Crisis Talk - The World Bank Group

The Case for Inflation; or, The End of Orthodoxy

I attended a symposium this morning on America's Debt Overhang, hosted by the non-partisan New America Foundation (NAF). There were several interesting discussions about the present and future implications of America's ballooning public, private and household debts. I will return to these debates in greater detail tomorrow.

One presentation in particular stood out: Christopher Hayes, a fellow at NAF, presented a controversial paper entitled Overcoming America's Debt Overhang: The Case for Inflation.

Hayes argues that America's debt burden has become crippling. Indeed, household debt has risen from 48 percent of GDP in 1981 to 97 percent today. Meanwhile, corporate debt has grown from 22 percent in 1981 to 120 percent in 2009. The federal government is borrowing and spending at unprecedented peacetime rates. This toxic cocktail may spiral out of control:

The Middle East Gets Down to (Insolvency) Business

Ten Middle Eastern countries have just signed a joint declaration to work on improving their insolvency regimes. Egypt, Jordan, Lebanon, Libya, Oman, West Bank and Gaza, Qatar, Saudi Arabia, Sudan, and United Arab Emirates met in Abu Dhabi earlier in the week and agreed to (excerpt):

ENCOURAGE policy makers, legislators and regulators to acknowledge the benefits of a well-functioning insolvency regime and work towards building and addressing the legal, regulatory and institutional frameworks necessary for sound insolvency regimes in the region;

ENGAGE market practitioners such as accountants, lawyers, insolvency professionals to work with policy makers to build the suitable infrastructure necessary for a sound insolvency regime--including the necessary regulatory architecture of insolvency practitioners;

STRENGTHEN the institutional framework of regulators and judiciary, and enhance their capacities necessary for effective and efficient implementation of insolvency laws;

RECOGNIZE the specific assistance being provided by the World Bank in the form of direct technical assistance to: (1) Improve insolvency legislation; (2) Build frameworks for out of court resolution of insolvency cases; and (3) Increase domestic capacity to effectively regulate insolvency practitioners all of which has the aim of, inter alia, reducing the time and cost associated with insolvency proceedings; and

ESTABLISH a Regional Forum on insolvency and creditor rights which will aim to engage, educate, and inform more stakeholders into the reform process and will serve as a platform for sharing of international and regional best practices on both policy and infrastructure areas on insolvency and creditor rights.

More Successful Bankruptcy Reforms During Crisis Episodes

I may have to take back what I said about crisis episodes not being optimal periods for reform of bankruptcy regimes. Leora Klapper, a senior economist at the World Bank, informs me in a short article on The Use of Bankruptcy in the Resolution of Corporate Distress that:

Importantly, systemic crisis periods are also periods of great opportunity for meaningful reform that would otherwise be stymied by powerful political interests.  Claessens et al. (2002) provide examples of such reforms from [the] East Asian financial crisis, which include the passage of improved bankruptcy laws in South Korea, Thailand and Malaysia, and the formation of specialized bankruptcy courts in Indonesia and Thailand.  Another example of a successful reform comes from Colombian bankruptcy reform introduced in the midst of a major financial crisis in late 1999. Gine and Love (2008) show that the reform significantly improved the efficiency of the bankruptcy process by streamlining reorganization proceedings.

Bankruptcy Reform: Better Late than Never

Recently, Simeon pointed out the need for a good bankruptcy regime as part of the crisis response: "No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies." Unfortunately, reforms of this magnitude take time to implement, so governments end up resorting to more interventionist measures (as Simeon points out in his post). New research suggests that it's not impossible to reform in the midst of crisis, though.

Writing in the Finance & PSD Impact newsletter, Xavier Gine and Inessa Love report that Colombia managed to carry out a successful reform of its bankruptcy code in late 1999:

Needed Urgently: Good Bankruptcy

As the crisis unfolds, the need for a good bankruptcy regime is starting to dawn on policymakers. No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies. Previous crises show that such bankruptcies lag behind the start of a crisis by a year or two. As demand falls, businesses try to cut expenses, restructure payments, renegotiate with suppliers. Ultimately, many live on. But some fail.

For these, it is useful to have an efficient bankruptcy regime so creditors do not have to write off the whole value of the loan. But bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options (for example, the use of asset-management companies) are needed.

A recent survey of previous experience in bankruptcy reform suggests a menu of possible reform choices while in crisis. The analysis is to a large extent based on the data from the Doing Business project, and its section on Closing a Business.

Here we present the section on dealing with systemic distress:

Effective Insolvency Regimes: Q&A with Mahesh Uttamchandani

Editor’s Note: Recently, I sat down to have a chat with Mahesh Uttamchandani, Senior Counsel for Insolvency & Creditors' Rights at the World Bank and head of the World Bank's Global Insolvency & Creditors' Rights Initiative. An expert on insolvency regimes, Mr. Uttamchandani kindly answered my questions about the role that effective insolvency regimes can play in helping emerging markets cope with the impact of the financial crisis. (A PDF of this interview is also available.)

