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Robert CHUDZIK

Banks as „Agents of Change“-

the Experiences with Restructuring of Bad Debts in Poland

Robert Chudzik is resarch fellow at the Chair for International Economics of the EuropeanUniversity Viadrina Frankfurt (Oder).

Banks as ”Agents of Change”the Experiences with Restructuring of Bad Debts in Poland1

1. Introduction

As in most transitional economies the Polish banking sector had to cope with theproblem of bad debts. The total amount of nonperforming loans at all state banksreached ca. 9,2 Bill. PZL in 1993 ( an equivalent of 4,3 Bill. $ at that time) whichwas 28 percent of all credits to the non-banking sector in this group (NBP 1994:61.3) Although the scope of the crisis was not so severe in comparison to otheradvanced transitional countries due to underdeveloped intermediation, this problemwas sufficiently large to undermine the overall stability of the financial system. Inthe long run it might even have led to the collapse of the largest banks making itimpossible for them to fulfil basic functions like operating the payment system.Even if this danger could be averted, the accumulation of bad debt distorts thecredit allocation in the economy (Perotti 1993; Buch et al. 1994, Begg/ Portes,1993; Rostowski 1995).

The easiest way to overcome the crises is to cleanup substandard credits and torecapitalise banks. However, many scientists argue that such a procedure generateshigh expectations on the side of both banks and enterprises for future bail-outs(Begg/ Portes 1993; Van Wijnbergen 1994; Bear/ Grey 1995; Long/ Rutkowska1995). What distinguishes the Polish approach from the rescue actions undertakenin other transitional countries was the attempt to address this double Moral Hazardissue (Kawalec/ Sikora/ Rymaszewski 1995). The program drawn up by thegovernment involved bank recapitalisation which was concomitant with thecommitment for bank managers to restructure bad debt portfolios. Thus the bankswere saddled with the role as „an agent of change“ for enterprises with seriousadjustment problems. The instruments to pursue this objective were set up by theLaw on Financial Restructuring on Enterprises and Banks, passed on 3 February1993.

The most promising measure was the so called Bank Conciliation Procedure (BCP)enabling rescheduling credit conditions (partial debt write-off or even debt -equityswap) for the firms that are supposed to have adaptive potential to the marketenvironment. However, the promise for debt relief was not unconditional sinceconciliation agreements commit borrowers (usually state owned enterprises) tooutline and implement a rescue program. It should have included measures toimprove firm performance and had to be accepted by main creditors. In this paper

1 The author is grateful to Arnold Holle for his help in collecting empirical data.

F.I.T. Discussion Paper 5/982

the author explores determinants and the efficiency of conciliation agreementssigned by seven state banks whose total bad debt portfolios amounted to about 1.5Bill. PZL. Table 1 shows the restructuring path taken by these banks. As you cansee the BCP was only initiated in the case of 30 % of borrowers. Moreover, theother methods of handling bad debts such as filing for bankruptcy or selling bankarrears to outsiders played only a subordinate role. But most surprising is the largenumber of borrowers, previously rated as bad debtors, who did not enter anyrestructuring path (almost 40% of cases contributing to 33% of total amount of baddebts). They decided either to repay a debt or at least to start servicing it whichusually induced banks to upgrade credit quality. A possible explanation for such anoutcome is macroeconomic upturn improving financial situation of state-ownedenterprises (SOEs) or reputational considerations. Any debt relief may be regardedby creditors as a loss of confidence toward borrowers. Thus, they must expectdifficulties in obtaining new funds while approaching a bank or suppliers (in caseof trade credit) in the future. However, it is the present writer’s contention thatthese explanations are not sufficient to solve this puzzle. Particularly, the reputationfactor could not have played such an important role as ascribed by many. Most baddebts originated before or in the first years of economic stabilisation. Therefore,managers had the possibility of arguing that heavy debt burden would havemounted anyway, since their most important origins appear to be attributed to theexternal factors concomitant with economic transformation. This view wascommonplace not only among firms’ managers but also among high bank officials.In the opinion of the author an important factor behind the firms’ reluctance toenter BCP lies in the inadequate addressing of agency problems in the conciliationprocess. The policymakers placed the right to initiate BCP only with the borrowers.As was already noted they were mostly SOE’s. It is generally known that theseenterprises are exposed to serious agency problems, since the government is unableto control them efficiently (Winiecki 1992; Pinto/ Belka/ Krajewski 1992; Raiser1997). In such circumstances firm’s insiders can make the most of this ownershipvacancy and determine even decisions elsewhere reserved to equity-holders. InPoland workers’ councils gained strong position vis-à-vis managers at thebeginning of transition. Pinto/ Belka/ Krajewski (1992) argue that the managerswere then able to restore at least part of their power. This process was due to twofactors. Firstly, mangers had usually a better knowledge about the firm’s score andmay use workers’ ignorance to persuade them to follow the policy they preferred.Secondly, the widespread ”corporatization” of state enterprises, which transformedthe firm in limited liability and joint-stock company, automatically strengthenedmanagers’ range of power. As the labour councils were disembodied and the newsupervisory boards usually behaved very passively, this process strengthened themanagers’ position vis-à-vis both outsiders and workers. As was said earlier, themanagers could then more easily dispose of cash flow.

R. Chudzik: Banks as „Agents of Change“ 3

It can be expected that debt renegotiation will usually harden the mechanism ofcontrol exerted by outsiders, as conciliation leads to the establishing of creditors’board equipped with wide range of powers. As a result, managers’ ability to disposeof the firm’s cash flow might be significantly restricted. But this is why themanagers might not have been enthusiastic about the program. In particular, themanagers of firms with relatively better financial perspectives could haverenounced this restructuring path. In section 3, we present a model which showsthat such a decision may, however, not be efficient. This paper is organised asfollows: In section 2 the general conditions of the Polish program of bank andenterprise restructuring are sketched. As was noted section 3 is devoted to themodel consisting of two parts. The first one formulates the condition providingincentives for both bank and borrower to enter BCP. It allows for the formulationof some hypotheses about the characteristics of firms signing BCP and preferredpatterns of financial restructuring. It provides support for the intuition that onlyfirms with relatively bad future perspectives in terms of operation riskiness willchoose BCP. On the contrary, SOE’s with more stable incomes refrain from anydebt renegotiation, since their managers will lose discretion in disposition over cashflow surpluses. This outcome stands in contradiction the views presented in otherworks (Belka/ Krajewska 1997: 31). Moreover, the model underpins theimportance of political considerations on the bank side when deciding about theextent of debt relief. Last but not least, it puts forward that debt equity swaps areonly committed when the manager is sure that the state will not be deprived of thedominant position among shareholders. Next, in section 4, we attempt to verifyempirically all these hypotheses. My work bases both on some stylised facts andregression analysis where I use financial data stemming from firms included in theprogram. Finally, in the last section, the general question is addressed whether thebank-led restructuring was an adequate approach to the bad debt problem inPoland.

2. The resolution of the bad debt problem at state banks

It is generally accepted view that the bad debt crisis cannot be only treated as aheritage of the Communist economies. The result of many researches suggestedthat the bad debt problem is also a consequence of behaviour of banks andborrowers in the transition period (Grey/ Holle 1996; Gomòlka 1995). Here evenone can recognise the double moral hazard problem. The first one pertains to thereluctance of SOEs’s to repay debt. It is observed that SOEs resisted to implementnecessary adaptive measures in response to macroeconomic stringency. Thedifficulties in the hardening of budget constraints are rooted in inheritedbehavioural patterns and low credibility of macroeconomic policy due to theinstitutional deficiencies (lax corporate governance structure, ineffectivebankruptcy threat) engendering very high transaction costs (Kornai 1993, Raiser


1997). Thus, the high expectation of managers of SOEs for future bail out couldremain for quite a long time after the implementation of the stabilisation programwhich usually ends up with accumulation of heavy debt burdens on firms’ balancesheets. The second kind of moral hazard has frequently to do with creditors’passivity in dealing with bad debts. J. Mitchel (1993) pointed out that creditors arenot willing to initiate the bankruptcy procedure because, e.g. a disclosure of a greatnumber of nonperforming loans could lead to trouble not only for the debtor butalso for the creditor (the sacking of the management). Besides the courts lackedboth infrastructure and experience to deal efficiently with bankruptcy applications2.In the World Bank sample the average time between the time when a firm stoppeddebt service and the first attempt to collect the debt amounts to almost two years.

