Information about Asia and the Pacific Asia y el Pacífico
Chapter

V Bank Restructuring

Author(s):
Leslie Teo, Charles Enoch, Carl-Johan Lindgren, Tomás Baliño, Anne Gulde, and Marc Quintyn
Published Date:
January 2000
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Information about Asia and the Pacific Asia y el Pacífico
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The three crisis countries and Malaysia implemented comprehensive bank restructuring strategies. This section discusses selected issues related to the design and implementation of these strategies. It reviews broad principles and policies underlying such strategies and discusses operational issues related to the restructuring, such as institutional arrangements, issues in valuing financial institutions, the speed of recapitalization, methods to deal with troubled institutions, management of value-impaired assets, the cost of the restructuring, institutional constraints, and linkages with corporate restructuring.

Broad Principles and Policies

A broad-based restructuring strategy should achieve the following economic objectives: (1) restore the viability of the financial system as soon as possible so that it can efficiently mobilize and allocate funds (a core banking system must be in place to preserve the integrity of payment systems, capture financial savings, and ensure essential credit flows to the economy); (2) throughout the process, provide an appropriate incentive structure to ensure effectiveness and, as far as possible, avoid moral hazard for all market participants, including bank owners and managers, borrowers, depositors and creditors, asset managers, and government agents involved in bank restructuring and supervision; and (3) minimize the cost to the government by managing the process efficiently and ensuring an appropriate burden sharing (by distributing losses to existing shareholders). To achieve these objectives, governments had to ensure effective governance of intervened banks, application of appropriate resolution procedures, maximization of the value of nonperforming assets, and optimal involvement of private investors. While all the crisis countries followed these broad objectives, strategies varied according to local circumstances, government preferences, and the depth of the crisis.

Systemic bank restructuring requires strong government leadership because the restructuring seeks to preserve an essential economic infrastructure and entails major macroeconomic and wealth distribution effects, even if in essence it is a microeconomic process. Key steps include decisions on institutional arrangements to deal with the crisis; criteria for evaluating institutions; a strategy to deal with nonviable institutions and to restructure the viable ones consistent with macroeconomic goals; the extent and modalities of public sector support for restructuring; the arrangements for loan recovery and workouts and asset management; arrangements to ensure operational restructuring; and the pace of restructuring and compliance with prudential norms (see Box 9). Experience also indicates that clear information to the public on the steps to be undertaken is a crucial part of the strategy; a nontransparent restructuring process may fail to restore the public’s confidence in the government and the financial system.

Box 9.Principal Issues in Devising a Bank Restructuring Strategy

The following issues need due attention in developing a strategy for restructuring banks.

  • Institutional and legal frameworks for the restructuring, including the allocation of qualified human resources;
  • Criteria for discriminating between those institutions that are sound and need no public support, those that are viable but require public support, and those that should exit the system;
  • Modalities to assess the financial condition of institutions (deciding on who will do the valuation, and on the valuation rules to be applied, including loan classification, loan-loss provisioning, and collateral valuation);
  • Methods for dealing with troubled institutions (liquidation, mergers, nationalization, use of bridge banks, or purchase and assumption operations);
  • Treatment of existing and new shareholders;
  • Role of government and private (domestic and foreign) sectors in contributing equity and subordinated debt;
  • Financing arrangements, including target level of recapitalization, types of instruments, terms and conditions for the government’s support of restructuring (guided by the principle of minimizing the government’s contribution);
  • Arrangements for loan recovery and workouts and management of problem assets;
  • Appropriate linkages with corporate restructuring;
  • Operational restructuring of banks;
  • Timeframe for the different steps in bank restructuring;
  • Information campaign and transparency on the restructuring strategy to ensure credibility and public confidence;
  • Exit strategy from government ownership of banks; and
  • Exit strategy from blanket guarantee.

The strategies adopted by the crisis countries have been broadly similar, in that they all have aimed at removing nonviable institutions and requiring strict compliance with international best practices for capital adequacy, loan classification, and loan-loss provisioning by the end of the restructuring period (Table 6). All countries aimed at maximizing (domestic and foreign) private sector involvement in the recapitalization process. In the event, the extent of private sector involvement has depended on country-specific circumstances, such as the depth of the crisis, the availability of domestic private funds amidst a deteriorating macroeconomic situation, and the legal framework for attracting foreign investors.

Table 6.Summary of Measures to Address the Financial Sector Turmoil
MeasureIndonesiaKoreaMalaysiaPhilippinesThailand
Emergency measures
Liquidity supportYesYesYesYesYes
Introduction of a blanket guaranteeYesYesYesNoYes
Institutional measures
Establishment of an overarching restructuring authorityYesYesYes1NoNo
Establishment of a separate bank restructuring authorityYesNoYesNoNo
Establishment of a centralized asset management corporationYesYes2YesNoNo3
Adoption of a special corporate debt restructuring frameworkYesYesYesNoYes
Operational autonomy of restructuring agenciesLimitedYesYesn.a.n.a.
Restructuring measures
Intervention in financial institutions that were weak or insolvent.YesYesYesYesYes
This would include:
Mergers of weak institutionsYes4YesYesYesYes4
Closure of insolvent institutionsYesYesNoYesYes
Use of public funds to purchase nonperforming assetsYesYesYesNoNo
Use of public funds to recapitalize institutions, including:YesYesYesNoYes
State intervention in banksYesYesYesNoYes
Elimination or dilution of current shareholder stakes of
insolvent banksYesYesYesYesYes
New direct foreign investmentYesYesLimited5YesYes
Other measures
Measures to encourage corporate restructuringYesYesYesYesYes
Steps to improve prudential supervision and regulationYesYesYesYesYes
Source: IMF.

Steering committee chaired by the central bank.

The powers and resources of a preexisting asset management company were substantially increased.