Q:

One of the issues that has been raised in the context of the crisis are the estimates for corporate debt in emerging markets – somewhere between $1.25 and $2 trillion is coming due in 2009. Do you see a wave of corporate bankruptcies in 2009? And if so, how prepared are emerging markets to deal with this?

A:

If you look first at the U.S. as an example, going from 2007 to 2008, you see a 2.5 times increase in the number of corporate bankruptcies, which is significant. But what is staggering – if you look at only non-financial firms – you see a 1,000 percent increase in the value of assets that have gone into bankruptcy. What we thought was a financial crisis is now a real-economy crisis, certainly in the United States. That’s got to migrate, and it has certainly migrated to the developing world. So, the implication is you’ll see rising unemployment and a significant drop in productivity as this hits the real sector.

In a lot of countries, particularly in Eastern Europe, the banks couldn’t raise money in the local market sufficiently, so they went to the foreign market and raised foreign currency and passed this foreign exchange risk on to their borrowers. So now you have borrowers who have seen a significant drop in the value of their local currency, which raises their indebtedness overnight. So I think that’s exactly what we’re expecting.

The U.S. as an Emerging Market?

Simon Johnson, a prolific academic writer and former Chief Economist of the IMF, has come out with a relatively negative view on the U.S. financial system, both current and past. According to Simon, the personal interlinkages between the political and financial systems in the U.S. are very similar to those in many, if not most, emerging markets. And the policy approach towards solving the financial crisis has been dominated by attempts to minimize the pain for bankers, rather than for the overall economy. The bank-by-bank approach with generous bail-outs, while avoiding more drastic actions that might risk shareholders’ equity stakes and senior manager bonuses, has not really helped so far. In order to really get out of the slump, Simon recommends more decisive action in the banking sector, including temporary nationalization and clean up of banks, but also the breaking-up of the financial oligarchy with its links to the political system.

Finally, Big Bankruptcy

GM is preparing for bankruptcy (see the CNN story), in case it cannot meet a June 1 deadline to reach concessions with unions and creditors. Finally.
 
US car-makers are about 70% as productive as Japanese ones - even those with plants in the United States. In a real market they would have restructured or exited some time ago. But the Big 3 have much lobbying power, and have used it to stay afloat. GM's luck may have finally run out. Who will benefit? The environment, for one.

The Outrage Over AIG

A few days ago, AIG revealed the biggest beneficiaries of its rescue, with Société Générale, Germany’s Deutsche Bank, and Goldman Sachs near the top of the list. Public outrage over AIG's CDS counterparty payments and bonuses quickly followed, but all this could have been avoided had the company gone into bankruptcy - this would have turned both CDS counterparties with monetary claims and employees with guaranteed bonus packages into creditors and put them in line along with everybody else.

The excuse for not pursuing this option was allegedly the lack of a special bankruptcy regime for NBFIs and the negative repercussions of normal bankruptcy proceedings and the related shock to the financial system (as illustrated by Lehman). I don't know if there was a way for the government to intervene more aggressively/promptly, but I am sure that it will be debated in the future.

For those who have re-read Galbraith's book on the 1929 stock market crash, it is instructive to see the parallels (e.g. buildup of leverage - this was done via investment trusts back then, another version of the shadow financial system) and some of the same names implicated in the scandals.

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

The Sacred Cows of Capitalism, Alive and Kicking

Wounded perhaps, but the sacred cows of capitalism are alive and kicking, according to a new World Bank working paper by Asli Demirguc-Kunt and Luis Serven. The authors of Are All the Sacred Cows Dead? argue that "the 'sacred cows' of financial and macro policies are very much alive...the on-going crisis does not simply reflect a failure of free markets, but a reaction of market participants to distorted incentives."

Demirguc-Kunt and Serven, however, aren't just adding another paper to the now large pile that do a post-mortem on the origins of the financial crisis. The approach is much more prospective than that. How are regulators and central bankers in emerging markets to deal with banking systems and financial markets facing severe stress? It's more of this type of analysis that's needed right at the moment.

On blanket guarantees (compare this to a recent post from Thorsten Beck):

It must be recognized that the short-term benefits of guarantees will vary with the fiscal strength of the guaranteeing government. To hasten the end of an insolvency driven banking crisis and to constrain the spread of insolvencies in the short term, the government must manifest a substantial capacity for absorbing losses. This is not a luxury most countries can afford since most governments do not have the required fiscal capacity. Depending on the depth of the systemic insolvency such support may not even halt the spread of crisis and delay healthy adjustments.

On government ownership of banks:

Given the extent to which lending policies are politicized, it is not surprising that state ownership appears to heighten the risk of crises instead of reducing it. If anything, research suggests that greater state ownership is associated with various measures of financial instability, including a greater probability of banking crises.

