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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.

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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

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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).

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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.

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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

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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.

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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

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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.

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Chart 1: Decade-Long Deflation in Japan

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0

1

2

3

4

1990/1Q3Q

1991/1Q3Q

1992/1Q3Q

1993/1Q3Q

1994/1Q3Q

1995/1Q3Q

1996/1Q3Q

1997/1Q3Q

1998/1Q3Q

1999/1Q3Q

2000/1Q3Q

2001/1Q3Q

(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,

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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.

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Chart 2: Economy Stagnated

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0

1

2

3

4

5

6

7

8

1990/1Q3Q

1991/1Q3Q

1992/1Q

3Q

1993/1Q3Q

1994/1Q

3Q

1995/1Q3Q

1996/1Q3Q

1997/1Q3Q

1998/1Q3Q

1999/1Q

3Q

2000/1Q3Q

2001/1Q

3Q

(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

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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

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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 Jun-97 Jan-98 Jul-98 Dec-99 Indonesia 136 100 25 18 34 Thailand 100 100 48 63 68 The Philippines 117 100 62 63 65 Malaysia 93 100 57 61 66 Korea 130 100 52 69 78 Japan 79 100 88 81 111

Table 2: Ratio of Domestic Credit to GDP

Indonesia Korea Korea� Malaysia Malaysia�� Thailand Thailand** U.S. Japan 58.13% 74.68% 134.85% 123.60% 165.10% 126.96% 157.29% 80% 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

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Table 3: Non-performing Loan Ratio

Malaysia Korea � Thailand Indonesia � Oct-98 Jun-99 Dec-98 Jun-99 Dec-98 Sep-99 Mar-98 Mar-99 Commercial Bank 13.0 12.8 7.4 8.7 42.9 44.6 19.8 58.7 Merchant Bank 30.6 31.6 20.0 11.9 � � � � Other FIs 26.8 23.9 13.1 14.5 70.2 62.3 � � AMC 100.0 100.0 100.0 100.0 � � � � All FIS 19.7 21.2 16.8 19.2 45.0 45.3 � �

Chart 3: Long Lasting High Interest Rate Policy

--- The Case of Indonesia

0

10

20

30

40

50

60

70

80

90

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98

Jul-98

Sep-98

Nov-98

Jan-99

Mar-99

May-99

Jul-99

Sep-99

Nov-99

(Source) International Financial Statistics, IMF

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Table 4: The Growth rate of GDP

� 1995 1996 1997 1998 1999 2000 2001 Hong Kong 3.9 4.5 5.0 -5.3 3.0 10.5 0.1 Indonesia 8.2 8.0 4.5 -13.2 0.9 4.8 3.3 Korea 8.9 6.8 5.0 -6.7 10.9 9.3 3.0 Malaysia 9.8 10.0 7.5 -7.4 6.1 8.3 0.4 The Philippines 4.7 5.8 5.2 -0.6 3.4 4.0 3.4 Singapore 8.0 7.7 8.5 0.0 6.9 10.3 -2.0 Taiwan 6.4 6.1 6.7 4.6 5.4 5.9 -1.9 Thailand 8.9 5.9 -1.4 -10.8 4.4 4.6 1.8 Chine 10.5 9.6 8.8 7.8 7.1 8.0 7.3 Vietnam 9.5 9.3 8.2 4.4 4.7 6.1 5.8 (Source) Asian Development Bank

Table 5: Inflation

� 1996 1997 1998 1999 2000 2001 Hong Kong 6.4 5.8 2.8 -4.0 -3.8 -1.6 Indonesia -39.6 35.6 46.5 -1.9 3.7 11.5 Korea 4.9 4.5 7.5 0.8 2.3 4.1 Malaysia 3.5 2.7 5.3 2.8 1.6 1.4 The Philippines 9.1 5.9 9.7 6.7 4.4 6.1 Singapore 1.3 2.0 -0.3 0.1 1.3 1.0 Taiwan 3.1 0.9 1.7 0.2 1.3 0.0 Thailand 5.9 5.5 8.1 0.3 1.6 1.7 Chine 8.3 2.8 -0.8 -1.4 0.4 0.7 Vietnam 4.4 3.6 9.2 0.1 -0.6 0.8 (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).

