The Evolving Role of Central Banks
Chapter

15 Resolving Troubled Thrift Institutions and Bad Banks: Lessons for Central Banks in Developing Countries

Editor(s):
Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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Author(s)
HENRY N. SCHIFFMAN

When depository institutions are in difficulty because of an inordinate volume of nonperforming loans, public policymakers may attempt to adopt a strategy to correct the situation; of the advice taken, that of the central bank should be among the most important. In the case of state-owned institutions, the government will play a decisive role, and even with privately owned institutions, the bank supervisory authority can influence remedial measures that could be taken. In countries with deposit insurance, like the United States, where a deposit insurance agency becomes the owner of assets of insolvent institutions, the government plays a leading role in resolving insolvent depository institutions. This paper analyzes the initiatives in the United States in recent years of both privately owned commercial banks and of the government agency that was created to resolve insolvent thrift institutions; the initiatives illustrate techniques and policies that can be utilized in developing countries for restructuring troubled financial institutions.

A basic technique that has been employed in the United States, and which has a few leading examples in the restructuring of troubled private commercial banks, is the segregation of nonperforming assets in a separate banking organization.1 Some of the objectives to be realized by privately owned banks in separating nonperforming assets are also realized in the case of public institutions, including those which acquire assets of insolvent financial institutions by virtue of being taken over by a deposit insurance agency. In this analysis of troubled private institutions, the objectives to be realized by a depository institution that wishes to survive its crisis caused by excessive nonperforming loans will be emphasized. By removing bad assets, the remaining healthy institution will have improved its credit standing and, consequently, will have reduced its high cost of funding, which was caused by a large volume of nonperforming assets. Equally important, by allowing management of the now healthy institution to concentrate on basic commercial banking for the future, rather than on the problems of the past, the prospects for conducting future profitable business are enhanced. These factors should also improve the price of the stock of banks that are publicly owned and thus the prospects for raising additional equity capital are improved.

The segregation of nonperforming assets into a separate entity also improves the chances for achieving greater values for such assets than might otherwise be realized had they remained in the bank. This is because such separate entities should become specialists in collecting or liquidating nonperforming loans and should be more effective than commercial banks, particularly if the same commercial banker who was responsible for extending the loan is responsible for its collection. When a bank seeks to collect its loan, it is often reluctant to undertake stringent measures in relation to a company that maintains a banking relationship with that institution. Commercial banks would normally be more lenient toward recalcitrant borrowers than an independent entity whose sole business is the realization of nonperforming assets. Liquidation specialists are often more conscious of the time value of money and of the importance of collecting sooner a lesser sum than that which is owed rather than hoping to collect payment in full over longer time frame.

Financial Structure and Conditions

A key question in the possible establishment of a separate entity to collect nonperforming loans is the funding of such a vehicle. For a solvent institution in an economy where asset-based financing is customary, financing may be obtained from the capital markets. The tradition of asset-based financing in the United States made possible the financing of the assets of Grant Street Bank, a “bad bank,” by the holding company of Mellon Bank to liquidate Mellon. Bank’s nonperforming assets in 1988. This bank was known as a “bad bank” as distinguished from the now healthy Mellon Bank, which was the “good bank.” Mellon Bank transferred assets that had an original book value of $1.35 billion and were valued at $640 million when transferred. Based on this asset value, the bad bank was able to place $513 million of high-yield, three-and five-year notes to fund most of its assets. The public investors had confidence that upon liquidating its assets, the bad bank would be able to pay its obligations.

In countries that may not have capital markets that can appraise the quality of assets of an entity that borrows to fund the purchase of nonperforming assets, credit enhancement techniques may be used to accomplish the same purpose, albeit at a slightly higher cost to compensate the party that provides credit enhancement. For example, a well-known financial institution in the country that can appraise the value of the asset portfolio could issue its guarantee on debt obligations issued by the entity that owns the nonperforming assets. Such a guarantor could even be a government agency in a country in which such a liquidation entity were an important part of financial public policy.2

