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

2 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

3 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

4 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

5 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.

6 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)

7 Separation of bad debts Spanish 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.

8 Separation of bad debts Reasons 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.

9 Separation of bad debts Reasons 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.

10 Separation of bad debts The 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

11 Separation of bad debts The 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.

12 Experience of three Central European Countries

13 Experience of three Central European Countries Summary 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.

14 Spanish model versus Polish model Comparison

15 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.

16 Thank you