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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

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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

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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.

20

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

21

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

� NPL Management Bank Recapitalization Mediation of Debt Workout

Indonesia

IBRA (Indonesian Bank Restructuring Authority) IBRA Jakarta Initiative Task Force

Korea

KAMCO (Korea Asset Management Corporation)

Korea Deposit Insurance Corporation

Corporate Restructuring Coordination Committee

Malaysia Danaharta Danamodal CDRC (Corporate Debt Restructuring Committee)

Thailand TMAC Financial Institutions Development Fund

CDRAC (Corporate Debt Restructuring Advisory Committee)

Table 7: Estimated re-capitalization costs for commercial banks, mid-October 1988

Estimated costs Amount disbursed � Remaining � � Percentages of GDP Percentages of GDP Indonesia 550 trillion Rupiah 100 trillion 11% 48% Korea 72 trillion Won 56 trillion 13% 4% Malaysia 31 billion Ringgit 13 billion 4% 6% Thailand 1121 billion Baht 751 billion 16% 8%

(Source) World Bank [1999], Global Economic Prospects and the Developing Countries

2000, Table 3.6

22

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])

23

Table 8: The treatment of failed financial institutions

� Closures State takeovers Mergers

Indonesia

64 Banks (18%) 12 commercial Banks (20%)

4 of 7 state banks to be merged into a single bank (54%)

Korea

5 commercial banks, 17 merchant banks, and more than 100 nonbank financial institutions (15%)

4 commercial banks (25%)

9 banks and 2 merchant banks to create 4 new commercial banks (15%)

Malaysia

None 1 commercial bank, 1 merchant bank, and 3 financial companies under central bank control (12%)

6 mergers of finance companies and commercial banks (2%)

Thailand

57 financial companies (11%) and 1 commercial bank (2%)

7 commercial banks (13-15%) and 12 finance companies (2.2%)

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.

24

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.

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Table 9: Transfer of NPL

� Indonesia Korea Malaysia Thailand Centralized asset management corporation buys assets at subsidized prices

Yes Assets were initially purchased above market-clearing prices with recourse. Since February 1998 purchases have been attempted at market prices

Purchased assets are valued by independent outside auditors

Not applicable

Type of assets transferred

Worst assets No particular strategy Loans larger than 5 million ringgit, and mostly loans secured by property or shares

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.

26

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.

27

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

28

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.

29

(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.

30

Table 10: The Breakdown of IBRA’s assets � Billion US$ Note and related objectives of IBRA Loan transferred from closed and re-capitalized banks 27.8 Objective (1), (3) Other assets transferred from closed banks 0.9 Objective (1) Holding share of re-capitalized banks 15.5 Objective (2) Holding share of non-financial companies 15.4 Objective (4)

Total 59.6 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.

31

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

32

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.

33

[References]

Fisher, Irving, [1933], “The Debt-Deflation Theory of Great Depressions,”

Econometrica 1 (October): 337-357

Fukao, Mitsuhiro and Fueda, Ikuko, [2001], “Manipulation of Monetary Policy under

Deflationary Economy --Strategy to Revive the Japanese Economy--,” Japan Center for

Economic Research, Japan Financial Review No.4: March 2001.

http://www.jcer.or.jp/eng/pdf/kinyuE4.pdf

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

Inconsistencies of Optimal Plans”, Journal of Political Economy Vol. 87: 473-492

Myers [1977], “Determinants of Corporate Borrowing”, Journal of Financial

Economics, Vol.5: 138-166

Radelet, Steven and Jeffrey Sachs, [1998], "The Onset of the East Asian Financial Crisis," mimeograph, February 1998.