bad debts, or indirectly by assisting debtor companies to restructure themselves. Direct Asset Management. A number of the assets of financial ins ti tut ions in distress have no real economic value and should be written off. Due to the usually high level of accrued but uncollected interest on loans in arrears and loans classified as performing when in reality they are not, the level of write-offs is invariably greater than what was anticipated ~t the outset of the restructuring process. A longer-term approach.to improve the liquidity of the asset portfolio would be.to adapt instruments, such as transferable loan facilities, that provide a built-in mechanism for trading the loan in the secondary market. This could be a temporary solution until a viable securities market is present. Indirect Asset Management. As an alternative to foreclosing on delinquent corporate debtors, the ailing financial institution may itself consider substituting debt for various forms of equity. A straight debt fo:r equity swap is undesirable, as it could transfer the ownership of a substantial portion of the productive sectors to the banking systems. This could lead to serious conflicts of interest, although the use of quasi-equity could reduce these problems. Conflicts of interest notwithstanding, such straight swaps have worked in the past. For example, during the Depression in Germany, banks were compelled to convert loans that were in default into equity. More recently, the AEG rescue package in 1979 included a new equity subscription by a number of banks with a limitation on subsequent resale. The quasi-equity instruments used in a financial restructuring would be subordinated in both service and repayment of principal, convertible into shares after a specified period (often 5 to 10 years) at a predetermined price per share and negotiable. The interest rate on the loans backed by these instruments would be substantially reduced. The instruments could be made convertible into nonvoting on preferred stock or, alternatively, banking regulations could prevent conversions by financial institutions . . In this way, the financial institution would 23 be able to obtain the fully realizable capital gain through selling the instruments to nonfinancial parties. Risk Management Financial deregulation and liberalization have acted as catalysts for financial innovation. The trend in OECD countries is toward risk sharing, quasi-equity instruments, and an unbundling of risk. Already a number of blue chip corporations are using new instruments that can customize the degree of risk. These instruments deal principally with credit risk and price risk. They include both off-balance- sheet instruments and on-balance-sheet instruments. The former include interest rate and currency swaps; futures; options and loan caps; forward rate agreements; letters of credit; note issuance facilities; and credit-enhancing guarantees on securities. The latter include asset sales without recourse, loan swaps, securitized assets and transf err able loan contracts; adj us table rate mortgages, floating rate loans, and back-to-back loans (see Table 2). 24 Table 2: A Classification of Innovations by Risk Management Function Function Price-risk Credit-risk Innovation transferring Transferring A. Off-balance-sheet Swaps x Futures x Options and loan caps x Forward rate agreements x Letters of credit x Note issuance facilities x x Credit-enhancing guarantee x B. on-balance-sheet Asset sales without recourse x Loan swaps x Securitized assets x Transferable loan contracts x Adjustable rate mortgages x Floatirtg rate loans x Back-to-back loans x Among examples of risk management are (a) an interest rate swap converting outstanding liabilities of an ailing bank from floating rate to fixed to eliminate an interest rate mismatch; (b) the matching of maturities of assets and liabilities by introducing variable rates with caps that limit the amount of increase, and even the amount of decreas~; (c) the issuance of notes indexed to the rate of return earned by a substantial or other part of the institution's loan customer base. The general approach by the ailing financial · institution to risk management should be first to apply the techniques to the liability/funding side, and, ·a fter gaining ·experience, only then to introduce them in the asset/lending rate. 25 Some of the instruments can also enhance liquidity: note issuance facilities, credit-enhancing guarantees on securities, securitized assets, and transferrable loan contracts. They can also generate credit (swaps} and reduce the . cost of funding (swaps, again, insofar as they are a form of liability arbitrage}. Restructuring Real Assets As financial ins ti tut ions do not have substantial real assets, such as factories, we are concerned with the divestment of any nonstrategic peripheral areas of business that the ailing institution has now decided are no longer part of its core business. For example, the Bank of America is likely to sell its discount brokerage subsidiary, Charles Schwab & Company. The sale of real property holdings would also come under ·this category. In the United States, a number of banks have sold their headquarters buildings and then leased them back. · This effectively removes real assets from the balance sheet. · Restructuring Intartgible Assets Restructuring intangible assets can take place in three arenas-- management, organization, and operational efficiency--as discussed below. Management Mismanagement is often at the core of an ailing financi.al institution's problems. When . a financial institution gets into trouble, top executives .tend to develop a style of management (concealing losses, disregard of prudent finan~ial practices} that is impossible to eliminate unless the managers are not removed. Moreover, the tendency for ev.en good managers to become bad managers when the institution gets into trouble compounds the need to remove top management when a financial institution undergoes restructuring, regardless of the shareholders' wishes. Organization Part of the restructuring process involves examining the institution's structure to determine, first, how well it suits the institution's functions and, second, what steps are needed to adapt to, or indeed anticipate, changes in the domestic and international economic and financial markets. 