When the rescue program is merely confined to the bank recapitalisation, it willbring no change, since the incentives of main actors remain unmodified. The Polishapproach attempted to directly address this issue. The prompt bank privatisationwas conceived as a remedy to managers’ opportunistic behaviour. Moreover, thedebt relief was made dependent on the implementation of a rescue program in theenterprises. This mechanism should have dispelled the firms’ expectation that bail-out would be an alternative to the painful adaptive measures. The Polish reformalready started in 1991 when Western auditing firms examined the quality of loanportfolios at 9 state banks. The non-performing credits were then transferred to thework-out departments set up within the bank organisation and the governmentforbade any new credit granting to the borrowers classified as substandard. Next, 7banks were additionally recapitalised with state bonds. Their issue was calculatedsuch that every bank could have reached the capital adequacy ratio at a level of8%.3The total face value of issued bonds was 4 Bill. PZL whereas 3 Bill. PZL wereinjected into two banks with the largest problems (Bank for Agriculture BGZ andState Saving Bank PKO BP).

The next part of the program referred to the restructuring of enterprises classified inthe group of bad debtors. The policymakers turned down an option to transferoverdue loans to specially created ”hospital”, since the banks seemed to be betterpredestined to the role of an ”agent of change”. At least they had the betterinformation about the borrowers real situation (van Wijnbergen 1994). Moreover,the program should have given them opportunity to train staff in dealing withnonperforming credits4. The banks were obliged to restructure their base portfolios

2 Additionally, the banks were reluctant to file for bankruptcy since their claims have lower priority than

dues to government, employees and very high court fees. Bear/ Grey (1996) mention 10% of a claimvalue as an usual fee requested by courts. Consequently, a part of potential liquidation value accrued tothe bank may have been negligible after others higher priority claims were redeemed.

3 As it turned out later for the majority of banks this ratio exceeded even 20%. It can be interpreted thatthe payment morality of their clients improved after hopes for unconditional bail out were not fulfilled.

4 For a discussion whether the firm restructuring should be led by banks or external ”hospital” agencysee: Long/ Rutkowska (1995) and van Wijnberg (1994).


by the end of March 1994 (that date was prolonged for PKO BP and BGZ to theend of September 1994). They could have chosen three paths of action:

• Signing a conciliation agreement with the debtors, which would foresee aconsolidation of its debts (partial reduction of credit amount, new paymentterms, or debt-equity swaps) in return for introducing a recovery plan. The debtrestructuring could include all kinds of debts (inclusively tax arrears) only withthe exception of mortgage-backed loans and contributions to the social securityoffice.

• Sale of liabilities at open auctions,

• Initiating bankruptcy proceedings if any other of the above mentioned paths wasnot taken.

As to debt renegotiation, the main role among creditors belonged to banks. TheBCP foresaw that only the enterprise was entitled to submit the application for debtrestructuring. The party deciding whether the firm was suited for the BCP or not,was the bank. It also let the remaining creditors know about its decision and thenconducted negotiations with both the debtor and other creditors. In practice thebank tried to achieve an understanding with the firm and the creditors representinghalf of the debt value before it organised the conciliation meeting where thearrangement was to be signed. The dominant position of the bank was additionallystrengthened by two circumstances. Firstly, in many cases the tax arrears added tothe bank credits exceeded the 50% of total debt included in BCP, so thatconsultation with other creditors was redundant and the tax office usually supportedthe standpoint of the bank as far as conditions of debt restructuring were concerned.Secondly, the bank controlled the information flow and limited access to it by othercreditors so that they lacked orientation in their position, e.g. they did not now howbig their claims were in relation to the firm’s total liabilities or who else owed thefirm. Therefore, they were virtually unable to built a coalition of those not satisfiedwith the proposed conditions till the general meeting of all creditors. The abovecircumstances legitimate the assumption that in reality the negotiation took placeonly between the debtor and the bank. As was noted most strategic decisions inSOE are taken by the insiders, or more precisely, by managers5. Thus, the decisionto enter BCP could have been taken only when it did not conflict with managers’preferences.

5 This assumption does not exclude a possibility that the manager takes into account the worker’s

preferences while making strategic decision especialy when the workers may strongly oppose it.


Table 1: The results of the debt restructuring for 7 state-owned banks

in Mill.PZL

in % Numberof firms

In %

Reconciliationprocedure

7577331 48,11% 198 25,0

Sell of debt 898082 5,70% 94 11,2

Liquidation/bankruptcy

1987465 12,62% 171 21,6

Repayment/goodclient

5224931 33,18% 312 39,4

Lack of action 60986 0,39% 17 2,8

Total 15748795 100,00% 792 100,0

Source: Ministry of Finance

The original version of the program foresaw the privatisation of all 9 banksseparated from the Central Bank by the end of 1996. This deadline was delayed,and the government has managed to sell its stake in only 6 banks. In the nextsection we explore whether the design of BCP which allows the firm managers toretain a strong position in debt renegotiation provides an explanation for the puzzlethat BCP was chosen by a relatively low fraction of borrowers as compared withoriginally formulated expectations.

3. The model of debt renegotiation

3.1. General assumptions

The model is based on the simplified framework chosen by Bester/ Hellwig (1989)to present the Stiglitz - Weiss - Model of credit rationing. It describes the situationin which high debt level discourages the borrower to adopt more secure behaviour,as he knows that all additional benefits stemming from the greater effort will flowonly to the bank as a debt repayment. To give them an appropriate incentive thebank has to reduce some part of the debt, so as to benefit from the betterperformance. This is a two period model where both sides have risk neutral


preferences (linear utility functions). The first period is devoted to the negotiationsbetween the bank and the firm about debt restructuring. They can not last beyondthe predetermined deadline but it is allowed to finalise them earlier only after bothparties reach an agreement. The negotiations start after the firm makes a first tenderabout which proportion of the debt should be cancelled. The bank may accept orrenounce this offer. In the latter case the bank gives its own proposal which can beeither accepted or renounced by the firm. Both sides can exchange their proposalsuntil they agree on the amount of debt to be written off. If they do not manage toagree by the deadline, the firm is obliged to service its debt to the full extent. It canalso give up negotiating at any time. A successful negotiation is finalised in thesigning of a debt conciliation agreement. At the beginning of the next period thefirm makes a decision about its future performance (to sign conciliation agreementor not). The result of the chosen strategy is revealed at the end of period two, whenthe firm should also repay the debt.

The model is based on the following assumptions:

1. The whole bargaining takes place between the firm’s manager and the bankwhich is also represented by its manager.

We assume that before renegotiation the manager enjoyed a great deal of latitudein the disposal of available cash flow. As noted, this postulate reflects thesituation of the Polish state enterprises which are loosely controlled by thegovernment, and consequently the decision to initiate BCP lies in the hands ofthe firm’s managers6. As the manager (or other incumbent beneficiaries ) enjoysa wide range of independence he is able to switch the free cash flows for theirsake directly. By way of illustration he can finance his personal consumption atwork, or engage in prestigious activities like empire buildings or even financeredundant workforce to preserve social peace in the enterprise.7. However, theseactivities have little in common with the principle of the maximisation of theshareholders’ value. This kind of behaviour is in the focus of the principal-agenttheory which addresses this issue precisely in the case when the costs of exertingcontrol rights over management appear to be significant for the outsiders. (Hart1996; Jensen/ Meckling 1976). In the case of publicly owned firms they areconsidered to be very high. This circumstance causes that the outsiders’ controlover SOEs is very lax (Winiecki 1992: 8-9; Frydman/ Rapaczynski 1994)

6 We assume that the government is lacking information whether the firm should enter BCP or not. In

particular it is unable to verify and correct the manager's decision not to enter BCP.7 One can observe in Poland that SOEs having cash flow surpluses readily engage in buying stake of

other firms, which leads to creation of conglomerate structure in the industry. This process preciselypertains to the former foreign trade companies which earned a lot of money on the strong Zlotydepreciation at the beginning of transition.