When the government assists in the disposition of nonperforming assets as part of the restructuring of a financial institution and wishes to encourage the private sector to acquire nonperforming assets of financial institutions, either from going concerns or assets of liquidated institutions, it has several techniques that can be employed to induce the private sector to acquire nonperforming assets. The government could provide cash or debt obligations that yield a market rate of interest to fund the acquisition of assets. It could also provide tax relief to entities that acquire nonperforming assets, for example, to allow tax loss carry forwards that exceed the normal period, or allow the losses of an entity that acquires nonperforming loans to offset gains from activities of affiliated profitable companies. Certain contractual provisions that enhance the attractiveness of acquiring nonperforming assets can also be used. The government could agree to take back certain assets for a certain period of time (“asset puts”), if the purchasing entity is unable to liquidate those assets in a certain time frame at such prices as it anticipates are required. The government could also provide that the acquiring entity would have guaranteed income at a certain level which will induce it to acquire the nonperforming assets. In such cases, the government would hope that the private sector would be able to adequately dispose of nonperforming assets; however, if, because of unanticipated adverse circumstances that is not possible, the ability to put assets to the government or an income guaranty could make the difference between the government indirectly disposing of assets and being saddled with assets without an appropriate means for their disposition.

Other Financial Feasibility Issues

In order to assess whether the establishment of a separate institution to administer nonperforming loans is feasible, two basic questions must be asked: (1) who bears the cost; and (2) what is the cost. As experience in the United States with private commercial banks has shown, the bank itself can bear the cost if capital is sufficient. When nonperforming assets are written down or written off before the establishment of the separate institution, these write-downs and writeoffs are made against the income or net worth of the transferring institution. Thus, if the net worth of an institution is sufficient, the cost will be borne by the capital of that institution. For government-owned institutions with insufficient capital to bear the cost, the government would, of course, bear the cost by realizing a loss in the capital accounts or income of the transferring institution and also perhaps in funding the separate institution. For a privately owned institution with insufficient capital to bear the cost, if the burden of nonperforming assets might cause its failure with an attendant cost to the government, either because public policy would require the government to pay depositors of the failed institution or because of an obligation of the government under a deposit insurance scheme, the government may wish to fund the cost of disposing of that institution’s nonperforming assets as a projected lower-cost alternative to letting it fail.

While the transfer of nonperforming assets to a separate institution does not necessarily require immediate cash payment by that institution to the transferring bank, the financial impact on the transferring bank will of course be reduced if the separate institution compensates the transferring bank for the transfer of assets. The cost of compensation, in the case of the Mellon bad-bank structure used recently in the United States, was borne by bond holders who were satisfied that the value of the transferred assets was sufficient to enable the separate institution to pay off the bonds. The separate institution could issue notes to the transferring institution as compensation, which could be interest-bearing to provide income. The separate institution could also simply have a balance sheet with equity represented by the transferred assets and, as assets, the transferred assets with equity owned by the bank transferring the assets.

Let us consider the total cost of establishing a separate institution to manage nonperforming assets. The most easily calculable cost is the cost of assets that have been identified as worthless: loans that have no chance of repayment and for which there is no collateral to dispose of. Where the transferring bank injects some equity capital into the separate institution as a means to attract third-party financing, a second cost would be the opportunity cost of this allocation of capital. When the transferred assets are exchanged for notes that bear an interest rate somewhat below the yield that may have been obtainable on other assets, another cost is incurred: the differential between the payment on the notes of the separate institution and the yield obtainable on alternative investments. Yet another cost, and what may be the largest cost (although if the assets are particularly troubled the write-offs may be the largest cost), is the difference between the book value of the assets and any accrued interest and the amount that will be ultimately recovered in the collection process. Another significant cost is the maintenance of assets like developed real estate or transportation equipment. A final cost is the management costs of the separate institution. This could be considerable, especially in an environment where the costs of legal process to recover assets are high. Thus, against all these prospective costs must be calculated the projected benefits that are to be achieved by the survival of a viable financial institution.

Examples of Asset Disposition Institutions

It is instructive to consider more closely some examples of the use of private sector debt collection entities in the United States to see how they have been structured and what some of the difficulties have been.

Let us consider first Grant Street Bank, Mellon Bank’s bad bank. To emphasize the asset-based financing nature of this transaction, one significant legal aspect is that title to Grant Street’s assets and the proceeds from collections were pledged to a trustee to secure repayment of the notes that were issued to finance the acquisition of the assets from Mellon Bank. Thus, bond holders had some additional confidence that they were purchasing the assets and not the business prospects in a more general sense of Grant Street Bank. Some flexibility in financing was another feature. Both classes of notes had provisions whereby the stated maturity dates could be extended for one year, in which case there would be higher interest payments of 0.5 percent and a premium paid on the principal of from approximately 1 percent to 3 percent, depending upon the maturity date. Thus, there was some flexibility to the financing, although such built-in rescheduling may not be acceptable to some prospective investors.