The Financial Sector Restructuring Agency (FRA) was established to liquidate 56 closed finance companies, and the asset management company to deal with residual FRA assets.

Between government-owned intervened institutions.

Foreign banks are allowed to purchase up to a 30 percent stake.

Source: IMF.

Steering committee chaired by the central bank.

The powers and resources of a preexisting asset management company were substantially increased.

The Financial Sector Restructuring Agency (FRA) was established to liquidate 56 closed finance companies, and the asset management company to deal with residual FRA assets.

Between government-owned intervened institutions.

Foreign banks are allowed to purchase up to a 30 percent stake.

Malaysia and the Philippines never experienced a full–blown crisis and applied different restructuring strategies from those in the three crisis countries. In Malaysia, the emergency measures assisted in containing pressures on the system and were followed by a package of proposals that focused on recapitalizing banks that were expected to become undercapitalized in the course of 1998; strengthening the finance company sector through consolidation (mergers); establishing a strong institutional framework to manage the restructuring; and strengthening of regulatory and supervisory frameworks. Faced with the threat of a crisis, the Philippines adopted a financial sector reform program in early 1998 to strengthen the ability of the system to withstand shocks. The main ingredients were a streamlining of the resolution procedures of troubled banks, encouragement of mergers, the privatization of the remaining government equity stake in the Philippine National Bank (the second largest bank in the country), now planned for mid-2000, and an enhancement of the prudential and supervisory frameworks.34

The cost of restructuring the financial sector is typically high and largely falls on the public sector. This reflects a severe lack of equity capital in the banking system and the corporate sector at the outset of a crisis. In the crisis countries, seeking efficient ways to restructure objectives at the least fiscal cost was a key concern of the authorities. A poor fiscal situation could severely constrain the public sector’s capacity to absorb the cost of the restructure. This was not the case in Indonesia, Korea, and Thailand, which all had relatively sound fiscal positions at the onset of the crisis.35 However, the immense scale of public support needed will most likely require special efforts to preserve medium-term fiscal sustainability.

Institutional Arrangements

The allocation of responsibilities for handling the restructuring was a crucial first step in the strategy. Taking into account not only technical considerations but also political circumstances and institutional and legal frameworks already in place, governments put in place a variety of institutional structures:

  • In Indonesia, no institution was in charge of restructuring until the Indonesian Bank Restructuring Agency (IBRA) was established in January 1998 under the auspices of the ministry of finance. Initial problems in providing adequate legal and regulatory powers to the IBRA delayed the effective start of bank restructuring and asset management. Bank Indonesia remained the principal supervisory authority, though its powers vis-à-vis state-owned banks and IBRA had not been clearly defined.
  • In Korea, responsibility for restructuring was given to the newly established Financial Supervisory Commission. The Financial Supervisory Commission also coordinated the work of the other agencies involved in addressing the crisis, including the Korean Asset Management Corporation (KAMCO), a bridge bank (Hanaerum Merchant Bank), and the Korean Deposit Insurance Company (KDIC).
  • In Malaysia, a well-designed institutional framework supported by strong legislation was already in place. The restructuring has been coordinated by an overarching steering committee chaired by Bank Negara Malaysia, which is also the supervisory authority, and includes managers of the three other agencies involved, that is, Danaharta (the asset management company), Danamodal (the bank recapitalization company), and the Corporate Debt Restructuring Committee (the corporate restructuring agency).
  • In Thailand, no new agency was set up with specific responsibilities for bank restructuring. The Financial Institutions Development Fund, a legal entity within the Bank of Thailand, which is also the supervisory authority, has been in charge of managing liquidity and solvency support to intervened banks. However, most decision making has been left with the Ministry of Finance. The Financial Institutions Development Fund has been hampered by a lack of clear legal powers. The Financial Sector Restructuring Agency (FRA) was set up to assess the viability of the 58 suspended finance companies and to liquidate the assets of the 56 companies that were closed. A public asset management company was established to purchase residual assets from FRA. Moreover, the Corporate Debt Restructuring Advisory Committee was set up to facilitate corporate debt restructuring.
  • In the Philippines, no new institutional arrangements were introduced. The central bank’s role in bank restructuring has been based on its role as regulator and supervisor. The Philippines Deposit Insurance Corporation (established in 1963) has continued to be involved with the resolution of insolvent banks; problems of weak but solvent banks have been addressed by encouraging mergers.

Issues in Valuing Bank Assets

Realistic valuation of banks’ assets is an important factor in establishing the viability of individual banks, but it is difficult during a crisis. In fact, in these circumstances there is no precise method for valuing nonperforming loans.36 There are no market prices for nonperforming loans. Valuation based on appropriately discounted present values becomes less reliable as estimates of cash flows, interest rates, and underlying business conditions become volatile. The valuation can be particularly difficult when the viability and repayment capacity of borrowers is in doubt. Also, it is hard to value collateral, not only because of uncertain prices and a limited market, but because of uncertainty as to whether, and when, the bank can seize the collateral.

Differing approaches to valuation were used to improve self-assessments by banks in the three crisis countries. While banks continued to be responsible for valuing their assets and making provisions for losses, they were also subject to intensified on-site examinations by supervisors and assessments by external auditors. These on-site examinations and external audits generally revealed situations that were worse than those reported by the banks. In Indonesia and Korea, these assessments were further supplemented with audits by internationally recognized accounting firms. In Thailand, the authorities questioned the value of additional assessments by international auditors of banks meeting all prudential and regulatory requirements. Each approach has advantages and drawbacks. Self-assessments are often biased due to conflicts of interests; external audits by local firms and supervisory evaluations may not carry sufficient credibility in the market; and foreign assessors may have a limited understanding of a borrower’s repayment capacity and other local circumstances. In addition, international auditors might be too cautious in their valuations, perhaps to limit their potential liability in case they overvalued assets. Resorting to international audits, however, seems essential for credibility purposes in cases of pervasive government interference or insider lending.