2. The manager is aware of the fact that successful renegotiation provides not onlydebt relief but also establishes a creditor board in order to supervise the firm’sfuture behaviour. Its range of powers may even significantly restrain manager’sdiscretion with the appropriate financial consequences. The banks are usuallyinterested in long term connections with the borrowers as future clients.Therefore, they may not be pleased, e.g. if the firm invests heavily in newindustries in which the managers have no experience. In this game themonitoring of the credit board limits the incomes remaining under control of themanager to the share c of the generated cash flow (after debt repayment).

0 < c < 1

This coefficient is later called an income ratio. In the standard conciliationagreement the range of control is endogenously negotiated by the parties. Itmight even be imaginable that under certain circumstances the creditors give upall control power. The assumption of the endogenity of the control extent israther inappropriate in the framework of the Polish reform. As was mentionedthe authorities also aimed at hardening the supervision of bad debtors. As thebanks’ owners they also had numerous possibilities to convince the bank toequip the creditor board with some minimal range of real competencies. Almostall agreements made the decision to sell assets, apply for new credit, or to makenew investments dependent on the approval of the creditor board. Suchconditions may restrain the manager’s discretion in disposal of free cash flow toa great extent, especially if there is some cash flow surplus to be appropriated byhim. Consequently, it is justified to assume that the value of c is thus treated asan exogenous one.

3. We make a simplified assumption that the firm disposes of two differentbinomial strategies. Strategy 1 generates high income (or cash flow surplus) r1but with a low probability of success α. In case of distress (1-α) the firm getsnothing. Strategy 2 gives lower income r2 but the probability of success ishigher β. The following three conditions describe the relationship between thetwo strategies:

(1a) r1 > r2

(1b) α < β

(1c) r1 * α < r2 * β

Strategy 1 is obviously the more risky one and its choice signifies the inefficientsolution since its expected income is lower than the second strategy (1c). Both


types of strategies can be used to characterise two different behaviours of stateenterprise. The first refers to the situation where the firm boosts revenues byselling products under very generous conditions (long payment period) withoutproperly proving the buyers’ credibility. This action must, however, end up witha high ratio of default bills, so the likelihood of collecting all payments turns outvery low (the case of low α). Probably such performance is connected withminimal effort on the part of managers, since favourable selling conditionssuffice to attract many buyers. From the standpoint of the firm’s long-runviability, such behaviour may be quite risky. On the contrary, the manager isable to restrain the riskiness of the firm’s operation by prudential screening ofbuyers, tightening payment periods or looking for new markets. Althoughadditional effort may in this case promise relatively less income, bill collectionstands out more securely (greater probability β). Therefore, the expected incomeof safer strategy 2, is greater than the riskier one. Consequently the choice ofstrategy is the efficient solution of the game. When the debt burden D = 0, themanagers will always choose strategy 2, and it will be preferred by the firmsince the whole income will accrue to them.

4. In the case of debt financing the firm is left with only the difference betweenreturn and debt. As was noted this surplus is than ”appropriated ” by managers.If the firm goes bankrupt the manager receives nothing, yet he suffers noreputational losses8. We assume that debt burden is so high that the inequalityholds:

(1d) α[r1 - D] > β [r2 - min(r2,D)]

This means that the manager will prefer the pattern of behaviour characterisedby strategy 1.

5. The condition (1d) creates incentive incompatibility between the bank and themanager since the expected credit repayment for the bank is always greater incase of strategy 2 than strategy 1, since:

(1e) α * D < β * min(r2,D)

As the bank is owned by the state, we assume that the cash inflows are alsocontrolled by its managers. Yet, their objective function must be supplemented

8 The assumption that the firm bankruptcy has no impact on a manager’s position in the market of

managerial skills may sound quite controversial as compared with the generally accepted view. See:Jensen/ Fama (1983) about the disciplinary impact of the labour market on managers’ performance.Nonetheless, the bankruptcy of SOE in transitional economies is frequently attributed by outsiders toexternal factors like transitional recession rather than managers’ incompetence. Thus, the managers’reputation must not suffer greatly from such an occurrence.


by one component. It is self-evident that the state is interested in avoiding thebankruptcy of the borrower, especially when it may engender a political contest.Thus the bankers may anticipate penalty (including the dismissal from the post)in the aftermath of borrower’s failure. The lower the probability of success, thehigher the probability of punishment. The potential wealth losses ensuing frombeing sack represent the political costs for the bank managers which should besubtracted from expected cash inflow. For the sake of simplicity, we supposethat political costs W(p) is a linear function with negative scope where p is theprobability that the implemented strategy ends up with success:

The value of the direction coefficient g may vary from firm to firm, and it maybe interpreted as a coefficient reflecting political sensitivity. Therefore, its valueshould rise with the number of employees.

6. Up to the renegotiation the information is distributed asymmetrically. Only thefirm manager knows the firm’s investment opportunities. However, when hefills for renegotiation he must reveal internal information so as the asymmetrywill be removed. It is excluded that he will not tell the truth9

7. In order to supervise the firm’s behaviour a creditors´ board is established. It isequipped with competencies which enable the board to restrict the payoff, whichcan be appropriated by the manager, to the ratio c.

8. To keep the analyses tractable, it is assumed that if the BCP ends successfully,the enforcement of the agreement causes no additional difficulty. The bank isable to detect any of its violations without bearing any monitoring costs. So, thefirm manager has no incentive to return to risky strategy 1 if the conciliationagreement obliges him to introduce the strategy 2.

Before presenting the condition to enter BCP the list of symbols of variables andparameters used is shown:

9 In the Polish program the banks appointed consulting firms whose aim was to examine the feasibility of

submitted rescue concepts. This measure was to help to minimise the importance of informationalasymmetry between negotiating parties.

≥

<−= β

ββ

pfor

pforpgpW

0

)()(


r1 - income of risky strategy 1

α - probability of success of strategy 1

r2 - income of safe strategy 2

β - probability of success of strategy 2

D - firm’s debt before renegotiation

∆ - the amount of debt reduction

c - manager’s income rate following from the government’s minimal requirementsof competencies of creditor boards.

W[p] - political costs for the government and state-owned bank.

g - the slope of the linear function of political costs

∆ F - the minimal required debt reduction level to induce the manager to enter BCP

∆ B - the maximal level of debt reduction accepted by the bank.

A(c,g) - the threshold value of probability of risky strategy. If the successprobability of the risky strategy is greater, the firms renounce entering BCP.

3.2. The renegotiation game

The value of debt reduction ∆ sufficient to change manager’s inclination towardsthe risky strategy 1 to the safe one 2 (for the certain value of c) must allow to holdthe following inequality:

(2a) β*c*(r2 - D + ∆) > α(r1 - D).

The right side expresses the cash flow which could be captured by the managerwithout debt reduction. The left side then refers to his disposable amount afterBCP. As was noted, the coefficient c stands for the impact of the creditor board. Itscompetencies and activity make it impossible for the manager to capture the share(1 - c) of the cash surplus. After some transformation we obtain the followingsolution:

(2b) Fc

rcrcDD ∆=−+−≥∆≥

ββααβ 21)(

,


where the expression on the right side called ∆F is the minimal debt reductionrequired by the manager.

Similarly, the bank accepts the write-off only if the bank is made better off withdebt reduction than without it:

(3a) α * D - W(α) < β (D - ∆),

The right side stands for the bank’s payoff after debt reduction. The left sidedepicts the situation before renegotiation. The bank must take into account that thefirm implements the risky strategy 1 if it does not receive a sufficient write-off.Moreover, it expects payoff αD to be reduced by the political costs W(α). Aftersome transformation we obtain:

(3b)( )

B

gD ∆=−+<∆β

αβ)(

The expression on the right stands for the maximal write-offB∆ that the bank is

prone to accept.

Both renegotiation parties manage to come to terms only if the maximum debtreduction level ∆B accepted by the bank is higher than ∆F - the minimal requiredvalue for the firm’s managers:

(4) ∆B < ∆F

Proposition 1 formulates the general condition that both parts have an incentive toenter BCP:

Proposition 1

The model suggests the existence of separating equilibrium for firms differingfrom each other only by the probability of risky strategy 1. The worse offenterprises with α < A(g,c) will enter BCP whereas the better off ones give updebt restructuring and decide to service the debt in full. Yet, they chooseinefficient riskier strategy 1. The amount A(g,c) defined in (5a) stands for athreshold value separating firms into two groups with contradictoryincentives.