The liquidation of Grant Street Bank’s assets is administered by a specially established subsidiary of the Mellon Bank Corporation, the holding company of Mellon Bank. This creates the potential for certain conflicts of interest, since Mellon Bank still maintains relationships with some of the obligors on the assets that are held by Grant Street Bank. The company that administers the liquidation is compensated by receiving 3 percent of the net cash flow that results from its activities. Net cash flow is defined by the excess of receipts from asset sales over operating expenses related to asset management. The separate liquidation company was chosen because it was felt that it would have a better focus and incentive to sell assets as soon as possible taking into account the time value of money. As mentioned earlier, the traditional loan workout approach of commercial bankers was considered to be ultimately more costly since they generally sought to collect full payment in a longer-term time frame.

The process of the liquidation of assets has several aspects. It includes restructuring certain loans, negotiating with banks that originated loans with respect to which Mellon Bank had loan participations, foreclosing on loans, selling collateral, participating in insolvency proceedings of borrowers, and managing and improving real estate. Again, the basic objectives of asset disposition are to produce proceeds from sales of assets in a time frame that permits payment of principal and interest on the notes and to maximize the net sales proceeds on a present-value basis.

The economics of the Mellon Bank transactions were projected to have been very good. Detailed forecasts of cash flows had indicated that after three years, the net cash available would have been $515 million, after five years, $770 million, and after 10 years, $964 million, which left an ample margin for debt service on the $513 million in three-and five-year notes. In fact, in the first year of operation, Grant Street had realized $334 million from asset sales, or more than half of the initial book value of the asset portfolio.

Another example in the United States of the use of a separate institution to dispose of assets of troubled banks is the reorganization of the First City Bancorporation of Texas, Inc., in 1988. Here, it appeared that a regional bank-holding company with assets of approximately $13 billion as of 1986 would fail because of a growing lack of confidence in its future by the money markets, and the Federal Deposit Insurance Corporation (FDIC) was faced with the possibility of a significant loss to the deposit insurance fund in the repayment to depositors upon liquidation of the subsidiary banks of the bank holding company.

A reorganization plan was devised by the FDIC, a New York investment bank, and a prominent American banker and presented to the First City Bancorporation board of directors and its shareholders on a “take it or leave it” basis; a prominent feature of the reorganization was the establishment of a so-called collecting bank, which would dispose of the nonperforming assets of the subsidiary banks of the holding company. As Chart 1 indicates, in this transaction the holding company’s subsidiary banks transferred assets with a book value of $1.8 billion to the collecting bank, which were written down to approximately $1 billion. The FDIC issued a note to the subsidiary banks for $970 million, and the FDIC received in turn $100 million in subordinated notes of the collecting bank and preferred stock in the collecting bank, which would only have value if the collecting bank did extraordinarily well. It was estimated at the inception of the transaction that the ultimate cost to the FDIC would be approximately $700 million.

Chart 1.First City Bancorporation Reorganization

Removing the bad assets from the subsidiary banks was the key to enable the restructuring of the First City Bancorporation to proceed, and that was based upon an injection of new equity capital from sophisticated investors and a line of credit from institutional investors. The collecting bank issued a note for $764 million to the subsidiary banks, which constituted a critical component of their assets. That the collecting banks’ assets were written down to approximately $1 billion and that the subsidiary banks also injected $230 million in equity in the collecting bank made the $764 million note a credible asset. The shareholding interest of the existing investors in First City Bancorporation was diluted to approximately 2.5 percent by the interest obtained by the new equity investors.

The Resolution Trust Corporation

The recent experience of the U.S. Government in taking over, managing, and selling or liquidating thrift institutions provides useful information on certain policies and procedures to be followed, which can be adapted to developing countries that are restructuring financial institutions. Because of the dimension of the work of the Resolution Trust Corporation (RTC), considerable effort has been put into resolving these troubled financial institutions at the least cost to the government; therefore, this experience, while very recent, is illuminating. An example of the dimension of this effort is that as of July 31, 1990, the RTC had in conservatorship 258 institutions with total assets of $124 billion; it also had in receivership 211 institutions with total assets of $40 billion. Institutions in conservatorship are ongoing businesses intended to be sold in whole or in part to another institution or rehabilitated; those in receivership are generally those that are to be liquidated piecemeal (a “liquidation receivership”) and to be transformed for conservatorship (a “pass-through receivership”). It is interesting to note that as of that date, of the total assets under RTC management, some 24 percent was in cash and securities and some 46 percent was in performing loans, for the most part residential mortgage loans, and thus 70 percent of its assets were good assets. However, in the highly leveraged business that is depository institutions, bad assets in excess of a low level of capital are sufficient to terminate the viability of an institution, and that is the case with the institutions under RTC management. In such institutions, some 10 percent of total assets are in nonperforming loans and approximately 11 percent of assets are real estate assets that have been foreclosed upon. It might be useful to briefly consider the reasons why the U.S. Government has the enormous task of resolving troubled thrift institutions. The immediate reasons for the deterioration of the industry over approximately ten years were their inability to cope with economic adversity and fundamental changes in financial markets; broadened banking powers; insufficient supervision by regulators; capital requirements, which required too little owners’ stake in the business; problems in real estate and high-yield bond markets; and mismanagement and misconduct. In a broader sense, the problem reflects the policy toward competition and licensing of financial institutions in the United States, whereby the criteria for chartering new institutions are more lenient than they could have been and too many thrifts found themselves being managed by people who were unable to cope with fundamental changes in circumstances.