26 Operational Efficiency Steps often include instigating a periodic review of the. loan structure and its maturity matching with liabilities; implementing a review process of every substantial loan by a separate, independent group within the institution; assigning a risk classification to all loans that is then monitored; improving administrative efficiency; reviewing information systems; and introducing a revamped business plan. The Merger Option Often mergers or government interventions are arranged as alternatives to outright bankruptcy. The ideal merger would be for the ailing financial institution to be merged with a conservatively leveraged ' one that has a complementary mix of financial products, services, and target markets. In the United States, the Federal Home Loan Bank System has arranged the mergers of a number of large "problem" savings and loan associations into sound institutions, and the Federal Reserve System has done the same thing for banks. However, in an environment of widespread financial distress, merging over indebted companies with soundly financed ones is difficult since the number of independently sound financial institutions is so small. The Macro Context of Restructuring In situations where financial distress is widespread, restructurings of financial institutions are only the first element of a two-pronged rehabilitation program. If macroeconomic conditions are not conducive to the efficient mobilization and allocation of resources, then the benefits of restructuring will be piecemeal and temporary. Possibly the only situation in which restructuring need not be undertaken in conjunction with macroeconomic reform is in the isolated case of financial distress caused by fraud. However, even in this case, one must question why bank supervisors did not detect the fraud earlier. As the government must be involved in the macro context, any restructuring of a financial institution will invariably involve a joint government/private sector rehabilitation program. The macro context of restructuring will encompass macroeconomic stabilization measures involving the removal of structural distortions, the development of capital markets, financial/bankruptcy legislation and regulation, supervision of financial institutions, and scope for a deposit insurance scheme. · 27 Macroeconomic Stabilization Macroeconomic measures to reduce financial instability can target structural distortions in the following areas: (a) Fiscal--large public sector deficits "crowd out" the private sector from the credit markets. This leads to misallocation of resources. Furthermore, many nations' fiscal policies are heavily distorted toward debt accumulation rather than equity capital, as interest payments are deductible while dividends are taxed. The trend toward reducing the levels of personal income tax while increasing the tax rate on capital gains has also narrowed any advantage held by equity holders in relation to the tax treatment of capital gains. (b) Interest rate policy--rigidities in the interest rates that financial institutions can offer and charge can lead to deposit outflows and disintermediation crises. Positive real interest rates are necessary to attract long-term funds for investment. Artificial controls on interest rates can lead to demonetization and a liquidity shortage, while subsidized credit can generate financial indiscipline on the part of the borrower. (c) Exchange rates--overvalued exchange rates distort relative prices and the allocation of real resources. They lead to speculation against the currency and short-term capital outflows. An exchange rate based on purchasing power parity is vital for an export-led economic recovery and external balance through a reduction of the current account deficit. (d) Wage policy--wage rigidities feed inflation by indexation in Brazil. (e) Forced investments and cross-ownerships of financial and industrial conglomerates--forced investments mandated by the government result in a misallocation of resources. So do the iending policies of financial institutions that have ownership linkages to industrial conglomerates. The allocation of credit is distorted because controlling groups will often allocate scarce credit to their own firms, even if they are financially and economically lower return enterprises, while allowing other higher return enterprises to go bankrupt due to severe liquidity problems. A United States style anti-trust, restrictive-trade-practices approach to limit 28 concentration and linkages would be the most effective structural reform to increase long-term financial stability. A caveat is that these groups tend to carry considerable political clout. Capital Markets Development Capital markets provide term financing· that reduces eXposure to liquidity difficulties, and equity finance that keeps indebtedness in check and absorbs risk. Without a viable capital market, a country's long-term economic development will be stunted. Most developing countries have legal impediments (for example, absence of regulations, inadequate protection of the rights of minority shareholders), tax imped1ments (as mentioned earlier), and institutional impediments to the development of a capital market (such as an absence of contractual savings institution's and securities firms with skilled personnel). Moreover, many government programs have tended to encourage, if not actually subsidize, the accumulation of debt rather than equity finance . . These range from bailout programs for depositors in failed financial institutions; lender-of-last- resort facilities that guarantee the liquidity of financial intermediaries; special institutions such as development finance institutions and housing banks that provide debt at subsidized rates; and bailouts for highly leveraged corporations. The absence of capital markets in developing countries precludes financial adjustments that strengthen the balance sheets in the long term. Hence, financial adj ustmerit is limit.ed to additional borrowing on short-term credit markets. Similarly, the absence of a stock exchange eliminates a secondary market outlet for the equity and quasi-equity issued as a result of financial restructurings. The absence of liquidity in these instruments is a serious disincentive for acquiring risk capital in potentially distressed financial institutions. Banking Regulation Banking regulation and supervision are key elements to prevent or limit the damages of poor management. Banking regulation lays down the "rules of the game," while supervision verifies that the rules are followed and enforced. Regulations include the following: (a) Limiting the degree · of leverage by set~ing maximum debt-equity ratios based on a risKp!ofile of assets. 