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Corporate and Bank Restructuring after the Crisis
Kozo Kunimune
Institute of Developing Economies
1, Introduction
Asian currency crisis accompanied serious financial crisis in some countries and
helped to build up huge pile of non-performing loans (NPL). It has been nearly five
years since the Asian currency crisis broke out, and there have been successes and
failures of diverse financial restructuring efforts conducted by individual countries.
While the Asian currency crisis was a spectacular disaster, Japanese experience
after 90’s were somehow boring, although dismal, repeats of alternations between
economic downturn and financial crisis.
However, the episodes of Japanese long-lasting depression and the Asian
currency crisis have something in common. Both were triggered by huge downward
swing of asset prices. In former case crush in the prices of stocks and lands played
major role, while in the latter case depreciation of exchange rates did. In either way, the
balance sheets of many debtors deteriorated and caused economy-wide NPL problems.
In the first place, why is the emergence of NPL matters? It is true that both the
debtor and creditor cares much about the NPL, but is it necessary for the government to
involve in the matter? Isn’t it absurd to use huge amount of public money for resolving
NPL problem? Didn’t the economist tell you that the government intervention
frequently causes a distortion in the economy?
My answer is that government intervention for solving economy wide NPL
problem is necessary because of two reasons. One is microeconomic; the other is
macroeconomic consequence of NPL problem that necessitates the governmental action.
1
The deterioration of debtor’s balance sheets has adverse effects on her incentives,
and consequently distorts the microeconomic resource allocations. This is the
microeconomic consequence of NPL problem.
If the deterioration of balance sheets are caused by some macroeconomic (i.e.
economy wide) shock and occurred in many firms at the same time, it becomes new
source of adverse macroeconomic shock and a vicious circle begins to roll. This is the
macroeconomic consequence of NPL problem.
The economics tells us that there are two justifications for government
intervention. One is the intervention for the purpose of improving microeconomic
resource allocations, while the market cannot attain the best allocation by any reasons.
The other is that for the purpose of stabilizing macroeconomy (although not all the
economists agree with this second justification). Both the micro- and macro-economic
consequence of NPL problem coincides with these qualifications.
Even when the government interventions are justified, it is important to take
enough care about the way that it is conducted, and make sure that it will not cause
another distortion. Then, the specific characteristics of individual policy measures
matter. In the last portion of this paper, I will analyze the wide-ranging corporate and
banking restructuring measures that has been adopted many Asian countries.
This paper is organized as follows. Section 2 analyses adverse incentive effects
of NPL, which distort microeconomic resource allocations as well as have
macroeconomic implications. Section 3 explains Japanese debt deflation episode and
the risk of it in the crisis-ridden Asian countries. Section 4 discusses the wide-ranging
measures of financial restructuring in Asian countries. Section 5 concludes.
2, Adverse Incentive Effects of NPL
From the debtor firm’s point of view, NPL problem means deterioration of their
balance sheets. If the deterioration comes from operational inefficiency, the change of
the firm’s way of doing must be necessary; i.e. raise their profitability by any means or
2
wind up their business. But if the deterioration comes from unexpected sudden change
of environment such as currency crisis or macroeconomic policy failure, and if this
change affects only the firm’s balance sheets but firm’s operational profitability, is there
any difference from ordinary NPL problem?
In this situation central concern is not on the firm’s business in itself but on the
incentive effects upon the firm’s managers by the balance sheets deterioration. Without
these incentive effects the problem would be only about the transfer of income among
the firm’s stakeholders. In other words the point would be who would shoulder the
burden made by sudden change of environment (which had been the cause of the
deterioration of balance sheets).
In reality we cannot and should not ignore the adverse incentive effects of NPL.
Even the firm, whose prospect of operational profitability is quite well but with adverse
incentive effects of NPL, may cause trouble. In this section, I will show three
troublesome phenomena caused by such incentive effects.
2-1 Debt overhung
‘Debt overhung’ is a phenomenon pointed out by Myers [1977]. It deters new
investment by debt laden firm even if the prospect of this investment is well.
Assume that the expected present value of new investment project is V, the cost
of investment is I, and the value of initial assets owned by the firm is zero.
Firstly I consider a firm without debt as a reference case. In this case the firm
decides to invest if and only if V-I ≥ 0. And this decision rule is desirable by the social
welfare viewpoint.
Next I consider a firm with debt whose present value is P, and other
characteristics are same as the reference case. In this case the firm decides to invest if
and only if V-I-P ≥ 0. And this decision rule may not be desirable by the social welfare
viewpoint. For example if the value of P, V, I satisfy the relation P > V-I > 0, the
investment is desirable by social point of view (because V-I > 0) but is not done by the
debt laden firm (because V-I-P < 0).
3
2-2 The Asset substitution
‘Asset substitution’ is a well-known distortion under the limited liability and
asymmetric information between debtor and creditor. The debtor’s preference for risk is
distorted and she conducts much more risky action (investment project) that is
undesirable by social point of view.
Assume that the present value of a firm is V, V is a random variable, the
distribution of V changes by the action d, d is a operational variable of the firm’s
manager and observable only by the manager, and all of relevant economic decision
makers are risk neutral.
Without any debt, the firm’s manager sets the value of d so as to maximize the
expected value of V. On the other hand, with debt, whose present value is P, the firm’s
manager sets the value of d so as to maximize the expected value of max[V-P, 0].
Because of limited liability, the two maximization problems differ from each
other. And in the latter case manager’s choice of d coincides with much riskier
distribution of V than the one of former.
2-3 Increase in agency cost
‘Agency cost’ is a cost incurred by the principal agency relation (Jensen and
Meckling [1976]). The cost consists of (1) lost value due to improper action by the
agent and (2) the cost for preventing agent’s improper action. In relation to the debt
contract, the principal is creditor and the agent is debtor. One example of the improper
actions taken by the agent (debtor) is above mentioned asset substitution. If the creditor
does not make effort to monitor debtor’s action, asset substitution occurs and
consequent loss due to this is agency cost. If the creditor makes some effort to monitor
and asset substitution is not occurs, the cost of monitoring is added to agency cost in
this case.
