Presentation based on the paper prepared for the conference

By

Stefan Kawalec and Krzysztof Kluza

The World Bank conference „Transforming Public Sector Banks”

Washington D.C., 9-10 April 2003

Two Models of Systemic Bank Restructuring: Interdependence with Privatization Strategy

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Issues discussed in the presentation

• Dealing with systemic banking crises – non-controversial principles

• Separation of bad debts • Spanish model of bank restructuring • Why the Polish authorities were looking for an alternative

solution• Polish model and the results of its implementation • Bank restructuring and privatization: Experiences of three Central

European countries • Conclusions on interdependence between the choice of the bank

restructuring model and the privatization strategy

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Dealing with systemic banking crises: non-controversial principles

If a banking crisis is dealt with both decisively and in a way that inspires confidence, the disruptive impact on economic growth may be minimized. It requires:

• Recapitalization

• Separation of bad debts

• Management change and privatization of troubled banks

• Creation of an effective banking supervision

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Recapitalization

• If the bank has negative capital and the government does not want its liquidation the bank should be recapitalized

either by the government or by new private owners.

• It would be good if a troubled bank could be quickly sold to a strong, fit and proper strategic investor ready to inject new capital and restructure the institution. However, this solution is often unfeasible. There may be no acceptable buyers willing to inject money into an insolvent bank or the government may not be ready to accept their terms. Trying to sell quickly in this type of situation without previous restructuring may in fact result in delaying both restructuring and privatization.

• Thus the recapitalization by the government is often the most practical option

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Why separate bad debts and bad borrowers from the bank?

Financial ties between a bank and bad debtors are dangerous

A banks with significant exposure to a company in a difficult financial situation is likely to be under pressure to provide new loans to allow the debtor to continue operations. The bank may act under political pressure and/or hope that this new money increases the chance to recover past loans. However, “good money” going after “bad money” usually just increases bank losses.

Management preoccupied with old debts can not adequately focus on current business and may be unable to introduce sound standards for new credit operations.

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Separation of bad debts Two main approaches

• Carving-out bad debts and transferring them into a specially created centralized restructuring agency (Spanish model)

• Internal separation of bad debt portfolio under the management of the work-out department separated from the credit department (Polish model)

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Separation of bad debtsSpanish model: carving-out

• Applied in Spain in the 1980s and in a number of countries in the 1990s (including Czech Republic, Slovakia, Slovenia).

• Assumes: Recapitalization of troubled banks with interest bearing government bonds Carving out bad debts and transferring them into specially created national

restructuring agency

• Advantages: Quick separation of bad debts and bad borrowers from bank’s healthy operations which:

Diminishes danger that the bank will finance old insolvent borrowers Allows the management to concentrate on new business

This approach could be compared to a surgical operation in which an unhealthy part of the body is extracted. The outcome of the operation may be successful if the rest of the organism is healthy or may be cured.

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Separation of bad debtsReasons for looking for an alternative solution (1)

Spanish model:

Suitable in established market economies where some banks encountered problems due to bad management and unfavorable macroeconomic trends. Thus the replacement of bad asset with government securities and establishment of new management may provide substantial cure to the troubled institutions.

Less suitable in former socialist countries where it was not sufficient to replace bad assets and management. It was essential to change the whole corporate culture and standards of banking activities.

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Separation of bad debtsReasons for looking for an alternative solution (2)

Polish decision makers: Believed that the carving out of bad debts would not address the cause

of the problem, which lay primarily in the lack of experience and expertise of the banks in assessing credit risk in the market environment. Painless removal of the bad debt burden from the banks creates the danger that the bad loan portfolio will reemerge in the near future.

Did not believe that a centralized, government sponsored agency could vigorously and effectively recover bad debts. It would not be possible to quickly create a strong institution with high quality staff. Nor would it be possible to devise an incentive system that would ensure the institution’s active approach toward indebted enterprises. It would be difficult to make such an institution resistant to political pressure.

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Separation of bad debtsThe Polish model: decentralized work-out (1)

• Recapitalization of troubled banks with interest bearing government bonds to such a level as to: allow the banks to create adequate provisions against bad debts and assure that after creating the necessary provisions the bank would reach

capital adequacy with a safe cushion above the minimum regulatory level.