29 (b) Establishing a minimum level of capital to total assets that would take into account the risk profile of assets and 50 percent of the contingent risk associated with off-balance- sheet activities. This seeks to prevent overextensio n and to assure an adequate level of capital to meet potential losses. By imposing conservative limits on bank liability to capital ratios, the assumption of risk by banks can be constrained. If banks are forced to risk substantial equity, they will not be inclined to lend imprudently even if depositors are complacent. (c) Requiring portfolio diversificati on by restricting the volume of credit banks can extend to any single client or industry sector, as well as connected lending. The volume of credit is restricted to a given percentage of the bank's capital. (d) Introducing loan loss provisions to ensure that the quality of assets on the bank's books is properly reflected in the balance sheet. (e) Developing an effective procedure to have banks recapitalized by outside investors or through the sale of shares on the market. (f) Requiring liquidity by prohibiting excessive maturity imbalances. (g) Maintaining standardized accounting, auditing, and disclosure standards. (h) Providing effe.c tive procedures for the central bank to remove the board and management of a bank, irrespective of shareholders ' wishes, and to appoint · temporary replacements in cases of insolvency, imprudent banking practices, or danger to the system's stability. (i) Allowing for government intervention , not only for purposes of liquidation, but also as a temporary measure toward restructuring or a merger. Supervision Banking regulation is only as effective as the quality and vigor of supervision. Bank supervision seeks to ensure that financial institutions are prudent in their lending and balance sheet management. Supervision is normally undertaken by any or all of the following: the 30 central bank, the superintendency of banks, the treasu'.G', securities and exchange commissions, and various self- regulatory industry associations. Supervision can take various forms, including: (a) Requiring banks to publish timely, accurate, and standardized consolidated accounts, and to send them to the supervising agency. (b) Mandating auditors to submit letters to management on improvements needed in the institution's systems for financial accounting, budgeting, costing, internal control, and management information. (c) · Stipulating that the bank's accounts and assets be audited by external auditors. (d) Monitoring the quality of the loan portfolio by checking for delinquencies on loan payments and "hidden" defaults on loans. ( e) Enforcing minimum professional requirements via a licensing system. Deposit Insurance Schemes In some countries deposit insurance is explicit: bank deposits, at least of small-holders and those in demand deposits, are guaranteed by an insurance system whose credibility is anchored in the central bank's unlimited capacity to create the means of payment. Yet; in almost all countries, the central bank's commitment to avert runs on bank deposits and multiple contractions in the · banking system is tantamount to an implicit scheme of deposit insurance. Deposit insurance is a double-edged sword. While on the one hand it is a powerful instrument to avert disastrous bank runs, it also breeds depositor complacency and bank complacency by the socialization of losses through this financial "safety net." An ironic long-term consequence is that deposit insurance may indeed help to foster patterns of financial instability. A means to mitigate the "flipside" consequences of deposit insurance is to apply it in a discriminating fashion, not automatically. The real risk of loss must be ever present. In countries lacking such a scheme, .one should be established along the lines of the United States' FDIC. It - would have the capacity to cover small deposits in case of failure, and would also be used as the publ~c sector vehicle 31 to ·recapitalize and restructure financial institutions in distress as well as to make them merge with solvent institutions. Restructuring and Allocation of Losses Probably the most difficult and politically sensitive stage in the restructuring of financial institutions is the al~ocation of losses already incurred. Insolvency implies important capital losses, and ultimately some economic agent wili have to absorb them. There is no magic formula for restructuring that can make losses disappear. This allocation of losses is a difficult and time-consuming process, because it involves political, legal, economic, and financial issues, in addition to more general problems of economic and welfare equity. Basically two groups, not mutually exclusive, can bear the main burden of loss absorption: economic agents directly involved in the operations of the institutions (shareholders, management, depositors, debtors, creditors), and a wider group including all of a country's financial institutions, taxpayers, and the general public. In virtually all actual cases of restructuring involving more than one institution, the loss allocation was made on a case-by-case basis, influenced by such factors as the guiding policy rationale, the extent of financial distress (that is systemic, widespread, or institution-specific) and the inten~ed mode of response (that is, liquidation and restructuring). Alternative Patterns of Allocations of Losses A first option facing decisionmakers and agencies ultimately responsible for allocating losses is to sit tight . and do nothing, hoping that the situation will right itself. Authorities generally have a tendency to delay intervention as much as