4
Jensen and Meckling [1976] included another type of agency cost in the case of
debt contract; bankruptcy cost. Bankruptcy incurs some extra costs for negotiation
between firm’s stakeholders and/or loss of firm’s value (for example, destruction of
trust from suppliers may increase the financial cost if they want outright cash payment
instead of deferred payment). And owing debt increases the probability of future
bankruptcy. Then bankruptcy cost, which is the expected present value of future extra
cost associated bankruptcy, was included in the agency cost of debt by Jensen and
Meckling.
Agency cost affects the firm’s total financing cost because potential creditor
does not lend money without the surcharge (or premium), which amount is equivalent to
the expected agency cost, put upon the safe interest rate.
Increase in debt associates with increase in agency cost. And the relation might
be non-linear. Most possibly, an increment of agency cost grows more than the
increment of the debt as the level of debt grows.
Assuming other things being equal and the firm’s debt alone grows. This has
real effect on the firm’s decision making. Because the agency cost grows, firm’s
financing cost also grows. It lessens the firm’s appetite to invest.
2-4 Summary of incentive effects and macroeconomic consequence
In sum, ‘debt overhang’ and ‘asset substitution’ distort the firm’s investment
decision. The former cuts back on the economically worthy new investment, the latter
makes firm’s managers take excessive risk. Both decrease the economic welfare, and
then are microeconomic cause of distortions. ‘Increase in agency cost’ leads to increase
in firm’s financing cost, and consequently decrease the managers’ appetite to invest.
The existence of agency problem itself means a sort of microeconomic distortion, and
then the agency cost is the resultant measure of this distortion.
‘Debt overhang’ and ‘Increase in agency cost’ also have interesting
macroeconomic implication if they occur as economy wide phenomena. This story
applies to the situation after the Asian currency crisis. Currency depreciation ballooned
5
the burden of debt denominated foreign currency. And many firms suffer at the same
time. Then their appetite to invest decreased at the same time either due to ‘Debt
overhang’ or ‘Increase in agency cost’. It lead to aggregate fall of investment demand
and caused negative demand shock upon the whole of the countries economy.
Similar story applies to Japanese post bubble depression. Next section discusses
these experiences.
3, Debt deflation and Asian experiences
3-1 Theory of debt deflation
Unexpected deflation makes income transfer from debtor to creditor. ‘Debt
deflation’ refers to the vicious circle between deflation and income transfer. The
original debt deflation story by Irving Fisher [1933] emphasized the difference of
propensity to consume between debtor and creditor; that of former is greater then that of
latter. Then deflation-com income transfer from debtor to creditor reduces the amount
of aggregate consumption. This accelerates deflation further and leads to the second
round of vicious circle.
There are possible other explanations for debt deflation. One of those is based
on the bank’s credit creation function in the economy. Income transfer deteriorates
debtor’s balance sheets and makes their creditors (i.e. banks) be cautious to lend extra
money. This reduces the monetary multiplier and, other things being equal, trigger
another round of deflationary process.
The incentive effects of debt burden mentioned last section is also available to
construct another version of debt deflation story. The first round of deflation causes
transfer of income from debtors to creditors, which deteriorates debtors’ balance sheets
and distort their incentives, which reduces aggregate investment and leads to the second
round of deflationary process.
Note that the mentioned three explanations are not mutually exclusive.
6
The trigger of first round of deflation may differ according to individual
episodes. In the case of the Asian currency crisis, currency depreciation directly caused
the income transfer, so that the initial deflation was not necessary. In the case of recent
Japanese experience, the burst of bubble economy late 1980s followed by the
mismanagement of economic policy thereafter was the cause of first round of
deflationary process.
But the second round and the after may be similar in any case. Then the counter
measures to stop the vicious circle are also similar with each other. And the corporate
and financial restructuring policies are the major components of these measures. Before
discussing them, let me touch upon the situation after the Asian crisis and recent
Japanese depression.
3-2 In the case of Japan
The bubble economy swelled during late 1980’s and crashed just around the
border between 80’s and 90’s. The crash had gotten rid of about 1000 trillion yen (about
7.7 trillion US dollar) worth of asset value from the market; i.e. land prices had become
less than 30%, and average stock prices become one third, of the highest value during
bubble era.
In the early days of 1990’s, many Japanese people welcomed these asset price
collapses. Actuary, the government policy intentionally accelerated, not prevented, the
asset price falls urged by this kind of opinion. One of the slogans of those days was “put
down the land prices so as to enable average income household purchase housing land”.
The government raised the holding tax of land on the purpose of forceful release of
unused land and the Bank of Japan (BOJ) tighten the monetary policy to get down stock
prices further even after the crash.
It was a crazy policy mix just after the burst of historical bubble economy
comparable to the one of recent American boom. But very few people were alarming
about the wrong policy at that era. Majority underestimated the bad effect of asset price
collapses. Because most portions of stocks as well as lands were soled and bought by
7
Japanese and not by foreigners, change of the asset prices means nothing but just the
income transfer between Japanese. Don’t worry about the capital loss of the buyer of the
land, they thought, since the seller of the land got the money and he or she is also a
Japanese after all.
But such optimism turned out to be wrong. It is true that the crash of the asset
prices only changes the balance sheets of the owner of it and leaves other things
unchanged, but, as I mentioned last section, this causes bad incentive effects and
induces problematic actions of the owner of the asset. And this was the origin of the
debt deflation thereafter.
However, until the midst of 1994 prices had continued grow and Japan had
narrowly escaped from deflationary spiral. If only the proper macroeconomic policy
mix and measures of corporate debt restructuring were took during those period, Japan
might have escaped from the disaster of financial crisis in the late 90’s.
The change of GDP deflators turned to be negative after the forth quarter 1994
excluding that of 2Q/1997 to 1Q/1998 (see Chart 1). During this exceptional period the
effect of the rise of consumption tax rate from 3% to 5% prevented the change of
deflators to be negative. However if you extract 2%, which is the increment of the tax
rate, from the change of deflators during 2Q/1997 to 1Q/1998, you also have the
negative value around minus 1%. Since Japanese government recently admitted that the
deflation will last for a while (another a year or two), we are now experiencing a decade
long deflation.
