announcement of the program was followed immediately by a 10 percent relative increase in delinquencies, predominantly attributable to new delinquencies among borrowers otherwise deemed least likely to default.23 Other studies showed the same—that previously “good,” or nondistressed, borrowers were more likely to strategically default or take longer to repay their loans after a bailout.24 Risks emerge for the political economy of credit as well. In India, defaults were found to be sensitive to the electoral cycle, and the pattern was magnified after the bailout.25 Furthermore, borrowers who are angrier about the economic situation, who trust banks less, and who want to see more banking regulation are more likely to default strategically. Borrowers are more willing to default as knowledge of others defaulting and media coverage of the same become more widespread.26 Ad hoc bailouts, as opposed to those conducted systematically, put governments in the position of picking winners—a skill they usually lack. The problems are compounded for emerging economies because there is less budget flexibility for bailouts.27 The moral hazard risk may be exacerbated in jurisdictions in which declaring bankruptcy is not a viable alternative or even an option in the current legal framework.28 Bail-ins, by contrast, are likely to increase the risk of financial sector collapse and may result in reduced future lending.29 International best practice, empirical research, and lessons from previous high-profile financial crises point to four critical areas for legal reform of insolvency: (1) strengthen formal insolvency mechanisms; (2) facilitate alternative dispute resolution systems such as conciliation and mediation; (3) establish accessible, inexpensive liquidation, in-court, and out-of-court procedures for micro-, small, and medium enterprises (MSMEs);30 and (4) promote debt forgiveness and discharge of natural person debtors. The remaining sections of this chapter address these four areas and elaborate on how to manage the expected increases in nonperforming loans in a way that enables an efficient and effective recovery.
Strengthening formal insolvency mechanisms A strong formal insolvency law regime is critical to the successful functioning of an insolvency system with both formal and informal options. Strong formal regimes have default rules and boundaries within which creditors and debtors can mediate or otherwise negotiate debt outside, but “in the shadow” of, formal insolvency law.31 Participants in out-of-court processes know how their case would be treated in the in-court system and behave accordingly. Furthermore, if out-of-court bargaining fails, participants have recourse to the formal system. A strong formal system thus creates the right incentives and defines the rights and behaviors needed to make both in-court and out-of-court workouts orderly, which, in turn, spurs innovation and economic growth, as articulated in the introduction to this chapter. Both debtors and creditors should have incentives to engage with the insolvency system and participate in good-faith negotiations. For creditors, the key incentives of a strong insolvency system include the possibility of negotiating an out-of-court debt restructuring plan that may yield a greater return than a forced liquidation. Effective insolvency systems also enable creditors to feel secure in their rights. Thus rather than resort to a unilateral approach, they are willing to coordinate with other creditors in the expectation that coordination will maximize returns. A strong insolvency regime creates incentives to negotiate a debt restructuring plan in good faith. Creditors may make concessions, and the plan may open a path to the continued operation and turnaround of the indebted business. In regimes in which management loses control of the business once the company enters administration, debtor companies may prefer to negotiate out of court to avoid losing control of their business. If the court system provides an avenue for creditor recourse, debtors are also less likely to misbehave by using out-of-court processes to stall or defer repayment. For these reasons, functioning insolvency laws underpin the reforms recommended in this chapter. No one-size-fits-all model will work in all jurisdictions and all circumstances. However, strong formal RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 127