The information collected through either of these valuation methods serves as a basic input for the restructuring authority’s decisions on the viability of financial institutions. Thus, regardless of the valuation methods used, the end result must allow the restructuring agency to compare banks, based on uniform and transparent criteria.37 This implies that the restructuring agency or the bank supervisor has to choose the valuation procedures, including the possible use of external valuation boards. It also implies that the agency be able to issue regulations on how banks should assess the value of their assets, but be prepared (and have the power) to overrule valuations by others where deemed appropriate. This power to overrule needs to be used judiciously, particularly in cases where the assessment has been done by independent outsiders. Moreover, valuations should be subject to revisions as economic conditions change. In any event, most prospective private investors will undertake their own due diligence valuations prior to any investment in or acquisition of assets or financial institutions.38

Speed of Recapitalization

In all countries, the bank restructuring strategy relied on a tightening of rules for loan-loss provisioning and the observance of minimum capital requirements.39 This gave banks a basis for recognizing their losses based on international best practices, identifying their capital shortfalls, and putting forward recapitalization plans. The tightening of regulations was gradual, however.40 On the one hand, markets were demanding more information about banks’ financial conditions and strengthened regulation and supervision. Meeting those demands was viewed as necessary for investors to restore the flow of funds to the affected countries and resume lending and provide capital to domestic financial institutions. On the other hand, insufficient resources (e.g., capital funds to meet minimum capital adequacy requirements or long-term foreign financing to eliminate maturity mismatches) made it impossible for banks to meet strict prudential standards in the short run. Requiring banks to meet international standards for capital adequacy requirements and loan-loss provisions in a very short timeframe would have forced them to shrink their balance sheets drastically. This would have further reduced credit to the private sector and aggravated the recession. Thus, a gradual approach was used. Moreover, it would have been impossible for banks to effect a reduction in their outstanding loans sufficient to meet the capital adequacy requirement.

Gradualism for achieving compliance with international standards can apply to loan-loss provisioning or capital adequacy. The former overstates capital adequacy while the latter shows a capital adequacy requirement below the regulatory minimum. Countries have used both approaches. IMF staff has emphasized that full transparency of the policy considerations behind the decisions should be assured to enable investors to make educated decisions.41 In Indonesia and Korea, banks have been given time to meet their normal capital adequacy requirements. The minimum capital adequacy requirement is currently at 4 percent in Indonesia, but is to increase to 8 percent by the end of 2001. In Korea, commercial banks were required to meet a capital adequacy requirement of 6 percent by March 1999 and 8 percent by March 2000 (a different schedule was applied to merchant banks). In Thailand, an 8.5 percent capital adequacy requirement for commercial banks (8 percent for nonbank financial institutions) applies in full while the loan-loss provisioning requirements are increased each semester until the end of year 2000.42 In Malaysia, valuation and provisioning rules were strengthened, but some gradualism was allowed with respect to public disclosure of nonperforming loans. In the Philippines, higher minimum capital requirements were phased in gradually, aiming at full compliance by the end of 2000.

Dealing with Troubled Institutions

Once nonviable banks were separated from viable ones, governments in all crisis countries and Malaysia devised strategies to rehabilitate those institutions deemed viable. To minimize the fiscal cost for the government and to preserve private ownership of banks, each government encouraged banks to rehabilitate themselves. In cases where market-based solutions were not forthcoming, governments sought to assist in forging such solutions. In case of insolvency, governments intervened. The degree of government involvement largely related to the degree of insolvency of the banks.

The main vehicle for seeking private-sector-based resolutions was for the respective governments to request recapitalization and rehabilitation plans from existing shareholders. In all countries, owners of undercapitalized banks were requested to provide timetables to raise the banks’ capital adequacy requirements to prescribed levels and to show their viability.43 In Korea, the government requested from banks with capital adequacy requirements below 8 percent self-improvement plans to reach that threshold, including contributions of new capital from existing or new shareholders. Approval of those plans was a requirement for banks to keep their license and for them to receive public sector support through the sale of nonperforming loans to KAMCO or in the form of equity. The precise content of individual plans varied depending on the circumstances and the size and significance of the institution. Memoranda of understanding between the banks and supervisory agencies were used to document the approval of the plans and the conditions attached to them. The conditions typically included operational improvement benchmarks on matters such as cost reduction, labor shedding, and rate of return on assets. Likewise, the Bank of Thailand requested half-yearly capitalization plans from all undercapitalized institutions, spelling out how they would bring in equity (domestic and foreign) to meet their capital adequacy requirements. These plans were agreed upon under binding memoranda of understanding with the Bank of Thailand.

The initial lack of private capital in the three crisis countries forced the governments to promote plans whereby new private capital contributions would be matched in varying proportions by the government. Under Indonesia’s joint recapitalization program, for banks with a capital adequacy requirement between +4 percent and -25 percent, owners have to submit a business plan demonstrating medium-term viability, in addition to passing a fit-and-proper test. Schedules to eliminate excess connected lending also had to be agreed upon. Owners had to provide 20 percent of the capital shortfall and the government the remaining 80 percent.44 Korea followed a case-by-case approach, under which the government was prepared to arrange for KAMCO purchases of nonperforming loans, purchase subordinated debt, or subscribe new capital, to assist private banks’ recapitalization efforts. In Thailand, the government will match any amount of capital injected by private investors, provided (1) the bank has brought forward and fully implemented the end of year 2000 loan classification and provisioning rules; (2) the new capital (public and private) is injected with preferred status; (3) the government and the new investor have the right to change management; and (4) an acceptable operational restructuring plan has been presented to the authorities, including procedures for dealing with nonperforming loans and for improving internal control and risk management systems.45 This scheme has contributed to restoring confidence in the Thai banking system, and hence, inducing private banks to find private investors with or without the public matching funds.