8
Chart 1: Decade-Long Deflation in Japan
4
3
2
1
19
90
/1
Q
1 9 3Q
91
/1
Q
1 9 3Q
92
/1
Q
1 9 3Q
93
/1
Q
1 9 3Q
94
/1
Q
1 9 3Q
95
/1
Q
1 9 3Q
96
/1
Q
1 9 3Q
97
/1
Q
1 9 3Q
98
/1
Q
1 9 3Q
99
/1
Q
2 0 3Q
00
/1
Q
2 0 3Q
01
/1
Q
3Q
0
-1
-2
-3
(Source) Economic and Social Research Institute, Cabinet Office, Government of Japan
Although deflation had started since late 1994, economy showed a sort of
autonomous rebound in 1995 and 1996 (see Chart 2). Then again following bad
macroeconomic policies there became really serious situation in 1997. A tax increase by
Hashimoto government was a last straw on the fragile economy.
In recent Japanese experiences, coordination failure between the government
and BOJ has been so serious that there has been no consistency in macroeconomic
policy in Japan. Fiscal authority wanted BOJ take the easy money policy and hoped to
escape from responsibility on the pump-priming macroeconomic policy and
concentrated on its own business of cutting back on the budget deficit. The BOJ wanted
the fiscal authority take the responsibility (i.e. loose fiscal policy) and hoped to avoid
the drastic change of monetary policy. (I am sure that the Japanese central bank is the
most conservative central bank of the world. It has been afraid of inflation even when
the prices have been falling.) As a result of the evasions of responsibility by both sides,
9
the pump-priming macroeconomic policy has been always too late and too little to get
out of deflationary viscous circle.
In April 1997 Japanese government raised the consumption tax by 2% from 3%
to 5%, which lead to a recession and triggered financial crisis late 1997. In February
1999 BOJ commenced so-called “zero interest rate policy” to prop up the economy.
BOJ might think it was driven to deal with the aftermath of government’s mistake. In
August 2000 BOJ ceased ‘zero interest policy” too early, which the government was not
satisfactory with. This policy change turned out to be a failure (spoiled the faint
possibility of economic recovery) and ended up with the resumption of ‘zero interest
policy” only seven month later (in March 2001). Just after that, in April 2001 prim
minister Koizumi assumed office with a commitment of cutting off budget deficit,
which of course contradict with the economic recovery effort.
It seems that, by trying to shift the responsibility onto each other, Japanese
government and BOJ always end up by doing something wrong that keeps the other
party from succeeding.
10
Chart 2: Economy Stagnated
8
7
6
5
4
3
2
1
/1
Q
1 9 3Q
91
/1
Q
1 9 3Q
92
/1
Q
1 9 3Q
93
/1
Q
1 9 3Q
94
/1
Q
1 9 3Q
95
/1
Q
1 9 3Q
96
/1
Q
1 9 3Q
97
/1
Q
1 9 3Q
98
/1
Q
1 9 3Q
99
/1
Q
2 0 3Q
00
/1
Q
2 0 3Q
01
/1
Q
3Q
0
19
90
-1
-2
-3
(Source) Economic and Social Research Institute, Cabinet Office, Government of Japan
Once the deflationary vicious circle has gathered momentum, it is very difficult
to stop it. After the outright banking crisis erupted late 1997, the government finally
recognized the threat of NPL problems and injected public money into almost all of big
banks (once in March 1998 and in March 1999 second time) as a preferred stock
totaling more than 9 trillion yen (70 billion US dollar). But these measures could not
resolve the NPL problem, because new NPL has constantly emerged keeping pace with
the development of debt deflation.
Although the infusion of public money strengthened the balance sheets of banks,
the profitability of banks had deteriorated by the progress of debt deflation and the
resultant emergence of new NPL. Fukao and Fueda [2001] pointed out that “(1) the
average spread the banks had been making on lending had been about 0.5 percentage
points, … (2) the losses incurred from defaults on loans in the four years from 1996 to
1999 have been about 1.4 to 2.8% of total loans. Thus, the spread that the banks have
11
been making are suspected to be negative.” “However, for the borrowing companies
that are suffering from declining sales due to deflation, it will be impossible for
financial institutions to raise their lending rates by a large margin.”
3-3 In the case of Asian currency crisis
In a sense the experience of crisis ridden Asian countries were similar to that of
the Japan. It was a crash of bubble like economic boom and accompanying income
transfer from debtors to creditors that triggered the crisis. But in this case the key asset
price was exchange rates and income transfer occurred not only among domestic
residents but also between residents and nonresidents.
Bubble like economic boom of East Asian countries collapsed around latter half
of 1996 to 1997. If there were few foreign participant in the market, there would not be
a currency crisis and the situation would be much more similar to that of Japan. Foreign
portfolio investors and banks scared by the burst of the bubble and rushed out of the
market. This raised the downward pressure on the exchange rates, and finally made the
fixed exchange rate system collapse. This process also had a circular nature like the debt
deflation process. As foreigner rushes out exchange rate depreciates, which scares
foreigner much more and leads to another round of rush-and-depreciation circle (see
Table 1).
The burden of debt denominated in foreign currencies grew enormous for the
domestic debtors. This effect added to the damage from the burst of the bubble. In any
case debtors income were transferred to creditors, whether foreign or domestic. It surely
had an enormous deflationary effect on these economies. Unfortunately quantity of debt
had ballooned during boom days so that the troubles caused by the deflationary effect
became much greater (see Table 2). The huge amount of NPL after the crisis indicates
the graveness of the situation (see Table 3).
But this was not the end of the story. IMF came in and made bad thing worse. At
first IMF underestimated the deflationary impact of NPL problem and subscript
excessively tight fiscal and monetary policy. Especially high interest rate policy for the
12
purpose of stabilizing exchange rates had not only pull down effect on overall economy
but also deteriorating effect on banks profitability (see Chart 3). Because maturity of
lending is longer than maturity of deposit, increase in interest rates of lending lags
behind that of deposit, and bank profitability is deteriorated. Even if the banks could
have raised lending interest rates promptly, there was no reason that the existing debtor
could repay the principal and interest under the crisis condition. Then banks’ cost of
funds (i.e. deposit rate) heightened but the income from lending did not (it even shrunk
due to NPL problem).