Proof: As was mentioned above the renegotiation will end up with success if thevalue ∆ is acceptable for both parties. As was noted it is only possible if:

FB ∆≥∆

In such case, there is at least one amount of ∆ which is greater than ∆F and lowerthan ∆B. After replacing both terms by expressions (3b) and (4b) and sometransformation we can come to the following formula:

(5a)( )

( ) ( )gcAcDcgr

grc,

11

2 =−−+

+< βα

So, the firm will enter BCP only if the success probability α of the risky strategy 1is lower than a certain threshold value A(c,g) represented on the right side of theabove inequality.

We can imagine a range of enterprises distinguished from each other only by thevalue of α. The successful debt renegotiation is, however, only possible for arelatively worse subgroup of these firms with α lower than the threshold valueA(c,g).

Q.E.D.

This model puts forward that the main objective of the program of bank andenterprise restructuring may not have been achieved. The program should, first andforemost, have supported enterprises with temporal problems ( great indebtedness)but with good chances for recovery and future development. However, such firmsare represented in the group with α > A(c,g), but they will renounce BCP.Although threshold value A(c,g) depends on many variables ,two of them, namely:c and g are the most interesting ones. The relationship between these two variablesand A is determined by the partial derivatives:

(5b)( ) [ ]

[ ] 0)1(1

)1(21,2

>−−+

−−−=cDcgr

cDcrrc

g

gcA β∂

∂

(5c)( ) ( )( )

[ ]∂

∂βA c g

c

r D g r

r cg D c

,

( )=

− +

+ − −>

1 2

1 10

2


The increase of g causes a rise in political costs for every value of α. Consequentlythe bank is more lenient in treating debtors with higher g and accepts greater write-offs. Thus large firms in terms of employment should come to terms with the bankmore easily in the renegotiation process. Similarly the increase of income ratio(measure of cash flow share remaining in manager’s disposition) makes themanagers more inclined toward BCP since their financial discretion is then lessrestrained.

Proposition 1 limits the amount of firms entering BCP to those, whose riskystrategy has a probability of success α ≤ A(c,g). The next step is to establish theamount of debt reduction obtained in the course of renegotiation. To this point weknow only that it is situated between ∆F and ∆B. The comparison of (3b) and (4b)already shows, however, that this amount may differ significantly. The last remarkconcerns especially borrowers causing serious danger of political cost for the bank(greater ∆B) or with low α (smaller ∆F).

The conciliation negotiation can be presented as a game, where both partsalternately give each other the write-off proposals lying between the borders valueof ∆B and ∆F. The solution to this game proposed below is based on Nash solution(Holler/ Illing 1996: 180-190) and is described by Proposition 2:

Proposition 2

The Nash solution to the bargaining process between bank and the firm leadsto the debt reduction equal to the maximal acceptable for the bank amount ∆B.

Proof: In the Nash solution both parties agree on the write-off value ∆ whichmaximises the so-called Nash-Product This is the multiplication of the differencesbetween the utility attained by each party after successful renegotiation (andconsequent debt reduction) and the conflict point for both parties. The last onerepresents the utility level available without renegotiation:

(6a) (uB - cB)(uF-cF) ⇒ max.

Assuming risk neutrality the utilities are expressed by the payoff functions of bothparties

The bank's utility function after successful renegotiation is then


uB = β ( D - ∆F - ∆1 )

its payoff at conflict point is then given by:

cB = α D - W (α)

Accordingly, the firm's expected payoffs for both cases are as follows:

uF = c β (r2 - D + ∆F + ∆1 )

cF = α (r1 - D)

where ∆1 is the additional write-off above the minimal required value ∆F, which canbe achieved in the bargaining process.

Because of additional restriction this problem is presented as a nonlinearprogramming case:

(6b) ( ) ( )[ ] ( ) ( )[ ]DrDrcWDD FR

F −−∆+∆+−+−∆−∆−∆

12max 11

1αβααβ

∆F + ∆1 ≤ ∆B

∆1 > 0

The solution can be found with the help of following Lagrangian

(6c)( ) ( )[ ] ( ) ( )[ ] )(12 111

BFFR

F yDrDrcWDDL ∆−∆+∆+−−∆+∆+−+−∆−∆−= αβααβ

The first derivatives of Lagrangian is as follows:

(6d) ( ) ( ) 0212 =∆−++−−−=∆

RRRR cyWcDcDrrcL αααβ

δδ


(6e)δδL

y F B= + − =∆ ∆ ∆ 0

after some transformation it is obtained:

∆ ∆ ∆1 = −B F ,

and the reduction level is then:

∆* = ∆F + ∆1 = ∆B

This outcome is corroborated by the Kuhn-Tucker conditions. Q.E.D.

Proposition 2 offers a very interesting inference for the program of debtrestructuring. Since the final debt reduction is close to ∆B, the high write-off maysuggest that we deal with the firm causing potential high political costs to the bankhere.

3.3. Debt-equity swap as a restructuring tool

The conciliation procedure allows not only for debt reduction but also for thepossibility of the debt-equity swap (DES) transaction. This tool seemed to beespecially promising to the authors of BCP as it was meant to contribute to theestablishment of a more efficient governance structure over the firm. Paradoxically,it may be the reason why firms avoided this restructuring method. The involvementof new equityholders like banks and other former creditors may seriouslystrengthen the control over management and reduce the income ratio below thevalue c. Consequently, the threshold probability A(c, α). By lower A(c, α) fewerenterprises decide to choose DES. But not all debt-equity transactions may havesuch outcome. When the leverage ratio before DES is relatively low or the statealso belongs to the significant creditors, then the dominant position of the stateshould remain unchanged after DES. On the other hand, DES can improve thebank´s readiness to endure a greater write-off. Since, in the course of DES the bankdoes not only give up a part of its previous debt but also receives a promise toparticipate in future profits, it is more prone to accept the greater maximum debtreduction B∆ under the assumption that this amount is exchanged with equity. The

following proposition can be formulated:


Proposition 3

The model suggests that debt-equity swap could only be preferred by state-owned enterprises with relatively low leverage (debt to equity ratio). However,this transaction may be insufficient to significantly strengthen the ownershipcontrol over the management, since the state will remain the largestequityholder. On the other hand, DES gives an incentive for firms to enterBCP which otherwise would not apply only for debt reduction, as the bank isready to grant more generous debt relief.

Proof: For simplicity, we assume that the debt to equity exchange rate is 1:1. As inthe basic model the debt reduction must fulfil a condition that the bank is not madeworse off after debt reduction:

(7a)( ) ( ) ( )

∆+∆=Γ

∆+−Γ+∆−≤−

Ewhere

DrDWD 2ββαα

and E is the firm’s equity before renegotiation.

The left side of the inequality represents the bank’s income without renegotiation.The bank´s income with renegotiation appears on the right side. It consists of twoparts. The first one is the expected amount of credit repayment and the second termthe bank’s share in the firm’s profit. The factor Γ stands for the bank’s participationin the firm’s future profit after DES since the equity E is increased by the amount∆. After some transformation we obtain the following condition for ∆ to hold:

(7b) ∆ > 0 if Er W D

<+ −β α α

β2 ( )

and

(7c) Bh∆≤∆ if Er W D

>+ −β α α

β2 ( )

where

( ) 121

>−+−

=rEWr

Eh

ααββα

, and E stands for equity.


The first result (7b) refers to the situation where the firm is equipped with arelatively low amount of equity. So, the bank actually has an incentive to exchangethe entire debt as it receives a claim to a greater share of the firm’s surplus.However, as was mentioned above, in this case the bank probably will gain controlover the firm. So, the manager expects that he might lose a great part of hisdiscretion in disposing of the firm’s profit. This is reflected in a lower income ratioc than in BCP without debt-equity swap. As a result the manager would ratherrenounce DES as a tool for debt restructuring.