To facilitate foreign participation in the restructuring process, governments have liberalized regulations on foreign ownership of financial institutions. In addition to bringing in foreign capital, these measures have also aimed at introducing international banking expertise into the domestic financial system to enhance competition. All countries have allowed foreign investment in existing financial institutions. In Indonesia, two sizeable private banks have recently been bought by foreign banks and further purchases are expected. In Korea, the banking law has been changed to allow foreigners to acquire a controlling interest in domestic banks, including full ownership, and the government is seeking to sell a controlling interest to foreign investors in two of the largest commercial banks. In addition, foreign investors have contributed capital to other major commercial banks and have started negotiations to invest in other segments of the financial sector, such as in insurance companies. In Malaysia, foreign shareholders are allowed to take a stake in domestic banking institutions to up to 30 percent. In Thailand, foreign ownership in excess of 49 percent in existing banks has been allowed to help restructure the system. Strategic foreign investors have taken a majority stake in two small private banks, and foreign ownership in some large banks is approaching 50 percent. Malaysia has indicated that foreign banks with operations in the country will be allowed to buy finance companies. The Philippines has not yet been fully opened to new foreign ownership of existing banks, but further liberalization is planned. Recently drafted legislation has been submitted to allow 100 percent ownership of distressed banks, but this is to be reduced to 70 percent over 10 years.

When self-rehabilitation was beyond reach, governments resorted to a variety of bank resolution methods to deal with troubled institutions. Such methods included interventions, nationalizations, mergers, purchase and assumption operations, and the use of bridge banks.

A general principle in resolving troubled institutions is that existing shareholders should bear losses until their capital has been fully written off. This principle was generally applied in the crisis countries, although in some countries shareholders were left with nominal stakes to take into account legal restrictions on a full write-down or to avoid costly legal challenges by the old shareholders. In Indonesia, for example, the shareholders in the largest bank taken over in April 1998 were diluted to 1 percent of total equity. In Korea, until amended in mid-1998, legislation prevented shareholder stakes from being written down below the minimum capital required for a bank to operate. In Thailand, the shares of owners in intervened banks have been written down to token values.46 Furthermore, in Indonesia, the authorities are pursuing former shareholders of failed banks for personal indemnification for past central bank liquidity support in those cases where banks have been in violation of prudential regulations, especially for connected lending.

The contribution of new shareholders is of key importance to help strengthen bank finances and governance. All countries have revised the rules and regulations governing new shareholders. Existing shareholders are required to meet fit-and-proper tests to remain eligible, and rules regarding conflicts of interest for shareholders have been strengthened. A key issue is the maximum size of the equity share of each individual shareholder: concentration of equity may facilitate governance and capital injections, but concentration may also lead to excessive connected lending and large exposure risks. New or amended banking laws in Indonesia and Korea address this trade-off. In Korea, for instance, the law limits the maximum shareholding stake of domestic residents in commercial banks unless that stake is matched by a foreigner’s stake.

In the three crisis countries, deep insolvency of private banks led to the nationalization of a significant part of the private bank sector. In Indonesia, IBRA has acquired control of 12 banks, representing 20 percent of the banking sector. The authorities continue to distinguish between the “banks taken over,” however, and the seven state banks existing before the crisis, because the aim is to resolve the former through privatization, mergers, or closures within a relatively short period. In Korea, public equity support was very extensive because the limits on single ownership of commercial banks meant that there were no significant strategic shareholders that could be called upon to inject funds into the banks. Thus, five of the six major corporate lending banks have ended up with government shareholdings in excess of 90 percent. In Thailand, public equity support has mainly been provided to the institutions that were state-owned at the outset of the crisis, to the six commercial banks and 12 finance companies that have been intervened, and to match private equity contributions in a few private banks.47 All the governments have expressed their commitment to privatize their state-owned banks as soon as feasible, Korea and Thailand have already made some progress in this direction.

Closures, mergers, purchase and assumption operations, and bridge banks were useful techniques to consolidate the financial sectors in most countries, and governments adopted them flexibly under the circumstances. As mentioned before, closures were an important measure in all three crisis countries, as indicated by the proportion of the closed entities in the sector. Government-assisted mergers were used in all countries to consolidate the banking system. In Korea and Malaysia, mergers involved private sector banks, but in Indonesia and Thailand such operations were limited mostly to the state-owned sector. In Indonesia, four of the seven state banks are in the process of being merged into a single bank. In Thailand, the authorities are merging the intervened banks and finance companies into three new banks. The 56 closed finance companies are being liquidated by FRA through public auctions; the liquidation continued through the end of 1999. Mergers, purchase and assumption operations, and bridge banks have been used in Korea.48 The strategy in Malaysia was different for commercial banks and finance companies. For the commercial banks, a recapitalization strategy was set up for 14 banks that were identified as undercapitalized, or projected to become undercapitalized in the course of 1998; in addition, four banks would be merged into two. One such operation, involving two banks, has been completed. For the finance companies, the government initially aimed at consolidating the 39 companies to less than half that number through mergers. As of August 15, 1999, 15 had been absorbed or merged.49 In the Philippines, private-sector-led mergers were encouraged through easing of accounting and prudential regulations.

In the event, governments used a wide variety of resolution strategies. In a deep systemic crisis, no standard solution can be prescribed within the broad overall restructuring strategy. Governments had to deal with troubled institutions on a case-by-case basis. The final solution for each institution had to take into account the interest of the parties involved (existing shareholders, potential domestic or foreign investors, the government, and creditors) as well as the legal and regulatory framework, and, often, the political situation. As a result, the outcome for the sector as a whole necessarily varied from country to country (Table 7).