Table 1: Value of Currency Collapsed
(Comparing to US$; Jun-97=100)
Jan-90
Indonesia
136
Thailand
100
The Philippines 117
Malaysia
93
Korea
130
Japan
79
Jun-97
100
100
100
100
100
100
Jan-98
25
48
62
57
52
88
Jul-98
18
63
63
61
69
81
Dec-99
34
68
65
66
78
111
Table 2: Ratio of Domestic Credit to GDP
Indonesia Korea Korea
Malaysia Malaysia Thailand Thailand** U.S.
58.13% 74.68% 134.85% 123.60% 165.10%
126.96% 157.29% 80%
Japan
128%
(Notes) Domestic Credit is the sum of that of Deposit Money Banks and Monetary Authorities
*) It is the sum of Domestic Credit and claims on private sector by Other Banking Institutions
**) It includes claims on Other Banking Institutions and Nonbank Financial Institutions
(Source) International Financial Statistics, IMF
13
Table 3: Non-performing Loan Ratio
Malaysia
Oct-98 Jun-99
Commercial Bank 13.0 12.8
Merchant Bank
30.6 31.6
Other FIs
26.8 23.9
AMC
100.0 100.0
All FIS
19.7 21.2
Korea Dec-98 Jun-99
7.4
8.7
20.0 11.9
13.1 14.5
100.0 100.0
16.8 19.2
Thailand
Indonesia
Dec-98 Sep-99 Mar-98 Mar-99
42.9 44.6 19.8 58.7
70.2 62.3 45.0 45.3 Chart 3: Long Lasting High Interest Rate Policy
--- The Case of Indonesia
90
80
70
60
50
40
30
20
14
Sep-99
Nov-99
Jul-99
Mar-99
May-99
Jan-99
Nov-98
Jul-98
(Source) International Financial Statistics, IMF
Sep-98
Mar-98
May-98
Jan-98
Nov-97
Jul-97
Sep-97
May-97
Mar-97
Jan-97
Sep-96
Nov-96
Jul-96
Mar-96
May-96
0
Jan-96
10
Table 4: The Growth rate of GDP
1995
Hong Kong
3.9
Indonesia
8.2
Korea
8.9
Malaysia
9.8
The Philippines 4.7
Singapore
8.0
Taiwan
6.4
Thailand
8.9
Chine
10.5
Vietnam
9.5
1996
4.5
8.0
6.8
10.0
5.8
7.7
6.1
5.9
9.6
9.3
1997
5.0
4.5
5.0
7.5
5.2
8.5
6.7
-1.4
8.8
8.2
1998
-5.3
-13.2
-6.7
-7.4
-0.6
0.0
4.6
-10.8
7.8
4.4
1999
3.0
0.9
10.9
6.1
3.4
6.9
5.4
4.4
7.1
4.7
2000
10.5
4.8
9.3
8.3
4.0
10.3
5.9
4.6
8.0
6.1
1998
2.8
46.5
7.5
5.3
9.7
-0.3
1.7
8.1
-0.8
9.2
1999
-4.0
-1.9
0.8
2.8
6.7
0.1
0.2
0.3
-1.4
0.1
2000
-3.8
3.7
2.3
1.6
4.4
1.3
1.3
1.6
0.4
-0.6
2001
-1.6
11.5
4.1
1.4
6.1
1.0
0.0
1.7
0.7
0.8
2001
0.1
3.3
3.0
0.4
3.4
-2.0
-1.9
1.8
7.3
5.8
(Source) Asian Development Bank
Table 5: Inflation
1996
Hong Kong
6.4
Indonesia
-39.6
Korea
4.9
Malaysia
3.5
The Philippines 9.1
Singapore
1.3
Taiwan
3.1
Thailand
5.9
Chine
8.3
Vietnam
4.4
1997
5.8
35.6
4.5
2.7
5.9
2.0
0.9
5.5
2.8
3.6
(Source) Asian Development Bank
It is a great fortune that Crisis ridden Asian countries barely escaped from
falling in debt deflation processes in spite of all those disastrous factors. Table 5 shows
that the rate of inflation in East Asia has been low but barely escape the deflation after
the crisis excluding Hong Kong that has taken currency board system. (Under the
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currency board system deflation is inevitable instead of depreciation of exchange rates
when the capital outflow occurs.)
However it seems to me that the dangers for Asian countries have not gone away
yet. Especially, the inflation rates of some of them are so low that the special attention
must be paid to it. Although it has been nearly five years since the Asian currency crisis
broke out, some of the crisis-ridden countries are still struggling to solve NPL problems.
Japan also had escaped deflationary spiral at least four years after the burst of its bubble
economy. But ridiculous macroeconomic policy mix combined with insufficient effort
to solve NPL problem in the early days of 90’s, lead to outright financial crisis in late
90’s and opened the way to debt deflation. With hindsight, Japan missed the opportunity
to fix the firms’ balance sheet problems during early days of 90’s when the
macroeconomic situation was relatively stable and prices were stable but increasing
moderately. And once the deflationary processes gathered momentum in the latter half
of 90’s, it became very difficult both to stop deflation and to solve NPL problem.
Next section analyses the experiences of Asian countries’ financial restructuring
efforts. There have been successes and failures and the countries’ experiences are
diverse.
4, Corporate and bank restructuring, and the prevention of debt deflation
4-1 An overview of policy measures analyzed in this section
Corporate and bank restructuring is not important for itself but for normalizing
the firm’s incentives and preventing the balance sheet effect spilling over to
macroeconomy. In theory, direct measure to fix the balance sheet might be a sufficient
prescription to the problem. But in reality, such a measure is difficult to execute
(subsection 4-2). Then there are broad ranges of indirect measures to assist the debt
restructuring processes. For example, Macroeconomic stimulus policies, which prevent
further deterioration of debtors’ balance sheets and encounter the deflationary effect of
debt restructuring processes, greatly help solve the problem (subsection 4-3).