Things look better if the equity is sufficiently high (7c). In this case, even if thedebt amount close to h∆B is exchanged with the equivalent amount of equity, thebank will not manage to extend a stronger control over the firm since the previousequityholder (the state) retains its supremacy. So, the minimal amount required bythe firm ∆F(c,α) will change only a little, since the value of c remains rather stabledue to the state dominance among shareholders. The fact that the firm has highequity may additionally suggest that it belongs to the state - owned enterprises in arelatively better financial situation. On the other hand, the bank’s readiness tocancel some part of firm’s debt is higher than in the basic BCP, since the maximumacceptable amount h∆B is higher than ∆B, anyway.

The above relation suggests that the proposal of debt-equity-swap may be wellsuited for the situation where both parties can not come to terms with the verywrite-off. This is the case if ∆B < ∆F. However, it might happen that at the sametime: FBh ∆>∆ and the DES is therefore profitable for both sides. The debt -

equity swap thereby lowers the scope of the separating equilibrium. Q.E.D.

3.4. Some proposals to improve the BPC

Proposition 1 shows that the negotiation model based on the structure of the Polishbank reconciliation procedure may lead to separating equilibrium, where only thebad debtors in relatively worse financial condition will enter this restructuring pathTwo factors could be responsible for this inefficient outcome:

The income parameter c is levied externally by the state which directly or indirectlysets a minimal range of power of the creditors´ board.

The right to initiate BCP belongs only to the firm’s manager.


The removal of these potential deficiencies should then restore pooling equilibrium,where all firms preferring risky strategies will switch to safer ones after receivingsome write-off in BCP. The following considerations are devoted to this issue.

The first solution consists of internalising the parameter c into the renegotiationprocess. It may be done when the state does not interfere with the renegotiation andforgoes its prerogative to determine the competencies of the creditor boards.

The second proposal refers to the standard postulate of the property right theorywhich suggests that the control rights over the borrowers should be immediatelytransferred to the debtor when it turns out that the firm is unable to serve its debt(Aghion/ Bolton 1989). In this case the transfer of control rights will followindependently of the very conciliation process.

The first proposal bases on the peculiarity of the ∆F value which may be treated as afunction of c. Then, the first derivative of the expression in (3b) is:

(7a)( )d c

dc

r

cF∆

= − − <αβ( )1 1

02

The manager is, therefore, ready to accept the smaller debt reduction if it bringsabout lower restriction of his discretion (greater c). If the bank promises not tointroduce any restraints on the manager (c=1) then, the smallest write- offacceptable by the manager amounts, according to (3b), to:

(7b)( )

∆ F

D r r* =− + −β α α β

β1 2

.

However, the value ∆ F* is always lower than ∆B, because:

(7c)( ) ( )

∆ ∆F B

D r r D W* ( )=

− + −<

− +=

β α α ββ

β α αβ

1 2

The renegotiation will always end up with success if the bank obligates itself not tointroduce any restrictions on cash disposition. However, this is the last point whichdetermines why this solution is inadequate for the renegotiation. In the course of itthe manager is able to retain entire control over the firm’s assets. This contradictsthe aim of the conciliation which is designed to introduce a more efficient


governance structure. Therefore, this is a reason why such a solution should not beimplemented to improve the efficiency of BCP.

More encouraging results can be achieved by implementing the second proposalwhich postulates switching full control rights to the creditors only after it turns outthat the firm is classified as a bad debtor. In such a case the firm already encountersex ante the restrictions in cash disposition before debt renegotiation starts. Thiscircumstance adequately changes the manager’s incentive. As in the old frameworkhe requires some minimal write-off ∆*

F to change his inclination toward the saferstrategy. This value can be computed from the following inequality:

(8a) c α (r1 - D) < c β (r2 - D + ∆);

In contrast to (3a) the income rate appears on both sides of the inequality. As wasmentioned, this is because the manager´s discretion in cash disposition is alreadyrestrained before BCP is initiated. After some transformation we get:

(8b)( )

∆ ∆>− + −

=D r r

F

β α α ββ

1 2 * .

As in the previous solution ∆*F is always smaller than ∆B, so there is space for the

successful renegotiation of the write-off. The parties in negotiation will alwayscome to terms and the efficient pooling equilibrium will be achieved. The aboveconsiderations can be summarised as follows:

Proposition 4

To achieve the result that all firms classified as bad debtors prefer to enterBCP (pooling equilibrium), the ∆F < ∆B must hold for all firms. Yet, thiscondition can only be warranted if the renegotiation structure is modified. Thebest proposal consists in switching the control right to creditors beforerenegotiation starts.

However, the results form proposition 4 are valid only when the costs toovercome the informational asymmetry are not passed on the bank. Thus,there must be a third party involved which finance the acquisition ofinformation needed to recognise the investment opportunities of the borrower.As noted this resembles the Polish case, where the government received theforeign aid in order to employ the external advisers to the banks.


4. The empirical evidence on the process of debt renegotiation

The main results of the above model put forward that only SOE’s in a relativelybad situation approach the banks for debt relief10. Moreover, the debt-equity swapappears not to be a popular restructuring tool since the managers are afraid oflosing their control rights over firms. It is also to be expected that the extent of debtcleanup could be quite high since the banks should have been driven by politicalconsiderations. In the empirical part of this work we attempt to find evidence whichprovides support for the aforementioned hypothesis. We make use of varioussources of information. The regression analysis is based on two data panels ofenterprises participating in the program. The first one includes 37 firms (panel A)with information from balance sheets and income statements for the years 1992 –1995. The second sample (panel B) is larger. It comprises 69 cases collected by theWorld Bank team and surveyed in the paper by Grey/ Holle (1997). It still lacksdetailed data covering 1995. Thus, we sometimes made computation for theseparate panels but, where it was possible, they are integrated into one group11. Theresearch consists of two parts. In the subsection 4.1. we explore the determinants ofdebt relief. It was most important to find evidence whether political considerationsplayed an important role in the process. In subsection 4.2 the determinants of debt-equity-swaps are considered. Finally, subsection 4.3. is devoted to the issuewhether BCP managed to change the behaviour pattern of indebted firms.

4.1. The negotiation stage

Table 2 provides information about average financial indicators for both panels in1992, before the program started.

In both samples the firms which not only had negative net profits, but also negativeoperating profitability prevailed at that time. This indicator suggests that firms’crises were not only rooted in heavy debt burden, but they had a deeper structuralcharacter. Thus, the restructuring which relies only on debt relief will not suffice toensure future recovery. Looking at the two moments of profitability distribution wecan see no significant difference between both samples in their distributions. Thisrefers also to the range of debt restructuring. Table 3 presents average debtreduction for both samples. Every panel is divided into two groups. The first oneincludes cases where only write-off was implemented. In the second group a part ofcancelled debt was exchanged against equity (debt equity swap).

10 As was noted this conclusion contradicts the view of Belka/ Krajewska (1997) that BCP was an

interesting proposition for firms in good financial situation. Yet, they provide no detailed evidencesupporting this view.

11 12 cases have similar financial figures in both panels and, therefore they are taken into account onlyonce in the integrated panel.


Table 2: The main financial indicators for two samples in 1992

Sample of 67 firms Sample of 67 firms

Mean Standarddeviation

Mean Standarddeviation

Operationalprofitability

-0,033 0,21 -0,0375 0,196

Net profitability -0,47 0,98 -0,279 0,378

Revenues to assets 0,77 0,355 0,7 0,395

Revenues toreceivables

4,42 2,47 5,83 3,96

The share of financialcosts in revenues

0,133 0,133 0,094 0,095

Equity to assets 0,223 0,36 0,48 0,23

The average reduction ratio in both samples for firms without DES exceed 50%.The scope of debt reduction was even greater for firms where DES wasimplemented and exceeded 80% in both samples. The great extent of debt reliefappears to provide first inferences about the nature of firms choosing BCP and theinfluence of political considerations while deciding about debt clean-up.