possible, but, as mentioned earlier, doing nothing is only postponing the problem if not aggravating it. The second alternative is to leave the allocation of losses to market forces, that is to bankruptcy proceedings. This alternative forces the holders of liabilities of the failed financial institutions to absorb the losses. Once these are absorbed, the failed institution disappears · and resources are free to be used again. Loss absorption through market forces also generates liquidity, since some of the assets are usually sold. Shareholders are obviously next in line for absorbing the losses. According to bank regulations existing in most .countries, in cases of financial distress, bank shareholders have to restore their bank's equity capital to adequate levels through the purchase of new shares. ~ If they do not 32 participate in the recapitalization of the endangered institution, they will probably see their ownership diluted, diminished, or wiped off as a consequence of losses being written off against their equity or a reduction in the par value of the shares to a level that reflects the institution's financial state. Shareholders have an incentive to participate in the restructuring because, under the absolute priority doctrine--applied in most countries-- claims in bankruptcy proceedings are paid in strict accordance with the priority of each line. Unlike secured creditors, common stockholders are last in line. Mismanagement often lies at the root of the distress problem. But management personnel can be changed or fired. Civil legal proceedings ·can be instituted for cases of failure because of lack of diligence, while criminal proceedirigs would be appropriate in cases of fraud. With regard to depositors' claims, a ·wide range of options exists. First, they can be left to take the losses. Second, they may be helped by a deposit-insuring institution. In this case depositors are reimbursed their deposit--usually up to a maximum amount. A third way to deal with deposits in a distressed institution is to have them transferred to a healthy financial institution that accepts these liabilities subject to some assistance in the strengthening of. its capital base and, more generally, its balance sheet. This assistance has in the past ranged from a straight grant to a soft .or market rated loan. This option may complement deposit insurance and be applied to deposits that do not meet the criteria .of the insuring institution. Under another formula, depositors are often given the option, or are even mandated by the restructuring authorities, to convert their claim into quasi-equity or equity of various kinds, including ·debt securities with equity kickers such as warrants. This equity.or quasi-equity may be in the restructured financial institution or in the institution to which the deposits have been transferred. Finally, depositors also bear losses when inflation erodes the real value of their claims. Creditors, even more than small depositors who will frequently be bailed out indirectly by a deposit insurance scheme or directly by the monetary authorities, must often accept some real loss in the value of their debt claim on the distressed financial institution. This typically involves a lengthening of the maturity for the debt, capitalization of interest payments, reduction in the interest rate of loans to below market rates, and conversion of loans to equity on unfavorable terms. 33 Financial institutio ns as a group may participa te in the restructu ring of a distressed financial institutio n. In that case, losses absorbed may take the form of increases in loan loss reserves. If financial institutio ns as a group fund a deposit insurance scheme which is tapped to reimburse small depositor s, then the distressed institutio n's losses may call for additiona l contribut ions to the deposit insurance scheme in order to replenish its funding base. Finally, a governmen t may · decide to finance the restructu ring of one or more financial institutio ns in distress out of the budget or the proceeds of a bond issue. In this case, the taxpayer or the general public ultimatel y absorbs the losses. Guiding Policy Factors to Restructu ring The · financial burden created by restructu ring distresse d institutio ns should be put as much as possible upon the sharehold ers and delinquen t corporate debtors. These parties, together with the managemen t, stood to benefit the most from the success and profits of the institutio n and consequen tly should bear the brunt of its losses. This involves the necessary acceptanc e of downsize potential of risk capital. Restructu ring measures should include-- as they often do--manda tory participa tion in the recapital ization of the financial institutio n. On the second tier, creditors should participa te in the losses, as the interest rate earned was partly based on the risk factor. This is justifiab le on the grounds of social equity. Any solution which places the primary burden of adjustmen t upon · the general public poses problems of fiscal and welfare equity. The final outcome of loss allocation will of course be influence d by the political clout of the different groups involved, the legality of different ways of allocating the losses, and the economic efficiency of the allocation process itself. The extent of financial distress is another guiding factor. Financial distress may be institutio n-specifi c, widesprea d (i.e., affecting a significa nt share of the financial system), or general. Dealing with one financial institutio n makes it easier to target the allocation of losses to sharehold ers, managemen t, and creditors selective ly. As the extent of financial distress increases , so too do the participa ting parties in the loss allocation process. Also, the wider the financial distress, the greater the need for sectoral and macroecon omic adjustmen t measures. 34 Due to the externalities of the financial sector, bankruptcy as an option is rarely proceeded with. It is mainly considered in cases where financial distress is ins.t itution-specific. When distress is widespread, the societal costs tend to outweigh the gains resulting from bankruptcy proceedings, and restructuring becomes the preferred option. .. 11111111111111 340/024 El539