16
Bank restructuring should be thought of as an indispensable prerequisite of the
corporate debt restructuring, since the creditor banks’ incentives must be normalized
before they play proper role in the course of debt workout negotiations. With distorted
incentives banks might rather become an impediment in the processes. Then some
combination of re-capitalization, closures, and mergers of banks becomes necessary
(subsection 4-4 and 4-5).
Government agencies may act as important players in resolving debt problems.
NPL may be transferred to centralized asset management companies that are set up by
the government (subsection 4-6). Government may settle a committee whose mission is
to mediate negotiations between the debtor and creditors and prompt the debt workout
processes (subsection 4-7). These measures are in a sense direct ones, but it is advisable
not to distort the private decision making by the excessive government intervention.
The measures to improve corporate governance and to strengthen prudential
regulation on banks are also helpful to financial restructuring (subsection 4-8 and 4-9).
These measures have significance not only in preventing the crisis but also in curing.
In conducting these wide-ranging measures, the institutional arrangement of the
governmental institutions becomes crucial. The division of labors among them is
important to avoid the conflict of interests inside of the individual institution
(subsection 4-10).
4-2 Direct and indirect measures
The simplest counter measure to combat debt deflation, as well as to normalize
debtor incentives, is to make an opposite income transfer; i.e. transfer from creditors to
debtors. For example the creditor cuts the value of their credit just the same amount as
the initial income transfer from debtor to creditor. This solution is very simple, but you
can never imagine the creditors voluntarily do that. In fact there are some kind of
macroeconomic externality to stop the debt deflation; the benefit of it comes to
everyone. Because the creditors cannot internalize this benefit, creditors’ supply of debt
forgiveness will be short of the socially optimal amount. In other word, the incentive of
17
creditor to forgive debt is smaller than that of socially optimum. Then some form of the
intervention policy to promote the process of debt restructuring negotiations between
debtor and creditor may be able to enhance economic efficiency. This sort of policies
belongs to ‘direct measures’ because they try to stop the debt deflation correcting a part
of vicious circle directly (in this case reversing the income transfer).
On the other hand, ‘Indirect measures’ contains broad range of policies, which
intend to make some counteractive effect against the deflationary vicious circle but
outside of it. For example expansionary fiscal policy has a prop-up effect over the
macroeconomy and counteract against the deflation but keeps the cause of debt
deflation intact. Other examples are loose monetary policy, manipulation of stock prices,
expansion of directed credit by government financial institutions, and so on, some of
which may cause distortion of allocation of economic resources.
In general direct measures have more effectiveness than indirect ones. But it is
necessary to consider the cost and the feasibility of conducting the policy at the same
time. After all, whether direct or indirect, some measures are undesirable and some are
desirable. We need to assess each measure individually (and I will do it below).
One sure criterion is whether the measure has distorting effect on resource
allocation or not. And desperate situation encourage such distorting policies. East Asian
countries in general prefer to take market-oriented policies, but during the Crisis they
sometimes took dubious policies that impair the market mechanisms. Hong Kong’s
authority was criticized their decision to buy up stocks in 2000. In Japan desperate
government sometimes tried to manipulate the stock prices by arbitrary change of
transaction rules and to prop up land prices by ad hoc change of tax treatment. To
prevent these kinds of things occur, effective counter measures against debt deflation
are necessary in the first place.
4-3 Macroeconomic policies
Expansionary fiscal and monetary policy is surely one of the indirect measures
and do not touch upon the cause of debt deflation directly. But, at least, it is strongly
18
advisable not to take contractionary macroeconomic policies when there are
deflationary pressures. This kind of things occurred during Asian and Japanese crisis
and made it harder to conduct financial and corporate sector restructuring (as mentioned
in section 3).
Some people insist that only the economic difficulty force the reluctant
governments take drastic economic reform. This kind of argument sometimes has used
as a justification of government’s and BOJ’s inaction of combating deflationary
pressures in Japan. Delay of IMF support is also sometimes justified by this theory. But
the reality is that economic downturn makes it much more difficult to reform the
economic system. This is especially true about the financial and corporate restructuring
under the deflation-prone economy. For example Japanese banks had written off NPL
worth 26.7 trillion yen (about 200 billion US dollar) from April 1998 to March 2001,
still NPL had grown 3.7 trillion yen (30 billion US dollar) during the same period. In
fact new NPL grows more than the decrease in old NPL that was written off. This is of
course due to Japan’s economic repression and deflation.
4-4 Bank bailout and recapitalization
In some situation, bailing out of banks become necessary to prevent panic and
chain of bank run; i.e. systemic banking crisis. However I focus the bank bailout policy
here as a counter measure to debt deflation and incentive problems but do not consider
the other objective of the policy such as the prevention of panic and bun run.
Because banks are creditor to the firms, they are expected to initiate the debt
restructuring process and lead the process. But if their financial healthiness is lost, their
incentive would be distorted, just like that of a non-financial firm would, and they might
become an impediment rather than promoter of the debt restructuring. Typical problem
is that bank just postpones the debt restructuring for fear of realization of loss and
bankruptcy of itself. Then the bailout of weak bank is an option to counteract debt
deflation, but its cost effectiveness is in sometimes dubious.
19
In some situations, it seems rational to transfer the NPL from the bank to other
institution specialized in debt restructuring and poring government money into it rather
than into the bank. I discuss this policy in later subsection.
Besides, bailout of bank in itself has an adverse incentive effect; it may cause
moral hazard problem in the bank management. Bank management would become less
cautious if the manager counts on the government rescue whenever the bank gets in the
trouble. This hampers debt restructuring workout lead by banks.
It is important to keep in mind that the normalization of bank’s incentives is the
ends, and the bailout of bank in itself is merely the means of that.
For fear of de fact nationalization of banks, Japanese government was reluctant
to infuse capital into weak banking sector. Time were lost just for making consensus,
and in the end government bought preferred stocks of banks to strengthen the banks’
capital adequacy norm. However, because the preferred stocks do not have voting right,
government had no clout in the bank management and could not play any role in
disciplining banks’ management. In fact this was a very generous bank bailout without
any meaningful penalties and might be a cause of future moral hazard problem of bank
management.