The basic objectives of the RTC are to manage and resolve institutions and to dispose of assets in a manner that maximizes returns and minimizes losses and minimizes the impact on local real estate and financial markets. In pursuit of these objectives, which would appear to be valid for any country embarking upon a program of restructuring financial institutions, the RTC has adopted policies in four main areas: case resolution, asset disposition, conflicts of interest and ethical standards, and relations with the public, which appear to have been well-founded.

With respect to case resolution or the management of institutions in conservatorship, a policy that has been adopted is that while institutions are in conservatorship, the RTC takes action to reduce its risk exposure from such institutions, to reduce their operating losses, and pay down their high-rate liabilities. To the extent feasible and cost-effective, the asset side of the balance sheet is reduced through the packaging and securitization and sale of financial assets. The RTC attempts to reduce the liabilities of thrifts so that the only liabilities remaining are deposits that have significant franchise value, that is, core deposits that could be sold at a meaningful premium to another depository institution. Those institutions that the RTC identifies as having significant franchise value because of their deposit base are permitted to maintain their asset levels. For those institutions with insignificant franchise value, the RTC has adopted procedures to begin shrinking such institutions’ balance sheets in a coordinated and orderly manner. Thus, procedures have been adopted such that loan origination ceases, and the cash flow from payments of principal and interest is used to repay high-cost deposits and secured borrowings. An exception to this rule would be when additional lending would reduce losses on existing loans.

With respect to the policy as to priorities in resolving institutions, those with the highest losses (both in absolute terms and relative to the expected cost of the resolution) and the greatest erosion in franchise value are given the first priority in order to save the RTC those additional losses. Similarly, the ongoing risk exposure to the RTC resulting from institutions with large interest rate or credit risk-exposure is considered.

With respect to alternative methods of resolution, which generally take the form of either liquidations or assisted acquisitions, the policy is to adopt the least-cost alternative. In an assisted acquisition, the acquiring institution assumes some portion of the assets and liabilities of the failed institution. The RTC provides sufficient cash to the acquiring institution to offset the difference between the amount of liabilities assumed and the market value of assets acquired from the failed institution, net of any premium paid by the acquiring institution for the franchise value. While the RTC would prefer to sell a troubled institution as a whole, often an acquiring institution acquires only the good assets (e.g., cash, securities, and performing loans) and the transaction is termed a “clean thrift” purchase (of assets) and assumption (of liabilities).

With regard to the forms of financial assistance that the RTC may provide and the consideration that the RTC seeks for such assistance, the financial assistance can include cash, notes, yield-maintenance agreements, capital loss coverage, asset puts, and regulatory forbearances. One policy is that the period of financial assistance involving a financial contingency (asset puts, asset guarantees, or capital loss coverage) for the RTC should, in general, not be longer than six months and should cover only the period required by the acquiror to complete its due diligence on the acquired assets. By taking an ownership in resolved institutions, the RTC can protect its financial interest when, at the time of the resolution, there is uncertainty regarding the value of the resolved institution, and, therefore, the appropriate level of assistance. This uncertainty creates the potential for large upside gains for the acquiror. Equity participation, such as common stock, gives the RTC a direct ownership position in a thrift and allows the RTC to share an upside gain. Equity participation, however, may create a conflict if the RTC assumes a controlling position and, thereby, becomes a competitor with other financial institutions. Therefore, the RTC prefers to use warrants, which are a passive equity instrument that allows the RTC to share in the profits of the resolved institution, but avoids the control issue.