Table 3: The share of write-off and debt-equity swap in total debt included in BCP

Sample 1 The average share ofwrite-off in total debt

The average share ofDES in total debt

45 firms without DES 0,6 (0,17)*

24 firms with DES 0,53 (0,23) 0,32 (0,18)

Sample 2 The average share ofwrite-off in total debt

The average share ofDES in total debt

11 firms without DES 0,54 (0,2)

26 firms with DES 0,44 (0,29) 0,39 (0,28)

* standard deviation in parentheses


Next, we examine which factors may have determined the outcome of conciliation.Table 4 includes all independent and dependent variables which are controlled inthe parameter estimation based on linear regression. The parameters are estimatedwith the method of ordinary last squares. Unfortunately, the assumption ofhomoscedascity could not be accepted without serious doubt. Particularobservations concern firms belonging to various industry sectors, so we could notreject that the standard errors have various variances. To overcome this difficulty,the White method of variance estimation of model parameters is implemented(Pindyck/ Rubinfeld 1991: 128-129; Greene 1993: 392 - 393).

Table 4: The determinants of debt write-offs

Dependent variables

WROFF The sum of debt to be reduced and debt to beexchanged with equity divided by the totalliabilities included in BCP

REDDEBT The sum of debt to be reduced and to beexchanged with the equity divided by the amountof liabilities recorded in the last balance sheetsbefore conciliation

Independent variables

EMPL The firm’s employment divided by the largestnumber of employees encountered in the panel(3891)

PROFMOD The operating profitability minus extraordinarylosses minus obligatory dividend payment anddivided by operating revenues

EQUIT Total equity divided by the total assets

DESDUMMY Dummy variable taking the value 1 if the BCPforesees DES and the value 0 if only write-off isconducted

The independent variables are represented by two measures of debt relief WROFFand REDDEBT. The second one is a modified version of WROFF which seems tobe more appropriate to capture the real importance of debt reduction. It isintroduced, since usually borrowers do not attribute the same importance to all debt


categories. In the Polish context the distinction between the principal and ordinaryinterest rate on the one hand and the so called penalty interest rate on the other hand(charged by creditor when the borrower fails to repay debt on maturity) is of crucialimportance. Usually, the borrowers put more weight on the first category. In thePolish experience creditors habitually give up the penalty interest rate obligationswhen the debtor decides to repay the regular outstanding arrears. This phenomenoncan be encountered in most conciliation agreements where creditors usuallyaccepted the entire reduction of overdue interest payments. Therefore, the real debtburden ( and accordingly debt relief) should rather be associated with the overdueprincipal and ordinary interest rate than with total debt included in BCP12.Consequently correction of WROFF is required where the adequate amounts ofaccrued interest are subtracted from the numerator and denominator in the formula.Unfortunately, there is no available data about on interest obligations. The onlypossibility which exists is to replace the denominator by the liabilities recorded inthe last balance sheet before conciliation. This amount does not include outstandingpenalty interest rate because the firms are not obligated to record it on the balancesheet. Thus this item could be a good approximation for the value of principal atthe moment of debt relief. Unfortunately, there is no reasonable method formodifying the nominator in the formula of WROFF. Therefore, the new variableREDDEBT includes only modification of the denominator.

All independent variables refer to the last period before reconciliation. The firstone, EMPL, is the firm’s employment scaled by dividing it through the largestnumber (3891) in the sample. The second one, PROFMOD, is the measure of thefirm’s performance. It is the modified operating profitability. The operating profitcould be a misleading indicator of the firm’s strength because a part of sales mightinclude those to insolvent buyers. A good approximation of this amount seems tobe an item of extraordinary losses as it includes defaulted trade amounts. Therefore,it is subtracted form the operating profit. The next variable: EQIT stands for theshare of total equity in all funds available to the firm. The last indicatorDESDUMMY is a dummy variable which has a value of 1 when conciliationagreement included the option for debt-equity swap. We run the regressions for allcases where the data on employment was available (88 observations). The resultsare presented in the following table:

12 The author was given the possibility to review the conciliation documents at one of the banks. It

turned out that in almost all cases the borrowers regularly serviced interest rate payments to the bank.The other interest rate dues were then penalty charges for exceeding the maturity date referring to thetrade credits and to the tax arrears.


Table 5: The Regressions on measures of debt write-offs

Sample with 88 firms

Independent Dependent variables

variables CONSTANT EMPL PROFMOD EQUIT DESDUMMY

REDDEBT 0,487

(7,69)

0,5

(2,49)

0,03

(0,4)

-0,03

(-0,43)

0,188

(2,47)

F statistic = 5.149 (0.001)*)

WROFF 0,6

(17,52)

-0,2

(-0,22)

0.01

(0,238)

-0.08

(-2.2)

0.272

(6,58)

F statistic = 13,22 (0.0001)*)

*) p - values in parentheses

otherwise the values of t - statistics

Both 2 regressions fail to prove that the efficiency measures (PROFMOD) played arole in the decision as to what extent to reduce a debt. Only in one case did thevariable EQUIT exert a statistically significant impact on the dependent variableWROFF with the expected negative sign. However, the value of the parameter isvery low. The results obtained do not allow a rejection of the hypothesis that thenumber of employees is unambiguous with regard to the range of debt reduction.The employment variable (EMPL) has a significant positive influence on themodified measure of debt relief (REDDEBT). This result does not allow a rejectingof the hypothesis that a political consideration played no role in deciding about theextent of write-off. What appears conspicuous is the high value of constantparameter. It suggests that the banks granted on average generous debt cleanups.This observation can be interpreted as a sign of general poor standing of firmsentering BCP. Nevertheless, it does not exclude the impact of politicalconsiderations. Even the middle–size firms can expect large bail out when they arethe largest employers in a town or small region, since their collapse might triggeroff serious political conflicts. As expected, the parameter measuring the impact of


the dummy variable DESDUMMY has statistically important positive value, whichcorroborates a hypothesis that DES contributed to the greater debt relief.

4.2. The attitude of banks and borrowers toward debt-equity swaps

Next, we explore whether the potential ownership structure after DES had animpact on the firm’s decision to accomplish debt - equity swap. The analysis isbased on Probit estimation. A good approximation of the odds that outsiders suchas bank or suppliers take control over a firm as new owners, is the ratio LIABIL. Itis the sum of bank loans and payables to suppliers divided by firm’s assets. Theintuition is that the greater the value of LIABIL, the higher the probability that afterDES, bank and suppliers will gain the majority of votes as new shareholders. Thisallows then them to take the effective control over the firm. The second variablePROFMOD controls the impact of profitability considerations on the decision toaccomplish DES. The estimation result corroborates a statistically significantnegative relationship between DESDUMMY and LIABIL and no impact ofPROFMOD13.

Table 6: The estimation of the probit model for the large sample of 90 cases

independent variable The parameters’ values

CONSTANT 0,41 (1,39)

LIABIL -1,108 (-1,78) P-value = 0.074

PROFMOD 0,12 (0,42)

R2 = 0,046

This negative relationship between LIABIL and DESDUMMY provides somesupport for the view that a high fraction of banks’ and suppliers’ liabilitiesdiscourages managers to choose BCP as a restructuring option. On the contraryprofitability considerations played no significant role. The low R2 suggests that theare other important factors determining the probability of DES. Belka/ Krajewska(1997) argue that banks enforced this operation when they saw a chance forrecovery in replacement of management. It is the author’s opinion that the firm’sprospects, especially the to potential to generate cash flow, could have incline

13 We omitted in the probit estimation 5 highly indebted firms with LIABIL larger than 1since they seem

to be influential variables. It did not change more in the results, as the estimation for the whole samplealso showed the same outcome.


banks to DES. Unfortunately, there was no complete information available tocontrol these additional variables.

It is interesting that only the weakest banks in terms of capital adequacy engagedthemselves more frequently in DES (see Grey/ Holle 1996). In our opinion theseoperations were treated by these banks as a tool to bind the borrowers to the bank14.As these financial institutions were insufficiently endowed with equity they werehardly able to compete with the price of credit to gain new good clients. Thelimited resources also impede introducing new services which are a significantfactor in market competition as well. Therefore, the weak banks may have realisedthat it had to make money on its old clients who had some chance of recovery inthe future. It must, however, be safeguarded that these client will not abandon thebank when their creditworthiness improves. In order to avoid this, the bankbecomes engaged in equityholding which ensures insights into the firm’soperations and allows influence on strategic decisions.

