Insolvency and Debt Recovery Procedures in Economic Development: An Overview of African Law

Legal reforms, Credibility , Bankruptcy, Debt recovery

Infrastructure Requirements in the Area of Bankruptcy Law

Infrastructure requirements have long played an important role in the development debate. Until recently these requirements referred to the need for improvements in roads, railways, electricity supply, telecommunications and the like. Lack of such infrastructure was seen as an important cause of a country's relative poverty. Investments in physical infrastructure seem not to have had the desired growth effects in developing countries, however. The search for the root cause of economic development has led the mainstream of economists to the system of rules for economic activity. The attention to rules and institutions became wide-spread only after the fall of communism, although Nobel prizes had been awarded to Friedrich Hayek and Gunnar Myrdahl in 1974, and Ronald Coase in 1983 for their contributions to institutional and political economics. These prices represented a recognition that institutional and political economics help explain important aspects of the organization of economic activity, but few economists took the additional step to analyze institutional factors as root causes of development and growth. An exception was Douglas North, who received the Nobel prize in 1993 after the fall communism and a renewed interest in institutional economics. This interest was to a large extent sparked by the formerly centrally planned economies' failure to start growing. Economic research began to focus on social institutions in general, and the legal system in particular, defining and securing property rights, enabling trade, and providing incentives for economic activity. Among social institutions the legal system is most directly subject to change, at least with respect to the letter of the law. Thus it is natural that policy-oriented economists would emphasize legal reform to enhance incentives leading to economic growth. Economic growth requires that old activities are phased out to make room for new ones, and that economic resources are reallocated from activities that are no longer profitable. This reallocation can occur within a variety of organizational structures, but the failure of projects and firms must be seen as an inherent aspect of growth process. The Asian crisis and a large number of more or less severe banking crises in a variety of countries during the last decades have led to questions about the ability of economic systems to deal with wide-spread failure of firms. Caprio and Klingebiel (1996) refer to the lack of procedures for banks to settle and recover claims on distressed firms as a cause of lingering and recurring banking crisis in many countries. Krugman (1994) noted before the crisis that investments kept flowing to projects of questionable value in many Asian countries. A mechanism for abandonment of non-profitable projects seemed to be missing. In the Eastern European transition economies state-owned enterprises or formerly state-owned large enterprises producing negative value could not be closed down in an orderly fashion. Laws, procedures, and court capacity was missing. Bankruptcy law was implemented in several of countries with mixed results as will be discussed below. While there may have been too few bankruptcies in Asia and Eastern Europe the argument in the Swedish policy debate after the banking crisis in the early 90s was that there were too many bankruptcies of viable firms, and that the recession therefore became unnecessarily deep. These experiences indicate that the procedures for dealing with insolvent firms may affect economic growth, and the depth and duration of crises. These procedures, and the institutions and organizations involved are viewed as the "infrastructure for bankruptcy" in this paper. At the center of the discussion stands insolvency law for firms and the court systems supporting the law, but the bankruptcy infrastructure could be considered to be much broader including or relating to a broad array of formal law and informal procedures. Informal procedures for insolvency are as important as the law and they necessarily involve banks as the major creditors. Therefore, law and regulation for financial institutions may be considered an aspect of the infrastructure for bankruptcy. From banks' point of view insolvency procedure is only one aspect of debt recovery. The procedures for debt recovery include security enforcement, which depend on property rights registration and enforcement. Other stakeholders than banks are also affected by a firm's insolvency. Employees, customers, suppliers, the state, and of course shareholders may have a stake and some kind of claim on a firm's assets. Insolvency essentially means that formal and informal contractual relations with some or all of the firm's stakeholders must be breached. Thus the variety of laws regulating contractual relations among stakeholders interact with insolvency procedures. Although bankruptcy is not a criminal offense, and debtors' prisons have been abandoned in most countries, criminal law relating to civil fraud and corruption has a bearing on insolvency procedures. Finally, personal bankruptcy procedures may affect insolvency procedures for firms even under limited liability, because a firm's owners' personal guarantees may be required by creditors. We will not cover all these aspects of the "bankruptcy-related" infrastructure but we focus, as noted on formal and informal insolvency procedures. Insolvency law will be used as a term covering both bankruptcy law and explicit law for restructuring of firms without change of ownership. Thus, bankruptcy always implies that a firm as a whole, or its assets, are offered for sale to new owners. While lawyers often focus on fairness and equity in their discussion of insolvency law, economists are concerned with economic efficiency, growth, and business cycle fluctuations. Wood (1995) notes that there are wide differences in insolvency law among countries based on differences in legal doctrines, but there is no obvious relation between legal doctrine and economic growth or economic wealth. Insolvencies happen everywhere but practices vary with respect to law, informal procedures, effectiveness, and predictability of procedures. Lack of bankruptcies does not necessarily mean lack of insolvency procedures. Informal work-outs are common, and informal procedures are well established in many countries. On the other hand, the existence of insolvency law does not necessarily imply that it has much influence on procedures, and in some countries procedures are neither well established nor predictable. Legal traditions and cultural factors affect the attitude to bankruptcy, and procedures for dealing with insolvency. Political factors affecting objectives of formal law and informal procedures vary, as well, across countries and time. Political influences on the banking system, and concentrated ownership of corporations forming strong vested interests can affect the allocation of credit and state subsidies in such a way that insolvency procedures are seriously undermined. We return to these issues. The paper proceeds in Section 2 with a discussion of the economic role of insolvency procedures for efficiency of resource allocation, economic growth, and the depth and duration of crises. Efficiency of procedures are discussed further in Section 3 where a distinction is made between ex ante (at the time financial commitments are made) and ex post (at the time of insolvency) efficiency. The purpose of Section 4 is to classify procedures in an economically meaningful way. It is common to distinguish between creditor-and debtor oriented procedures. More interesting from an economic viewpoint is whether procedures tend to lead to "excessive survival" or "excessive shut-downs" of firms. These distinctions do not necessarily coincide. In Section 5, we look at the wide differences in restructuring laws across countries. Stylized facts about the performance of laws in different countries in terms restructuring vs shut-down, and survival vs shutdown are presented in Section 6.. Stylized facts from developing countries point to the important issue of enforcement of law. Two aspects of enforcement are discussed in Section 6. First, the legal system may be ineffective in its application of existing law. Second, political influences on the banking system in particular may render insolvency procedures irrelevant. The strongest policy implications refer to enforcement. This and other aspects of design of formal insolvency procedures and their associated infrastructure are discussed in Section 8. The basic question whether or why insolvency law is needed at all is also asked.

