FINANCE FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Addressing the Corporate Debt Overhang MARCH 2022 © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. 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Cover photo: @ hallojulie / Shutterstock Cover design and layout: Clarity Global Strategic Communications / www.clarityglobal.net >>> Acknowledgments The White Paper “Addressing the Corporate Debt Overhang” is a collaborative effort between three programs of the Finance, Competitiveness & Innovation (FCI) Global Practice of the World Bank Group, namely the Financial Stability Program, the Insolvency & Debt Resolution Program, and the Long-Term Finance Program. The lead authors of the paper were as follows: Beulah Chelva (Chapter 1); Emile van der Does de Willebois and Nigel Jenkinson (Chapter 2); Antonia Menezes, Sergio Muro, and Adolfo Rouillon (Chapter 3); and Bryan Gurhy and Søren Lejsgaard Autrup (Chapter 4), under the supervision and guidance of Cedric Mousset (Acting Practice Manager, FCI); Mahesh Uttamchandani (Practice Manager, FCI); and Anderson Silva Caputo (Practice Manager, FCI); and overall direction of Jean Pesme (Global Director, FCI). In addition, the team is grateful to Ana Carvajal, Fernando Dancausa, Zeenat Edah-Tally, Erik Feyen, Akvile Gropper, Harry Lawless, Andres Martinez, Nina Mocheva, Owen Nie, Will Patterson, and Jing Zhao for their extensive inputs and support. The authors would like to thank the following peer reviewers for their review and insightful contributions to this publication, helping ensure that it is suitable for different regions across the globe: Professor Charles Booth (Professor of Law at William S. Richardson School of Law); Karlis Bauze (Senior Financial Sector Specialist, EECF2); Gunhild Berg (Senior Financial Sector Specialist, EECF2); Lucero Burga (Senior Economist, EFNDR); Julian Casal (Senior Financial Sector Specialist, EAEF2); Miquel Dijkman (Lead Financial Sector Specialist, EECF2); Oliver Masetti (Senior Financial Sector Specialist, ELCFN); Marta Sanchez-Sache (Senior Investment Officer, CFGAM); and Sagar Shankar (Operations Officer, CSAA1). Sincere appreciation is extended to Susan Boulanger for editing and to Clarity Global Strategic Communications for design and production services. The empirical analysis in Chapter 1 would not have been possible without the datasets kindly shared by the Firms, Entrepreneurship, and Innovation unit, who designed the Business Pulse Survey, and the Corporate Vulnerability Index from the EFI Macro-Financial Review. Additionally, special thanks go to the many insolvency specialists from more than a hundred jurisdictions who contributed to the unique survey created especially for the purposes of this report. A full list of said survey contributors can be found in the Annex. The team would like to acknowledge that this survey was jointly developed and administered through a fruitful partnership between the World Bank Group, INSOL International, and the International Association of Insolvency Regulators (IAIR). >>> Contents Foreword 1 Executive Summary 2 Acronyms 5 Chapter 1: Setting the Scene: The Evolution of Corporate Vulnerabilities and Firm Debt Dynamics up to and During the Pandemic 7 I. Introduction 7 A. Corporate Vulnerabilities 8 B. Corporate Debt 9 C. Policy Response 10 D. Impact of Nonperforming Loans on the Banking Sector 11 II. Conclusion 11 References 20 Annex 1A: Measuring “Debt at Risk” Using the BPS: Methodological Approach 22 Annex 1B: Corporate Vulnerability Index Methodology 24 Annex 1C: Bottom-Up Reverse Stress Test: Methodological Approach 26 Chapter 2: Failing to Prepare Is Preparing to Fail: Getting Ready for Financial Hardship—Nonperforming Loans and Financial Stability 27 I. Introduction 27 II. Need for Action 28 A. What Have We Learned from Previous Crises? 28 B. What Are the Current Vulnerabilities and Risks from High Corporate Leverage? 30 III. The Building Blocks for NPL Resolution 32 A. An Enabling Legal Environment 32 B. Relying on Solid Regulatory and Supervisory Foundations 33 C. Backed by Supervisory Guidance and Action 39 IV. Dealing with NPLs: Bank-Led Strategies and Public Policy Interventions 40 A. Private Action: Ensuring Bank Readiness to Manage NPLs 40 B. Public Action on NPL Reduction 43 V. Conclusions and Policy Recommendations 45 References 47 >>> Contents Chapter 3: Addressing Insolvency Risk Through Corporate Debt Restructuring Frameworks 52 I. Introduction 52 II. The Purpose of CDR Frameworks 53 A. Benefits of Effective CDR Frameworks 53 B. Different CDR Frameworks Address Different Levels of Corporate Distress 55 III. An Empirical Description of Legal Frameworks for CDR 58 A. Out-of-Court Workouts and Enhanced CDR Frameworks 59 B. Hybrid and Preventative Hybrid Procedures Addressing Noninsolvent Debtors 61 C. Formal Reorganization Mechanisms 65 IV. Survey Data and the Role of CDR Frameworks 66 V. Lessons Learned from Implementing CDR Frameworks in EMDEs 70 A. Designing a CDR Framework 71 B. Implementation of CDR Frameworks 74 VI. Conclusion 76 References 77 Annex 3A 80 Chapter 4: The Role of Capital Markets in Dealing with the Corporate Debt Overhang 87 I. Introduction 87 II. The Type of Corporate Financial Problem Dictates the Solution 89 III. Literature Review 91 IV. Analytical Mapping 92 V. Assessing Capital Market Solutions 96 VI. Types of Public Sector Interventions 99 VII. Instrument Overview 101 A. Debt Instruments 101 B. Equity Solutions 106 C. Hybrid Solutions 110 VIII. Conclusion and Policy Recommendations 112 References 113 Annex 4A 115 Annex 4B: Overview of Capital Market Solutions for Corporate Debt Overhang 118 >>> Foreword The ability of businesses to borrow affects investment, entrepreneurship, and overall economic growth. However, there can be too much of a good thing. A buildup of debt can pose risks to the financial system and impair economic growth. Excessive corporate debt can lead to higher cost of capital and cause businesses to forego productive investment opportunities. It can raise businesses’ risk of default, which can in turn weaken financial institutions that lend to them. If left unchecked, the so-called “corporate debt overhang” phenomenon can compromise economic recovery and stability of the financial system. After years of the COVID-19 pandemic, nonfinancial corporate debt levels in many countries are at record levels, fueled by extensive public support programs introduced in many countries to maintain economic activity. According to statistics from the Bank for International Settlements, nonfinancial corporate debt has nearly doubled in emerging markets and developing economies (EMDEs) since the global financial crisis of 2008–2009. If not brought down urgently and in a balanced way, excessive corporate debt will likely inhibit new investments and slow down recovery from recession caused by the COVID-19 pandemic. As such, addressing corporate debt overhang will be a central pillar in facilitating an equitable recovery from the pandemic, which was the focus of the recent 2022 World Development Report. Much current corporate debt is not sustainable, particularly in EMDEs. Cross-country studies suggest that a large percentage of nonfinancial firms in EMDEs entered the COVID-19 pandemic with fragile balance sheets—with over a quarter of them being unable to cover interest payments with current earnings—which in turn made them susceptible to insolvency in the event of a shock to earnings and receivables. As fiscal support measures are gradually withdrawn, nonperforming loans (NPLs) could rise quickly and a wave of insolvencies could spill over to the financial sector, restricting its ability to support growth. To avoid this dire outlook, policy makers should take comprehensive and expedient action to reduce the risks associated with corporate debt overhang. This report, “Addressing the Corporate Debt Overhang,” draws on the World Bank Group’s extensive experience implementing on-the- ground solutions for reducing financial risks, in collaboration with financial institutions, regulators, and other public sector authorities. Among the cross-cutting solutions assessed in this report are strategies for resolving NPLs, measures to strengthen corporate debt restructuring frameworks, and ways capital markets can help alleviate debt levels. Policy recommendations provide valuable guidance to anyone facing the multifaceted challenge of a corporate debt overhang. I highly recommend this report to policy makers and World Bank staff alike. Jean Pesme Global Director, Finance Finance, Competitiveness & Innovation Global Practice EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 1 >>> Executive Summary This White Paper considers the problem of corporate debt overhang and discusses the policy tools to address it. Corporate debt overhang describes the scenario in which a company’s debts are so great that they deter new lenders, affect corporate decision-making, and stifle new investment. At scale, this phenomenon can compromise economic recovery. A greater level of debt can be tolerated in a booming economy, where returns on investment are high, but in a stagnant or contracting economy, where returns on investment are low, the risks associated with corporate debt overhang tend to be more severe. The White Paper is timely and unique in its breadth and perspective. It presents the different elements of the possible solution sets to the corporate debt overhang problem, drawing on the World Bank Group’s unique field experience in designing and delivering these solutions. The findings in this paper can be used to help policy makers understand the tools available to them and, more importantly, which tools are most likely to deliver the highest marginal benefit for their country. Three sets of interlinked policy tools for mitigating debt overhang risks are considered. First, financial stability instruments (particularly approaches to address bank nonperforming loans (NPLs)), second, corporate debt restructuring (CDR) frameworks, and third, capital market solutions. While each of these policy tools is considered in a stand-alone chapter (Chapters 2 through 4), they have several common threads. First, they are concerned with the creation of effective enabling regulatory environments. Second, cognizant of government balance sheet limitations, the policy settings are intended to operate in a manner that reduces the risk for widespread government fiscal intervention. Finally, these reforms are experience-driven rather than theoretical, building on the lessons from what has and has not worked in previous financial crises. Chapter 1 “sets the scene” with an empirical analysis of the evolution of corporate debt vulnerabilities up to and during the pandemic. While there is no set value at which corporate debt levels become economically harmful, the post-2009 rise had begun to cause concern even before the COVID-19 pandemic. The policy response to the COVID-19 pandemic, characterized by widespread fiscal support to keep businesses afloat, has exacerbated these fears. The concern is that when these temporary support measures are phased out, many businesses in need of fresh funding to kick-start their operations after months in quasi-hibernation will be unable to secure this funding because of the scale of their existing debts. In this context, the chapter analyzes the evolution of corporate debt vulnerabilities up to and during the pandemic. Drawing on a set of novel datasets, the chapter highlights the scale and distribution of corporate vulnerabilities across regions, sectors, and firm size. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 2 Given the record level of corporate leverage in many enhancing coordination among the various stakeholders, countries and the adverse economic shocks caused by both public and private, is essential. This can be achieved by the pandemic, there is a high risk of a sharp increase establishing a committee or working group. Such processes in defaults in the nonfinancial corporate sector. This can help the authorities develop coordinated strategies for would in turn affect financial sector stability because higher NPL resolution as well as obtain buy-in and inject impetus into proportions of NPLs threaten both the profitability and the the chosen approach. liquidity of financial institutions. This is particularly important at present because recent stress-test analysis reveals that, Chapter 3 considers CDR frameworks that can help for the median bank, all that is required to wipe out 20 percent deal with the ensuing corporate debt overhang and the of its capital buffer is a 3.8 percent increase in NPLs. In expected rise in the number of financially distressed addition to increasing financial sector stability risks, high NPLs businesses. In-court and out-of-court processes for corporate inhibit future recovery. History shows that jurisdictions with debt restructuring are also an integral part of any effective NPL high levels of unresolved NPLs typically experience deeper management strategy. Well-developed CDR frameworks offer and more protracted recessions and slower recoveries than a variety of procedures that can be used for different levels jurisdictions in which NPL problems are speedily addressed. of corporate financial distress, with varying levels of court involvement/supervision. The chapter presents a taxonomy Chapter 2 focuses on the link between nonperforming of CDR tools and uses a specially created dataset to provide loans and financial stability, as well as the measures that evidence of the development and key features of CDR authorities and financial institutions can take to identify mechanisms in 114 economies around the world. In particular, it and resolve problem assets at an early stage. The chapter shows that, despite the known benefits of informal restructuring underlines the risk of inaction when encountering rapidly tools, they remain less widespread than formal insolvency tools. deteriorating bank asset quality and provides a high-level Out-of-court workouts (private agreements between creditors overview of the most important factors in ensuring proper and debtors with limited or no judicial involvement) also remain management of NPLs. The chapter also reviews the strategies relatively uncommon. Jurisdictions with a framework, guideline, and tools adopted by banks and the public sector and provides or agreement regarding the conduct of out-of-court workouts policy recommendations. enjoy greater creditor participation. This is important because economies where creditors regularly use informal restructuring NPL resolution requires sound laws that create clear tools tend to have higher levels of access to credit. Even when rights and procedures for creditors and debtors; a these tools are available, however, special rules to deal with regulatory framework that establishes unambiguous, micro, small, and medium enterprises in financial distress— accurate, and timely indicators of bank asset quality; often the great majority of firms within an economy—seldom and an effective supervisory system to ensure NPLs are exist and are particularly critical in contexts like that created promptly identified and addressed. Financial institutions by the COVID-19 pandemic. An additional finding of the should be encouraged to set up dedicated workout units and data analysis in Chapter 3 is that “separate entry systems,” to develop a strategy and timeline to address loan quality in which an indebted company can choose to file for either problems and reduce NPLs. Components of such a strategy restructuring or liquidation (unlike “single entry systems,” which can include loan restructuring, legal action, debt write-offs, offer one entry path that can branch off into either liquidation or and sales. In the event of a system-wide increase in NPLs, restructuring), are associated with substantially higher rates of creditor recovery. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 3 Many tangible and intangible elements are needed for Capital market solutions are most applicable in countries CDR frameworks to be successful, including the enabling with relatively developed local capital markets. These environment, the right choice of tools, and effective markets are characterized by a well-functioning local currency implementation. In recognition of this complexity, Chapter 3 government bond market, a broad and diversified investor also sets out 20 practical lessons learned in developing CDR base, and the presence of foreign investors. Of course, in frameworks in emerging markets. The lessons are presented some instances, international capital markets will be relevant, in two sections: first, those most relevant in the early, design although in most cases this relates only to large international stage of a CDR framework and that may influence the choice companies with established access to these markets. For of CDR mechanism, and second, those that should be the majority of EMDEs with no developed capital markets, considered for the implementation stage. The overarching the low depth of local capital markets significantly limits their message from these lessons learned is that there is no “one- access. In jurisdictions that show potential for capital market size-fits-all” solution, and a good understanding of a country’s development, a combination of policy reforms and government market needs, negotiation and business culture, and existing support could help propel some market-based financing legal and institutional environment is critical for developing an mechanisms. Chapter 4 provides a framework to assess effective CDR framework. the need for interventions, while assuming that the exact mechanism of support will depend on local specificities and Chapter 4 focuses on the role that capital market the type of problem confronted. Further, although the task is solutions can play in helping nonfinancial corporations challenging, the experiences of Asian countries after the Asian (NFCs) in emerging markets and developing economies Financial Crisis (1997–1998) and of many euro area countries (EMDEs) deal with debt overhang as the COVID-19 crisis after the euro crisis (2007–2012) do show that implementing continues to evolve. The chapter outlines both debt and a policy reform agenda and government support can lead to equity approaches that can help NFCs improve their balance an increase in the availability to businesses of market-based sheets and financial position to deal with already high levels financing mechanisms. Thus, it is critical that government of leverage and help lower-leveraged NFCs improve their authorities factor in the importance and benefits of developing performance and probability of survival, given the severe capital markets when they assess whether to intervene and, adverse shock of the pandemic. Capital market solutions for if so, what type of interventions would be needed as their NFCs suffering from a debt overhang should focus primarily on countries move into the recovery phase. increasing the equity base of the corporate to address the high leverage, helping reduce adverse effects on economic activity   from unintended NFC deleveraging. NFCs with low leverage before the pandemic will not necessarily face a threatening debt overhang, but they may nonetheless experience liquidity problems, and well-designed debt solutions could suffice to address their current financial problems. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 4 >>> Acronyms AMC asset management company ASEAN Association of Southeast Asian Nations BP break point BPS Business Pulse Survey CDR corporate debt restructuring CVI Corporate Vulnerability Index DaR debt at risk EAP East Asia and Pacific EBIT earnings before income and taxes EBITDA earnings before interest, taxes, depreciation, and amortization ECA Europe and Central Asia EMDE emerging market and developing economy EU European Union FSAP Financial Sector Assessment Program GDP gross domestic product GFSR Global Financial Stability Report (IMF) IAIR International Association of Insolvency Regulators IASB International Accounting Standards Board IFC International Finance Corporation IFRS International Financial Reporting Standards IIF Institute of International Finance IMF International Monetary Fund LAC Latin America and the Caribbean MENA Middle East and North Africa MSEs micro and small enterprises MSMEs micro, small, and medium enterprises NFC nonfinancial corporation EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 5 NPL nonperforming loan OCW out-of-court workout OECD Organisation for Economic Co-operation and Development PE private equity SAR South Asia Region SAR Special Administrative Region SSA Sub-Saharan Africa SMEs small- and medium-sized enterprises UK United Kingdom UNCITRAL United Nations Commission on International Trade Law US United States USD United States dollar VAT value-added tax EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 >>> Setting the Scene: The Evolution of Corporate Vulnerabilities and Firm Debt Dynamics up to and During the Pandemic I. Introduction The ongoing COVID-19 pandemic has prompted an unprecedented scale of public support to help businesses through the crisis. While these measures have been crucial in ensuring business survival in the short term, as policy support begins to unwind, a wave of insolvencies is expected. Corporate debt overhang disincentivizes overleveraged firms from engaging in productive investments,1 thus amplifying the adverse business cycle shock and compromising the economic recovery. If unchecked, a sharp increase in corporate vulnerabilities will profoundly impact the banking system, spilling over to the broader financial sector (Group of 30 2020; Helmersson et al. 2021). Hence, efficient procedures for restructuring or liquidating unviable firms will minimize the financial and economic damage inflicted by a wave of defaults. The purpose of this report is to describe the scale of this problem, to highlight why policy makers should be concerned about it, and to present tools and policy options that countries should consider for dealing with these problems. The report sets out the key policy tools and “lessons learned” from extensive work by the World Bank Group in mitigating debt overhang risks by promoting financial sector stability in emerging markets and developing economies (EMDEs), facilitating corporate restructuring, and where appropriate, strengthening access to capital market finance to weather the effects of a crisis. Table 1.1 summarizes measures to deal with the corporate debt overhang using the lenses of financial stability, corporate debt restructuring, and capital market solutions. 