With respect to bidding procedures, the RTC believes that a significant way to reduce the cost of resolution is to encourage active participation in the resolution process by all qualified bidders. This can best be achieved, according to the RTC, by having an open and widely publicized bidding process and a broad dissemination of information regarding institutions being marketed and the terms of previous transactions. This is to assure that the RTC receives the best offer from prospective purchasers of institutions or assets.

With respect to the management of the resolution process and the use of the private sector, the RTC uses the services of private persons and firms if such services are available, and it determines that the utilization of such services is practical and efficient. Such services include managing institutions or performing due diligence for the RTC.

With respect to the disposition of assets acquired by the RTC, these assets fall into three categories: cash and readily marketable loans, servicing rights, and securities; high-risk or other undesirable, but performing, loans; and real estate owned and nonperforming loans, including loans in foreclosure.

One important policy decision was to dispose of assets as soon as possible and avoid deferring the marketing of properties. It was felt that holding properties off the market for an extended period of time would increase the ultimate cost of asset disposition because of the expenses associated with managing and financing property while it was under the RTC and the risk of deterioration. Holding property off the market may also be contrary to the interest of the local community because of the uncertainty arising from not knowing when the property may be placed in the market for sale.

In the disposition of assets, the RTC also must use the private sector for the management and disposition of assets, subject to RTC policies and audit. The RTC attempts to use appropriate incentives for contractors as a means of ensuring that the government receives the maximum net present value return on its assets. For example, contractors receive as compensation a percentage of the proceeds net of expenses, with the percentage increasing as proceeds increase relative to the estimated market value of assets. In other cases, the RTC enters into contracts that have the RTC and the contractor sharing in better-than-expected returns, as well as sharing the risk that net proceeds will fall short of expectations (i.e., yielding the contractor less than the market rate of return). The RTC has attempted to dispose of assets in large, wholesale transactions as being the most efficient method of disposing of assets; however, in some instances, such as the sale of single family homes or rural homes in distressed areas, adverse market effects of such wholesale transactions may dictate another course of disposition. For example, in areas where the RTC is a large holder of similar properties, disposition can be made according to a pre-advertised multi-month marketing schedule rather than disposing of a large number of properties in a single day.

With respect to the RTC’s continuing involvement with assets, the policy is to generally avoid retaining long-term equity interests in assets under its jurisdiction; however, it does considers ways in which it can participate through passive equity interests in an extraordinary gain that may be realized by the acquiror of an asset. The RTC will sometimes invest in capital improvements (i.e., buildups of incomplete properties and rehabilitation of completed structures) prior to marketing. There may be cases in which the net present value of properties will be enhanced by capital improvements prior to sale, but in most instances, properties are sold in an “as is” condition. The RTC has decided to finance asset sales sparingly and only when necessary to complete real estate transactions that maximize the present value of return to the RTC, net of the value of any concessions provided in the financing. The general policy is that only real estate is eligible for RTC financing; the buyer of the asset should make a significant equity contribution (i.e., at least 25 percent) and pledge the asset as collateral; RTC-provided financing should be senior to that of other creditors; concessionary terms on the financing should be minimized and always recovered through a higher sales price; and all loans made by the RTC should be sold, to the maximum extent feasible.

With respect to the basic objective of minimizing the impact on local real estate markets of its asset dispositions, the RTC has adopted a special policy for distressed areas. It should not sell at less than a specified minimum disposition price, which is 95 percent of market value, except when sales at prices below 95 percent would save interest expense and the holding period for properties and transactions costs sufficient to offset any shortfall fall below the 95 percent figure. Of course, the term “market value” can be subjective. The RTC has recognized that appraisals are an appropriate tool for estimating market value for many RTC assets; the lack of qualified appraisers, however, is not an obstacle that stalls the process of asset disposition. A firm policy is that the RTC should not attempt to outguess the market by speculating on future developments not reflected in the current market values of properties.

In the area of conflicts of interest and ethical standards, the RTC has issued rules and regulations that apply to independent contractors regarding conflicts of interest, ethical responsibilities, and the use of confidential information. Other rules apply to officers and employees of the RTC and govern the avoidance of conflict of interest, ethical responsibilities, and postemployment restrictions. Specific, written guidelines concern the avoidance of political favoritism and undue influence upon awarding contracts and decision making.

With respect to relations with the public, the RTC has decided that maintaining open communications with the public regarding the RTC’s policies and procedures for the sale or disposition of real estate is critical for the success of its efforts. As a result, considerable effort is undertaken to keep the public informed as to past actions of the RTC, its current policies, and ways in which the private sector can work with the RTC, including through the purchase of institutions or assets.