The Efficiency of the Bankruptcy Process. An International Comparison

Failure of projects and firms are an inherent element of growth. Economic growth requires that old activities are phased out to make room for new ones, and that economic resources are reallocated from activities that are no longer profitable. In an economy where most firms are financed by debt to a substantial extent, insolvencies inevitably play an important role in restructuring. Insolvency leads to formal bankruptcy when legal procedures are employed to liquidate the insolvent firm’s assets in order to pay stakeholders fully or partially according to a priority established in law or contracts. In some countries legal procedures exist for restructuring as well as for liquidation. In other countries the restructuring of an insolvent firm is handled informally through negotiation. The economic roles of insolvency procedures are discussed (in Section 2) with an emphasis on dynamic aspects. In discussing the efficiency of insolvency procedures (in Section 3) we distinguish between ex ante and ex post efficiency. Since efficiency ultimately must be evaluated in terms of its dynamic effects, simple efficiency criteria are not easily identified. Formal insolvency procedures in different countries are classified (in Section 4) as more or less creditor or debtor oriented. Legal approaches can also be classified as more or less contractual or statutory. The important interdependence between formal and informal procedures is discussed in Section 5.Thereafter we turn in Section 6 to the empirical evidence on bankruptcy and restructuring in a number of countries with substantial differences in legal approaches to insolvency. We ask in Section 7 what explains the relatively high bankruptcy frequency in Sweden in an international comparison. Is the high frequency an indication of efficiency of procedures or does it indicate that viable firms are forced into bankruptcy unnecessarily?Bankruptcy; Insolvency; Restructuring; Contracting

Basel II and the Need for Bank Distress Resolution Procedures

It is argued that without increased market discipline Basel II is not likely to resolve the regulatory problem caused by explicit and implicit guarantees of depositors and other creditors of banks. One way to enhance market discipline is to implement proposals for mandatory subordinated debt. For these proposals to achieve their objective, the non-insurance of holders of subordinated debt must be credible. Increased credibility of non-insurance of one or several groups of creditors could be enhanced if distress resolution procedures for banks were pre-specified, and if they made possible bank failures without serious disruption of the financial system. The existence of rules for dealing with banks in distress not only enhances the credibility of non-insurance of some creditors, it also allows for predictability of distress resolution costs for shareholders and management of banks. Such costs—if predictable—reduce the moral hazard incentives caused by deposit insurance schemes

Recognizing Macroeconomic Fluctuations in Value Based Management

Value Based Management (VBM) has become a common tool for ex ante and ex post evaluation of corporate strategies and projects from the perspective of shareholder value maximization (SVM). VBM-frameworks are designed to support investment and divestment decisions, ex post evaluation of management and their major strategic decisions, and bonus-systems. Traditional VBM frameworks make no distinction between sources of temporary changes in performance, and sources of performance reflecting the intrinsic competitiveness of the firm. Temporary changes in performance are often caused by macroeconomic fluctuations. In this article we develop an approach for “filtering” the impact of macroeconomic fluctuations out of measures of performance in order for management to obtain better information for purposes of investment, divestment, and exposure management decisions. We focus on filtering for purposes of performance assessment employed in compensation schemes. A case study illustrates the approach, and shows the potential magnitude of effects from macroeconomic events.Value Based Management (VBM); Shareholder Value Analysis (SVA); Economic Value Added (EVA); Performance Measurement; Macroeconomic Fluctuations; Bonus System