Moreover, the banks included clauses in the reconciliation agreements to grant anew credit or to make it dependent on their approval15

4.3. Has BCP modified the patterns of borrowers’ behaviour?

To assess how BCP exerted an impact on the behaviour of the enterprises we takefour financial ratios: the net profitability (net profit to revenues), operatingprofitability, the total assets turnover (revenues to total assets) and the tangibleassets turnover (revenues to tangible assets). At the beginning lets look at thestructure of the balance sheet before and after signing the bank conciliationagreement (chart 1).

One can see that the apparent result of the process is the increase of the share ofequity which was to be expected after the cancelling of some liabilities. It isespecially visible in panel B where the average equity in 1993 even had a negativeworth. The situation got better in the next year after conciliation agreements weremostly signed and the average share of equity improved to more than 15%. Asimilar development emerged in panel A which stands out better against panel B, asthe share of equity always remained positive during the research period. However,in 1994, some drop of equity was also visible. This occurrence may be explained bythe fact that firms showed on average negative net profitability in that year, and

14 This view is based on interviewing which the author made with bank officials.15 In the sample collected by the World Bank research team the new credit grants were rather

uncommon. In spite of it one "weak" bank deeply involved in debt equity swaps permits to grant newcredits for almost all bad debtors.


additionally, most of the extraordinary gains from write-offs already appeared onthe balance sheets in 1995. In both panels the share of bank loans and payables tosuppliers decreased after debt restructuring, which may be attributed not only to thedebt clean-up but also to some reluctance of banks and suppliers to provide newfunds. This outcome is to be expected, as any write-off brings about some loss inborrower’s reputation. In Panel B some substitution of aforementioned financesources by other liabilities, among which tax arrears usually prevail, can beobserved. Yet, this tendency suggests that the hardening of budget constraints stillencounters obstacles for this group of firms.

Chart 1: The changes in Balance sheet’s structure

The improvement of capital structure was not the main objective of BCP but only ameans to give an incentive for the management to improve performance. Yet, chart3 provides no definitive evidence that these arrangements were sufficiently efficientin this respect Although the net profitability improved significantly in both panelsbut it was a one-off event caused by the write-off, since it is booked as anextraordinary gain. The more appropriate measure of profitability is, therefore, theoperating profitability which is not distorted by the changes of extraordinary items.Its average amount has not improved in both panels after 1993 which indicates thatthe program was a failure for most firms as far as their performance is concerned.However, taking into account other efficiency measures leads to a more moderateview. We take into account turnover ratios. They provide some inference as to howefficiently the available funds are used in the firm’s day-to-day performance. Incontrast to profitability both ratios under consideration improved significantly forboth samples. So, the point that no restructuring occurred at firms at all, shouldrather be rejected. The improvement in turnover ratio means that managersmanaged to economise at least on available funds. They probably reducedinventory and collected overdue bills more efficiently. However, this is insufficientin restoring positive operating profits as it usually requires painful activities inorder to cut costs.

The capital structure of firms in the panel B

-20%

0%

20%

40%

60%

80%

100%

1991 1992 1993 1994

the capital structure of panel A

0%

20%

40%

60%

80%

100%

1992 1993 1994 1995

Other liabilities

payables tosuppliersBank loans

Equity


Chart 2: Net profitability and operating profitability

PANEL A PANEL B

Chart 3: Turnover ratios

PANEL A PANEL B

The inferences based on average data provides only superficial insight to thedevelopment of firms in question. Therefore, additional research is required. Weexamine whether the starting situation of the firm or the type of debt restructuringhas an impact on future performance. The first relationship is controlled byregressing the change in operating profitability between 1992 and 1994 (or 1995for only panel B) on its value in 1992. We introduce also in all regressions thedummy variable DESDUMMY to examine whether debt–equity swap and expectedchange in ownership structure exerted an impact on the firms’ performance. Thedetailed description of variables in question is contained in the following table 7.

-0,3

-0,25

-0,2

-0,15

-0,1

-0,05

0

0,05

1992 1993 1994 1995

-0,6

-0,5

-0,4

-0,3

-0,2

-0,1

0

0,1

1991 1992 1993 1994

Net profitability

Operatingprofitability

0

0,5

1

1,5

2

2,5

3

3,5

1992 1993 1994 1995

0

0,5

1

1,5

2

2,5

1991 1992 1993 1994

Revenues toassetsRevenues totangible assets


Table 7: The determinants of the changes in operating profitability

Variable Description

OPPR92 Operating profitability in 1992

OP9492 The difference between operating profitability in 1994and 1992

OP9592 The difference between operating profitability in 1995and 1992

INPR The change in production (between the years appearingin the name of variable) in the industry to which theappropriate firm belongs

RELPR The real change in the industry output prices betweenyears appearing in the name of variable

The obtained results of the first regressions’ type is contained in the Table 8. Itshows that there is a strong negative relationship between the initial operatingprofitability in 1992 and its subsequent change. Chart 4 also corroborates suchdevelopment. This means that relatively weak firms managed to improve theirsituation whereas the stronger ones worsened their performance in the samepassage of time. At first glance this outcome puts forward that the BCP helped onlythe first group of firms and at the same time was not able to change the incentivesof the firms in a better starting position. So we can speak of some kind of partialefficiency of the programme. Unfortunately, this pattern of behaviour is similar togeneral attitudes of state-owned enterprises. It is well-known that such firms start tothink about restructuring only after their situation was dramatically deteriorated. Onthe other hand the firms in quite a good position delayed the implementation ofnecessary steps to accommodate to the changing market environment.Consequently their performance declines with time. Looking at both panels fromthis standpoint one could admit that the program allowed firms in very badsituation to survive. However, at the same time, it weakened the financial disciplineover the firms with positive profits. As a result they did not modify their behaviour,as they were not forced by sufficient financial constraints. The regression shows nosignificant influence of debt equity swap on performance change. The resultingownership change was insufficient to modify managers’ incentives. According tothe results obtained in subsection 3.4. and information provided by Holle/ Grey(1996), DES usually failed to deprive the state of the dominant position amongshareholders. Thus, other outsiders may have problems with exerting pressure on


firms’ managers to implement more active restructuring strategies. As was to beexpected the increase of real prices is reflected positively on an increase ofoperating profitability. On the contrary the changes in real output in the wholeindustry have no significant impact on dependent variables.

Table 8: Regression on the profitability changes

REGRESSION I

Independent Dependent variables

variables OPPR9492 for the totalsample of 95 cases

OPPR9592 formpanel B

CONSTANT -0.955

(-1,66) P-value = 0,1

-0.364

(-2,45)

OPPR92 -0,474

(-3,147)

-0,75

(-3,51)

DESDUMMY -0,064

(-1,11)

0,045

(0,64)

RELPR 1,38

(2,25)

0,35

(1,91)

INPR -0,2

(-0,71)

0,006

(0,14)

F-statistic 5,56 18,02

Summing up, the declining operating profitability puts forward that the enterprisessigning a conciliation agreement did not have sufficient potential to adaptsuccessfully to the changing market environment even after granting them agenerous bail-out. This circumstance provides an indirect support for proposition 1in subsection 3.2.


Chart 4: The changes of operating profitability

Therefore, it is warranted to argue that the high debt write-offs were granted bybanks in order to loosen ties with bad debtors. It must be admitted, however, thatthe foundations of the bank conciliation proceeding prompted such behaviour. TheLaw of Bank and Enterprise Restructuring included the possibility of termination ofthe agreement if the firm fails to meet its conditions, only in the first three yearsafter signing it. After that period the bank takes full responsibility for the futuredebt service. Thus, almost all agreements are valid for this passage of time and thebanks accommodated the repayment conditions to the expected cash flow levelwithin three years. However, this circumstance does not entirely explain the banks’indulgence in their treatment of bad clients. Being the creditor of large distressedstate companies, the bank is always exposed to pressure exerted by the state tocontinue to finance them. Consequently, it is more convenient for it to extensivelyreduce the old credit and to require a less ambitious rescue program or even toaccept the unrealistic one in particular if the firm’s current situation does notpromise a large performance improvement. Such treatment, however, generates theadverse incentive for the management of SOE’s. The firms of the World Banksample reported the operating profitability close to zero, before the introduction ofthe rescue plan. This indicator had not changed until 1994, although they plannedsignificant improvement in this field (Grey/ Holle 1996). This may suggest thatmany rescue plans were unrealistic from the beginning. This serious objection issupported by the fact that most agreements were signed just before the deadline setfor negations (May 1994). Also, some specialists involved in the preparation of therestructuring concepts signalled this problem (Bochniarz 1994: 14). When onereads some of the business plans one sees conspicuous similarities in them. In mostcases the rescue concept comprised only the setting up of the marketing division or

-1

-0,5

0

0,5

1

1,5

2

-1,5 -1 -0,5 0 0,5

operating profitability 1992

chan

ge in

ope

ratin

g pr

ofita

bilit

y 19

92-1

994


the sale of the firm’s assets. They do not foresee more offensive strategies likeinvestments in new technology or distribution channels in new market segments.Also, the BCP does not commit the firm to abide by the time table whileimplementing rescue measures. It is also striking that banks do not complain aboutthe firms´ behaviour. Although the enterprises have not improved theirperformance, they have nevertheless managed to abide by the conditions of theagreement16. But this only bears out the bank’s leniency. All these occurrences sentadverse signals to many enterprises. The big write-offs and banks´ acceptance ofunconvincing business plans may have confirmed their belief that they are stillexcluded from market discipline.