Table 7.Mergers, Closures, and State Interventions of Financial Institutions(June 1997 to June 1999)
MergersClosuresState Interventions
IndonesiaFour of the seven state commercial64 commercial banks (18 percent).12 commercial banks
banks to be merged into a single(20 percent).
commercial bank (54 percent).
KoreaNine commercial banks and twoFive commercial banks, 17 merchantFour commercial banks
merchant banks to create four newbanks, more than 100 other nonbank(14 percent).1
commercial banks (15 percent).financial institutions (15 percent).
Malaysia15 mergers (6 percent)(financeNone.One merchant bank and three
companies and commercial bank).finance companies under
central bank control (3 percent).
PhilippinesFour commercial bank mergersOne commercial bank (1 percent).2None.
(2 percent).
Thailand3Three mergers involving five56 finance companies (11 percent)Six commercial banks and 12
commercial banks and 12 financeand one commercial bank (2 percent).finance companies (12 percent).
companies (16 percent).
Source: IMF.Note: Figures in parentheses refer to percentage of total banking system assets held by the corresponding group of institutions

Banks with over 90 percent government ownership. The government owns varying amounts of shares in seven other commercial banks.

Closures of a number of rural banks and small thrifts are not included. Such closures are routine operations in the Philippines.

In Thailand, most of the intervened institutions were later merged. Thus, columns one and three include the same institutions.

Source: IMF.Note: Figures in parentheses refer to percentage of total banking system assets held by the corresponding group of institutions

Banks with over 90 percent government ownership. The government owns varying amounts of shares in seven other commercial banks.

Closures of a number of rural banks and small thrifts are not included. Such closures are routine operations in the Philippines.

In Thailand, most of the intervened institutions were later merged. Thus, columns one and three include the same institutions.

Dealing with Impaired Assets

Proper management and disposition of nonperforming assets is one of the most critical and complex aspects of successful and speedy bank restructuring. The government’s overarching objective should be to maximize the value of the impaired assets in the system, minimize fiscal costs, and prevent credit discipline of borrowers from deteriorating. Various approaches can be adopted to achieve those objectives. Impaired assets may either be held and dealt with by the financial institutions themselves or sold to special companies or agencies created to handle bad assets. The likelihood that the borrower will be able to honor his loan contract should determine whether the asset should be handled as a loan subject to collection or as a case for liquidation, including collateral. The more likely that the borrower will honor the loan contract, possibly after renegotiation, the more reason there is to keep it in a bank. If the borrower is bankrupt, or otherwise unlikely to repay, and the bank has to seek recovery of collateral— which often takes the form of real estate or other physical assets—a separate institution with special knowledge in asset resolution techniques most likely should undertake the recovery.

The optimal strategy for managing and disposing of impaired assets has many variations, depending on factors such as the nature of the problem assets, their overall size and distribution, the structure of the banking system, the legal framework, and available management capacity in the banks and in the public sector. There is no single optimal solution but rather a combination of solutions for each country that may vary over time and for each bank. The strategy will need to consider the speed of disposition of the assets and whether to use a centralized or decentralized process and institutional framework (Table 8).

Table 8.Framework for Managing Impaired Assets
Speed of DispositionDecentralizedCentralized
Rapid (sale or liquidation)Direct asset sales by banks;Rapid resolution vehicles
Liquidation of a bank.(Thai Financial Sector
Restructuring Agency, or FRA).
Long-term (assetIndividual asset managementLong-term disposition
management)companies (Thailand); bank(asset management).
workout units (all countries).

Speed of disposition is determined by the quantity, quality, and type of assets; market demand for such assets; and whether the assets belong to a bank that has been closed or to one in operation. While economic recovery requires some asset sales or liquidations to help markets find new price levels, the markets may be extremely thin and care needs to be taken not to destroy values for the entire banking system through “fire-sale” liquidations. This is of particular concern in a systemic crisis when the amount of problem assets typically is very large. The value of impaired assets may be better preserved through careful management and gradual sales by specialized institutions (in this paper all such units located outside banks are referred to as asset management companies). At the same time, it is important not to “park” severely impaired assets for years in asset management companies while waiting for an economic upturn. Such an approach may result in accrual of carrying costs and ultimately bigger losses. Moreover, poor management of the assets may deteriorate their value. In the case of failed banks, it is important to move the better quality loans to other operating institutions as fast as possible to preserve value. In Korea this was done through bridge banks, while in Thailand most of the assets of the 56 closed finance companies have been sold to the private sector through public auctions carried out by the FRA.50

Each country considered the advantages and disadvantages of dealing with impaired assets in a centralized or decentralized asset management company structure and related ownership issues in its own circumstances (Table 9). Centralized asset management companies, which typically need to be state-owned, have been used in Korea and Malaysia, and more recently in Indonesia. Advantages and disadvantages of state-owned, centralized asset management companies are shown in Box 10. A key objective of a state-owned centralized asset management company is to buy nonperforming loans from banks and thus help banks clean up their balance sheets as fast as possible. It is also useful in cases of mergers or bank sales when the merging or purchasing party may not wish to get a large amount of nonperforming loans as part of the deal. Thailand has chosen a decentralized process, encouraging each commercial bank to establish its own separate asset management company. However, a public asset management company was established to purchase residual assets from FRA. In Indonesia private asset management companies to deal with failed banks were ruled out due to governance concerns.51 The sale of banks’assets to an asset management company forces immediate recognition of the value of the loan. This may deter such sales in cases where banks have been carrying these loans at inflated values.