1. Firms are less incentivized to raise finance for new investments with a positive net present value as proceeds from new investments will predominantly service debts held by existing creditors instead of benefiting shareholders or new holders of debt. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 Even before the pandemic, policy makers had expressed because of their thin equity cushions, lower liquidity buffers, concerns that the potential impact of high nonfinancial limited financing, and less diversified revenue streams. Where corporate debt, increasingly from subprime issuers, bank lending is concentrated in vulnerable sectors, this may could lead to financial stress and impair economic growth be a source of problems for small and regional banks with high (International Monetary Fund 2019; United Nations 2019). SME exposure (International Monetary Fund 2020). Nonfinancial corporate debt in EMDEs has been accumulating since the global financial crisis—from 56 percent of gross To provide context, the following analysis draws on the domestic product (GDP) in 2008 to 103.5 percent of GDP in Corporate Vulnerability Index4 (CVI) and the Business Q4 of 2020.2 Preceding the pandemic crisis, many firms took Pulse Survey5 (BPS) to highlight how corporate advantage of the “lower for longer” interest rate environment, vulnerabilities have developed over the pandemic crisis accumulating additional debt in a period of low economic and presents some measures of how much corporate debt is growth and subdued corporate earnings. Over this period, at risk.6 This review culminates in a more complete analysis the growth in corporate syndicated loans and the shift from of private sector developments. Analysis based on the survey bank to bond debt in some countries led to concerns over debt provides insights into the financial pressures facing firms sustainability and refinancing.3 In light of these developments, across two snapshots in time during the crisis. Complementing many firms entered the pandemic crisis with elevated pre- the survey insights, the CVI uses balance sheet data to existing vulnerabilities. track how corporate sector vulnerabilities have evolved and covers listed nonfinancial corporates using granular balance Recent studies show the risks of a potentially rapid sheet data for a more detailed analysis of corporate sector deterioration of corporate sector health. In a sample of vulnerabilities. Both data sources in tandem provide rich advanced economies and several major EMDEs, Banerjee, insight into corporate sector health across the universe of Noss, and Pastor (2021) found that, for most firms in their firms, highlighting the potential magnitude of the ensuing debt sample, if corporate revenues fell by 25 percent in 2020, in the overhang and differences in firms’ experiences. absence of any corporate refinancing, corporate debt service and operating expenses would exceed cash buffers and A. Corporate Vulnerabilities revenues. Demmou et al. (2020) similarly reported that social Results from the BPS analysis during wave 2 (September distancing measures would precipitate liquidity shortfalls after 2020) indicate that two-thirds of firms are financially three months for 35 to 38 percent of European firms. Didier vulnerable based on estimates drawn from 20,500 firms in et al. (2020) noted the unprecedented collapse in revenues 19 countries. Firms are deemed financially vulnerable using and reported that, in the United States, cash flow would present and forward-looking measures of financial vulnerability. cover less than 30 days of operating expenses. Kroeger et al. Within the group of financially vulnerable firms, just over half (2020) indicated that over half of corporate debt in ASEAN and are already at risk,7 while 36 percent of all firms are expected Vietnam is at risk. to face difficulties in meeting their future debt obligations.8 With more firms showing signs of financial vulnerabilities, as A growing body of evidence indicates that certain captured by forward-looking measures, decisive action now segments of the economy have been significantly may prevent firms from entering into arrears and potential impacted by the pandemic crisis. For example, small- debt defaults down the line. and medium-sized enterprises (SMEs) are more vulnerable 2. Bank for International Settlements statistics: Data of total credit to nonfinancial corporations (core debt) recorded as a percentage of GDP (https://stats.bis.org/statx/srs/ table/f4.1). Aggregates are based on conversion to US dollars at market exchange rates. Note: The estimate from the Bank for International Settlements includes only emerging market economies: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hong Kong SAR, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Poland, Russia, Saudi Arabia, Singapore, South Africa, Thailand, and Turkey. 3. Syndicated loans are often denominated in foreign currency and primarily extended by foreign lenders (Chen et al. 2019). 4. Using balance sheet information from 17,284 listed nonfinancial firms in 74 countries (for 2020Q4), the Corporate Vulnerability Index (CVI) is based on seven indicators that capture four key dimensions of firms’ financial vulnerabilities: debt service capacity, leverage, rollover risk, and profitability/market valuation. The seven indicators are interest coverage ratio, leverage ratio, net debt to earnings before income and taxes (EBIT) ratio, current liabilities to long-term liabilities ratio, quick ratio, return on assets, and market to book ratio. For methodological details, see Feyen et al. (2017). 5. The World Bank’s Business Pulse Survey provides insights into the economic conditions experienced by over 100,000 firms across 72 countries during the pandemic. Covering primarily low- and middle-income countries across almost all economic sectors, the dataset provides the most comprehensive information on the current impact of COVID-19 on businesses across the world (Apedo-Amah et al. 2020). The first wave comprised 57 countries surveyed between April and November 2020. Data processing from the second wave, which took place from April 2020 to March 2021, is ongoing. Information from the second wave is used to track how the debt levels have evolved from January to September 2020. 6. The BPS analysis is based on preliminary results adapted from Chelva, Farazi, and Feyen (2022). BPS data is currently being processed and revised, with forthcoming information on wave 3 expected. See the forthcoming working paper for the most up-to-date analysis. 7. Firms are identified as financially vulnerable at present if they are already in arrears. 8. Firms in this latter category are identified by their anticipation of going into arrears, having already made amendments to their loan payment schedules, or having clients in or expecting to go into arrears. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 Analysis from the BPS shows that in early 2020 sales were countries in Sub-Saharan Africa have seen an improvement in hit hard for the universe of firms across the board, with scores, with the exception of Zambia. The situation continues micro, small, and medium enterprises (MSMEs) facing a to deteriorate in Latin America and the Caribbean and in most much more severe contraction in sales compared to large of Europe and Central Asia. Taking the proportion of corporate firms (Figure 1.2, Panel A). The magnitude of this shock debt to total debt into account, the arrears in Bangladesh, to earnings is likely to compromise a firm’s ability to repay Nepal, Vietnam, and Zambia have the potential to adversely debts and cover current expenses. The pandemic led to a impact the banking sectors in those countries. substantial fall in sales in early 2020, 48 percent on average,9 with South Asia showing the highest median drop in sales On the listed and unlisted side, regional estimates of (64.5 percent) and Europe and Central Asia the lowest (37.9 expected time to cash flow shortages show that firms percent). Disaggregated by firm size, MSMEs faced a much face tight funding conditions across all regions, with East more severe contraction in sales compared to large firms: Asia and Pacific, the Middle East and North Africa, and median country estimates of large firms show a 37.8 percent Latin America and the Caribbean experiencing the largest sales decrease, as compared to 44.5, 50.7, and 56.6 percent squeeze (Figure 1.2, Panel B). The conditional average falls for medium-, small-, and micro-sized firms, respectively. number of days during which an establishment can cover its With this in mind, corporate vulnerabilities are likely to be even costs with cash on hand, controlling for size, sector, and weeks more severe for MSMEs than for the listed firms (which are after peak, was calculated by region using BPS wave 1 data. typically large) captured by the CVI. Expected time to cash flow shortages shows that firms in East Asia and Pacific have as few as 43.3 days on average, while Balance sheet vulnerabilities of EMDEs’ listed non- firms in Europe and Central Asia have the largest cash buffers, financial corporations have increased since the global at 74 days on average. In contrast, listed firms in Europe and financial crisis and are now at the highest level recorded Central Asia show the most severe vulnerabilities across since the first CVIs in 2006.10 All regions have trended upward regions. Regional averages mask a significant amount of since 2018; however, 2020Q3 and 2020Q4 data indicate that variation at the firm level, partly represented by the confidence this has stabilized at a heightened level in most regions, apart intervals demonstrated in Figure 1.2, Panel C. from Europe and Central Asia, where it continues to increase (see Figure 1.1) on the back of deteriorating debt service B. Corporate Debt capacity and highly leveraged firms in Bulgaria and Latvia. Listed nonfinancial corporate debt in the 74 countries Several sectors adversely impacted by the pandemic include surveyed reached US$5.64 trillion, with almost 54 percent aviation, hospitality, transportation, tourism, and energy. classified as “financially vulnerable” according to at least Figure 1.1 shows that listed firms in the consumer services one balance sheet indicator, similar to the estimate from two sector display the highest vulnerabilities, while technology, quarters ago. While levels of vulnerability have stabilized, consumer goods, and telecommunications have remained this stabilization comes after a record accumulation of global stable. nonfinancial corporate debt, exceeding 103 percent of GDP11 for emerging markets and US$80.6 trillion globally in 2020Q4, From January to September 2020, the median proportion compared to 92 percent of GDP and US$75.2 trillion in of firms in or expecting to be in arrears remained at around 2019Q4.12 Supportive government measures, such as debt 43 percent, with significant heterogeneity at the country moratoria and loan guarantee programs, as well as improved level, consistent with the stable but elevated vulnerabilities market sentiment, may have pushed corporate debt levels up of listed firms captured in the CVI. BPS results (Figure 1.2, further in the recovery phase of the pandemic. As such support Panel D) highlight corporate vulnerabilities across the 72 measures are unwound, the full effect of potential corporate countries, measured by the proportion of firms in or expecting insolvencies and resulting credit losses may be substantial to go into arrears. South Asia shows consistently high levels (for instance, losses are estimated to be US$1 trillion or of firms struggling to meet their debt obligations, coinciding 2 percent of GDP for G7, Australia, and China) (Mojon, Rees, with the worsening health crisis, which has yet to abate. Most and Schmieder 2021). 9. Median country estimates from BPS wave 1 dataset. 10. See Feyen et al. (2020) for an in-depth analysis of corporate vulnerabilities in listed firms. 11. High debt to GDP ratios also reflect the deep contraction in GDP during this period. 12. Global debt monitor database, Institute of International Finance (IIF). IIF estimates of nonfinancial corporate debt are based on 31 emerging markets and incorporate cross-border and domestic bank loans as well as onshore/offshore outstanding bonds. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 Vulnerabilities related to debt service capacity policy measures to prevent firms from technically entering stabilized for listed corporates during 2020Q2 to 2020Q4 into arrears, but the firms remain at risk of doing so in the (Figure 1.3), with some regional differences. Estimates are future (captured in future debt at risk). A significant proportion shown for debt at risk in terms of debt service capacity using of debt at risk falls within future debt at risk measures, where the interest coverage ratio.13 In 2020Q4, listed firms facing anticipated effects are a key concern. In this sense, policies difficulties in covering their interest expense with earnings that prevent such situations from being realized are crucial to held 21.3 percent of total listed corporate debt, similar to the protecting the viability of corporate debt. 21.6 percent observed two quarters ago. Europe and Central Asia experienced the largest increase, from 14.6 percent to C. Policy Response 21 percent, while South Asia experienced an improvement EMDEs have implemented a variety of policy measures to from 20.1 percent to 11.9 percent. Other regions experienced ensure credit flows to the corporate sector are maintained. more modest changes during the period: 31.2 percent of listed These measures were intended to provide immediate relief to EMDE firms are at risk, according to the application of the firms by directly lending to corporates, introducing temporary interest coverage ratio, suggesting that smaller listed firms in debt moratoria, introducing state guarantee schemes, and general face more severe earnings difficulties. strengthening debt workout mechanisms. Policies have also incentivized banks to continue lending to firms by using Corporate debt levels on aggregate have stabilized, but capital buffers and measures to avoid liquidating viable firms. with significant disparities below headline estimates. These much-needed measures are likely to have pushed Preliminary results from the BPS wave 2 for the 20 countries nonfinancial corporate debt some 8 percentage points higher, listed in Figure 1.2 show that the dynamics of corporate debt to 100 percent of GDP.15 accumulation are highly heterogenous even within regions. Seven countries show a decrease in corporate debt levels The COVID-19 Financial Sector Policy Compendium shows while 10 are increasingly indebted. Several countries in Sub- that over 3,100 measures have been adopted in over 150 Saharan Africa have seen a decline in indebtedness, but countries since September 2020, with the pace of policy concerns of a new COVID-19 wave and a slow vaccine rollout interventions recently decreasing (Figure 1.6). Since last weigh on the corporate sector outlook, exacerbated by the fall, the number of policies that roll back support measures high proportion of debt at risk in the region. has increased. The eventual unwinding of these measures is likely to depend on how the pandemic further develops Debt at risk measures for listed and unlisted firms show and on the accompanying macroeconomic conditions and that the overwhelming majority of debt could be at risk outlook. While the support measures have helped to prevent and adversely impact the banking sector when future unnecessary bankruptcies and economic scarring and have prospects are taken into account (Figures 1.3, 1.4, and limited the contraction in private sector activity, such policies 1.5). With a median country value of around 87 percent in both are temporary and costly, impact market functioning, and January and September 2020 (Figure 1.5), this assessment were introduced when several EMDEs had limited budgetary highlights that the potential financial impact on the banking resources to achieve their overall goals. In addition, to avoid sector is significant and has yet to decline.14 However, most severe consequences from unwinding these measures countries have under half of total debt at severe risk, measured too quickly, countries would benefit from rolling them back by present debt at risk, with a country median of 32.9 percent, gradually and from carefully targeting ongoing support policies which also shows a moderate decline since January 2020, toward viable firms that continue to face severe temporary when it stood at 38.5 percent. This is potentially driven by liquidity problems. 13. The interest coverage ratio is defined as EBIT divided by interest expenses. 14. Analysis is currently under way looking at disaggregating the proportion of debt at risk by firm size. By separating the impact of large firms, which are likely to have access to alternative sources of funding, from banks, debt at risk measures will be further refined. 15. IIF Global Debt Monitor (February 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 D. Impact of Nonperforming Loans To tackle the impact of the corporate debt overhang, on the Banking Sector a range of policy options and tools are presented in the subsequent chapters of this paper, categorized by The negative effects of COVID-19 have not yet been observed financial stability instruments (particularly approaches to in bank capitalization and asset quality, according to analysis address bank NPLs), measures to strengthen corporate by Feyen and Mare (2021), who measure the resilience of the debt restructuring and insolvency frameworks, and capital banking sector to the potential wave of NPLs. EMDE banks are market solutions. In reality, however, these measures are resilient to credit shocks in the short term, although this varies often complementary and overarching. For example, measures widely across regions and countries. Conducting a bottom-up to reduce NPLs through increased access to finance in capital reverse stress test, Feyen and Mare identify banking systems markets may prevent NPLs from accumulating in financial that appear most vulnerable to a deterioration in asset quality institutions, thus easing financial sector vulnerabilities. The and that could render a significant fraction of the banking development of CDR measures to reduce the number of system undercapitalized. Figure 1.7 shows the results from firms applying for bankruptcy is likely to reduce pressure this analysis, highlighting how much NPLs would have to on a potentially overwhelmed and underdeveloped court or increase to wipe out capital buffers in the banking system legal framework charged with handling the anticipated scale across regions. Feyen and Mare find that the banking systems of potential NPLs. And lastly, careful use of capital market in South Asia appear the most vulnerable. The measure of solutions has important requisites, such as a sufficiently distance to bank undercapitalization indicates that the median developed capital market, without which such measures may percentage point increase in NPLs (as a percentage of gross be unfeasible. With these interlinkages in mind, the following loans) that would render at least 20 percent of total banking chapters present a range of policy tools, along with historical system assets undercapitalized is 3.8 percentage points. examples, to better equip policy makers to address corporate debt vulnerabilities. The wide variation in countries’ vulnerability to credit shock calls for a careful assessment of country circumstances, including the effect of unwinding credit moratoria and other borrower support measures on bank resilience. The findings underscore how a weak economy and slow recovery may weigh negatively on the banking sector, which, especially in Bangladesh and India, is already under heightened pressure. In this regard, an increase in the NPL ratio of 0.1 and 3.3 percentage points for these two countries would render banks representing around 20 percent of total banking system assets undercapitalized. II. Conclusion The COVID-19 outbreak has generated a severe global shock requiring widespread official measures to support the nonfinancial corporate sector, with an estimated two-thirds of all firms deemed financially vulnerable. The corporate sector entered the crisis in an already financially vulnerable position, with record debt levels and weak earnings. Emergency liquidity credit lines have supplied viable firms with much-needed short-term support to avoid a wave of bankruptcies, but at the cost of propping up “zombie” firms. These exceptional measures have shielded firms from market forces, including the enduring changes in consumer demand and supply chains induced by the pandemic. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 > > > F I G U R E 1 .1 Corporate Vulnerabilities in Listed Firms Panel A: Global CVI Panel B: Regional CVI CVI Global CVI CVI Regional CVI trends 0.20 0.20 0.15 0.15 0.10 0.10 0.05 0.05 0.00 0.00 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Q1 2020Q2 2020Q3 2020Q4 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Q1 2020Q2 2020Q3 2020Q4 EAP ECA LAC MENA SAR SSA Panel C: CVI by Sector CVI CVI 0.20 0.20 0.15 0.15 0.10 0.10 0.05 0.05 0.00 0.00 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Q1 2020Q2 2020Q3 2020Q4 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Q1 2020Q2 2020Q3 2020Q4 Basic materials Consumer goods Health care Industrials Consumer services Energy Technology Telecomunications Source: World Bank staff estimates from Corporate Vulnerability Index. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 > > > FIGURE 1.2 Corporate Vulnerabilities in Listed and Unlisted Firms from Business Pulse Survey Panel A: Impact of COVID-19 on Sales Median change in sales by region and firm size SSA SAR MENA LAC ECA EAP -80 -70 -60 -50 -40 -30 -20 -10 0 % change in sales Micro (0-4) Small (5-19) Medium (20-99) Large (100+) Panel B: Median Proportion of Firms in Arrears or Expecting Panel C: Liquidity by Region to Be in Arrears in the Next Six Months by Region Median % of firms already in arrears or expecting to Available liquidity: Number of days during which be in arrears in the next six months by region establishment can cover its costs with cash on hand 80 80 73.5 70 64.0 59.6 costs with cash available Days the firm can cover 60 60 52.8 50.8 43.3 50 40 40 30 20 20 10 0 0 EAP ECA LAC MENA SAR SSA SAR ECA LAC SSA MENA EAP Wave 1 Wave 2 10th 90th percentile Source: Business Pulse Survey, World Bank. Panel A Source: Business Pulse Survey wave 1 data, World Bank. Note: Median percentage change in sales by region and firm size. Median regional estimates comprise country-level data (measured in the month given in parentheses), accessed via the BPS dashboard, as follows: EAP: Cambodia (May), Indonesia (September), Mongolia (May), Philippines (July), Vietnam (June). ECA: Albania (June), Armenia (June), Bulgaria (June), Croatia (June), Cyprus (September), Georgia (June), Greece (June), Hungary (July), Italy (June), Moldova (June), Poland (July), Romania (June), Russian Federation (June), Slovenia (June), Turkey (June). LAC: Brazil (June), El Salvador (April), Guatemala (June), Honduras (June), Nicaragua (June). MENA: Jordan (June), Morocco (August), Tunisia (June). SAR: Afghanistan (June), Bangladesh (June), Nepal (August), Pakistan (August), Sri Lanka (May). SSA: Chad (June), Côte d’Ivoire (June), Guinea (June), Kenya (July), Madagascar (July), Niger (June), Nigeria (June), South Africa (July), Sudan (May), Zambia (June), Zimbabwe (June). Panel B Source: Business Pulse Survey, World Bank. Note: Regional percentage estimates are taken from the median country values listed in Table 7. Values are unadjusted based on the survey date as reported in Table 7. Wave 1 took place from April 2020 to November 2020; wave 2 is dated from October 2020 to March 2021. Panel C Source: Business Pulse Survey, World Bank. Wave 1 data used in Apedo-Amah et al (2020). Wave 1 surveys were conducted from April to November 2020. Country periods are reported in Table 1.1. Note: Number of days during which establishment can cover its costs with cash on hand, by region, controlling for size, sector, and weeks after peak. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 Panel D: Heatmap of Firms in Arrears or Expecting to Be in Arrears in the Next Six Months BPS wave WAVE 1 WAVE 2 Firms in or expecting to go into arrears 0.0 100.0 Source: Business Pulse Survey, World Bank. Note: Wave 1 took place from April 2020 to November 2020; wave 2 took place from October 2020 to March 2021. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 > > > TA B L E 1 .1 Proportion of Firms in Arrears or Expecting to Be in Arrears in the Next Six Months BPS Wave 1 BPS Wave 2 Change in Debt Corporate (April 2020 (October 2020 (percentage Debt as a % to November 2020) to April 2021) points) of Total Debt Arrears (%) Survey Date Arrears (%) Survey Date EAP Mongolia 71 Aug 86.2 Feb ↑ Philippines July–Aug 76.2 Nov–Dec 49.5 Malaysia 59.5 Oct 34.4 Vietnam 49.8 June–July 41.7 Sep–Oct ↓ 96.5 Cambodia 38.5 June Sep 67.7 Indonesia 13.4 June Oct–Nov 43.7 ECA Moldova 52 May 57.7 Oct–Nov ↑ 0 Latvia 5.6 Oct 44.6 April ↑ 30.4 Romania 45 May–Sep 42.5 Nov–Jan ↓ 31.4 Slovak Republic 34.2 Jan–Feb 28.8 Turkey 40.9 June–July 33.2 March ↓ 71.2 Slovenia 22.6 July 29 Nov–Dec ↑ 31.7 Portugal 16.7 Sep–Oct 29 Jan–Feb ↑ 26.8 Poland 20.7 May–Aug 27.5 Sep–Dec ↑ 23.6 Lithuania 84.4 Oct March 27.2 Kosovo 55.2 July 58.9 Kyrgyz Republic 45.5 Aug–Sep 52.5 Armenia 42.7 June 46.4 Italy 38.6 May–June Nov–Dec 30.2 Albania 38 June 59.7 Uzbekistan 36.6 Aug–Sep 75 Croatia 32.1 Sep Jan 29.1 Georgia 29.6 June Oct–Nov 47.7 Tajikistan 27.8 Aug–Sep 57.5 Hungary 27.6 Sep Jan–Feb 35.7 Bulgaria 27.4 May–Aug Nov–Dec 56.6 Greece 26.3 June Nov 34.3 Cyprus 24.2 June Nov–Dec 32.2 Belarus 15.7 Aug 69.3 Estonia 13.7 Oct Feb 35.9 Czech Republic 13.4 Sep–Oct Jan–Feb 24.6 Russian Federation 12.2 June 43.8 LAC El Salvador 44 June–July 60.8 Nov–Dec ↑ 40.9 Nicaragua 50.6 June–July 54 Dec–Jan ↑ 43.4 Honduras 55.8 June–July Nov–Jan 0 Colombia 50.9 May–June 35.1 Guatemala 40.4 June–July Dec–Jan 62.9 MENA Morocco 39 July–Aug 58 Feb ↑ Jordan 51 July–Aug 18.3 Lebanon 23.5 Nov 90 EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 > > > TA B L E 1 .1 Proportion of Firms in Arrears or Expecting to Be in Arrears in the Next Six Months BPS Wave 1 BPS Wave 2 Change in Debt Corporate (April 2020 (October 2020 (percentage Debt as a % to November 2020) to April 2021) points) of Total Debt Arrears (%) Survey Date Arrears (%) Survey Date SAR Nepal 83.2 May–June 65.1 Bangladesh 79.3 April–June 77.6 Afghanistan 74.2 June 0 Sri Lanka 69.1 May 0 India 53.5 May–June 18.3 Pakistan 53.3 June–July 58.4 SSA Zambia 41.2 June 66.9 Dec–Jan ↑ 58.5 South Africa 90.1 May–June 62.1 Oct–Dec ↓ 31.5 Senegal 64.3 April–May 56.4 Dec ↓ Sierra Leone 40.4 Oct–Dec Malawi 40.2 Nov–Dec 60.7 Sudan 58.2 July 34.5 Oct–Nov ↓ Tanzania 46.7 June–July 31.2 Nov–Dec ↓ 46.6 Kenya 71.7 June–Aug Sep–Oct 63.5 Gabon 70.1 May–June 41 Niger 63.9 June Guinea 53.7 June 89.4 Togo 51 June Nigeria 49.2 July–Sep 82.7 Zimbabwe 42.5 June–July Burkina Faso 26 Oct Chad 5.9 June 0 Source: Business Pulse Survey and IMF FSI. Note: Country estimates are unweighted. Hence, measures represent corporates in the sample that may not reflect national trends. Some values are omitted as data from the survey is still being processed. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 > > > > > > F I G U R E 1 . 3 Debt at Risk in Listed Firms: F I G U R E 1 . 4 Debt at Risk for Selected Balance Debt at Risk Over Time Sheet Indicators US$ Debt at risk, interest coverage ratio, 2019Q4, 2020Q2, and 2020Q4 billion 6,000 90 5,000 80 Debt at risk, % of total debt 70 4,000 60 3,000 50 2,000 40 1,000 30 0 20 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Q1 2020Q2 2020Q3 2020Q4 10 0 All regions EAP ECA LAC MENA SAR SSA Total DaR1 DaR2 DaR3 2019Q4 2020Q2 2020Q4 DaR4 DaR5 DaR6 DaR7 Note: See the section on corporate vulnerabilities above for methodological Source: Bloomberg; staff calculations. details. Note: The interest coverage ratio captures the ability of a firm to cover interest expenses with current earnings. Debt is considered to be at risk for firms with an interest coverage ratio < 1. A lower value indicates higher difficulty to meet these expenses. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 > > > FIGURE 1.5 Debt at Risk from Listed and Unlisted Firms Present and Future Measures of Debt at Risk in Jan vs Sep 2020 Region Country 2020 BPS wave EAP Indonesia January September Mongolia January September Philippines January September ECA Bulgaria January September Poland January September Romania January September Turkey January September LAC Brazil January September El Salvador January September Guatemala January September Honduras January September Nicaragua January September SSA Kenya January September Malawi January September Senegal January September Sierra Leone January September South Africa January September Sudan January September Tanzania January September 0 10 20 30 40 50 60 70 80 90 100 Debt at risk (%) DaR measure Future Present Source: Business Pulse Survey. Note: Debt at risk measures total debt owned by financially vulnerable firms as a proportion of total debt of all firms from the BPS. Firms are deemed financially vulnerable using present and forward-looking measures of financial vulnerability. Firms already in arrears are classified as at present risk, while firms in the future category are identified by their anticipation to go into arrears, have already made amendments to their loan payment schedules, or have clients in or expecting to go into arrears. The debt associated with firms in these categories is aggregated and presented as a proportion of reported total liabilities of all firms, as discussed in Annex A. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 > > > F I G U R E 1 . 6 Percentage of Active Measures Over Total Interventions Since the Beginning of the Crisis by Type and Region Panel A: Prudential Policies Panel B: Direct Support to Borrowers (active, % of all interventions) (active, % of all interventions) 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% AFR EAP ECA LCR MENA SAR AFR EAP ECA LCR MENA SAR Relaxation in capital requirement Mandatory credit rep. moratorium Relaxation in NPE treatment Other credit rep. moratorium State subsidies, dir. loans, and tax inc. State guarantees on loans Source: FCI GP COVID-19 Financial Policy Response Compendium as of February 15, 2021. Note: Panel A and B present information on interventions undertaken in the World Bank developing regions (low, lower-middle, and upper-middle income) since the beginning of the pandemic. Panel A presents the percentage of still active specific prudential measures; Panel B presents the percentage of still active measures that provide specific support to borrowers. > > > FIGURE 1.7 Bank Undercapitalization Panel A: Increase in NPLs that Will Wipe Out Panel B: Increase in NPLs (in percentage points) that Capital Buffers for at Least 20% of Total Banking Will Wipe Out Capital Buffers for at Least 20% of System Assets (in percentage points) Total Banking System Assets and Real GDP Growth (2021 forecast) 40 NIC Consolidated distance to break point AGO GUY (in percentage points) 30 ZMB GHA LBR UGA MWI UZB 20 BGR KAZ MKD NGA AZE BRA IDN SRB GEOMNG MYS BTN MEX TUR GIN CHN UKR DOM MNE PER 10 BLR RUS ECU ZAF PHL PAK MDG BWA JOR BIH XKX BOL COL RWA PSE EGYLKA MAR HND IND NPL KEN LBN BGD 0 EAP ECA LAC MENA SAR SSA -15 -10 -5 0 5 10 Real GDP growth – 2021 forecast EAP ECA LAC MENA SAR SSA Source: FCI Macro-Financial Unit and World Bank MFMOD (October 2020). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 >>> References Apedo-Amah, M. C., B. Avdiu, X. Cirera, M. Cruz, E. Davies, A. Grover, L. Iacovone, U. Kilinc, D. Medvedev, F. O. Maduko, and S. Poupakis. 2020. “Unmasking the Impact of COVID-19 on Businesses.” Policy Research Working Paper 9434, World Bank, Washington, DC. https://openknowledge.worldbank.org/handle/10986/34626. License: CC BY 3.0 IGO. Baldwin, Richard, and Beatrice Weder di Mauro. 2020. “Introduction.” In Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, edited by Richard Baldwin and Beatrice Weder di Mauro. Washington, DC: CEPR Press. Advance online publication. https://voxeu.org/ content/mitigating-covid-economic-crisis-act-fast-and-do-whatever-it-takes. Banerjee, R. N., J. Noss, and J. M. V. Pastor. 2021. “Liquidity to Solvency: Transition Cancelled or Postponed.” Bank for International Settlements Bulletin, No. 40. Bank for International Settlements, Basel, Switzerland. https://www.bis.org/publ/bisbull40.pdf. Chelva, B., S. Farazi, and E. Feyen. 2022. “A simple framework to measure corporate vulnerabilities during the COVID pandemic: Evidence from the World Bank Business Pulse Survey.” Working Paper (forthcoming). Chen, S., M. P. Ganum, L. Q. Liu, M. L. Martinez, and M. S. M. Peria. 2019. “Debt Maturity and the Use of Short-Term Debt: Evidence form Sovereigns and Firms.” International Monetary Fund, Washington, DC. Cirera, Xavier, Marcio Cruz, Elwyn Davies, Arti Grover, Leonardo Iacovone, Jose Ernesto Lopez Cordova, Denis Medvedev, et al. 2021. “Policies to Support Businesses through the COVID-19 Shock: A Firm-Level Perspective.” Policy Research Working Paper 9506, World Bank, Washington, DC. https://openknowledge.worldbank.org/handle/10986/35012. License: CC BY 3.0 IGO. Demmou, L., G. Franco, S. Calligaris, and D. Dlugosch. 2020. “Corporate Sector Vulnerabilities During the COVID-19 Outbreak: Assessment and Policy Responses.” OECD papers, Organisation for Economic Co-operation and Development, Paris. Didier, Tatiana, Federico Huneeus, Mauricio Larrain, and Sergio Schmukler. 2020. “Financing Firms in Hibernation During the COVID-19 Pandemic.” Policy Research Working Paper 9236, World Bank, Washington, DC. https://openknowledge.worldbank.org/handle/10986/33745. License: CC BY 3.0 IGO. Feyen, Erik, Fernando Dancausa, Bryan Gurhy, and Owen Nie. 2020. “COVID-19 and EMDE Corporate Balance Sheet Vulnerabilities: A Simple Stress-Test Approach.” Policy Research Working Paper 9324, World Bank, Washington, DC. https://openknowledge.worldbank.org/ handle/10986/34170. License: CC BY 3.0 IGO. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 Feyen, E., N. M. Fiess, I. E. Zuccardi Huertas, and L. A. V. Lambert. 2017. “Which Emerging Markets and Developing Economies Face Corporate Balance Sheet Vulnerabilities? A Novel Monitoring Framework.” World Bank Policy Research Working Paper 8198 (September 19, 2017), World Bank, Washington, DC. Feyen, E., and D. Mare. 2021. “Assessing Banking Sector Vulnerabilities in EMDEs: A Basic Reverse Stress Testing Approach.” Policy Research Working Paper (forthcoming), World Bank, Washington, DC. Group of Thirty. 2020. “Reviving and Restructuring the Corporate Sector Post-Covid: Designing Public Policy Interventions,” Group of Thirty, Washington, DC. Helmersson, T., L. Mingarelli, B. Mosk, A. Pietsch, B. Ravanetti, T. Shakir, and J. Wendelborn. 2021. “Corporate Zombification: Post-Pandemic Risks in the Euro Area.” Financial Stability Review 1. International Monetary Fund (IMF). 2019. “Global Financial Stability Report: Lower for Longer.” International Monetary Fund, Washington, DC. International Monetary Fund (IMF). 2020. Chapter 1: Global Financial Stability Review. Washington, DC: International Monetary Fund. Ivan, Huljak, Martin Reiner, Moccero Diego, and Pancaro Cosimo. 2020. “Do Non-Performing Loans Matter for Bank Lending and the Business Cycle in Euro Area Countries?” ECB Working Paper Series, European Central Bank, Frankfurt. Kroeger, T., A. T. N. Nguyen, Y. S. Zhang, P. D. Thuy, N. H. Minh, and D. D. Tuan. 2020. “Corporate Vulnerabilities in Vietnam and Implications of COVID-19,” IMF note, Washington, DC. Mojon, B., D. Rees, and C. Schmieder. 2021. “How Much Stress Could Covid Put on Corporate Credit? Evidence Using Sectoral Data.” BIS Quarterly Review (March). Ong, M. L. L. 2014. A Guide to IMF Stress Testing: Methods and Models. Washington, DC: International Monetary Fund. United Nations. 2019. “World Economic Situation and Prospects.” United Nations, New York, NY. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 >>> Annex 1A: Measuring “Debt at Risk” Using the BPS: Methodological Approach The objective of the debt at risk measure is to identify which firms are financially vulnerable and how much debt is associated with these firms. Should these firms fail to perform, how much debt is at risk to the banking sector? Using the BPS wave 2 survey data, we carried out the following steps to construct the “debt at risk measure” defined below. We used firm-level data for over 20,500 businesses across 20 emerging and developing countries to quantify the amount of debt held in January 2020 and in September 2020. In the survey, firms reported total liabilities in January and September 2020. These values were used to estimate debt in each period. Firms were identified as financially vulnerable at present if they were in arrears. A forward-looking measure of financial vulnerability classifies firms as at financial risk in the future if they anticipated going into arrears, have adjusted their payment schedule, or had clients that were in arrears with them or anticipated going into arrears with them. We then consolidated the amount of debt held by firms in present and future financially vulnerable positions at the country level. The future debt at risk group is exclusive of firms anticipating going into arrears. > > > F I R M - L E V E L E S T I M AT E S STEP 1 Using cov6e survey responses, we assumed debts at the firm level were equivalent to the reported total liabilities values in January 2020 (cov6e1) and September 2020 (cov6e2). Hence, debt in January 2020 was equal to total liabilities as of January 2020, and debt in September 2020 was assumed to be equal to total liabilities as of September 2020. STEP 2 Categorized firms based on whether the firm was financially vulnerable. The financially vulnerable variable took a value of 1 or 0 depending on whether the firm satisfied the criteria for each group below: Current group: Firm was already in arrears. Future group: Firm anticipated going into arrears in the next six months; OR the firm had made adjustments to its payments schedule; OR clients of the firm were in/expected to go into arrears with the firm. STEP 3 Multiplied firm-level debt variables in Step 1 by financial vulnerability group variables in Step 2 to create monetary measure of vulnerable debt. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 > > > A G G R E G AT E E S T I M AT E S STEP 4 Sum total firm-level debts by country (this can also be done for sector and firm size). When either the firm debt level or the measure of financial vulnerability group indicator is missing, the record is omitted from the aggregation. Country-level total debt in January 2020 was considered equal to the sum of firm-level total liabilities in January 2020. STEP 5 Summed firm-level debts for firms categorized as financially vulnerable in Step 3 by country (this can also be done for sector and firm size) to derive debt at risk measure values for current and future estimates in January and in September 2020, respectively. STEP 6 Divided sum of debts from financially vulnerable firms by sum of all firm-level debts by country to calculate debt at risk measure as a % of total debt. STEP 7 Assigned colors based on the centile of debt at risk measure. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 >>> Annex 1B: Corporate Vulnerability Index Methodology The CVI is based on the concept of debt at risk—the total amount of outstanding debt in a country (or industry) associated with firms that are deemed financially vulnerable. Debt at risk (DaR) is an attractive concept to track corporate vulnerabilities since it exposes both the risk and magnitude present in the tail of the firm’s distribution, as opposed to other methodological approaches, such as calculating averages or medians of (normalized) firm vulnerability indicators. Specifically, we define DaRy as the share of corporate debt in a country that is considered vulnerable according to indicator Y at time t and country c. > > > F I G U R E 1 B . 1 Structure of Corporate Vulnerability Index (Feyen et al. 2017)16 Corporate Vulnerability Index (CVI) Debt service capacity Leverage Rollover Profitability/Market value Interest coverage ratio = Leverage ratio = Current liabilities to Return on assets = Earnings before interest Total debt long-term liabilities = Net income and taxes (EBIT) Total assets Liabilities maturity <= 1 year Total assets Firm’s interest expense Liabilities maturity > 1 year Net debt to EBIT = Total debt – Cash Quick ratio = Market to book ratio = and cash equivalents Current assets – Inventories Market value of firm EBIT Current liabilities Book value of firm > > > TA B L E 1 B .1 Thresholds to Classify a Firm as Financially Vulnerable Indicator “At Risk” Thresholds ▪ Interest coverage ratio < 1 (profits less than interest expenses) ▪ Leverage ratio > 90th percentile value of the indicator for all firms within ▪ Net debt to EBIT the same industry, for the whole sample 2006–2016. ▪ Current liabilities to long-term liabilities One threshold per industry ▪ Quick ratio < 10th percentile value of the indicator for all firms within ▪ Return on assets the same industry, for the whole sample 2006–2016. ▪ Market to book ratio One threshold per industry Note: Our sample includes financial information from 14,273 listed nonfinancial firms in 96 emerging and developing economies, for years 2006 to 2016. A representativeness restriction is imposed in which countries with at least five firms in the sample are considered in the calculations. Therefore, the adjusted sample includes 14,207 firms from 69 countries. 16. As discussed earlier in Chapter 1; see Feyen, Fiess, Zuccardi Huertas, and Lambert (2017) for the methodology to construct the CVI in detail. All figures and tables are adapted from this paper. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 > > > C O U N T RY C OV E R AG E Country Region Country Region Cambodia East Asia & Pacific Jamaica Latin America & Caribbean China East Asia & Pacific Mexico Latin America & Caribbean Indonesia East Asia & Pacific Panama Latin America & Caribbean Laos East Asia & Pacific Paraguay Latin America & Caribbean Malaysia East Asia & Pacific Peru Latin America & Caribbean Mongolia East Asia & Pacific Trinidad and Tobago Latin America & Caribbean Philippines East Asia & Pacific Uruguay Latin America & Caribbean Thailand East Asia & Pacific Venezuela Latin America & Caribbean Vietnam East Asia & Pacific Bahrain Middle East & North Africa Bosnia and Herzegovina Europe & Central Asia Egypt Middle East & North Africa Bulgaria Europe & Central Asia Israel Middle East & North Africa Croatia Europe & Central Asia Jordan Middle East & North Africa Czech Republic Europe & Central Asia Kuwait Middle East & North Africa Estonia Europe & Central Asia Morocco Middle East & North Africa Georgia Europe & Central Asia Oman Middle East & North Africa Hungary Europe & Central Asia Palestine Middle East & North Africa Kazakhstan Europe & Central Asia Qatar Middle East & North Africa Latvia Europe & Central Asia Saudi Arabia Middle East & North Africa Lithuania Europe & Central Asia Tunisia Middle East & North Africa Macedonia Europe & Central Asia United Arab Emirates Middle East & North Africa Montenegro Europe & Central Asia Bangladesh South Asia Poland Europe & Central Asia India South Asia Romania Europe & Central Asia Pakistan South Asia Russian Federation Europe & Central Asia Sri Lanka South Asia Serbia Europe & Central Asia Botswana Sub-Saharan Africa Slovak Republic Europe & Central Asia Côte d’Ivoire Sub-Saharan Africa Slovenia Europe & Central Asia Ghana Sub-Saharan Africa Turkey Europe & Central Asia Kenya Sub-Saharan Africa Ukraine Europe & Central Asia Malawi Sub-Saharan Africa Argentina Latin America & Caribbean Mauritius Sub-Saharan Africa Bahamas Latin America & Caribbean Mozambique Sub-Saharan Africa Bolivia Latin America & Caribbean Nigeria Sub-Saharan Africa Brazil Latin America & Caribbean South Africa Sub-Saharan Africa Chile Latin America & Caribbean Tanzania Sub-Saharan Africa Colombia Latin America & Caribbean Uganda Sub-Saharan Africa Costa Rica Latin America & Caribbean Zambia Sub-Saharan Africa Ecuador Latin America & Caribbean Zimbabwe Sub-Saharan Africa EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 >>> Annex 1C: Bottom-Up Reverse Stress Test: Methodological Approach The objective of reverse stress testing is to identify banking systems that appear most vulnerable to a deterioration in asset quality and that could render a significant fraction of the banking system insolvent (Feyen and Mare 2021). The test uses bank-level data for over 1,500 banks across 58 emerging and developing countries to quantify the rise in nonperforming loans necessary to trigger a bank’s undercapitalization. For each bank, we compute the NPL ratio at which its capital buffers are depleted (BP) and the percentage point increase in NPLs that would render a bank undercapitalized (DBP). We then consolidate the results at the banking system level (CDBP), focusing on the set of most fragile banks (i.e., those with the smallest DBPs), which collectively represent at least 20 percent of total banking system assets (“banks at risk”). > > > B A N K - L E V E L A N A LY S E S STEP 1 We assume the overall level of provisioning for NPLs is 55 percent, in line with the IMF (Ong 2014). This is based on the average of common provisioning levels across NPL categories (e.g., substandard, doubtful loans, loss). STEP 2 Compute capital buffers: total regulatory capital – minimum capital requirement. STEP 3 Compute the bank break point (BP, % of gross loans) by solving for NPLs in the following equation: ((BP-NPLs)/gross loans) × 55% = capital buffers. STEP 4 Compute the bank distance from BP (DBP, in percentage points): max {bank break point – bank NPL ratio,0}. > > > C O U N T R Y - L E V E L A N A LY S E S STEP 1 Sort banks according to their DBP (from small to large) and by bank assets (large to small) to break ties for banks with the same DBP value. STEP 2 Identify banks at risk, the set of banks that are most fragile (i.e., that exhibit the lowest DBP values), which jointly represent at least 20 percent of banking system assets. STEP 3 Calculate the consolidated BP (% of gross loans) of banks at risk. This is the weighted average BP of the individual banks, weighted by the size of their gross loans. STEP 4 Calculate the consolidated DBP (percentage points). This is the weighted average DBP of the individual banks, weighted by the size of their gross loans. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 >>> Failing to Prepare Is Preparing to Fail: Getting Ready for Financial Hardship—Nonperforming Loans and Financial Stability I. Introduction “Going into the recent financial crisis, there was a widespread view that debtors and creditors had learned from their mistakes and that financial crises were not going to return for a very long time, at least in emerging markets and developed economies,” wrote Carmen Reinhart and Kenneth Rogoff in 2009. They continued, “We have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.” 17 In recent years, corporate leverage has risen to record levels globally, leaving many companies ill-prepared to weather the major adverse impact of the COVID-19 pandemic. There has, however, been a massive policy response to provide temporary support to incomes and relief from credit payments, to tide firms and households over and to prevent unnecessary and costly economic scarring. Moreover, the pandemic crisis stems from a health crisis: the economic shock did not arise from the pricking of a credit bubble. But while this time truly is different (Kennedy 2020), the pandemic has created or exacerbated multifaceted economic and financial vulnerabilities on a foundation of already weak economic fundamentals in many countries. While the coronavirus did not start as a financial crisis, Carmen Reinhart has highlighted that it may well morph into one (Reinhart 2021). 17. Reinhart and Rogoff 2009, 290–92. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 Given the vulnerability from high leverage and the shock II. Need for Action of the pandemic, the risk of a sharp rise in corporate financial stress is great. Indeed, in many cases, debt vulnerabilities have increased as a result of the pandemic as Financial crises are very damaging and costly. Policy actions support measures have facilitated provision of additional credit to lower vulnerabilities and risks and the probability of crisis to ease strains on corporate cash flow. Moreover, support and to strengthen frameworks to manage and lower the measures are very costly and distort market functioning, impact of financial stress are vital. This section highlights even as the pandemic changes demand and production the need for policy action, drawing on the lessons from patterns in ways that will have a widespread impact on many previous crises, and current vulnerabilities and risks from corporations’ business prospects. As support measures are high corporate leverage. gradually withdrawn, given the depth of the economic slump, many commentators and policy makers have highlighted A. What Have We Learned the risks of a sharp increase in corporate distress, which in from Previous Crises? turn will quite likely have a profound impact on the banking system as debt servicing problems expand (Group of 30 2020; Past experience has shown that high corporate leverage European Central Bank 2021). can presage a sharp increase in NPLs, which may impair banking intermediation and, in the most severe cases, jeopardize financial stability and precipitate a financial Past experience highlights the importance of taking early, crisis. Evidence from previous episodes of financial crisis decisive action to address rising payment performance shows that high corporate leverage is often an important problems. If unaddressed, these problems tend to mount contributory factor to major banking system stress (often and become more difficult and costly to resolve. Furthermore, alongside overleverage in other sectors and low levels NPLs act as a deadweight on financial intermediation and on of resilience in the banking system itself). Exploiting the the economy more broadly, as credit is locked up in weak and vulnerability of high corporate leverage, the scenario of an failing firms to the extent that new, innovative, dynamic firms unexpected adverse shock hitting corporate income and find it difficult to obtain. Failure to address a major overhang of triggering loan repayment problems has been played out NPLs typically leads to a protracted period of stagnant credit many times. NPLs can increase rapidly. For example, in the provision and lackluster economic growth. aftermath of the global financial crisis, NPL ratios were around 45 percent in Cyprus and Greece and 15 percent in Italy, Experience also emphasizes the value of advance Spain, and Slovenia, while during the 1997 Asian Financial preparations to improve the effectiveness of the Crisis, NPL ratios peaked at over 50 percent in Thailand and underlying framework for addressing high levels of 13 percent in Korea (Baudino and Yun 2017). A sharp rise in NPLs. Weaknesses in bank approaches to the management NPLs, in turn, depresses bank earnings and weakens bank of problem loans; shortfalls in banking supervision; and balance sheets; erodes bank capital and lending capacity to ineffective legal systems to protect creditor and debtor support economic recovery; and exacerbates the risks of a rights and enable speedy resolution of disputes can all act vicious deleveraging cycle and potential financial crisis. as significant impediments, adding to the delay and cost. Reviewing and strengthening the preparedness to address High levels of NPLs can thus prove very costly. failure is a prudent investment that will not only pay dividends Jurisdictions where NPLs are high and remain unresolved in the event of a major surge in NPLs in the coming period, typically experience deeper and more protracted recessions but also help address future financial stress and strengthen and slower recoveries than those where NPL problems are market functioning. more speedily addressed.18 An unresolved overhang of NPLs preserves the extension of credit to weak and failing firms, In addition to this introduction, this chapter has four main props up often ultimately nonviable “zombie” borrowers, and sections. The next section outlines the need for action, drawing thereby reduces the availability of finance to support vibrant, on lessons from previous periods of financial stress. Section more productive firms. Impaired banking credit intermediation III covers the building blocks that enable successful resolution channels damage economic prospects and often result in of NPL problems, while Section IV reviews the strategies and prolonged periods of stagnation (Peek and Rosengren 2005; tools adopted by banks as well as by the public sector. Section Caballero, Hoshi, and Kashyap 2008; Acharya et al. 2020). As V concludes and provides some policy recommendations. 18. Ari, Chen, and Ratnovski (2021), using a sample of 92 financial crises since 1990, present evidence of a close relationship between NPL problems—elevated and unresolved NPLs—and the severity of post-crisis recessions. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 a recent example, the weak banking sector, burdened with a For example, detailed independent reviews of loan quality in legacy of NPLs from the global financial crisis, was a major the form of system-wide asset quality reviews conducted at contributor to sluggish growth in many Eastern European and the request of supervisory authorities have typically revealed Central Asian economies in recent years (Bauze et al. 2020). hidden problems. In the case of Serbia in 2015, a special In India, too, both credit growth and overall economic growth diagnostic review identified an additional 4.7 percentage have remained subdued in the past five years as bank balance points of NPLs in the total loan book (lowering the capital sheets have been burdened by a legacy of high NPLs (which adequacy ratio by almost 1.8 percentage points),20 while an reached 10 percent in 2015 and upward of 15 percent in public asset quality review in India in 2015/16 identified an additional sector banks), following a period of excessive credit growth in 2.5 percentage points of bank advances as nonperforming.21 the wake of the global financial crisis. In Ukraine, following several rounds of asset quality reviews that revealed high volumes of NPLs in bank lending to related Action to address NPLs must confront a series of parties, the NPL ratio grew from 13 percent in 2014 to some adverse incentives that delay recognition of the problem 55 percent in 2017.22 and its magnitude. In particular, banks face incentives that encourage an underappreciation of growing credit problems. Underestimation of the magnitude and extent of rising As a deterioration in asset quality indicates a weakening in the NPLs delays remedial actions by banks and policy financial health of a bank and requires prompt remedial action, responses by authorities. Such delays can be costly, banks have strong internal incentives to take a sanguine view amplifying and prolonging credit misallocation. Previous of loan performance to avoid signaling financial weakness and experience suggests that failure to take early action typically to forestall supervisory intervention. An optimistic assessment necessitates taking larger and more costly actions later. Left reduces the requirement to increase provisions against unchecked, individual loan performance problems tend to expected losses that lower income and profitability and may increase over time. Debt levels rise through the capitalization eat into reported capital buffers. If not countered by strong of unpaid interest. And collateral values often fall, for example, internal governance and credit risk management,19 as well as as real estate is not serviced and maintained, given the by effective prudential bank regulation and supervision, the pressures on borrower cash flow. Moreover, failing borrowers incentives would enable the bank to record an overly rosy may also be encouraged to take additional, excessive risks, financial position. As signs of financial weakness are likely frequently termed “gambling for resurrection.” While the to raise the cost of bank funding and, if severe, risk sharp most likely outcome of such risks may be further losses, if adverse reactions that could ultimately threaten the availability borrowers are technically insolvent (with shareholders losing of funding and prompt depositor flight, the pressures to “look their equity stake), these downside risks would be borne good” are understandable. by creditors in the form of lower recoveries, whereas the gains from a successful gamble would disproportionately The under-recording of deteriorating loan quality may benefit shareholders. Alternatively, problem banks may also manifest itself in multiple forms. For example, banks may exhibit extreme defensiveness in terms of credit provision, delay the recognition of payment problems facing particular deleveraging their books to preserve and protect dwindling borrowers by “evergreening” loans—simply rolling credit over capital levels, in the hope that they can survive and will be at maturity in the event of potential repayment difficulty; they saved by a sharp recovery in the economy (Ben-David, Palvia, may also take an optimistic valuation of collateral posted and Stulz 2019). If multiple banks restrict credit in this way, as security for a loan or they may transfer problem loans however, the resulting credit crunch will in practice substantially to off-balance-sheet affiliates that are not reported in the reduce the likelihood of such a recovery (Bauze et al. 2020). consolidated financial statement. Thus, underlying credit problems may turn out to be larger than originally estimated. 19. Internal controls are often organized under the three lines of defense framework set out by the Institute of Internal Auditors: the first line, management by risk owners; the second line, risk control and compliance; and the third line, risk assurance, typically provided by internal audit. The internal controls are supplemented by external assurance through external audit and regulation and supervision; these have sometimes been defined as providing a fourth line of defense (Arndorfer and Minto 2015). 20. National Bank of Serbia Financial Stability Review (2015), fsr_2015.pdf (nbs.rs). 21. Reserve Bank of India, Financial Stability Report June 2016, 0FSR2316BB76DB39BF964542B9D1EBE2CBC273E7.PDF (rbi.org.in). 22. IMF Financial Soundness Indicators Database. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 Historical experience highlights the importance of various for example, 30 percent of the 92 countries that have obstacles that can hamper the resolution of a burgeoning experienced banking crises since 1990 still recorded elevated NPL problem. In particular, experience demonstrates that NPL levels above 7 percent seven years after the start of the regulatory and supervisory framework may be deficient the crisis.24 Given the costs of an ineffective and inefficient and fail to guard against the incentives to underestimate the protracted response, advance preparations to improve the emergence of major loan performance difficulties and the framework and infrastructure to handle corporate failures and corresponding pressures that encourage a delay in taking the debt overhang consequently may have a high payoff. action to address them. Weaknesses in legal frameworks can also be a major impediment. Slow and ineffective legal B. What Are the Current procedures typically lead to a significant loss of asset value, Vulnerabilities and Risks from as well as tying up resources in unproductive uses for an High Corporate Leverage? extended period. Moreover, weak legal frameworks for debt The vulnerability of nonfinancial companies to adverse resolution in turn affect creditor and debtor incentives. Absent economic and financial shocks has increased since the a strong framework that protects and enables the enforcement global financial crisis in many countries, as companies of property rights and facilitates the timely resolution of claims took advantage of accommodative monetary policy and the and disputes and the orderly workout of debts, creditors are associated low (and in some cases negative) interest rates more likely to agree to other options. For example, without an to expand leverage. At the end of 2019, global nonfinancial effective option for legal redress, creditors are more likely to corporate debt had expanded to 91 percent of GDP, compared acquiesce to the evergreening of loans and to questionable to a level of 75 percent in early 2007 in advance of the global debt restructuring deals that kick the problem down the road financial crisis. Although levels vary significantly across but do not address the fundamental performance issue. countries and regions (as well as across industrial sectors), The tax system may also create misaligned incentives that the rise has been sharpest on average in emerging markets, discourage writing down or crystallizing losses that may where the level of nonfinancial sector corporate debt increased hold back timely resolution of NPLs. There may also be no from 62 percent of GDP in early 2007 to 91 percent at the end developed market structure for selling distressed assets, of 2019.25 which can also have a significant influence on the speed and efficiency of NPL resolution. One reason may be that the necessary legal foundations are not in place to support such The weakening of corporate sector balance sheets has markets and thus encourage the entry and growth of specialist lowered their resilience to the stress from the pandemic. debt management firms with experience and expertise in Extensive support (in the form of income assistance to workers debt workouts. Small countries may also be disadvantaged and firms, debt payment moratoria, and credit guarantees, if the size of the NPL market is insufficient to justify the initial among others) has succeeded in cushioning the impact of the investment by potential purchasers in understanding the pandemic and limiting the costs of unnecessary foreclosures domestic legal and regulatory structure.23 and the risks of scarring. But as many firms entered the crisis with already stretched debt servicing capacity, there remains a high risk of a substantial rise in NPLs and in corporate Given these hurdles, resolving major NPL problems has insolvencies, as support measures are gradually withdrawn often proved to be a difficult and protracted process, and market conditions normalize. For example, in advance highlighting the value of early preparations to address of the support measures being introduced, staff at the Bank them. Resolving NPLs is a complex and multifaceted problem, for International Settlements estimated that, as a result of given the multiple stakeholders involved and the web of the COVID-19 shock, around 50 percent of firms would not incentives, influences, and interactions among the commercial have sufficient cash buffers to cover their debt servicing drivers, regulatory and legal frameworks, tax codes, and and operating costs (Banerjee, Noss, and Pastor 2021).26 financial market structure. The process of workout and Moreover, a simple balance sheet stress test based on pre- cleanup of balance sheets is thus often long and drawn out; 23. It is noteworthy, however, that as a result of steps taken to develop the NPL market in Eastern Europe following the global financial crisis, a number of deals have also taken place in frontier markets in the Western Balkans, as well as in larger countries in the region. 24. Ari, Chen, and Ratnovski (2021). The authors review NPL data from 92 crises since 1990. An elevated NPL level is defined by the authors as an NPL ratio of 7 percent or greater. 25. This information comes from the IMF Global Financial Stability Report (GFSR) from April 2021, based on Institute of International Finance data for 52 countries, including advanced economies and emerging markets. Note that there are some quite marked differences across regions; see Figure 2.1.1 of the IMF GFSR April 2021 Online Annex. All regions experienced an increase in nonfinancial corporate leverage over the past 10 years or so—the highest regional level is in Europe, followed by Asia and Pacific, the Americas, the Middle East and North Africa, and Sub-Saharan Africa. 26. The study, published in April 2020, was based on a sample of some 40,000 companies in 26 advanced economies and emerging markets. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 COVID-19 data suggests that nonfinancial corporates in As temporary financial support measures are gradually EMDEs may be vulnerable to liquidity and earnings shocks lifted, banks are likely to face increasing payment delays. (Feyen et al. 2020). MSMEs are particularly vulnerable to the In some cases, where borrowers have experienced purely pandemic shock (Aidan et al. 2020; DÍez et al. 2021; Group of temporary income stress during the pandemic, banks and 30 2020). borrowers are likely to be able to reschedule loans to enable borrowers to repay over a longer period without any loss to While various support measures from governments the bank (in terms of net present value). But in other cases, and banks have enabled many corporates to weather particularly where the viability of the firm’s business model has the initial shock, these measures have added further to come into question, the quality of banks’ assets will deteriorate already high debt and leverage and thus to future risks. as arrears start accruing. Bank for International Settlements staff (Banerjee, Noss, and Pastor 2021) note that while ample credit provision facilitated NPLs have a major impact on banks’ financial strength by support measures succeeded in significantly lowering given the heightened prospects of loss in recovering the bankruptcies relative to levels that would typically have claims as well as the immediate drop in servicing income. been expected, given the sharp drop in economic activity, An increase in NPLs has a number of effects: a reduction “significant increases in leverage and weak earnings forecasts in net interest income; a rise in provisions and impairment in some sectors suggest that for some firms, greater credit costs; an increase in capital requirements to reflect higher risk extension may have only postponed, rather than cancelled, weights;29 a rise in bank funding costs; and an increase in staff their insolvency.”27 Indeed, the IMF estimates that the ratio and management time and costs to address the problem. To of global nonfinancial corporate debt to GDP rose by 11.5 support effective management by banks, as well as to inform percentage points between the end of 2019 and 2020Q3 policy responses by supervisors and national authorities, it is (International Monetary Fund 2021). While the sharp decline vital that supervisors ensure that banks apply rigorous and in GDP, particularly in emerging markets, contributed to the consistent classification standards and record accurately and rise in the ratio, the IMF notes that a rise in debt levels during transparently any deterioration in loan quality. Supervisors the COVID-19 crisis was also visible. must also ensure that banks apply robust provisioning policies based on realistic assessments of expected losses and thus In most countries, banks are the main providers of credit that capital strength is recorded accurately.30 to nonfinancial corporates. This is especially the case in EMDEs that have underdeveloped capital and corporate bond Published data on NPLs was broadly stable at the markets. High corporate indebtedness and the associated risks global level during the first year of the pandemic, but it of a sharp rise in corporate financial stress and debt servicing does not provide an accurate signal of underlying asset problems consequently pose a significant risk to banks. quality, given the suppressing forces from extended Indeed, recent IMF research highlights that high corporate payment moratoria and other forms of regulatory relief leverage significantly increases the likelihood that a banking and government support measures. On average, NPLs system will face stress from elevated NPLs (Ari, Chen, and rose by 0.1 percentage points during 2020 at the global Ratnovski 2021). The risk from corporate debt is compounded level, although low-income countries experienced a rise of by high levels of household leverage in many countries; 0.5 percentage points. But such measures are significantly although, in aggregate, household debt has dipped slightly as affected by payment moratoria, which freeze the classification a share of income in recent years in advanced economies, of assets by payments past due as well as by other forms there has been a contrasting sharp rise in household leverage of regulatory easing in some countries. Moreover, in addition in emerging markets (International Monetary Fund 2021).28 to the cushioning impact of the temporary support measures, 27. Based on a sample of more than 11,000 firms in nine advanced economies (Banerjee, Noss, and Pastor 2021). 