Of course, government’s clout in the bank management itself does not assure the
proper disciplining of bank management. Government is prone to conflict of interests to
conduct any policy. For example government may use its clout in bank management for
the purpose of assisting small and medium-sized enterprises (or any powerful lobbyist
group) by prompting the banks to lend them money without commercial consideration.
To avoid this kind of things happen, government can set up specialized body
which objective is strictly limited to own and manage the bank stocks bought by
government. The motivation of this institution must be same as that of private
shareholders; i.e. maximization of the stock value. A good example is Danamodal set up
by Malaysian government after the crisis. Table 6 shows institutional arrangement of
financial restructuring of selected Asian countries, and only the objective of Malaysia’s
Danamodal is restricted to stock management narrowly. Some of others have multiple
20
purposes (IBRA of Indonesia) and some are a section of some institution that has other
objectives, which may be prone to conflict of interests.
Table 6: Institutional arrangement of financial restructuring
Korea
NPL Management
IBRA (Indonesian
Bank Restructuring
Authority)
KAMCO (Korea
Asset Management
Corporation)
Malaysia
Danaharta
Korea Deposit
Corporate Restructuring
Insurance Corporation Coordination Committee
CDRC (Corporate Debt
Danamodal
Restructuring Committee)
TMAC
Financial Institutions
Development Fund
Indonesia
Thailand
Bank Recapitalization Mediation of Debt Workout
IBRA
Jakarta Initiative Task Force
CDRAC (Corporate Debt
Restructuring Advisory
Committee)
Table 7: Estimated re-capitalization costs for commercial banks, mid-October 1988
Estimated costs
Indonesia
Korea
Malaysia
Thailand
Amount disbursed
550 trillion Rupiah 100 trillion
72 trillion Won
56 trillion
31 billion Ringgit 13 billion
1121 billion Baht 751 billion
Remaining
Percentages of GDP Percentages of GDP
11%
48%
13%
4%
4%
6%
16%
8%
(Source) World Bank [1999], Global Economic Prospects and the Developing Countries
2000, Table 3.6
21
4-5 Bank closures and mergers
In fact bank closure solves nothing in itself. There are bank’s assets (some of
which are NPL) and liabilities (much of which are deposits) left behind. How to dispose
of these assets and liabilities is the key factor that divides success and failure of bank
restructuring.
The merger of failed bank by other healthy one is the simplest solution for
disposals of both assets and liabilities. However under the crisis situation, it is hard to
find out healthy bank that has appetite for merger. Then government sometimes is
forced to close failed bank or nationalize it at least temporary, just for buying time.
In certain situation bank closure becomes rational even if there is another bank
that has an incentive to acquire the failed one. For example if the reduction of
employees of acquired bank or salary of them is necessary but expected to be very
difficult due to specific characteristic of labor law of the country, bank closure
immediately followed by acquisition by other bank solves the problem. Employees are
fired at the point of closure and employed by the acquiring bank anew, when the whole
new condition of employment contract can be made or selection of employee can be
made.
The treatment of deposits is usually a source of headache. Other liabilities might
well be wiped out in due course of resolution, but loss on deposits often causes
contagion of bank run to other viable banks and political backlash. The greatest care
must be paid for the treatment of failed bank’s deposits. To have an explicit deposit
insurance scheme in advance is the ideal, but if there is no explicit rule in advance,
government usually has no choice but provides blanket protection of deposits in a crisis
situation.
Indonesia’s closure of 16 banks in November 1997 without any mention about
the treatment of deposits triggered overall bank run and deteriorate the economic
situation further. Some scholars criticized this action, and attributed it as a major cause
of Indonesian currency and financial crisis. (Radelet and Sachs [1998])
22
Table 8: The treatment of failed financial institutions
Closures
64 Banks (18%)
State takeovers
12 commercial Banks
(20%)
Indonesia
Korea
Malaysia
Thailand
5 commercial banks, 17 4 commercial banks
merchant banks, and
(25%)
more than 100 nonbank
financial institutions
(15%)
None
1 commercial bank, 1
merchant bank, and 3
financial companies
under central bank
control (12%)
57 financial companies 7 commercial banks
(11%) and 1
(13-15%) and 12
commercial bank (2%) finance companies
(2.2%)
Mergers
4 of 7 state banks to be
merged into a single
bank (54%)
9 banks and 2 merchant
banks to create 4 new
commercial banks
(15%)
6 mergers of finance
companies and
commercial banks (2%)
5 commercial banks and
13 finance companies
into 3 banks (20%)
Note: Figures in parentheses refer to percentage of assets in the financial sector
(Source) World Bank [1999], Global Economic Prospects and the Developing Countries
2000, Table 3.5
4-6 Transfer of NPL
Many of crisis ridden Asian countries set up government owned Asset
Management Company (AMC) specialized in management of NPL and transferred
banks’ NPL to it. There are pros and cons of this policy.
Government-owned institution has an advantage to have a good coordination
with police, judge and other relevant public institutions to collect NPL. And
concentration of NPL to one body (i.e. to the AMC) avoids the possible coordination
failure among many creditors. In addition, government-owned institution can take into
account the social value of resolving NPL, but private banks cannot.
23
On the other hand, information about the individual debtor gathered and stored
by the bank may be lost when the transfer of NPL is conducted, or such information
may be very difficult to transfer.
Setting rules of qualification about transferable NPL to AMC is worthy to be
considered. For example in Malaysia loans larger than 5 million ringgit was eligible to
transfer to AMC, while in Indonesia worst category of NPL was eligible. The bigger the
loan amount, the more the number of creditors and the bigger the merit of concentration
of NPL to one body for avoiding coordination failure among creditors. And the
information about the debtor stored in the creditor bank may not be vital to dispose of
the most rotten NPL.
Private institution can also set up AMC. In some country government urged
banks to set up AMCs by themselves and transfer NPL to them. But in Asia such policy
was apt to fail than to succeed.