Table 9.Public Asset Management Companies in the Asian Crisis Countries
Amount Purchased by the
Centralized/Public AssetEnd of April 1999 (face
Management Companiesvalue as a percent of GDP)Eligible LoansPricing Policy
IndonesiaBecame fully operational in20Loss loans from state banks,Zero value.
April 1998 within Indonesianand private banks eligible
Bank Restructuringunder the government’s joint
Agency (IBRA).recapitalization scheme.
KoreaKorean Asset Management10All financial institutions.45 percent of face value for for
Corporation (KAMCO) wassecured loans; 3 percent
reconstituted as an assetunsecured loans.
management company in
late 1997.1
MalaysiaDanaharta was established in172All financial institutions, of Malaysian banks andAverage discount has been large loan, it has been 60
mid-1998.including Labuan Subsidiaries37 percent (excluding one
development financialpercent).
institutions.
PhilippinesNo asset management
company.
ThailandFinancial Sector17.5Assets of the closed financedAuctions. In a first round
Restructuring Agency (FRA)companies.only private bidders and, if
established on October 24,not sold, to the asset
1997, to deal with suspendedmanagement companies.
finance companies.
An asset management company43Finance companies orIn the second round, the
was set up to act as bidder ofintervened banks (so far onlyasset management companies
“last resort” for assets offinance companies).purchased at 20 percent of
closed finance companies.book value on average.
Source: IMF.

KAMCO existed before the crisis

End of June 1999.

This 4 percent is included in the 17.5 percent

Source: IMF.

KAMCO existed before the crisis

End of June 1999.

This 4 percent is included in the 17.5 percent

Box 10.Advantages and Disadvantages of a Centralized Public Asset Management Company

The crisis countries considered the following when deciding whether to adopt a centralized, public asset management company.

Advantages

  • Serves as a vehicle for getting nonperforming loans out of troubled banks, based on uniform valuation criteria.
  • Allows government to attach conditions to purchases of nonperforming loans in terms of bank restructuring.
  • Centralizes scarce human resources (domestic and foreign).
  • Centralizes ownership of collateral, thus providing more leverage over debtors and more effective management.
  • Serves as a third party for insider loans (Indonesia).
  • Can better force operational restructuring of troubled banks.
  • Can be given special legal powers to expedite loan recovery and bank restructuring.

Disadvantages

  • Management is often weaker than in private structures, reducing the efficiency and effectiveness of its operations.
  • Such agencies are often subject to political pressure.
  • Values of acquired assets erode faster when they are outside a banking structure.
  • Nonperforming loans and collaterals are often “parked” long-term in an asset management company, not liquidated.
  • If not actively managed, the existence of a public asset management company could lead to a general deterioration of credit discipline in financial system.
  • Cost involved in operating an asset management company may be higher than a private arrangement.
  • If dealing with private banks, determining transfer prices is difficult.

Pricing is the most difficult issue for a public asset management company purchasing assets from private banks. The issue is less severe for a public asset management company buying assets from a state-owned bank or a private asset management company buying assets from a private bank.52 This is due to the valuation difficulties for impaired assets discussed earlier. Purchases of a bank’s assets at inflated values by an asset management company amount to a back-door recapitalization of the bank and a bailout of the bank’s shareholders.53 The impossibility of determining an unambiguously fair market price for nonperforming loans has so far deterred the Thai authorities from setting up a public, centralized asset management company and they have instead opted for a decentralized approach. Proper transfer pricing is also of key importance for the incentive structures for both the asset management company and the banks—there is a need to set up a system that provides the right balance. Excessive prices for nonperforming loans may also induce banks to reduce their recovery efforts, which could lead to a general deterioration of credit discipline and loan values throughout the banking system.

A decentralized approach that encourages each bank to set up its own asset management company allows arrangements to suit each bank’s conditions (see Table 10). Thailand followed such a route, encouraging banks to set up their own asset management companies to which they can transfer assets at market value. Five private banks are in the process of setting up asset management companies and other banks (including state-owned ones) are expected to follow. Until recently, however, this process has been held up due to capital scarcity.

Table 10.Pros and Cons of Decentralized Asset Management
AdvantagesDisadvantages
Within banksKnowledge of the borrower mayLack of skills for restructuring of
facilitate debt restructuring.troubled debt, operations of
Access to borrower throughcompanies, debt-equity swaps, etc.
branch network.Hampers “normal” banking functions
(lending activities), particularly if the
nonperforming loan portfolio is large.
Less loss recognition up front. Does
not clean up the bank’s books.
In private assetSpecialized skill mix. Focus onLack of knowledge of the borrower.
managementrestructuring function.Bank may not have sufficient capital to
companiesCreation of an asset managementrecognize losses up front.
industry and secondary market for
distressed assets.
Loss recognition up-front.
Cleans up the bank’s books.

The final results of the various strategies will only be known when the process of recovering impaired assets has been completed. This process will take time. As noted earlier, it would be unwise to undertake massive sales of assets in the midst of the crisis. Also, practical problems—such as the need to acquire proper legal title to collateral and to prepare an inventory of the assets—require time to be solved. Nonetheless, sales of impaired assets have begun in Korea, Malaysia, and Thailand.

Cost of Restructuring

Estimating the cost of financial restructuring is one of the more challenging issues. There are costs both in the private and public sectors to cover losses and contribute new capital. The private sector outlays will not be considered here. The government’s gross costs for the restructuring arise from paying out guaranteed bank liabilities; providing liquidity support; assisting in meeting capital adequacy requirements; and purchasing nonperforming loans. The net costs will only be known after proceeds from (re)privatization of banks and recoveries of loans accruing to the government have been taken into account.54 A more complete picture of the cost would also include the indirect effects of the crisis and subsequent reforms. The magnitude of these costs and the need for political support for the process require transparent accounting rules and disclosure of information.