Supervisory Conversions

Another experience in the United States involving troubled thrift institutions that may have relevance for developing countries, for commercial banks as well as for thrift institutions, is the process of supervisory conversions of mutual thrift institutions. This occurred during the 1980s when more than one hundred mutual savings institutions were converted to stock form of ownership. These institutions were converted by the thrift supervisory agency to be able to sell capital stock to the public and were compelled to raise new capital largely as a result of asset and liability interest rate mismatches and consequent losses, which eroded capital. Many now survive as financially sound institutions. In approving the conversions, the supervisory authority approved a new business plan and often new management; this was an inducement to investors as it indicated that the troubled institution would be rehabilitated. Financial assistance was not provided in these cases.

This experience may be illustrative for countries that have government-owned institutions that the government may wish to privatize in whole or in part. Often government-owned institutions must be converted to a corporate form of organization so they can sell equity interests to private parties. The government would have to provide financial assistance to the ailing institution that pretends to sell equity interests to the public, in many cases, as a matter of fairness, so that the public would be investing in a solvent institution with reasonable prospects for future success. In the United States, the former mutually owned institutions had substantial success in selling stock because sales were often to existing customers and to others in the local community that had come to look favorably upon these institutions as desirable community thrifts and were interested in seeing the institutions survive. This may also be true in some developing countries. In others, a troubled institution may have a negative image in the mind of the public and a better solution may be to liquidate the existing institution and attempt to sell stock in a de novo institution, which perhaps could purchase good assets and assume certain deposits of the former institution, as in a pass-through receivership.

Lessons for Developing Countries

The corporate structures, financing techniques, and policies and procedures for the disposition of assets that were described above and that are based on the recent experience of private banking organizations and the U.S. Government’s RTC can be adapted in many circumstances to developing countries that are restructuring troubled financial institutions.

The facets of rehabilitating or liquidating financial institutions that were discussed will not be repeated here, but certain basic points will be emphasized. The first is that it is desirable to address the problems of financial institutions that are caused by nonperforming loans at an early rather than a late stage, to reduce the ultimate cost of restructuring. At an early stage, there may still be value in selling an institution stripped of its bad assets or an institution may be rehabilitated. Over time, the situation may deteriorate to the point where liabilities are at a higher cost, new loans are higher risk, and the cost of paying off depositors will be much greater.

A second point is that the segregation of bad assets in an institution that specializes in loan collection and asset dispositions may well result in higher recoveries than if nonperforming assets are left for collection by a depository institution. The use of liquidation specialists, bulk sales techniques, incentive compensation for asset brokers, and emphasis on net present value recoveries are all factors that are often lacking in a financial institution that originated a loan when it comes to loan collection or liquidation of collateral. A third point is that in countries where the government must bear the ultimate cost of failed financial institutions, governments should take bold steps to resolve failed institutions, including the provision of financial assistance for the purchase of financial institutions and financing of asset purchases.

It should also be noted that as a matter of policy, in almost all cases in situations involving a conservatorship and generally when any financial assistance is being extended by the government, as in the case of a bad bank like that of First City Bancorporation, the upper echelons of management of a troubled financial institution who presided over the unhappy state of affairs should be replaced. This includes officers as well as inside and outside directors. Discipline is an important part of financial restructuring and those who contributed importantly to or who had legal responsibility for an institution that was managed in an unsafe or unsound manner should be held accountable.

For countries contemplating restructuring financial institutions using some of the techniques discussed above, it is important that there be an adequate legal foundation. Thus, laws that allow the financial institution’s supervisor to intervene and place an institution in conservatorship or receivership are required. In addition, to increase the prospect of recoveries on nonperforming loans, there should be a basis to execute upon assets of borrowers who are in default on their loans. Finally, it should be emphasized that it is crucial that governments establish sound bank supervision laws, regulations, and practices to assure that the problems that led to the need for major financial institutions restructuring will not arise again, or if they do, they will be more manageable.

*The author is a Consultant in the Central Banking Department of the International Monetary Fund.
1In the United States, a banking organization has been used because of the securities laws. In other countries, a nonbank company could be utilized to dispose of former bank assets.
2It was recently estimated that in the United States, a dozen banking companies and at least one securities firm have issued $40 billion of commercial paper for special purpose companies to finance assets ranging from trade and credit card receivables to business loans, and some of this commercial paper has been guaranteed by letters of credit from major banks.

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