Possible reason of failure of private AMCs was that banks of which incentive
was distorted, set them up. Such banks used AMC just for buying time and covering up
of their balance sheets. To prevent this to happen, it is important that restoring the
healthiness of bank management should come first and next the corporate debt
restructuring. In Japan major banks jointly set up private AMC in early days of 1990’s
but it hardly worked to settle NPL problem and only was useful for covering up of the
bank balance sheets, whereas the government settled AMC, though its assets were NPL
transferred from failed nonblank financial institutions, did its task quite well.
24
Table 9: Transfer of NPL
Indonesia
Centralized
Yes
asset
management
corporation
buys assets at
subsidized
prices
Korea
Malaysia
Assets were initially Purchased assets
purchased above
are valued by
market-clearing prices independent
with recourse. Since outside auditors
February 1998
purchases have been
attempted at market
prices
Type of assets Worst assets
transferred
No particular strategy Loans larger than 5 Not applicable
million ringgit, and
mostly loans
secured by
property or shares
Thailand
Not applicable
(Source) World Bank [2000], East Asia: Recovery and Beyond, Table 4.5 (extracts)
4-7 Intervention in debt restructuring process
Normally government sets bankruptcy law and provides juristic system. It is up
to private economic agents’ will to utilize these government facilities to settle NPL
problem. They are free to negotiate outside the juristic procedures. But some of the
Asian countries’ governments went further after the Crisis and intervened in the private
debt restructuring process directly.
In part, this was because the formal bankruptcy law and procedures had some
drawbacks in some country. Although the reform of bankruptcy procedures was
initiated at the early stage after the Crisis, it took time for the reform to take effect. Then
the government intervened in private negotiation as an emergency action.
However it was wise that Asian governments have avoided excessive
intervention in the private negotiation. They have acted as a mediator and prompter of
the negotiation but not as a decision maker. They have set the model procedure and
timetable of the negotiation, and provided tax incentives to settle the negotiation earlier,
but left the final decision to the participants.
25
Many of crisis ridden countries adopted this strategy; in Malaysia CDRC
(Corporate Debt Restructuring Committee), in Thailand CDRAC (Corporate Debt
Restructuring Advisory Committee), in Indonesia Jakarta Initiative Task Force, and in
Korea Corporate Restructuring Coordination Committee was set up and assume the task
of mediating private debt workout negotiations.
Again the prerequisite of this policy to succeed is the normalization of banks’
incentive, since ill-motivated bank could utilize the private negotiation as the
opportunity to cover up for the true problem. For example it may cook up a
restructuring plan that will break down in the end but endure for a while. The records of
those countries that were late to take drastic measures to normalize bank balance sheet
and incentives before promoting private debt workout (such as Japan and Thailand),
turned out to be mixed. And sometimes the restructuring plan made by creditor banks
had failed and another round of debt restructuring negotiation became necessary.
4-8 Improvement in corporate governance and the agency cost of debt
Much was talked about the need of improvement on corporate governance in
Asia after the crisis. Since the corporate governance is important always, nobody can
deny this statement. But it is useful to think why it is so for the purpose of financial
restructuring after the crisis. It seems a preventive measure rather than cure of the crisis.
If so, you could say that excessive stress has been put on it.
However, there is one reason that makes the improvement of corporate
governance a cure to the crisis. Improvement of corporate governance reduces the
agency cost mentioned former section and raise the appetite for new investment by
firms whose financial cost decreases with the agency cost. For example improvement on
disclosure of information of a company makes it easy to issue debt security in the
market. Putting more clout to common share holders raises potential investors’
willingness to pay for acquiring new stocks.
26
On the other hand, it is important to note that this measure solely would not
solve the problem. It must be considered as one of the wide-ranging measures. The
danger is that it is used as an excuse for not taking other measures.
4-9 Prudential regulations on banks and Moral hazard
This, again, seems a preventive measure against the future banking crisis and
has nothing to do with a cure of the crisis. However it has a subtle relation with the cure
of the crisis, if the strengthening of prudential regulations are combined with the
government commitment that future bank failure will be treated much more harshly.
This commitment has a favorable effect on bank incentives (preventing moral hazard)
and makes banks perform expected role in the process of corporate restructuring.
Usually, large-scale financial crisis necessitates some sort of government’s
assistance provided for banks. By looking this, bank managers may expect future
governments assistance and become imprudent on bank management. Then it is
important for the government to persuade bank managers that in the occasion of future
bank failure its attitude against the failed bank will become much more severe than this
time. This is surely a difficult task, and it is not enough for the government to declare its
policy intentions of future stringent banking policy. It has to show some proof that the
policy regime on banking has definitely shifted and future bailout will not come so
easily.
Because of the time inconsistency problem (Kydland and Prescott [1977]),
government announcement cannot be trusted. Once a banking crisis occurs, the
government payoff, when it bails out weak banks, will surpass the one of otherwise.
Then people rationally believe that government’s bailout of banks is much more
possible than not. In such a situation occurrence of moral hazard is unavoidable. The
measures to lessen the government payoff when it bails out the banks, and measures to
increase the payoff when it does not bail them out, are necessary to convince people of
the government’s commitment. This is because it is the incentive of the government, not
just the talk of the government, that the people take into account. And the strengthening
27
of prudential regulation combined with the policy of early prompt action over the bank
closure will lessen the cost of no-bailout policy, and then subsequently increase the
credibility of the government commitment.
Note that superficial adoption of prudential norm has no effect, since it makes
no difference in the government’s incentive structure.
4-10 Avoidance of conflict of interests
In the face of overall financial crisis, the government has to plan and implement
financial restructuring. It may re-capitalize weak banks and assume some portion of
NPL from the banking sector. Since the government has many objectives at a same time,
it is important to arrange the institutional settings to implement financial restructuring
policy properly. To avoid possible occurrence of conflict of interests inside a
governmental organization, it is advisable to set up specialized institutions concentrate
on one objective by each. For example central bank may not be a suitable institution to
plan and conduct financial restructuring, since it has had already other policy objective;
that is, stabilization of general price movement.
Following this viewpoint, the Indonesian Bank Restructuring Authority (IBRA)
has had too many objectives, which can be classified into four groups listed below.