Gross costs in the three crisis countries and Malaysia are likely to range from 15 percent to 45 percent of GDP (Table 11). Estimating the cost of restructuring is an evolving exercise because loss recognition is still taking place as part of the corporate restructuring process.55 The cost of restructuring will depend on several factors, including domestic and external macroeconomic conditions, the effectiveness of corporate restructuring, and the efficiency of bank restructuring efforts. As a result, estimates for the cost of restructuring vary widely, with government numbers generally lower than market estimates.56 While IMF staff has continuously made estimates based on different scenarios to discuss policy options with the authorities, it has refrained from including any estimates in official documents because of their sensitive and crude nature.

Table 11.Authorities’ Estimates for the Gross Cost of Financial Sector Restructuring
In Percent of GDP
Indonesia45
Korea15
Malaysia12
Philippinesn.a.
Thailandn.a.
Source: National authorities.Note: Gross costs do not include recoveries. The cost will depend on a number of factors, including macroeconomic conditions, effectiveness of corporate restructuring, and the efficiency of the bank restructuring effort. Estimates of these costs are based on different assumptions and methodologies and may therefore not be comparable across countries.
Source: National authorities.Note: Gross costs do not include recoveries. The cost will depend on a number of factors, including macroeconomic conditions, effectiveness of corporate restructuring, and the efficiency of the bank restructuring effort. Estimates of these costs are based on different assumptions and methodologies and may therefore not be comparable across countries.

The need for immediate liquidity support at the onset of the crisis meant that the central banks in the crisis countries were the main providers of funds. In Indonesia and Thailand, formal arrangements to allocate costs between the central bank and the government were weak or did not exist. Meanwhile, in Indonesia, the government has issued 150 trillion rupiah (13 percent of GDP) of indexed bonds to the central bank to compensate it for past liquidity support. In Thailand, the government was authorized to issue bonds for 500 billion baht (10 percent of GDP) to cover losses in the Financial Institutions Development Fund, and the government has announced its intention to cover additional losses in a similar way.

Bonds issued or guaranteed by the governments of Indonesia, Korea, and Thailand are the main instruments for financing the government’s contribution to the restructuring costs (Table 12). Market interest rates and regular coupon payments are needed, because, as opposed to zero coupon bonds, they help banks’cash flows. Tradable bonds help banks manage their liquidity, as they can sell the bonds if liquidity is needed.57 Given the large amount of bonds to be issued, making them tradable also assists the development of a government bond market and reduces the cost for the government; thus, the development of an efficient microstructure for government securities markets becomes critically important.58 Only Korea and Malaysia used a combination of cash and bonds to provide capital, although cash injections in both cases were so minimal that they did not interfere with monetary policy. The government of Indonesia has recently approved the issuance of another 100 trillion rupiah of bonds (9 percent of GDP) to the banks to finance the first wave of bank recapitalization. The interest cost of all the bonds is borne by the budget. In Korea, parliament approved the issuance of 64 trillion won of bonds to finance KAMCO and KDIC (15 percent of GDP).

Table 12.Instruments Used to Recapitalize and Purchase Non performing Loans
InstrumentReceivedDescription
IndonesiaBonds.Equity.Variable and fixed coupon bonds. Owners under
the private bank scheme may purchase back
shares after three years; tradable.
Bonds.Nonperforming loans.Variable coupon bonds; tradable.
Debt to equity conversions.Equity.Index-linked bonds; tradable.
KoreaBonds or cash.Equity or preferred shares.Variable coupon bonds issued by KAMCO and
KDIC and guaranteed by the government; tradable.
Shares.Equity or preferred shares.Governments share in public enterprises.
Bonds.Nonperforming loans.Fixed (initially) and variable coupon bonds; traded.
MalaysiaBonds or cash.Convertible preferred sharesZero coupon bonds; not easily traded.
or subordinated debt.
Bonds.Nonperforming loans.Zero coupon bonds; not easily traded.
PhilippinesNot applicable.
ThailandDebt to equity conversions.Equity.FIDF loans converted to equity.
Bonds.Equity.Fixed-coupon bonds; tradable.
Bonds.Subordinated debt.Fixed-coupon bonds; nontradable.
Source: IMF.
Source: IMF.

A full and transparent recording of the cost of bank restructuring is important. While the initial support by the central banks was not very transparent, bringing the outlays into the budget would imply more transparency. All of the crisis countries have incorporated into their budgets the interest payments on the governments’ recapitalization bonds. However, the cost of earlier liquidity support and the capital cost of government bonds have not yet been accounted for in the budgets. Incorporating the total restructuring costs into the budget is crucial, not only to have a clear overview of the total cost, but also to be in a position to better assess the countries’ medium-term fiscal sustainability. This can be achieved through the use of an augmented fiscal balance that would explicitly incorporate all major quantifiable fiscal costs of bank assistance operations (Box 11). For financial programming purposes, however, the carrying costs of financial sector restructuring is a more appropriate concept.

Box 11.The Augmented Fiscal Balance

The concept of augmented fiscal balance would explicitly incorporate the major quantifiable fiscal costs of bank assistance operations that are not included in the current definitions of the overall balance.1 The augmented balance is not intended to replace the overall balance, but to present an additional measure of the fiscal stance for countries where bank assistance operations are important. Use of the augmented balance would allow a transparent, comprehensive, and reasonably comparable presentation of government financial assistance for bank restructuring across countries. If not using an augmented balance framework, complete details of the capital cost of bank restructuring operations should be recorded separately, regardless of whether they are budgetary or quasi-fiscal costs.

1 See Daniel, Davis, and Wolfe (1997).

Institutional Constraints

Restructuring a banking system following a systemic crisis of the magnitude experienced in Asian countries is a complex process that goes far beyond purely technical operations. Restructuring strategies have to take into account local business practices, the availability of human resources, the deficiencies in the legal and judiciary framework, and depend largely on the degree of political support. In the three crisis countries, the changeover in the political regime had a clear positive impact on the pace of restructuring. Full recognition by the new governments of the magnitude of the crisis not only increased their resolve to implement the restructuring strategy, but also made it easier to gather broad-based support for the restructuring.59

Bank restructuring requires a large number of people with a wide variety of skills. Countries seldom have such resources readily available because crises are only sporadic occurrences. Governments often had to rely on outside expertise to help develop their strategy and carry out specialized tasks. In addition, the number of people needed was considerable. For instance, approximately 5,000 people (foreign and local experts, officials from different agencies, and security forces) were involved in the final closing of the 56 finance companies in Thailand. Similar numbers were involved in such operations in Indonesia.