Internal separation of the Bad Loan Portfolio (BLP) within the bank

Creation of work-out department separated from the credit department to manage the BLP

Deadline to complete the restructuring of the BLP within one year

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Separation of bad debtsThe Polish model: decentralized work-out (2)

Specification of eligible methods for the BLP restructuring program. The law obliged the recapitalized banks to ensure that before the one year deadline elapses one of the following events had taken place: the loan was recovered in its entirety the debtor regained its credit worthiness which was proven by at least a three month record of

servicing the debt a conciliatory agreement was reached between the debtor and creditors - under such agreement

creditors could agree on rescheduling claims, write of part of them and/or convert them into equity of the firm, to enable implementation of the financial and business restructuring plan of the indebted company

the debtor was declared bankrupt by the court liquidation of the debtor was initiated the loan was sold by the bank on the open market .

Formal ban on providing new credit to an enterprise, the debt of which has been placed in the BLP, unless such credit was given a furtherance of a conciliatory agreement.

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Experience of three Central European Countries Czech Republic Hungary Poland

Starting conditions In early 1990s 30-70% of loans in state-owned banks were non-performing and many major banks became technically insolvent

Bank restructuring

methods applied in

1991-1994 Spanish model

Mixed approach with partial carving-out

and less than full recapitalization failed.

Banking culture was not changed and

the government repeated recapitalization

twice.

Polish model

Bank privatization Partial privatization in 1992 but the

government retained control.

In 1997 in face of persistent bad debts

problems the government decided to sell

controlling stakes to strategic investors which

happened in 2000-01.

Government ultimately decided to

ensure proper governance through

strategic investors. Most banks sold to

strategic investors in 1994-1997

Privatization implemented at much slower

pace than originally planned. Ultimately all

banks originally covered by the program

were taken over by foreign banks by 2000

(7 years after recapitalization).

Contribution of

banking supervision in

containing bad debt

problem

Weak Moderate Significant

Results Room created by carving out old bad debts

was soon filled by new ones.

The government had to recapitalize major

banks again in 2000 before their sale to

strategic investors.

High fiscal costs of three consecutive

recapitalizations.

Ultimately, the most healthy banking

sector in Central Europe, as a result of

the sale of the banks to foreign strategic

investors.

There was a positive change in bank

behavior. Banks originally covered by the

program retained capital adequacy

(regained through recapitalization) and

were ultimately sold to strategic investors

with high premiums to their book values.

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Experience of three Central European CountriesSummary

• The Czech Republic bank rehabilitation program using the Spanish approach did not result in a change in bank behavior and bank/ enterprise relations. Banks in these countries, freed from old bad loans, remained under state control, were subjected to political influence in their lending policies and were extending new bad loans.

• In Hungary, the mixed bank rehabilitation program was costly and did not change bank culture. The deep change of bank behavior occurred afterwards as a result of the sale of controlling stakes to foreign strategic investors.

• In Poland, the program of banks and enterprises financial restructuring as well as the prospect of bank privatization contained moral hazard and changed the behavior of banks, although privatization itself was implemented slowly.

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Spanish model versus Polish modelComparison

Spainish model Polish model

Easier to manage More difficult to manage

Banks are quickly freed of old problem and may

concentrate on current business

Restructuring takes time

Does not change bank culture Strongly affects bank culture

Bad debts are more likely to reappear unless the bank

is quickly sold to a decent strategic investor

Diminishes the danger of reappearance of bad debt

problem.

Enables quick privatization and finding a strategic

investor

Privatization should be delayed until restructuring of

bad loan portfolio is completed

Centralized restructuring agency is rather unlikely to

vigorously and effectively recover corporate bad

debts and/or force debtor restructuring

Vigorous work-out of corporate debt is more feasible

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Spanish model versus Polish model Conclusions

• If the government is committed to selling majority stakes in troubled banks to reputable banking investors right away, then the Spanish model has an advantage as it facilitates quick privatization and finding a strategic investor. A good quality bank as a strategic investor seems to be the best means to change corporate culture and avoid the reappearance of the bad debt problem.

• In the Polish model, the prospect of privatization plays a significant role as an incentive for management. However, if the troubled bank is to be privatized without a strategic investor, or privatization will be delayed, then the Polish model has important advantages as it contributes to the change of corporate culture and diminishes the danger of reappearance of the bad debt problem.

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Thank you