(1) The planning and implementing of bank restructuring
Major tasks classified in this category are selection of the banks that should be
closed, selection of the banks that should be re-capitalized, and making restructuring
plan of nationalized banks.
(2) The commencement of re-capitalization and the administration of resultant
government share holding of banks
Major tasks are holding of the banks’ stocks that the government acquired in
return of infusion of capital, playing the shareholder’s role, and administration of the
resale of the stocks.
28
(3) The administration and disposals of NPL
Major task is administration and disposals of NPL transferred from closed and
re-capitalized banks.
(4) The administration and disposals of other assets
This task was added later when IBRA acquired non-financial firm’s stock from
owners of failed banks as a penalty for breaking the regulatory ceiling of group lending.
The administration and resale of these stocks for the purpose of raising money for
government coffer became also one of the IBRA’s objectives.
As the IBRA’s objectives grew, the amount of assets under IBRA’s
administration also grew. Table 10 shows the break down of the assets administered by
IBRA as of December 2000. Total worth of assets became huge and was 1.6 times as
large as the amount of national budget of 2001.
In addition to the problem of conflict of interests, there is another danger
associated with the concentration. Because of this, IBRA had come to the fore as a
target for the lobbyist. It is very much cost-effective for them to lobby when the targets
are concentrated than when they are dispersed. In due course, IBRA has already
involved in scandals and political chaos in many times. This of course hindered it from
conducting its duties.
29
Table 10: The Breakdown of IBRA’s assets
Loan transferred from closed and recapitalized banks
Other assets transferred from closed banks
Holding share of re-capitalized banks
Holding share of non-financial companies
27.8
0.9
15.5
15.4
Total
59.6
Billion US$ Note and related objectives of IBRA
Objective (1), (3)
Objective (1)
Objective (2)
Objective (4)
1.6 times as large as the amount of
national budget of 2001
Note: Please refer to the text for the objective (1) to (4)
(Source) Nikkei Kinyu Shinbun, 2000/12/15
5, Concluding remarks
The episodes of Japanese long-lasting depression and the Asian currency crisis
have something in common. Both were triggered by huge downward swing of asset
prices. The immediate effect of asset price change is only on the balance sheets of their
owners and no more. However if a firm that owes debt experiences a deterioration of its
balance sheet by whatever reasons, its incentive will be distorted and problematic
actions by it will be induced. For one thing, it will assume much more risks than
otherwise (due to asset substitution). For another, it will conduct much less new
investments than otherwise (due to debt overhang and increase in the agency cost).
These incentive effects in themselves cause microeconomic distortions, but also
have macroeconomic implications if they occur in many firms at the same time. Since
asset price falls were prevalent in episodes of Japan and Asia, incentive effects of
individual firms accumulated and had great downward pressure on their economy. And
there were great danger of debt deflation, or self-enforcing downward spiral process. In
Japanese case this realized actually several years after the burst of bubble economy.
Asian countries seem to have barely escaped it to turn into reality at least for now.
However Japan also had escaped deflationary spiral at least four years after the burst of
its bubble economy. Bad macroeconomic policy mix combined with insufficient effort
to solve NPL problem in the early days of 90’s, lead to late 90’s outright financial crisis
and opened the way to debt deflation.
30
It has been nearly five years since the Asian currency crisis broke out, and some
of the crisis-ridden countries are still struggling to solve NPL problems. It seems to me
that the dangers for Asian countries have not yet gone away. Especially, the inflation
rates of some of them are too low to be worried about.
Japanese experience teaches us that both the macroeconomic prop up measure
and the resolving NPL problem are the indispensable policy actions to prevent disaster
after an economy-wide huge negative swing of asset prices that deteriorate many
debtors’ balance sheets.
Corporate and bank restructuring is not important for itself but for normalizing
the firm’s incentives and preventing the balance sheet effect spilling over to
macroeconomy. In theory, direct measure to fix the balance sheet might be a sufficient
prescription to the problem. But in reality, such a measure is difficult to execute. Then
there are broad ranges of indirect measures to assist the debt restructuring processes.
For example, Macroeconomic stimulus policies, which prevent further deterioration of
debtors’ balance sheets and encounter the deflationary effect of debt restructuring
processes, greatly help solve the problem.
Bank restructuring should be thought of as an indispensable prerequisite of the
corporate debt restructuring, since the creditor banks’ incentives must be normalized
before they play proper role in the course of debt workout negotiations. With distorted
incentives banks might rather become an impediment in the processes. Then some
combination of re-capitalization, closures, and mergers of banks becomes necessary. In
conducting it, special attention must be paid for avoiding moral hazard of bank
management, which might be caused by generous bank bailout policy, and systemic
bank crisis, which might be caused by imprudent closures of banks.
Government agencies may act as important players in resolving debt problems.
NPL may be transferred to centralized asset management companies that are set up by
the government. Government may settle a committee whose mission is to mediate
negotiations between the debtor and creditors and prompt the debt workout processes.
These measures are in a sense direct ones, but it is advisable not to distort the private
decision making by the excessive government intervention. The NPLs, which are
31
suitable to transfer to government agency, should be scrutinized, since the banks may
have valuable information for solving NPL problem, which have been collected through
their repeated transactions with the debtor. The mediation committee might coordinate
with other governmental bodies to arrange the environment, which facilitate the debt
workout process (such as the introduction of tax incentive or revision of relevant law),
but should not make and impose its discretionary restructuring plan on the participant.
The measures to improve corporate governance and to strengthen prudential
regulation on banks are also helpful to financial restructuring. Although they
supplement it very much, it is misleading to put too much stress on them and dilute the
importance of other measures mentioned here.
In conducting these wide-ranging measures, the institutional arrangement of the
governmental institutions becomes crucial. For example, the division of labors among
them is important to avoid the conflict of interests inside of the individual institution.
32
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Deflationary Economy --Strategy to Revive the Japanese Economy--,” Japan Center for
Economic Research, Japan Financial Review No.4: March 2001.
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Jensen, Michael C., and Meckling, William H., [1976], “Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial
Economics.
Kydland, F.E., and Prescott, E.C., [1977], “Rules Rather Than Discretion: The
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33