WHO SHOULD MANAGE THE BAD ASSETS

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WHO SHOULD MANAGE THE BAD ASSETS?

• Should the resolution of bad loans be managed by
  a separate agency or by the banks themselves?
• Two views
• -- Leave the management of bad loans to the
  banks
• -- Move all problematic loans to a separate
  agency

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• Arguments for leaving the loans in the banks are
• -- Banks know their customers better and can
  resolve any problems
• -- It is desirable for the bank to get some
  experience with loan resolution (e.g. banks keep
  some small problematic loans)

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• But, there are also arguments for removing bad
  loans from banks
• -- Banks may be less objective and may continue
  lending to delinquent borrowers (e.g. Japanese
  case)
• -- Banks may become very risk-averse and
  restrict new lending when trying to resolve bad
  debts

4

• -- It is easier to find a buyer for a troubled
  bank in this case
• Should the asset management agency be centralized
  or decentralized?
• -- In a decentralized approach, a troubled bank
  is divided into a bad bank and a good bank
• -- In a centralized approach, there is a bad
  bank for the whole system

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CENTRALIZED vs. DECENTRALIZED ASSET MANAGEMENT

• The decentralized approach works well when there
  are a few troubled banks
• It also works well when it is important that
  bank-customer relationships are maintained (e.g.
  C I loans)
• In this case, the bad bank should not end up
  with the bad staff, as well

6

• In a centralized approach, there is an Asset
  Management Corporation for the whole system (e.g.
  RTC in the SL crisis in the US)
• This approach is preferable when there are
  several troubled banks and the problematic assets
  are homogeneous (e.g. real estate loans)
• The AMC should be an independent agency
• The AMC staff must have incentives to achieve a
  quick resolution of the crisis

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LESSONS FROM SYSTEMIC BANK RESTRUCTURING

• Diagnosis is a very important component of a
  restructuring program
• A successful program must have a comprehensive
  approach and address shortcomings in
• -- accounting framework
• -- legal framework
• -- regulatory framework

8

• Prompt action is very important
• Operational restructuring is a necessary
  condition for future profitability of banks
• Systemic restructuring must be implemented by a
  designated lead agency
• Continuous monitoring of the restructuring
  process is necessary

9

• Central bank must stand ready to provide
  liquidity support
• Exit policies must be an integral part of the
  process
• The principle of loss-sharing between the state,
  the banks, and the depositors is an integral part
  of a successful strategy

10

• Problems with state-owned banks can be addressed
  through privatization
• Macroeconomic policy that will stimulate growth
  can support the restructuring efforts

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CORPORATE GOVERNANCE

• Corporate governance deals with ways in which
  suppliers of finance to corporations assure
  themselves of getting a return on their
  investment
• -- How do suppliers of finance get managers to
  return some of the profits to them?
• -- How do they make sure that managers do not
  steal the capital they supply or invest it in bad
  projects?

12

• -- How do suppliers of finance control managers?
• Less developed and developing economies can
  significantly improve their corporate governance
  systems
• Corporate governance mechanisms are economic and
  legal institutions that can be improved through
  political decisions

13

• Couldnt the product market solve any corporate
  governance problems?
• In other words, shouldnt inefficient firms fail
  or experience a decrease in the amount of capital
  supplied to them?
• Yes, but the product market still does not
  prevent managers from expropriating funds after
  the amount of capital is invested

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THE AGENCY PROBLEM

• The main issue in corporate governance is to
  address the agency problem
• Suppliers of finance (shareholders/owners) are
  the principals who need to monitor the
  managers, who are the agents, to ensure that
  they receive the return on their investments

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• This agency problem is referred to as the
  separation of ownership and control
• -- principals own the firm, but
• -- agents may have more control on the
  decision-making process
• Most modern corporations are organized in this
  way shareholders are not the managers
• In some cases, owners are also the managers
  (family business)

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HOW DOES THE AGENCY PROBLEM ARISE?