5. Is the Polish approach to deal with bad debt a success story ?

Formulating such a question raises the expectation that a unanimous answer may begiven. When we look at some financial ratios of the seven banks involved in theprogram, it may seem that the program ended with success (Table 9)17. Thisconclusion, however, should be treated very carefully when we take into accountdata referring to the banks not recapitalised by the state treasury (Table 10). Theyhave even greater achievements in the struggle with bad debts. It is, therefore,reasonable to ask whether the significant improvement has other sources than theprogram of bank restructuring. The strengthening of Polish financial institutionswas surely due to the improvement of the economic situation. In the author’sopinion a more important factor was the introduction of a restrictive prudentialregulation and better performance of the Bank Supervision Office. Its rapidinterventions changed the banks’ incentives and limited their ability to ”gamble forresurrection”. In this context the question arises whether the institution of the bankconciliation procedure was really necessary to overcome the crisis.

The strengthening of the banking sector could be achieved through itsrecapitalisation. It is true that the latter may awaken the expectations among bankmanagers to be bailed out as soon as the worsening economic situation hurts bankcredits. The authors of the program expected such an effect and therefore theylinked the recapitalisation with the obligation to restructure bad debts portfolios.However, it is not sure that such a mechanism manages to weaken the expectationsfor future bailouts. The state would have received much better effects in combatingthe moral hazard behaviour if it would have engaged more decisively in theprivatisation of the financial institutions. As is generally known, this processencounters serious difficulties and is significantly delayed.

16 The state supervision office (NIK) also stated that most enterprises signed a banking conciliation

agreement (33 cases included in the control procedure) still generate losses but they repay theirrescheduled debt on time.

17 It must be mentioned, however, that this bad debt ratio should be seen as fairly high compared tointernational standards


Table 9: Substandard credits and capital adequacy ratios at 7 state banks

Substandard creditsin total credits

capital adequacyratio

1992 1995 1992 1995

1 Bank Przemyslowo-HandlowySA Krakow

12,21% 13,96% 11,20% 13,90%

2 Bank Gdanski SA 18,10% 7,67% 22,10% 33,90%

3 Powszechny Bank KredytowySA W-wa

28,17% 24,85% 5,85% 21,30%

4 Bank Zachodni SA Wroclaw 40,39% 19,79% 5,30% 15,80%

5 Pomorski Bank KredytowySA Szczecin

36,72% 21,33% 9,50% 17,30%

6 Bank Depozytowo-KredytowySA Lublin

42,28% 22,29% 3,20% 21,00%

7 Powszechny Bank GospodarczySA Lodz

11,80% 3,67% 3,50% 17,60%

Source: Gazeta Bankowa

Although the bank reconciliation agreement was thought as a measure to break thepassivity of firms and banks managers, it may have produced an adverse result.There are too many signals which can be interpreted by outsiders that the BCP wastreated more as an expedient way to receive lenient bailout than to initiate anambitious rescue program. The high write-offs for large state-owned enterprisesmay rather suggest that the banks approved applications for conciliation in order toavoid high political costs accruing if the firm goes bankrupt and sacks itsemployees. All this may generate the expectation that it was not the one-off actionand the state will certainly introduce the new rescue program if the generaleconomic situation gets worse in the future. It does not mean that we neglect therole of the institutional arrangements in approaching the problem of defaultcreditors. On the contrary the bad debt crises revealed the inefficiency of the Polishbankruptcy law. As in other postcommunist countries (with the exception ofHungary) it enables the creditors to behave passively and does not punish managerswhen they delayed to initiate bankruptcy procedure. One possible solution is to


introduce the mechanism of the automatic triggering and integrating the bankruptcyand renegotiation law. According to it the manager of a firm will be obligated bylaw (with an appropriate punishment clause) to initiate the whole procedure withoutwaiting for creditor’s reaction on first signal that the firm is illiquid. In the firststage, time should be allowed (3 months) for creditors and managers to workout arescue program. Only when the renegotiation fails, the bankruptcy procedureshould be introduced. This mechanism may be much more efficient than theexisting law in breaking the passivity (that of managers and creditors) andestablishing the financial discipline.

The mechanism of automatic triggering was introduced in Hungary in 1992. As itengendered a wave of bankruptcy filings the legislator lifted it a year latter.Nevertheless, the Hungary experience indicates that other institutional factors likethe underdevelopment of the legal infrastructure seemed to be responsible for thefailure of the first reform attempt (Mizsei 1994; Bonin/ Schaeffer 1995, Grey/Schlorke/ Szanyi 1995).

The projected amendment of Polish bankruptcy law goes in the similar directionsince it introduces penalty for the managers who delay the filing for bankruptcy.However, there was no obstacle to accomplish the reform already at the time ofbanking crisis instead of creation a special form of conciliation procedure for some”privileged” group of borrowers. Despite this criticism the author shares the viewwith other observers that the Polish program has made banks more conscious of theimportance of the bad debt issue. It compelled them to establish work-outsdepartments with the task to deal with non-performing loans and to train staff forthis purpose. However, this result could have been achieved even without anyspecial treatment of the old bad debtors. The government could have obliged thebanks to take action with respect to nonperforming loans up to some pre-specifieddeadline along with general reform of bankruptcy low. This approach would havecreated a new institutional framework to strengthen the disciplinary role of the debtwithout raising expectation on the part of the firms for future bail-out. The Polishapproach to debt cleanup seems to be rather insufficient to provide a strongguarantee that this will be not the case in the future.

To sum up, the available evidence form Poland cannot corroborate the view that thebanks are particularly suited to play an active role in the restructuring of distressedfirms. Most of them showed no significant improvement after their financialrestructuring. This point to the lacking expertise in Polish banking sector to pursuethe task of firm’s operational restructuring. For this reason, it is not advisable thatthe Polish banking sector should follow a pace of Japan where the banks are deeplyget involved in assistance to the defaulted companies. It is rather impossible thatthe lacking skills can be readily and promptly acquired by the bank servants.


Furthermore, the bank involvement in equityholding appears not to providesignificant improvement in this respect. Thus, the present authors shares theconcern, that equityholding will rather burden them with additional systemic riskthan give them any greater benefits. This view is however not synonymous with aplea for the market-oriented financial system. The banks in transitional economieshave an crucial role to play in the process of monitoring and control of financialagents. But it should occur not through equity involvement but the loan contractwhich provides a powerful device. Thus, the government’s effort should bechannelled in the first front of line to establish the basic elements of workable legalprotection of debtholders.

Table no. 10: Bad debts in total credits in the Polish banking system

31.12.1993 31.12.1994 31.12.1995 30.6.1996

9 banks excluded from the

National Bank of Poland a)

32,7 % 27,2 % 16,4 % 13,2 %

6 specialised state owned

banks

32 % 32,9 % 27,2 % 23,1 %

co-operative banks 22,7 % 21,3 % 11,7 % 7,4 %

remained banks 28,7 % 24,8 % 16,3 % 12,1 %

total 31,1 % 28,8 % 20,4 % 16,2 %

a) this group comprised the 7 banks recapitalised by the state.

Source: the General Supervision Office of Polish National Bank


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