Deficiencies in national legal and judicial frameworks have been major obstacles to the restructuring process in the crisis countries. Key issues include the initial lack of proper and tested exit policies for banks (especially insufficient authority to take early action against weak banks and to eliminate shareholders); the lack of legal protection of officials (the absence of immunity from prosecution and civil suits of officials in the exercise of their duties is still a major problem in the Philippines and Thailand); the inadequacy of foreclosure procedures and bankruptcy laws and an appropriate judicial infrastructure to deal with the massive corporate debt restructuring problem; a legal framework that often favored debtors over creditors; and the slowness and inexperience of the courts. Once deficiencies were recognized, it took a considerable amount of time before laws could be changed, and parliaments sometimes introduced counterproductive amendments, further delaying the process.

Linkages to Corporate Sector Restructuring

The severity of the corporate sector crisis in the three crisis countries has affected bank restructuring more than in most other bank crises. In most crisis countries, corporate sector restructuring began slowly and is lagging behind bank restructuring. This stems from the fact that the loss recognition process took longer, legal frameworks for addressing the issues were not or only partially in place, additional skills were needed that were not readily available, and the sector itself is more complex and diversified than the banking sector. Most important, unlike the banking sector, the private, corporate sector is not under the control of one single regulatory and supervisory agency. Moreover, corporate debt restructuring (the part that has a direct bearing on bank restructuring) largely depends on a broader business restructuring, which is usually a slow process. To the extent that corporate restructuring continues to lag behind, bank restructuring might be delayed. Generally, the two processes should proceed as simultaneously as possible, although bank restructuring should take the lead. This is so, not only because it is more feasible because banks are fewer and are already subject to an established supervisory regime, but also because it is necessary to have functioning financial institutions as counterparties to facilitate the corporate restructuring. Several initiatives have been taken to expedite corporate sector restructuring (Box 12.).

Box 12.Linkage to Corporate Restructuring

Corporate restructuring is lagging behind bank restructuring, and has been hampered by a lack of leverage of most banks vis-à-vis their borrowers. The countries generally lacked frameworks for restructuring failing borrowers, such as coordinating credit committees under the guidance of a lead bank. Moreover, in many countries, the courts have tended to be lenient and provided little support for creditors, at least in the initial stages. Companies have been able to continue to operate under the court’s protection, allowing interest to be deferred. This has undermined credit discipline. In some countries, measures have been taken to address this problem: first, through strengthened bankruptcy and foreclosure procedures to lessen the balance in favor of the borrowers, and second, by providing incentives and mechanisms for banks and corporate clients to restructure before reaching the courts. Initiatives also have been taken to improve court procedures.

The speed at which corporate restructuring takes place depends on a variety of factors, including the legal and regulatory framework at the onset of the crisis, the vigor of its enforcement, the structure of the corporate sector, and the nationality of the creditors. Corporate restructuring in Indonesia has so far been slow because new bankruptcy and foreclosure laws have not been enforced, in particular by the state-owned institutions. Korea is more advanced than the others because it adopted new laws fairly rapidly, has a corporate sector concentrated around the chaebols, and has clearly specified its restructuring objectives and provided strong leadership. The legal framework is strongest in Malaysia. Thailand suffered from delays in adopting a new legal framework for bankruptcy and disclosure.

Countries have given a variety of incentives to banks to address and expedite corporate debt restructuring. The “London Approach,” which provides a framework whereby creditors would jointly approach the debtor and work out a mutually beneficial (out-of-court) arrangement, has so far been used most aggressively for government-led restructuring in Korea, where a number of medium-sized corporate groups have been dealt with in this way (debt rescheduling with some interest rate reduction, or issuance of convertible bonds and debt/equity swaps). In Thailand, the Corporate Debt Restructuring Advisory Committee (CDRAC) was formed by the Bank of Thailand and representatives from debtor and creditor groups, which agreed upon a framework for corporate debt restructuring based on the London Approach (the “Bangkok Approach”). The CDRAC initially targeted large debt restructuring cases but has recently expanded its coverage to small- and medium-size cases. A scheme that would combine government support for recapitalization with corporate debt settlement (Tier 2 options) has also been in place to encourage corporate debt restructuring. In Indonesia, the government has adopted a four-way classification of delinquent borrowers, based on their degree of cooperation with the workout process and business prospects. The state institutions and Indonesian Bank Restructuring Agency (IBRA) are adopting a coordinated approach vis-àa-vis each major delinquent borrower, beginning with the largest, broadly along the lines of the London Approach (the “Jakarta Initiative”). In Malaysia, the asset management company (Danaharta) has been given very extensive powers in dealing with the borrowers of any loans it buys. These powers seem to have had a significant effect on borrowers, because banks threatened to sell to Danaharta if the borrower failed to resume servicing the debt.

The banking system provides a key lever for corporate restructuring, in particular as regards corporate debt. Tightening and stronger enforcement of prudential regulations can make a major contribution. For instance, in Korea, tighter regulations on maximum exposure limits, connected lending, liquidity mismatches, and cross guarantees have required corporations to seek other sources of finance or shrink their balance sheets. Also, Korean banks—following strong government leadership—have been instrumental in approving and monitoring corporate restructuring plans. International financial institutions, particularly the World Bank, have strongly supported this process, including the banks’ heavy involvement as key counterparts.

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