Corporate Distress and Restructuring with Macroeconomic Fluctuations: The Cases of GM and Ford

Traditional methods for evaluating corporate credit risk rarely consider the impact of the macro economy on corporate value and performance. We argue that lenders and management can obtain valuable information about the need for and approach to restructuring by decomposing default predictions into "intrinsic" and macroeconomic factors. We apply a method previously used for measuring macroeconomic exposures on default predictions in order to filter out macroeconomic factors. In this paper the method is applied on an analysis of the Z-scores for GM and Ford for the period 1996–2005. The macro economy has affected the two firms in different ways with implications for managements' and creditors' approaches to restoring their financial health.Credit Risk; Creditworthiness; Z-Scores; Default Predictions; GM; Ford; Restructuring; Macroeconomic Exposure

Law, Legislation and Liberty: A New Statement on the Liberal Principles of Justice and Political Economy. Volume 3: The Political Order of a Free People by Friedrich A. Hayek

Clas Wihlborg reviews F.A. Hayek\u27s Law, Legislation, and Liberty

How to Avoid Compensating CEO for Luck: The Case of Microeconomic Fluctuations

Incentive effects of performance-based compensation schemes for management may be weakened or biased by macroeconomic influences on remuneration. These influences can be seen as reflecting luck from the CEO’s perspective. In this chapter we present a model for how to avoid compensating CEO for luck by filtering out the macroeconomic influences. In the empirical section we analyze the impact of macroeconomic, industry and firm-specific factors on the compensations (salary, bonus, options, and pensions) of CEOs in 127 Swedish corporations during the period 2001-2007. We find macroeconomic influences on Swedish CEOs’ compensation to be substantial. Distinguishing between favorable and unfavorable macroeconomic developments, we find compensation to be more responsive to favorable than to unfavorable developments in macroeconomic variables.Executive compensation; Salary; Bonus; Option; Pension; Macroeconomic uncertainty; Macroeconomic factors; Performance; Luck

Origins and Resolution of Financial Crises; Lessons from the Current and Northern European Crises

Since July 2007 the world economy has experienced a severe financial crisis originating in the U.S. housing market. The crisis has subsequently spread to the financial sectors in European and Asian economies and led to a severe worldwide recession. The existing literature on financial crises rarely distinguish between factors that create the original strain on the financial sector and factors that explain why these strains lead to system-wide contagion and a possible credit crunch. Most of the literature on financial crises refers to factors that cause an original disruption in the financial system. We argue that a financial crisis with its contagion within the system is caused by failures of legal, regulatory and political institutions. One policy implication of our view is that the need for various forms of rescues of financial firms in times of crises would be reduced if appropriate institutions could be put in place Lacking appropriate institutions to avoid contagion within the financial system and a potential credit crunch, ad hoc financial crisis management is required. We draw on experiences from the financial crises in the Nordic countries at the end of the 1980s and the beginning of the 1990s. In particular, the Swedish model for crisis resolution, which has received attention during the current crisis, is discussed in order to illustrate the problems policy makers face in a financial crisis without appropriate institutions. Current European Union approaches to the crisis are discussed before turning to policy implications from an emerging market perspective in the current crisis.Financial Crisis; Institutional Failure; Insolvency Procedures; Contagion; Systemic Effects; Macroeconomic Shock; Financial Crisis Management; Swedish Model

The CFO’s Information Challenge in Managing Macroeconomic Risk

In this chapter we examine the role of the CFO in setting risk management strategy with respect to macroeconomic risk, in particular, and we consider the information requirements for setting a strategy that is consistent with corporate objectives. We argue that macroeconomic risk management requires a broad approach encompassing financial, operational and strategic considerations. Furthermore, several interdependent sources of risk in the macroeconomic environment must be taken into account. Once this interdependence among, for example, exchange rates, interest rates and inflation are taken into account macroeconomic risk management can be considered a relatively self-contained aspect of Integrated Risk Management (IRM) provided relevant information is available to management. Financial risk management cannot be considered a self-contained part of macroeconomic risk management, however, since value increasing investments in flexibility of business operations affect corporate exposure and make it uncertain.Risk Management Strategy; Macroeconomic Risk; Integrated Risk Management; Chief Financial Officer; Information Needs; Corporate Strategy; Financial Risk; Real Options