• Suppose an entrepreneur has a great idea and
  raises money from investors to implement it
• Investors need the entrepreneur (also manager) to
  run the business due to her knowledge of the
  idea
• Suppose also that the manager does not have
  enough funds and needs the investors

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• How can the investors be sure that their funds
  will not be wasted on unprofitable projects?
• One solution is for the two parties to write a
  contract that says
• -- what the manager does with the funds
• -- how the returns from the investment are
  divided between the manager and the investors

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• The problem with this solution is that, in an
  incomplete world, there is uncertainty about all
  possible future states of the world
• E.g. if the company can expand into a new market
  overseas due to favorable demand conditions, who
  will make the decision?
• Thus, the owners and the manager must allocate
  residual control rights

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• This means that they must agree, a priori, as to
  who will have the right to make decisions as to
  what the firm can and cannot do
• Other examples may involve the way the company
  will raise additional funds or allocate its
  profits
• One way to solve the problem of residual control
  rights is for the owners to keep these rights (to
  be the ones who make the decisions)

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• The problem is that the manager knows a lot about
  the business and the owners need the managers
  knowledge
• Thus, the manager ends up having a lot of those
  residual controls and, as a result, discretion
  as to how funds will be allocated
• Another problem is that any contract between the
  owners and the manager must be simple enough to
  be enforced by courts

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• Also, if the funds are collected from many
  investors, they may be too small and poorly
  informed to deal with the manager
• Managers can then expropriate funds by, for
  example,
• -- transfer funds to businesses of their
  relatives
• -- consume perquisites (drive fancy cars and
  have fancy offices, etc.)

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• -- try to expand the business beyond its scope
  for personal benefits (e.g. empire-building
  through mergers, etc.)
• -- expropriate investors by making it difficult
  for owners to replace them

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HOW CAN WE SOLVE THE AGENCY PROBLEM?

• Corporate governance deals with finding optimal
  mechanisms that
• -- will give managers incentives to put
  constraints on themselves
• -- will allow owners to put constraints on the
  managers
• In this case, owners funds will not be
  misallocated ex post

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• Thus, owners will have an incentive to supply
  funds ex ante
• A few such mechanisms are
• -- Performance-based pay for the CEO
• -- The role of the Board of Directors
• -- The role of major shareholders
• -- Takeovers

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• Shareholders often do not know what actions the
  CEO can take or which of these actions will
  increase shareholder wealth
• In this case, the CEO compensation can be
  designed in a way to give the CEO incentives to
  maximize shareholder wealth
• Note that CEOs will decide on taking certain
  action by comparing their private costs and
  benefits only

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• Some mechanisms that align the CEOs incentives
  with those of shareholders are
• -- performance-based salary and bonuses
  revisions
• -- stock options
• -- performance-based dismissal decisions

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• The Board of Directors should represent the
  interests of shareholders and monitor the CEO and
  top management
• The BOD plays a governance role by
• -- writing top managements employment contracts
• -- evaluating and ratifying proposals for major
  decisions of strategic importance

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• -- replacing top management
• However, CEOs participate in the BOD and, often
  times, have considerable influence on who sits on
  the board and how the members decide
• There are three types of directors on the board
• -- inside directors

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• -- gray directors
• -- outside directors
• The corporate governance role of the board
  improves with more outside directors
• Also, major shareholders (controlling 10 or 20
  percent of the firm) can play a role in corporate
  governance and they often sit on the BOD

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• Large shareholders have an incentive to collect
  information about the firm and the CEO and
  monitor the managements activities
• Large shareholders can exercise their role only
  if their voting rights are legally protected
• This corporate governance mechanism is stronger
  in countries with strong legal systems

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• In countries where large shareholders are
  uncommon (US and UK), another corporate
  governance mechanism is hostile takeovers
• Hostile takeovers typically target poorly
  performing firms and their management is replaced
• Thus, the threat of a hostile takeover will
  convince managers to align their decisions with
  shareholders interests