On market discipline and Basel II:

Many interpreted the crisis as a vivid example of market failure, evidence that there is no such thing as market discipline, reinforcing calls for stronger regulations through improvements in Basel II accord. But the crisis also spawned a growing argument about the role Basel I accord may have played in causing the crisis. Indeed, it is no secret that Basel I contributed to the growth in securitization by assigning lower capital charges and thus giving incentives to institutions to move their assets into off balance-sheet securitization vehicles. While advocates claimed that Basel II, had it been implemented earlier, could have lessened or prevented the turmoil, critics of the Basel approach to capital regulation pointed out that the crisis has simply reconfirmed fundamental flaws that have been evident in this approach.

>> Download a PDF of Are All the Sacred Cows Dead?

A European Contribution to Crisis (Management)

A lot has been written about the failures of bank regulation and supervision in the U.S., where the sub-prime crisis started, but what about Europe?  Problems abound here as well – bank runs in England, governance issues in state-owned banks, such as in Germany, where some of the first banks fell, and lots of interventions into failing banks. 

Unlike in the U.S., however, matters are complicated by the lack of a Europe-wide regulatory and supervisory framework despite the emergence of a pan-European banking system.  The consequence: national approaches, often resulting in nationalization, such as in Belgium and the Netherlands.  Private market solutions for large banks are not feasible as no bank strong and sound enough in the respective country exists to take on a large failing bank.  And private market solutions in Europe are impeded by the lack of a Europe-wide authority who could take the lead in organizing such a solution as the Federal Reserve or the FDIC do in the U.S. 

A Lapse of Reason

In last week's Wall Street Journal, two of the top financial economists wonder whether economists have lost their marbles. Oliver Hart (Harvard, and my co-author on a recent paper on bankruptcy regimes) and Luigi Zingales (Chicago) wrote an op-ed that starts with:

This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Their main argument is that the US government should let financial and auto companies enter bankruptcy procedures, rather than rely on ad hoc bailouts. Bankruptcy, Hart and Zingales argue, provides an opportunity for claimants to figure out whether the company's financial trouble was the result of bad luck or bad management, and to decide what should be done. Short-cutting this process through a government bailout is dangerous. Does the government really know whether a company should be saved?

As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.

Super-Bankruptcy

Old ideas get recycled, including bad ones. One such idea is the adoption of “super-bankruptcy,” a temporary tool to be used when a country faces systemic bankruptcy brought on by large macro-economic disturbances. Read paper on bankruptcy regimes during financial distress.

The super-bankruptcy approach was advocated by Joe Stiglitz during the early stages of the East Asian crisis.  The basic presumptions of the super-bankruptcy are that management stays in place and that there is a forced debt-to-equity conversion. The existence of such a bankruptcy option will likely result in higher interest rates in normal times. However, in a systemic crisis it can preserve the going concern value of firms by preventing too many liquidations and keeping in place existing managers, who sometimes know best how to run the firms. Sounds very much like today's announced rescue of Citigroup, albeit what Stiglitz had in mind was a procedure for the whole economy.

An important issue is when to call for super-bankruptcy. When is the crisis of a systemic nature, and who has the authority to call for such a suspension of payments? Also, as wealth is often concentrated in emerging markets and some debtors stand to gain disproportionately from a suspension of payments, this could lead to social upheaval.

The evidence from East Asia suggests that adopting a temporary super-bankruptcy is unnecessary. While corporations and banks moved slowly to restructure outstanding debt, in the hope that economic recovery will obviate the need for write-offs (for banks) or surrendering of equity control (for large shareholders), few firms appeared to be prematurely liquidated. If anything, too many firms continued to operate for too long, as was the case with several chaebol-related firms in Korea, and that equity holders bore too little of the costs of restructuring.

No Exit

A question not yet asked in the unfolding global crisis is whether the existing bankruptcy regimes can adequately deal with the likely deluge of corporate and perhaps financial failures. Bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options are needed.

To judge how efficient bankruptcy regimes may be in times of systemic distress, it is useful to know how well they perform in normal times. Not well. A recent study finds that bankruptcy procedures are time consuming, costly, and inefficient. In a sample of 88 high- and middle-income countries, only 36% of the countries achieve the efficient outcome of keeping the business as a going concern. Between the transaction costs of debt enforcement, the delay cost of the proceedings, and the loss from reaching the wrong outcome, a worldwide average of 48% of the business’s value is lost in debt enforcement. On average, the bankruptcy cases take 2.64 years to resolve. And this on a simple case (a downtown hotel), with only one secured creditor. The usual case probably takes longer, costs more and has smaller chance of successful outcome.

Ways to Tackle Procyclicality in Banking

Ask most bank supervisors and bankers about the causes of the subprime-cum-financial crisis, and their responses are typically the same. Banking problems manifest themselves in a different way every time, and one can debate whether excessive risk-taking behavior by banks is primarily due to misaligned incentives or to irrational exuberance. However, they all confirm that such behavior is conditioned by, and contributes to, the business cycle. It is difficult for banks to follow more prudent policies during an economic upturn, especially in a highly competitive environment. Credit mistakes made during that period only become apparent in the downturn, resulting in the well-known privatization of gains during good times (excess earnings shared among bank shareholders and staff) followed by the partial socialization of losses during bad times (public bailouts).