28. Globally, household debt stood at 60 percent of GDP at the end of 2019. The IMF estimates that household leverage rose by 5 percentage points between the end of 2019 and 2020Q3. 29. Under the Basel III Standardized Approach to Credit Risk, higher risk weights apply for the unsecured portion of any loan (other than a qualifying residential mortgage loan) that is past due for more than 90 days, net of specific provisions (including partial write-offs). See Paragraph 20.26 of the Basel Framework (Basel Committee on Banking Supervision 2019). See also Annex 2 of Awad et al. 2020. 30. Banks take provisions against expected losses as a pre-emptive step to ensure that income is accurately recorded, taking account of lending losses that are likely to be unavoidable. Capital provides a buffer for abnormal or unexpected losses, and thus increases the financial strength of banks to absorb such unexpected shocks while remaining solvent. Under-provisioning against expected losses overstates banks’ income and capital strength. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 NPLs are typically a lagging indicator of asset quality problems III. The Building Blocks as it takes time for banks to recognize and acknowledge emerging payment difficulties.31 Current NPL data is thus likely for NPL Resolution to underestimate the true extent of asset quality deterioration. Other indicators, where available, such as the number of loans Timely and efficient resolution of NPLs depends on the covered by the moratoria and/or that are being restructured as effectiveness of the legal and regulatory framework. a result of the pandemic, may provide a better forward-looking Several preconditions should be met to deliver success: indicator. (i) an enabling legal environment; (ii) solid regulatory and supervisory architecture, drawing on a sound reporting Given high leverage levels, there is a significant risk of a and accounting framework; and (iii) practical supervisory sharp increase in NPLs in the coming years as support guidance and oversight. This section highlights several key measures are phased out and payment profiles are aspects of these interrelated elements.35 normalized. This may place significant stress on banking systems. Positively, many banks and banking systems across A. An Enabling Legal Environment the globe have bolstered capital levels in recent years, reflecting the tightening of international regulatory standards A sound legal framework is an essential precondition in response to the lessons of the global financial crisis, and are for the efficient, effective resolution of NPLs.36 The thus much better positioned to meet the stress than in the past. framework should clearly set out and specify the rights and Average Tier 1 capital ratios rose from 11.5 percent in 2010 responsibilities of creditors and borrowers, as well as the to 15.1 percent in 2019, with an increase from 11.2 percent process and range of tools for enforcing claims and settling to 16.0 percent in emerging markets (International Monetary disputes. Although many NPLs are resolved by negotiation Fund 2020). Capital levels, nonetheless, vary significantly and agreement between creditors and borrowers, in some across jurisdictions and regions (as well as within), highlighting cases after rescheduling or restructuring payment profiles, the differences in the capacity of banks and banking systems to legal infrastructure provides the bedrock for such agreements. absorb the pandemic shock.32,33 Furthermore, notwithstanding In particular, as highlighted in Chapter 3 of this report, the the positive steps to strengthen global financial regulation insolvency framework supplies the structure and mechanism and supervision, there are shortfalls in implementation,34 for the enforcement of creditors’ claims while also protecting and policy frameworks to address a surge in NPLs remain borrowers’ interests, thus underpinning and providing a legal relatively weak in many countries, as discussed further below. backstop to negotiations between creditors and debtors.37 Against this background, strengthening such frameworks and Such frameworks frequently enable the ultimate resolution the preparedness to address a potential sharp rise in NPLs of disputes through court procedures, although as such following the pandemic would provide helpful contingency processes may be lengthy, complex, and costly, many planning that would also be valuable for addressing future jurisdictions have introduced out-of-court workout procedures adverse shocks. to settle simpler and more straightforward cases and promote and gain the benefits of more efficient CDR approaches. As 31. For example, Ari, Chen, and Ratnovski (2021) note that, on average, NPL levels keep rising for almost 2.5 years after the start of a banking crisis. 32. Analysis within the World Bank of the vulnerability of banks and banking systems to a rise in NPLs due to the pandemic suggests that the South Asia region is the most vulnerable, with the Middle East and North Africa and Europe and Central Asia regions second and third. The weakest banks in the Latin America and the Caribbean and Sub-Saharan Africa regions could, on average, sustain higher increases in NPLs before capital is depleted, although there is significant variability across jurisdictions within each region (Feyen and Mare 2021). 33. Fiscal capacity to support the economy and the financial system also differs significantly across countries. Fiscal positions have deteriorated substantially, reflecting the shock to the economy and the extensive support measures taken to cushion the impact. 34. A recent review by IMF staff of lessons from Financial Sector Assessment Programs (FSAPs), which are conducted jointly by the World Bank and IMF, notes that while jurisdictions have made steady progress in implementing the major regulatory reforms, progress in enhancing banking supervision has been slower (Dordevic et al. 2021). 35. In particular, effective financial regulation and supervision depend on a strong legal foundation. The Basel Core Principles for Effective Banking Supervision note that a system of business laws that are consistently applied and that provide a mechanism for the fair resolution of disputes is an important precondition for effective supervision. 36. Chapter 3 presents an in-depth assessment of the legal infrastructure covering corporate debt restructuring and sets out policy recommendations. 37. The preconditions for use of the insolvency framework must be met, namely that the debtor is unable to pay debts as they become due or has liabilities in excess of assets. The insolvency framework is a multilateral process involving all creditors of a debtor entering insolvency. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 Chapter 3 emphasizes, such out-of-court workout approaches foundational document for settling disputes. More broadly, help resolve individual cases more quickly and cheaply and a modern collateral registry that records claims on movable thus preserve value for both debtors and creditors. Such assets (as used in factoring and leasing, for example) may processes also decrease the pressure on judicial capacity, also protect creditors and help resolve claims on other types which is often a constraint and, indeed, one that may bind of secured transactions (World Bank 2015a). particularly severely when there is a surge in the number of NPLs. Putting in place robust architecture that can facilitate A supportive tax structure is an additional building negotiated settlements and lower the number of cases that block for effective NPL resolution. As losses on loans require court deliberations will help to overcome such a are a business expense that reduce bank tax payments, tax constraint. Such streamlined, low-cost NPL resolution tools authorities naturally seek strong evidence and proof of loss will be particularly helpful when there is a large volume of before granting tax deductions. This may create an incentive problem loans to MSMEs, as well as to retail borrowers, which to delay NPL resolution, which would be at odds with the may be the case in the aftermath of the pandemic, given the desire of the financial authorities to encourage a rapid cleanup severity of the impact (Aidan et al. 2020; DÍez et al. 2021). of bank balance sheets and avoid the costs to the economy of Chapter 3 provides a series of lessons and recommendations weak and misallocated credit provisioning. Communications to support efficient corporate debt restructuring. and dialogues that deliver a clear and consistent government policy will help ease such tensions. Other key elements of NPL resolution also depend on the strength of the legal framework. In particular, a robust legal B. Relying on Solid Regulatory and infrastructure enables creditors to enforce claims on collateral Supervisory Foundations that has been pledged as security on a loan contract (or real Establishing accurate and timely indicators of bank estate transaction), as well as to resolve any disputes arising asset quality is an essential first step to understanding over the transfer and title, in the event that the borrower fails and managing the pressures on banks and the financial to meet contractual payments when due. Furthermore, the system from rising NPL problems. Asset quality indicators framework should also set out the conditions governing the underpin assessments of banks’ capital positions and financial potential sale and transfer of creditor claims, which provide health, as well as provide clear signals of emerging loan an important tool to facilitate NPL resolution. For example, performance problems that warrant remedial action and help does the framework enable the creditor to transfer or sell avoid the associated deadweight costs of a major overhang of NPLs (together with all creditor rights and privileges) to third troubled assets. Reliable data provides the cornerstone to help parties, such as specialist investors and workout firms, or are ensure that banks provision appropriately for expected credit such transfers prohibited? When permitted, do such sales losses, while also highlighting banks that require heightened require the prior consent of the debtor, which could thus act supervisory attention due to their high NPL exposure. In as a potential roadblock to the development of distressed debt particular, timely and accurate information is needed to gauge markets? the magnitude of the problem as well as the banks’ ability to weather and absorb the impact of likely credit losses, while Accurate and reliable information on creditor claims and also retaining sufficient capital strength to supply new credit to on the ownership of collateral facilitates the resolution support a sound and sustainable economic recovery. of NPLs, as well as supports market functioning and credit provisioning more broadly (World Bank 2015a). For Given the various incentives for banks to signal strength example, credit registries enable lenders to record their claims and to underestimate and under-report incipient credit and to pool information on outstanding debt commitments problems, a disconnect between reported figures and the and payment performance of individual borrowers and firms. underlying economic realities can readily arise. To support Improving the information infrastructure not only helps to timely and effective responses by banks and policy makers to develop and deepen credit provisioning, it also facilitates the address rising NPLs, it is important to counter the risk of such resolution of debt performance problems should they occur. a disconnect. Succumbing to the pressures to underestimate Business registries may also provide valuable information the deterioration in asset quality, on the other hand, will to support the pursuit and recovery of claims. Given the not resolve the underlying problem—banks would still face importance of land and real estate as collateral for loans, increasing credit losses, and pressures on provisions and a high-quality cadaster (or land registry) that provides an capital would still materialize. But it would delay the response, accurate legal record of the ownership of title, as well as likely adding significantly to the risks and costs. the details of land and real estate holdings, is often a key EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 Applying well-founded accounting principles and guidelines and expectations on the prudential implications and standards is an important precondition. A large majority application of accounting and reporting standards. World Bank of countries have adopted International Financial Reporting staff recently set out a number of policy recommendations Standards (IFRS) developed by the International Accounting for prudential supervisors in EMDEs to support this process Standards Board (IASB).38 In the past few years, the IASB has (Caruso et al. 2021). introduced a new standard for financial instruments (“IFRS 9”). As a response to the lessons from the global financial crisis, a Clear, unambiguous, consistent definitions of the key major change from the previous standard is to require banks to concepts that underpin banks’ loan classification and account and provision for estimates of expected credit losses, grading schemes are a critical component of effective rather than to wait for losses to be incurred, which had led to monitoring and assessment of asset quality. Although provisioning being regarded as too little, too late under the there is as yet no internationally harmonized framework that previous accounting framework.39 Although more challenging governs the measurement of nonperforming assets and the to apply, the introduction of a specific forward-looking approach calculation of provisions (Baudino, Orlandi, and Zamil 2018), is very helpful in encouraging bank management and boards the Basel Committee has provided valuable guidance on to intensify their focus on prospective payment performance definitions and terminology that has helped to promote greater and to identify emerging problems at an early stage. Assets consistency (Basel Committee on Banking Supervision are grouped into three categories: Stage 1, assets where 2017a and 2017b). In specific relation to problem assets, the there has been no significant increase in credit risk since initial guidance on the categorization and classification of loans is recognition; Stage 2, assets where a significant increase in centered on the degree of delinquency (90 days past due) or credit risk has occurred; and Stage 3, when the asset is credit- the unlikeliness of repayment (see Box 2.1). This guidance impaired. Under IFRS 9, expected credit losses switch from a forms the basis for many national approaches. 12-month perspective to an expectation of credit losses over the full lifetime of the asset on moving from Stage 1 to Stage 2, Standard setters have also published helpful guidance with an associated impact on provisions. Bank boards and on applying regulatory frameworks during the pandemic management have the responsibility to ensure that financial (Financial Stability Board 2020a and 2020b; Basel Committee statements provide an accurate picture, and thus that estimates on Banking Supervision 2020; International Accounting of expected credit losses are of high quality. External audit Standards Board 2020). The Basel Committee highlighted, is essential to provide independent quality assurance and first, that payment moratoria should not be counted in days opinion on the accounts and financial statements. Steps have past due for assessing loan performance, and second, that been taken to strengthen the quality of external audits of banks judgments of the ability to meet payment obligations should in recent years following the lessons of the global financial focus on the borrower’s ability to meet the requirements crisis (Basel Committee on Banking Supervision 2014). of rescheduled payments after the moratorium ends. But equally, to underpin such judgments, and thus policy actions Banking supervisors play a key role in upholding clear, by the bank and the authorities, it is vital that banks continue, consistent, robust standards of credit risk management during the moratoria, to undertake in-depth, high-quality and loan asset classification, as well as in ensuring that monitoring of the financial health of borrowers and conduct banks produce clear and accessible financial statements rigorous assessments of their payment capacity and likely subject to external audit. Although supervisory reporting has longer-term viability, drawing on a range of financial and been streamlined during the pandemic, it is crucial that banks economic indicators. As payment moratoria temporarily report reliable, frequent, detailed, and up-to-date information switch off the important signal from any deterioration in actual on credit quality, including on the performance of loans that payment performance, additional emphasis must be placed have benefited from borrower relief measures, to underpin on strengthening banks’ analysis of the unlikelihood to pay in high-quality prudential supervision and broader policy analysis. undertaking such credit assessments. Supervisors also have an important role in setting out clear 38. The United States is a notable exception. 39. A similar forward-looking perspective has also been introduced into the US system, under the current expected credit losses framework. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 > > > B OX 2 .1 International Guidance on Loan Classification and Problem Assets Definition of nonperforming exposures. There is no centrally agreed international standard for loan classification and treatment of problem assets. While there are many common features, such as extensive reliance on formal loan classification schemes that bucket loans into categories (e.g., pass or standard, special mention or watch, substandard, doubtful, and loss), national approaches consequently differ (Baudino, Orlandi, and Zamil 2018). To support greater convergence, in 2017 the Basel Committee published detailed guidance on the definition of nonperforming exposures (as well as forbearance), providing a clear reference point. In addition to exposures that are in default or impaired under the accounting framework, there are two principal criteria to guide nonperformance: • Delinquency: material exposures that are more than 90 days past due (i.e., unpaid); or • Unlikeliness to pay: where there is evidence that full repayment on the contractual terms (original or, when applicable, modified) is unlikely without the bank’s realization of collateral, regardless of whether the exposure is current and regardless of the number of days the exposure is past due. In addition to specific actions by the bank that signal an unlikelihood of receiving full repayment, such as making a specific provision against the exposure, assessments of likelihood of payment should draw on a comprehensive analysis of the financial situation of the borrower using all available inputs. Specific indicators suggested by the Committee to aid such analysis include the following ratios for nonretail counterparties: leverage; debt/EBITDA (earnings before interest, taxes, depreciation, and amortization); interest coverage; current liquidity ratio; ratio of (operating cash flow plus interest expenses)/interest expenses; and loan-to-value ratio; and, for retail counterparties: debt service coverage ratio; loan-to-value ratio; credit scores; and any other relevant indicators. The Committee also provided guidance on the potential recategorization of nonperforming exposures as performing, namely in the event that the counterparty’s situation improves such that full repayment of the exposure is likely and that the borrower has successfully made repayments when due for a probationary or cure period. Forbearance. The Committee also provided definitional guidance that forbearance applies to cases where there is: • Financial difficulty: a counterparty is experiencing financial difficulty in meeting its financial commitments; and • A concession: a bank grants a concession that it would not otherwise consider. There are many types of concession, including extending maturities, rescheduling payment profiles, providing grace periods, lowering interest rates, and forgiving or deferring principal or interest. Forbearance may be granted on performing or nonperforming exposures. Not all concessions lead to a reduction in the net present value of the loan, and therefore a concession does not necessarily lead to the recognition of a loss by the lender. Guidance in the pandemic. The Basel Committee (2020) provided guidance on the application of the above criteria in the pandemic, clarifying that payment moratoria periods relating to the COVID-19 outbreak (whether public or granted voluntarily by banks) can exclude the days past due and that assessments of the unlikeliness to pay should be based on whether the borrower is unlikely to be able to repay the rescheduled payments (specifically the likelihood of payment of amounts due after the moratorium period ends). This approach applies both to the definition of nonperforming exposures and to the treatment in the capital framework. The Committee also highlighted that borrower acceptance of a payment moratorium or other relief measures, such as guarantees, should not automatically lead to the loan being categorized as forborne. Supported by statements from the IASB (2020), the Committee also highlighted that when estimating expected credit losses (and applying IFRS 9 or alternatives), banks should not apply the standard mechanistically. The flexibility inherent in IFRS 9, for example, to give due weight to long-term economic trends should be used. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 Building on reliable data and clear definitions, supervisors and provisioning policies while also confirming that supervisors are tasked with ensuring that banks apply appropriate have been granted, and where necessary apply, powers policies and standards to identify and manage problem and remedial measures to ensure that loan classification is assets. The Basel Core Principles for Effective Banking appropriate and that provisioning, reserves, and capital are Supervision (Basel Committee on Banking Supervision 2012) sufficient (see Box 2.2). In practice, this entails conveying set out clear expectations and best-practice international powers for the supervisor to require higher provisions standards to guide the supervisory approach. The principles that enable the supervisor, for example, to put in place a were comprehensively reviewed and strengthened from the prudential backstop for provisions over and above accounting 2006 version in light of the lessons from the global financial requirements when judged necessary (Gaston and Song crisis. Principle 18 focuses specifically on problem assets, 2014; D’Hulster, Letelier, and Salomao-Garcia 2014; Caruso provisions, and reserves and sets out 12 essential criteria for et al. 2021),40 as well as to set additional capital requirements supervisors to fulfil, covering, inter alia, the quality, timeliness, to cover the risks of high levels of NPLs where remediation accuracy, and prudence of bank loan classification schemes strategies appear weak.41 40. Backstops of various kinds are applied, for example, in the European Union, Singapore, and Thailand (see Caruso et al. 2021). In recommending that prudential supervisors should consider prudential backstops on provisioning, Caruso et al. argue that “IFRS 9 amplifies management judgment and might give rise to undue discretion when dealing with model choices. To preserve adequate coverage of NPLs, supervisors in EMDEs could implement prudential backstops.” 41. For example, under Pillar 2 of the Basel Framework. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36 > > > BOX 2.2 Basel Core Principle 18: Problem Assets, Provisions, and Reserves The Basel Core Principles for Effective Banking Supervision (2012) set out clear expectations for the supervisory treatment of problem assets and reserves. Principle 18 specifies that: “The supervisor determines that banks have adequate policies and processes for the early identification and management of problem assets, and the maintenance of adequate provisions and reserves.” To guide this determination, Principle 18 specifies 12 essential criteria outlining international best-practice requirements. In summary, these require the supervisor (or laws) to determine that: 1 Banks formulate policies and processes for identifying and managing problem assets; 2 Policies and processes for loan classification and provisioning are adequate; 3 Off-balance-sheet exposures are included; 4 Provisions and write-offs are timely and accurate; 5 Banks have appropriate policies, processes, and organizational resources for the early identification of deteriorating assets; ongoing oversight of problem assets; and collecting on past-due obligations; 6 Banks have adequate documentation to support classification and provisioning, and supervisors have access to regular, detailed information; 7 Classification of assets and provisioning is adequate for prudential purposes (and if not, that the supervisor has the power to require changes to loan classification and increases in provisions, reserves, or capital and, if necessary, to impose other remedial measures); 8 Banks have appropriate mechanisms for regularly assessing the value of risk mitigants, including guarantees, credit derivatives, and collateral, and that the valuation of collateral represents the realizable value, taking into account prevailing market conditions; 9 Criteria are established for assets to be identified as problem assets and reclassified as performing; 10 Bank boards obtain timely and appropriate information on the condition of the bank’s asset portfolio; 11 Valuation, classification, and provisioning are conducted on an individual item basis, at least for significant exposures; and 12 The supervisor regularly assesses trends and concentration in risk and risk buildup across the banking sector in relation to banks’ problem assets, taking into account risk mitigation strategies, and considers the adequacy of provisions and reserves at the bank and banking system level in the light of this assessment. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 37 Other core principles set out requirements on critical provisioning frameworks were noted in around 65 percent accompanying policies that buttress and reinforce the of the 29 detailed assessments of EMDEs conducted during effective management of problem assets and of credit FSAPs since 2012, while practices for valuing collateral and risk more broadly. Of particular relevance are the following: upgrading restructured loans, supervisory definitions, and Principle 17 (Credit Risk, which highlights the critical supervisory oversight also fall well short of expectations in importance of managing credit risk over the full credit life some 25 to 40 percent of the same assessments. Noting that cycle); Principle 27 (Financial Reporting and External Auditing, the framework for the management of problem assets needs which specifies the importance of external validation of asset urgent improvements, common priority areas identified in classification and loan loss provisions, as well as requiring the review for improvements to meet the agreed standards independent verification of valuation practices used by banks include: to assess the fair value of assets, including distressed assets and collateral, and emphasizing that accurate financial • Strengthening criteria for the classification of assets, as reporting is essential to provide transparency and aid market well as processes to avoid the evergreening of loans; functioning); Principle 28 (Disclosure and Transparency, which • Buttressing implementation of loan classification and outlines the requirement for banks to publish easily accessible provisioning by more frequent supervisory reviews; information that fairly reflects the financial position as well as key risk management and risk metrics); and Principle 11 • Providing clear definitions of NPLs, loan restructuring, and (Corrective and Sanctioning Powers, which sets out the criteria forbearance, to support transparency, market discipline, for effective enforcement of banking supervision policies and reporting; and and regulatory requirements). Together with Principle 18, • Strengthening policies and processes for the valuation and the overarching framework governing effective banking of collateral to improve bank provisioning (including supervision provided by the entire Basel Core Principles,42 independent verification of the valuation approach). these principles set out a solid supervisory foundation for the management and resolution of NPLs. Applying these supervisory principles clearly and consistently is important to ensure consistency and Although in recent years the supervisory community comparability across banks and jurisdictions, as well as has strengthened frameworks for identifying and over time. The pandemic has placed additional pressures on managing problem assets in light of the lessons from supervisors to dilute definitions and weaken the application the global financial crisis, further progress, nonetheless, of credit risk management and asset quality requirements. remains a priority. Detailed assessments of supervisory While an easing of standards may lower measured NPLs, it practices and processes undertaken as an integral part weakens the comparability and consistency of reported data, of the joint World Bank/IMF Financial Sector Assessment increasing opacity on the financial position of borrowers and Program (FSAP) reveal continued significant shortfalls banks. Such a relaxation would thus hamper the analysis and from international minimum standards and good practices, understanding of emerging asset quality problems and hinder highlighting the importance of continuing efforts to strengthen their resolution. The majority of supervisors have consequently frameworks for the early identification and management of maintained a consistent regulatory framework and have problem assets and maintenance of adequate provisions typically provided helpful guidance on its application during the and reserves. A recent review of the lessons from FSAPs pandemic, taking account of moratoria and other measures. (Dordevic et al. 2021) showed that Principle 18 is among In some countries, however (e.g., Argentina and Turkey), this the five least well observed of the 29 Basel Core Principles, pressure has led to relaxation in regulatory definitions and to with over 30 percent of the assessments judged as materially divergence from international standards, including stretching noncompliant or noncompliant with the principle.43,44 For the 90-days-past-due criterion commonly applied to identify example, significant weaknesses in asset classification and NPLs. In other cases, supervisors have been under pressure 42. The Basel Core Principles are a framework of minimum standards for sound supervisory practices and are considered universally applicable. Powers, responsibilities, and functions of supervisors (including key issues such as mandate, independence, legal powers, and protections) are set out in Principles 1 through 13, while the second group (Principles 14 through 29) focuses on prudential regulations and requirements for banks. 43. In a detailed assessment report of the application of the core principles, often conducted as part of an FSAP, assessments are made for each principle using one of four categories (in addition to Not Applicable): Compliant, Largely Compliant, Materially Non-Compliant, or Non-Compliant (Basel Committee on Banking Supervision 2012). 44. Of the principles highlighted above, Core Principle (CP) 11 (Corrective and Sanctioning Powers) and CP 27 (Financial Reporting and External Auditing) are also among the 10 least well-observed principles of the 29. Observance of CP 17 (Credit Risk) and CP 28 (Disclosure and Transparency) was somewhat stronger, although around 20 percent of the assessments were nevertheless judged as materially noncompliant or noncompliant with both of the principles (Dordevic et al. 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 38 to treat restructured, forborne NPLs as new performing loans • Nonperformance and unlikeliness to pay. A key element without going through the normal probationary period of of the identification and management of NPLs is the successfully meeting rescheduled payments for one year.45 assessment of the borrower’s payment capacity and the Shortening or eliminating this period enables banks to release likelihood the borrower will meet contractual obligations. provisions and thus present a stronger financial position on Supervisors play an important role in ensuring that banks the surface. But it also runs high risks, which justified the need use strong analytical systems to make such assessments for the one-year cure period in the international regulatory and also take a forward-looking view. In particular, guidance. More broadly, in cases where standards have been supervisors should ensure that banks do not simply focus relaxed during the pandemic, clarifying that the weakening on loan delinquency metrics, such as the days scheduled of the classification system is temporary and developing and payments are past due, which are backward-looking and implementing clear plans to restore international prudential which have also been heavily impacted, and in some standards of asset quality will help guard against a loss of cases distorted, by payment moratoria.46 confidence in the supervisory framework and in the integrity • Viability assessments. Assessments of the unlikeliness of financial data. to pay are closely related to judgments on the economic viability of the borrower, in particular, on whether the C. Backed by Supervisory borrower is deploying a business model that can generate Guidance and Action sustainable profits and meet debt service requirements Building on solid regulatory and supervisory foundations, over an extended period. Supervisory scrutiny of bank providing intensive, intrusive supervision of problem viability assessments and the underlying methodology is assets is the third key building block of effective NPL important to guard against incentives for banks to continue identification and management. In several areas additional lending to zombie firms. guidance, reinforced by supervisory scrutiny and challenges, • Write-offs. Supervisors must ensure that banks fully may be particularly valuable: provision against exposures with no realistic prospect • Loan classification schemes. Supervisors play a key of recovery and determine that banks have policies that role in ensuring that loan classification schemes are clear subsequently write off the loans from the balance sheet and effective and are applied rigorously by banks. As in a timely manner.47,48 Holding the board responsible for moving between classification categories is likely to have disclosing accessible and fair financial and risk data will implications for provisioning levels and risk weights, it avoid the risk of misrepresentation of financial statements is important to guard against the incentives for banks to and associated misinterpretation. preserve the existing categorization and avoid downgrading. • Provisioning practices and recognition of losses. • Monitoring and reporting frameworks. Strong asset Guidance and close monitoring by the supervisor are quality monitoring frameworks are needed within banks important to ensure that provisioning policies are sufficiently to underpin effective responses by management and prudent (with the supervisor stepping in to require oversight by the bank’s board, as well as to ensure that additional provisions if not) and that banks recognize supervisors have the necessary information. It is important losses on a timely basis. Provisioning should take account that banks collect information on a broad set of indicators of the effectiveness of the domestic framework for debt signaling both current and prospective borrower financial enforcement and insolvency, as discussed in more depth health to guide assessments of payment capacity and of in Chapter 3. For example, if debt recovery rates in a incipient performance problems. jurisdiction are typically low, higher provisions are likely to be needed.49 45. This applies to restructured loans that were nonperforming, either on grounds of delinquency or unlikeliness to pay, and that were granted a concession and thus classified as forborne. On the other hand, some restructured loans at the end of the payment moratoria may simply reflect a rescheduling or retiming of payments with no change in the net present value of the loan. In the latter case, the loans continue to perform, and as no concession is granted, the loans are not forborne, as per the Basel Committee 2020 guidance. 46. Temporary moratoria on debt payments switch off the signal on asset quality from payment delays and days past due, thus placing additional weight on the importance of rigorous assessments of the unlikeliness to pay based on a broad set of indicators of borrower financial health and economic and business prospects. 47. Basel Core Principle 18 essential criteria 4 states: “The supervisor determines that banks have appropriate policies and processes to ensure that provisions and write-offs are timely and reflect realistic repayment and recovery expectations, taking into account market and macroeconomic conditions.” As noted above, write-offs may also be influenced by the accounting and tax regime. 48. Several supervisory authorities have taken specific measures to strengthen write-off policies. For example, Malawi introduced a new regulation in 2017 to force banks to step up loan recovery and write off NPLs from their balance sheets, which helped to lower NPLs from 15.7 percent at the end of 2017 to 3.6 percent in September 2019 (Eyraud et al. 2021). 49. As highlighted in Chapter 3, the World Bank Doing Business Report provides information on creditor recovery rates under insolvency. The chapter also notes that significant variation occurs across countries and regions, reflecting the strength of the arrangements (World Bank Group 2020). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 39 • Collateral valuation. To guard against the risk of IV. Dealing with NPLs: Bank-Led overoptimism, supervisors should require that banks apply appropriate approaches to the valuation of collateral, taking Strategies and Public Policy into account prevailing market conditions and delivering a Interventions realistic assessment of the realizable value. This includes substantiating that banks’ valuation approaches are subject to independent verification and validation through Under the direction of the board, bank senior management the external audit process. Guidance that sets out clear is responsible for the prudent day-to-day management of supervisory expectations will help to ensure that banks the bank. Banks should have NPL resolution strategies and adopt rigorous valuation approaches. effective internal arrangements in place to implement them. While banks carry the main responsibilities for working out • Consolidated reporting and supervision. Given bad loans under supervisory oversight, more direct public spillovers, contagion, and reputation risks across banking intervention might be warranted should rising NPLs become groups, it is essential that banking supervisors take a a threat to financial stability. comprehensive and consolidated approach that embodies all aspects of the business conducted by the banking group A. Private Action: Ensuring Bank worldwide and set prudential standards accordingly.50 Readiness to Manage NPLs Ensuring that banks report positions accurately on a consolidated basis across the whole group, including Managing payment performance problems is a core affiliated entities, is an important precondition to support activity for commercial banks. Loans are underwritten and effective supervision as well as management of group- priced to reflect credit risk, thus acknowledging and expecting wide risks. For banking groups operating across borders, that some borrowers will face adverse shocks and be unwilling strong coordination and cooperation between home and or unable to meet their contractual obligations. When payment host country supervisors is vital to ensuring the smooth problems do arise, banks have systems and processes to sharing of information and effective supervision of the manage the relationship with the borrower and to maximize group and group entities.51,52 the recovery of the claim. Implementing effective systems is a core responsibility for bank boards and management—as Targeted use of specialist resources can help strengthen highlighted above, bank supervisors play a key role in the effectiveness of supervision and the resolution of ensuring that processes for managing problem assets and NPL problems. For example, in cases where the supervisory setting provisions are thorough and rigorous. authority detects a mushrooming NPL problem within a particular bank, it is important that the on-site supervisory Systems designed to manage payment problems on team include staff with expertise in NPL resolution. Equally, in a case-by-case basis may, however, be ill-equipped to cases where there are significant doubts about the magnitude handle a simultaneous surge in NPLs. In particular, systems and extent of NPLs across a banking system, bringing in may become overloaded, and specialist expertise may be independent experts to conduct a detailed asset quality review spread too thin, leading to bottlenecks and holdups in decision- can provide a valuable option for the supervisory authority to making, as well as risking the application of inconsistent, help diagnose the problem. Such experts may also provide loan piecemeal, and ineffective remedies. Supplementary policies loss forecasts to be used as inputs to stress tests, which are and complementary approaches may be needed in such often undertaken as a complementary diagnostic tool following circumstances. an asset quality review (Gutierrez, Monaghan, and Piris 2019). 50. Basel Core Principle 12 specifies criteria to deliver effective consolidated supervision (Basel Committee on Banking Supervision 2012). 51. Basel Core Principle 14 addresses home-host supervisory relationships (Basel Committee on Banking Supervision 2012). 52. Where banking groups operate regionally, cooperation though regional supervisory groups may be helpful in strengthening frameworks for information exchange, supervision, and crisis management. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 40 Experience has shown the importance of four basic • Development and implementation of an NPL reduction building blocks that enable banks to successfully tackle strategy. Faced with a major buildup of NPLs, banks should sizable numbers of impaired assets: set a clear strategy and timeline to address the loan quality problems and clean up the balance sheet. The strategy • Clear recognition of the problem. Strong monitoring should be approved and subsequently closely monitored systems facilitating early identification and timely recognition by the bank supervisor to ensure effective implementation. of deteriorating asset quality are a prerequisite for effective Measures to address NPLs may be grouped into four resolution. Recognition of the problem must be backed by broad categories: loan restructuring; legal actions to provisioning that takes full account of expected losses. recover claims; write-offs of loans; and sales of distressed assets to third parties (Bauze et al. 2020; Baudino and • Setting up dedicated workout units. Specialist expertise Yun 2017).56 These measures are not mutually exclusive is required to manage NPLs, and it may initially be in short and may be used in sequence (or even, in some cases, in supply. Concentrating expertise and building up well- parallel), guided by the objective to maximize the recovery resourced, dedicated workout units,53 separated from the in terms of net present value, which takes account of the day-to-day operation of the bank and with direct reporting time value of money.57 In more detail, the measures are as to senior management and the board, has proven to be the follows (see also Table 2.1): most effective strategy to address bulk NPL problems.54 Reliable information systems are essential to support > Loan restructuring. This approach may be used in the workout process. Addressing any major information cases where the borrower is cooperating with the bank deficiencies is consequently likely to be a priority.55 and is viable. There are two broad subcategories; both are likely to be used extensively as payment moratoria • Segmentation of the impaired asset portfolio. Policies and other support measures to cushion the impact and approaches to addressing payment performance of the pandemic are lifted. The first applies when the problems are likely to differ depending on the cooperation borrower is suffering from a purely temporary squeeze and financial health of the borrower. As outlined in more on cash flow and liquidity, with little or no impact on detail below, if the borrower is actively engaging with the long-term payment capacity. In this case, agreement bank and has a viable business model, then seeking a may be reached on a rescheduling or reprofiling of the negotiated agreement on rescheduling or restructuring timing of payments with no impact on the net present payments may offer the best approach. Recourse to legal value and thus no loss for the bank. In other cases, procedures is likely to be needed in cases where the the borrower may face greater distress, but the bank borrower is not cooperating and/or is not judged to have a judges, from a detailed assessment of affordability, viable medium-term future. Underpinned by assessments that viability can be restored by agreement to grant a of borrower viability, segmentation of impaired assets concession on loan payments in some form in terms into categories by whether borrowers are cooperative or of net present value (such as a lower interest rate, a uncooperative and whether the business is viable will help partial write-down of principal, a grace period, or an guide the NPL reduction strategy (see Table 2.1). extension of maturity without full compensation for the 53. For example, by recruiting and training supervisory staff. 54. Separation of NPL resolution into a dedicated unit distinct from day-to-day supervision also enables line supervisors to focus on ongoing issues and eliminates any potential conflict of interest between the originating officer and the troubled borrower; it also builds and concentrates expertise and experience within specialist workout staff and management. As a recent example, the Bank of Tanzania required banks to set up separate workout units as part of a broader strategy to lower NPLs (Bank of Tanzania 2018). 55. For banking groups operating across borders, it is important to ensure that the flow and sharing of information is effective and captures risks across the whole group. 56. Although each approach reduces NPLs on bank balance sheets, in some cases the NPL problem is resolved when the bank and the borrower reach agreement (in some cases, with the assistance of the court); in others, the responsibility for resolution is transferred by the bank to a third party to resolve with the borrower. 57. The time value of money reflects the point that US$100 today is worth more than US$100 in a year’s time given the capacity for the US$100 to earn positive interest over the year. Net present value takes account of the need to adjust (discount) future payments by the rate of interest to derive an estimate of how much they are worth today. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 41 time value of money). A concessional restructuring may > Sales. The final option for reducing NPLs is to sell offer the best solution in such circumstances, given the the distressed assets together with the creditor rights costs of, and likely recoveries from, using alternative (including security protections such as claims on measures.58 Where there are multiple creditors involved, collateral) to a third party that has developed specialist such an approach may be followed as part of a CDR expertise in debt workout. In addition to requiring an package, as highlighted in Chapter 3. It is important that enabling legal framework that permits such sales without supervisors closely monitor the processes within the undue obstacles,60 this option depends on the depth bank guiding loan restructuring decisions and terms, and development of a market for distressed assets. including governance, risk management, and internal Information barriers can be inhibitory, so mechanisms controls, as well as the subsequent management and that support information availability and facilitate due performance of the restructured loans. That will help diligence by potential investors (such as hedge funds, ensure that banks develop and implement effective private equity, and specialist distressed debt funds) are policies, procedures, and practices to manage important. For this reason, distressed debt markets asset quality problems and thus avoid the risks of have often been used for unsecured products such as evergreening and of overly optimistic assessments of consumer loans and credit card debt that are typically payment capacity and resultant under-provisioning and relatively straightforward to work out and that can be overstatement of capital. valued relatively easily given the absence of collateral, although markets for distressed corporate debt have > Legal action. In cases where the borrower is also been developed in some countries, with sales to uncooperative or the bank judges that the borrower specialist funds and distressed debt companies. A key does not have a viable business model, legal action challenge is information asymmetry between the seller may be taken by the bank to protect and maximize and the buyer, with the latter concerned it may be sold the recovery of its claim. In cases where loans are only poor-quality assets. Encouraging the development secured, the bank may seek to enforce its rights over of standardized, audited “data tapes” may be helpful the collateral (if necessary, through court processes if to lower the asymmetry. In some cases, to overcome claims are disputed). More broadly, the bank may also information barriers and bridge a gulf between the price utilize the insolvency framework to reach a settlement, the seller is seeking and the price an investor is willing to either through an out-of-court procedure or by initiating pay for distressed assets, the seller may retain a partial proceedings against the borrower to protect its claim claim and share future collections with the investor. by forcing either reorganization or liquidation. In some Many different financial instruments have been used in cases, the borrower may choose to file for bankruptcy private markets for distressed debt, including bilateral protection, in which case the bank will need to register sales, auctions, and securitization. Nevertheless, and promote its claim through the bankruptcy process. given the preconditions and challenges, distressed > Write-offs. In cases where the bank is unsuccessful in debt markets have yet to get off the ground in some obtaining remediation through alternative approaches countries and regions.61 The World Bank is working and has provisioned fully against the exposure, actively through technical assistance and mobilization the bank may seek to write off the claim from its of funds under the International Finance Corporation’s financial statements on the grounds that the loan is (IFC’s) Distressed Asset Recovery Program to support uncollectible.59 While full provisioning ensures that and stimulate the growth and development of such the approach meets regulatory objectives, given the markets (World Bank Group 2019).62 interaction with the tax system, the bank may have to provide evidence to the tax authorities that all avenues have been pursued and exhausted before obtaining full tax relief from this option. 58. Bank assessments, weighing the relative merits of restructuring versus legal actions, will depend on the efficacy of the insolvency framework and judicial process, which provide a backstop alternative and buttress to creditor/debtor negotiations. Weak protection of creditor rights from an ineffective legal backstop creates incentives for correspondingly weak restructuring agreements that often do not solve the underlying problem. See Bauze et al. (2020) and Chapter 3 of this report (especially lesson 17 of the 20 lessons for designing CDR frameworks). 59. The bank is unlikely to formally forfeit its claim to avoid creating adverse borrower incentives, absent a further decision to provide debt relief. 60. The ability to transfer claims and creditor rights to specialist firms, and to undertake such transfers without the prior approval (or veto power) of the debtor, is a key precondition for a distressed debt market. 61. For example, distressed debt markets are mostly nonexistent or marginal in Sub-Saharan Africa at present (Eyraud et al. 2021). 62. For example, IFC is currently assessing secondary markets for NPLs in Angola, Côte d’Ivoire, Kenya, Mozambique, Nigeria, Senegal, and Uganda. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 42 > > > TA B L E 2 .1 NPL Reduction Strategies Instrument Subcategory Description Borrower Eligibility Requirements Loan restructuring Rescheduling Deferment of borrower’s debt service Borrower is experiencing “Workout” obligations to a future date, usually in a net short-term liquidity difficulties. present value-neutral manner. Borrower is cooperative. Concessional Loan restructuring that entails a net present Borrower is distressed but restructuring value reduction. viability can be restored with restructuring that entails debt relief. Borrower is cooperative. Legal actions Collateral enforcement Enforcing the collateral or guarantee pledged None. “Collection” against the loan in or out of court. Insolvency process Initiation of an insolvency petition against the None. debtor to force a reorganization or liquidation of the borrower. In other cases, the debtor may voluntarily file for insolvency, in which case the bank will need to prove its claim. Write-offs Write-off Fully provisioned NPL moves to the off- Banks may need to demonstrate “Disposal” balance-sheet records; borrower’s debt that all measures have been remains. exhausted. Sale To a third party Sale of NPL on commercial terms to an None. investor; investor continues collection effort. To a public asset Transfer of NPLs to a centralized agency None. management company that manages recovery efforts; used in some systemic crises, complementing individual banks’ efforts. Source: Bauze et al. (2020). B. Public Action on NPL Reduction Audit of asset quality. Given the various incentives to underestimate NPLs and to understate NPL provisioning, an There may be challenges in applying some measures in the important first step to develop a system-wide strategy is to event of a major system-wide rise in NPLs that threatens confirm the magnitude of the problem to be tackled. While financial stability. For example, in such circumstances, more intensive supervision of asset quality is helpful, an in- there may be huge pressures on judicial capacity and no depth independent review across the system in the form of an ready market for distressed debt. Moreover, actions taken asset quality review (conducted by independent experts using by individual banks in their own interest to reduce NPLs may standardized methodology approved by the supervisor and have an adverse impact and spill over on the functioning of conducted under supervisory oversight) may be required in the broader financial system. In particular, such actions may some cases to provide a more rigorous assessment (Gutierrez, precipitate fire sales of assets, lowering asset values and Monaghan, and Piris 2019). Careful consideration should forcing further asset sales in a downward spiral, as well as be given to the potential timing of an asset quality review, reining back credit provisions as banks lower leverage to as such exercises are costly and are designed to provide a preserve capital, raising attendant risks of a harmful credit point-in-time assessment of the accuracy of the carrying value crunch (Baudino and Yun 2017). Additional public action of the banks’ assets.63 Given the fundamental uncertainties may be needed to facilitate a more coordinated system-wide generated by the pandemic, an asset quality review may not resolution of NPLs. be an immediate priority, but it may become useful at a later stage in some jurisdictions when there is greater clarity on the Drawing on past experience, several public policy inter- longer-lasting economic impact (Bauze et al. 2020). ventions may be considered to help address a system- wide increase in NPLs: 63. Asset quality reviews may also provide inputs to, and subsequently be combined with, stress tests designed to assess the likely asset quality trends under potential adverse macroeconomic scenarios. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 43 Policy coordination. Multiple agents are likely to be involved address NPL problems. AMCs do not provide a silver bullet, in resolving major NPL problems, including the following: however.66 Historical experience has revealed weaknesses governments (including fiscal, judicial, and taxation arms); that have bedeviled the operation of many AMCs: poor financial authorities (supervisory authorities, central banks, governance, including unclear objectives, combined with bank resolution agencies, and deposit insurers); banks and extensive political interference; inflated acquisition prices, other creditors; borrowers; insolvency practitioners; legal which effectively provide public subsidies to sellers of experts; courts; auditors and valuation experts; consumer distressed debt, rendering it impossible for the AMC to and investor protection advocates; and investors in distressed generate a return and create contingent fiscal liabilities; and debt markets. Enhancing coordination among the various difficulties attracting high-quality staff.67 stakeholders, for example, by establishing a committee or working group, can help the authorities develop coordinated Bank resolution frameworks. Some banks may have in- strategies for NPL resolution as well as obtain buy-in and sufficient capital to absorb a major spike in NPLs or may fail inject impetus into the chosen approach. Bringing together to meet minimum regulatory standards. In some such cases, the key stakeholders also facilitates the development and banks may be able to develop a viable medium-term capital application of policies to overcome potential stumbling blocks. restoration plan that gains supervisory approval, enabling For example, this approach was successfully applied at the implementation under strict supervisory oversight. But where national level in a number of jurisdictions in Eastern Europe this is not feasible, the authorities should have the capability that were burdened with major NPL problems following the to place the bank into a tailored bank resolution process that global financial crisis.64 Domestic coordination can also be provides the authority with the necessary powers and tools complemented by strengthened international coordination in to undertake an orderly resolution that preserves financial cases where there is heavy foreign bank participation, as was stability while minimizing any need for taxpayer support.68 the case, for example, with the Vienna Initiative following the Following the lessons from the global financial crisis and global financial crisis (Bauze et al. 2020). other financial crises that corporate insolvency frameworks are ill-suited to handle bank failures, considerable progress Asset management companies. In cases of major system- has been made toward developing and implementing special wide NPLs, authorities may consider the respective arguments resolution regimes for banks, drawing on the key attributes for setting up a public asset management company (AMC)65 of such schemes as that developed by the Financial Stability to take on the responsibility for the resolution. AMCs typically Board (2014). Further progress remains crucial, nonetheless, form part of a broader package of reforms to support financial as surveys by the International Association of Depositors stability and the continued provision of credit. The broad aim show that, in relation to low-income countries, only about half is to generate momentum and focus for the solution as well of the reporting sample currently have instruments other than as to maximize NPL recoveries by concentrating specialist liquidation available within their toolkit (Dobler, Moretti, and resources and expertise. AMCs have been used both to work Piris Chavarri 2020). Moreover, progress in implementing the out and to liquidate assets from failed financial institutions key attributes remains uneven among the larger EMDEs that (e.g., the Resolution Trust Company in the United States are members of the Financial Stability Board—no EMDE re- and Securum in Sweden), as well as to work out assets ported full compliance as of September 2020.69 Strengthening purchased from open banks that continue to operate (e.g., the the toolkit and requiring major banks to develop recovery Korean Asset Management Company (KAMCO), Danaharta plans and provide the necessary information to underpin in Malaysia, and, more recently, SAREB (Spain) and NAMA workable resolution plans70 are important preparatory steps to (Ireland)). Some EMDEs, such as Vietnam (in 2013) and managing potential bank failure. Angola (in 2016), have more recently set up AMCs to help 64. Bauze et al. (2020) highlight the experience of Albania and Serbia. 65. The assumption in this subsection is that the AMC is fully or largely publicly owned. Private asset management companies are also present in some countries. 66. Cerutti and Neyens (2016) review the experience of nine public AMCs, highlighting their strengths and weaknesses. Overall, the nine cases show a mixed track record. The authors note some challenges, for example, in the operation of the AMC (AMCON) in Nigeria relating to mission creep, transparency, and governance. Drawing on the lessons from these nine case studies, Cerutti and Neyens put forward a toolkit for AMC operation. 67. Based on this evidence, Dobler, Moretti, and Piris Chavarri (2020) set out seven design features or preconditions necessary to operate an AMC successfully: (i) mandate; (ii) governance; (iii) independence; (iv) sunset clause; (v) valuation of assets; (vi) transparency and accountability; and (vii) funding. 68. Such tools include powers to undertake a partial transfer of assets and liabilities to another bank (often known as “Purchase and Assumption” or “P and A”); use of a bridge bank; powers to “bail in” loss-absorbing liabilities (writing down and converting loss-absorbing liabilities of the bank in resolution into equity); and liquidation of all or part of a bank’s book. All are subject to safeguards such as preservation of the hierarchy of creditor claims and a provision that no creditor will be worse off from deploying the tools than under the fallback default of liquidation (Financial Stability Board 2014). 69. See Annex 1 of the FSB Resolution Report for 2020 (Financial Stability Board 2020b). 70. Recovery and resolution plans should be informed by regular resolvability assessments that evaluate the feasibility of resolution strategies and their credibility in light of the likely impact of the firm’s failure on the financial system and the overall economy. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 44 V. Conclusions and Policy of payment capacity and borrower viability, and create accurate and prudent provisions. Recommendations > Banks. Develop strategies and policies for managing a sharp rise in NPLs; set up adequately staffed and The risk is high that a major surge in corporate debt resourced dedicated workout units; and enhance problems will follow the pandemic, given the record analytical and information systems. Supervisors should levels of corporate leverage in many countries and the actively engage with banks in the near term to review magnitude and depth of the adverse shock. Although their operational readiness and to require speedy payment moratoria and government support mechanisms remedial action to address any deficiencies found. have successfully blunted the impact and helped prevent unnecessary economic scarring, it is prudent policy to > Legal framework. Review the effectiveness of the strengthen preparations for managing a sharp rise in corporate framework and implement improvements, for example, distress should it occur. Historical evidence shows significant by developing and strengthening out-of-court processes incentives for banks to underestimate deteriorating asset to handle bulk claims quickly and efficiently, increasing quality, thus stalling necessary corrective actions. History judicial capacity through training, and removing any legal also reveals that such delays can be very costly, as bad loans impediments that hamper the development of markets typically become worse over time if not addressed. Moreover, for distressed debt. Review and, where necessary, weaknesses in legal and supervisory frameworks can also enhance the information infrastructure underpinning hamper the effectiveness of the response to burgeoning NPL the legal framework, in particular, the registration of problems, which in turn distorts credit allocation and dampens credit, businesses, and collateral (especially land and economic growth. real estate). Actions to strengthen the legal framework are likely to take time to implement—authorities are encouraged to initiate a rapid time-limited review to Against this background, the following policy inform and underpin an implementation plan with clear recommendations are suggested to prepare for the priorities and deadlines that recognizes the importance potential financial shock from rising corporate NPLs. of quick wins. As countries prepare plans for an orderly withdrawal of government support measures and ending payment moratoria, > Early intervention and bank resolution. Review they are encouraged to implement the following:71 the policy framework for bank resolution against the Financial Stability Board’s key attributes and take action • Undertake detailed reviews of the respective policy to address any shortfalls in tools and procedures. Again, frameworks and their practical application that some actions may require changes in regulations or impact the resolution of NPLs, identifying and laws that may take time—as for the legal framework, remedying deficiencies. Such reviews will also facilitate initiating a speedy review and developing a clear action the development of a coordinated and holistic national plan to strengthen the resolution framework offers a approach to the resolution of NPLs, given the strong good way forward. An immediate step is to encourage interactions and interconnections between them. Specific active recovery and resolution planning for major banks. actions may include the following: Where recovery and resolution plans are not currently available, authorities can promote the development > Supervisors. Review and, where necessary as a result, of recovery plans by major banks under the oversight take immediate steps to strengthen the supervision of of supervisors and resolution authorities and develop problem-asset classification and provisioning, drawing resolution plans. Once initial plans have been prepared, on Basel Core Principle 18 as a best-practice guide.72 In a process of regular resolvability assessments will particular, ensure that banks uphold rigorous standards enable authorities to assess the feasibility and credibility of asset classification, undertake detailed assessments of the recovery and resolution plans. 71. Although such measures have been very helpful, they are also costly and distort market functioning. In addition, fiscal pressures are high in many countries, with the authorities facing difficult balancing acts and trade-offs on (i) whether to continue temporary support to firms that are viable but face a severe liquidity squeeze, and (ii) the timing, and process, of exit (Kongsamut, Monaghan, and Riedweg 2021). In many countries, support policies are becoming narrower and more targeted as a precursor to full withdrawal. 72. A self-assessment by the supervisory agency against the performance criteria for Basel Core Principle 18 may be a helpful first step if no recent external assessment is available. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 45 > Coordination in the resolution of NPLs. While Swift action to implement these recommendations and respecting the independence of different stakeholders, strengthen the policy framework to address potential authorities are encouraged to develop a coordinated, failure has broader benefits beyond the current holistic approach to avoid potential policy conflicts and conjunction of high corporate debt and severe adverse to provide momentum to solve the problem, as well as shock from the pandemic. Such frameworks can be used to actively monitor and review progress and follow up to address future periods of financial stress. Importantly, they where needed. National authorities are best placed to also help market functioning in normal times. The knowledge develop the coordination structure—one possibility is that there is an effective failure mechanism that can and will that the national financial stability authority could take be used reinforces market discipline and reduces adverse charge of putting the coordination framework together; incentives. Preparations for failure can thus be an important if there are potential fiscal implications, another option ingredient of the recipe for success. is for the finance ministry to take on this function. • Take action quickly and decisively to reinforce the enabling framework where deficiencies are found, as well as to ensure that the NPL problem is actively managed and not allowed to fester. Building on the specific components above, consider the case for developing and implementing a national strategy for reducing and resolving NPLs to clean up bank balance sheets and thus promote efficient credit allocation to support sustainable economic growth. 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EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 50 Kennedy, Simon. 2020. “Harvard’s Reinhart and Rogoff Say This Time Really Is Different.” May 18, 2020. Bloomberg.com. https://www.bloomberg.com/news/features/2020- 05 -18/harvard-s- financial-crisis-experts-this-time-really-is-different. Kongsamut, P., D. Monaghan, and L. Riedweg. 2021. “Unwinding COVID-19 Policy Interventions for Banking Systems.” IMF Special Series on COVID-19. Monetary and Capital Markets Department, International Monetary Fund, Washington, DC. Laeven, M. L., and M. F. Valencia. 2018. “Systemic Banking Crises Revisited.” International Monetary Fund, Washington, DC. National Bank of Serbia. 2015. Financial Stability Review. National Bank of Serbia, Belgrade, Serbia. Peek, J., and E. S. Rosengren. 2005. “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan.” American Economic Review 95 (4): 1144–66. Pomerlano, M., and W. Shaw, eds. 2005. Corporate Debt Restructuring: Lessons from Experience. Washington, DC: World Bank. Reinhart, C. M. 2021. “From Health Crisis to Financial Distress.” World Bank Policy Research Working Paper 9616, World Bank, Washington, DC. Reinhart, C. M., and K. S. Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. Reserve Bank of India. 2016. Financial Stability Report. June 2016. Reserve Bank of India, New Delhi, India. World Bank Group. 2015a. The Importance of Credit Registries. Doing Business Report. World Bank, Washington, DC. World Bank Group. 2015b. Principles for Effective Insolvency and Creditor/Debtor Regimes. World Bank, Washington, DC. World Bank Group. 2017. A Toolkit for Out-of-Court Workouts. World Bank, Washington, DC. World Bank Group. 2019. DARP—Creating Distressed Assets Markets: Lessons Learned since the Global Financial Crisis and Opportunities for Investors in Emerging Markets Today: Distressed Assets Recovery Program. Washington, DC: International Finance Corporation, World Bank. World Bank Group. 2020. Doing Business Report. World Bank, Washington, DC. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 51 3. >>> Addressing Insolvency Risk Through Corporate Debt Restructuring Frameworks I. Introduction Corporate debt restructuring tools are key for dealing with a significant debt overhang in firms. As emphasized in Chapter 1, nonfinancial corporate debt in EMDEs has been accumulating since the global financial crisis—from 56 percent of GDP in 2008 to 103.5 percent of GDP in 2020Q4. Chapter 1 also highlights how, when firms become overleveraged, they face financial stress and may be forced into inefficient decision-making. This debt overhang may lead them to forgo value-enhancing projects (Myers 1977) and engage in risk-shifting behavior (Jensen and Meckling 1976). In addition, overindebted businesses may be unable to obtain additional financing or to refinance existing credit facilities. Ultimately, such firms face a lower ability to service debt, face higher risks of default and insolvency, and could potentially become nonviable. Informal and formal CDR tools—as part of the larger insolvency toolkit—are key mechanisms to help address the debt burden and mitigate wasteful resource allocation typically associated with financial distress. Despite the importance of corporate debt restructuring, systematized evidence is scarce concerning the existence and features of CDR frameworks at a global level. The evidence in this chapter addresses this gap and demonstrates the need to implement these restructuring mechanisms. Specifically, the chapter shows that informal tools for restructuring are lacking in 67 percent of the economies studied, while more formal tools—both hybrid and formal—tend to be more prevalent. Moreover, this chapter describes the low uptake of special restructuring procedures—hybrid or formal—geared toward MSMEs (existing in 10 percent of the economies in the sample). In addition, it shows that separate-entry systems (i.e., insolvency systems with separate, parallel procedures for reorganization or liquidation) are associated with a mean creditor recovery rate that is 36 percent higher than that of single-entry systems (i.e., insolvency systems with a single, common entry point that may develop into either a reorganization or liquidation). Finally, where banks regularly use informal restructuring tools, economies tend to have higher levels of access to credit, and banks’ use of the tools is positively related to the existence of guidelines or a framework agreement for out-of-court workouts. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 52 The effectiveness of CDR frameworks is largely dependent (ii) a framework for secured lending and debt enforcement; (iii) on the broader enabling environment and the suitability a framework for informal corporate workouts; (iv) commercial of the selected tools and their effective implementation. insolvency laws; and (v) implementing institutions. These Practical experience from a number of countries around the elements all work in synergy with each other. Legal and globe, in both crisis and noncrisis contexts, provides critical regulatory frameworks providing for adequate credit reporting lessons learned in developing CDR frameworks. These include systems and the protection of secured lending help countries understanding that a robust restructuring culture, incentives reduce information asymmetries and help address legal (for both the creditor and debtor), and removal of regulatory uncertainties that increase risk to lenders and limit the impediments are critical for successful restructurings. Informal supply of finance to the corporate sector. At the same time, out-of-court tools might need to be enhanced by regulatory effective corporate workout and insolvency regimes deal with support, particularly in crisis situations, or complemented the insolvency risks of distressed debtors by saving viable with hybrid tools involving both out-of-court negotiation and a businesses, maximizing collective recovery for creditors, degree of court supervision. Effective implementation support and ensuring that nonviable businesses quickly exit the includes the need for a local champion, stakeholder access to market, allowing the deployment of assets to more productive robust information, and confidential treatment of negotiations uses. Supporting this legal and regulatory environment to avoid exacerbating a debtor’s distress. are transparent, independent, and predictable institutions, which are needed for effective implementation of the legal In addition to this introduction, this chapter contains frameworks and oversight of stakeholders. four main sections. Section II reviews the unique features and benefits of each tool and its place in resolving corporate Empirical evidence shows that effective CDR frameworks distress. Sections III and IV present a novel dataset created are associated with many economic benefits, including from a survey of insolvency professionals from 114 economies better access to credit, job preservation, and the promotion that provides descriptive and exploratory analysis to help better of entrepreneurship. These benefits help ameliorate the understand the tools available to address financial distress insolvency risks of distressed debtors by saving viable and debt overhang at a global level. Finally, Section V sets out businesses and maximizing collective recovery for creditors. some key lessons learned from putting these frameworks into Effective CDR environments prevent value destruction by practice; these lessons are offered with the goal of enhancing averting unnecessary liquidations and asset fire sales. This, reform effectiveness and assisting policy makers in preserving in turn, reduces the failure rates for businesses and preserves viable firms in their economies. jobs while at the same time improving creditor recovery. Empirical studies show that insolvency regimes that include effective judicial reorganization and out-of-court restructuring II. The Purpose of processes are associated with lower cost of credit, increased CDR Frameworks availability of credit, improved creditor recovery, job preservation through reorganization and business rescue, promotion of entrepreneurship, and other economic benefits A. Benefits of Effective CDR Frameworks (Menezes 2014). For example, the 2005 bankruptcy law CDR frameworks can take many different forms. Generally, reform in Brazil aimed at striking a greater balance between the restructuring of an enterprise means a financial restruc- reorganization and liquidation and introduced a new out-of- turing (adjusting the liabilities of the enterprise in a fundamental court reorganization system for prepackaged restructuring way, also referred to as a debt restructuring or balance sheet plans (Araujo, Ferreira, and Funchal 2012). After the reform, restructuring) and/or an operational restructuring (a significant a statistically significant increase in the Brazilian private credit adjustment to the assets or operations of the enterprise, also market was noted, with a 10 to 17 percent increase in total debt referred to as a turnaround). Corporate debt restructuring can and a 23 to 74 percent increase in long-term lending (Araujo, refer to either the procedure or its outcome. For the purposes Ferreira, and Funchal 2012). Another study quantified the of this chapter, it is interpreted broadly to include all of these benefits and costs of corporate debt restructuring by looking at aspects. the example of the Republic of Korea (Chung and Ratnovski 2016). It concluded that corporate debt restructurings “pay off” with faster GDP growth due to increased corporate investment CDR frameworks are an integral part of the overarching and the creation of more jobs (Chung and Ratnovski 2016). insolvency and creditor/debtor regulatory systems. On the other hand, higher barriers to restructuring have been Inclusive insolvency and creditor/debtor rights systems found to be associated with “zombie congestion” in high comprise the following elements: (i) a credit information system; EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 53 turnover industries, and with a misallocation of capital and strategy (Menezes and Gropper 2021; Menezes et al. 2021). lower productivity (McGowan, Andrews, and Millot 2017; see An analysis of NPL data from the European Union (EU) member also Andrews and Petroulakis 2019). states for the period 2007–2012 shows that well-designed pre- insolvency restructuring tools helped stabilize NPL levels in A functional CDR framework is important for financial the aftermath of economic shocks (Menezes et al. 2021, citing sector stability. As part of the larger insolvency and creditor/ Carcea et al. 2015). By reducing the risks of debt overhang debtor rights framework (World Bank 2021), CDR tools can in the nonfinancial corporate sector, maximizing the value help mitigate the rise in NPLs and resolve existing NPLs, of recoveries by creditors, and helping avoid unnecessary thereby strengthening overall financial sector stability and liquidations of viable firms, CDR frameworks play an important limiting credit misallocation (Menezes et al. 2021). As was role in lessening the impact of economic shocks and are learned from the global financial crisis, and as described in necessary for a well-performing financial sector and financial Chapter 1, they are integral to any effective NPL resolution stability (Leroy and Grandolini 2016). > > > B OX 3 .1 The World Bank Principles for Effective Insolvency and Creditor/ Debtor Regimes (ICR Principles) The World Bank ICR Principles, together with the recommendations from the UNCITRAL Legislative Guide on Insolvency, represent the international consensus on best practices for evaluating and strengthening national insolvency and creditor rights regimes. Following the Asian Financial Crisis in the late 1990s, the Financial Stability Board mandated that the World Bank Group and the United Nations Commission on International Trade Law (UNCITRAL) identify and develop internationally recognized best practices for assessing effective insolvency and creditor rights systems. In response, in 1999, the World Bank Group organized the Insolvency & Creditor/Debtor Regimes Task Force (ICR Task Force), which informs the World Bank Group’s role as a joint standard-setter. The ICR Principles were first published in 2001. These principles have been periodically revised and updated to reflect evolving best practices and new or emerging areas of insolvency of concern to the World Bank Group’s member nations. The principles, together with the recommendations from the UNCITRAL Legislative Guide on Insolvency,73 are now internationally recognized benchmarks for insolvency and creditor/debtor regimes.74 Both the principles and the Legislative Guide recognize the importance of CDR frameworks within the insolvency and creditor/debtor rights systems. As stated in the World Bank Principles, “The rescue of business preserves jobs, provides creditors with a greater return based on higher going concern values of the enterprise, potentially produces a return for owners, and obtains for the country the fruits of the rehabilitated enterprise” (World Bank 2021). The World Bank Principles and the Legislative Guide establish best-practice benchmarks to help countries design modern business rescue procedures, including formal (judicial reorganization) and informal (workouts).75 73. The UNCITRAL Legislative Guide on Insolvency is available at https://uncitral.un.org/en/texts/insolvency/legislativeguides/insolvency_law. 74. Financial Stability Board, https://www.fsb.org/2011/01/cos_051201/. 75. See World Bank Principles for Effective Insolvency and Creditor/Debtor Regimes, Part B, “Risk Management and Corporate Workouts, Principles B3 to B5” and Part C, “Legal Framework for Insolvency”; and UNCITRAL Legislative Guide on Insolvency, Part One, Chapter II.B, “Voluntary Restructuring Negotiations,” and Part Two, “Core Provisions for an Effective and Efficient Insolvency Law.” EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 54 B. Different CDR Frameworks Address 1. Out-of-Court Workouts and Different Levels of Corporate Distress Enhanced Workouts There is a wide range of CDR processes that differ in A new, out-of-court workout and voluntary approach to design and degree of formality. Country experience shows CDR (known as “the London Approach”) was developed that there is no “one-size-fits-all” approach when it comes to by the Bank of England during the recession of the 1970s. CDR. Well-developed CDR frameworks offer a “toolbox” of Before the adoption of the administration procedure in the procedures that can be used to address differing needs of United Kingdom, a new CDR tool emerged outside the formal business debtors, including for different levels of corporate insolvency system. A voluntary, collective approach to CDR financial distress for either noninsolvent or insolvent debtors. was developed by the Bank of England during the recession Accordingly, as shown in Table 3.1, CDR processes cover a of the 1970s to “help [the] financial community preserve value” spectrum of procedures. They vary in levels of formality from (Kent 1993). The London Approach, adopted in the London informal, out-of-court workouts, to enhanced workouts with corporate banking market (Kent 1993), has served as a model the involvement of an administrative authority, to hybrid and of informal banking-sector coordinated workouts in other preventative hybrid workouts with some court involvement, to jurisdictions. The London Approach, as described in the 2022 formal traditional reorganization procedures.76 World Bank Toolkit for Corporate Workouts, comprises a set of nonbinding general principles and guidelines on how banks The various approaches to CDR should be understood in and other creditors should collectively respond to news that the context of countries’ specific legal, institutional, and a company to which they are exposed faces serious financial commercial environments at the time of their adoption. problems. Noteworthy changes to corporate legal regimes have taken place worldwide over the past several decades. Below is a brief overview of the different CDR frameworks as they have emerged and matured in several jurisdictions. > > > TA B L E 3 .1 Spectrum of Insolvency and Corporate Debt Restructuring Processes CDR processes Level of formality Workouts Formal insolvency procedures Out-of-court Enhanced workout Hybrid workout Preventative hybrid Judicial Liquidation workouts (OCW) A workout with A procedure that workout reorganization A court-supervised A privately negotiated the involvement of involves private Hybrid procedure A court-supervised process by which restructuring an administrative negotiation of aimed at restructuring process assets are sold between the debtor authority but with no a restructuring restructuring, aimed at restoring and disposed of and all or some of its provision for a court agreement and while under court the financial well- for distribution creditors to play a role provides for a protection, of a being and viability of to creditors, in court role short of debtor’s business a debtor’s business accordance with a supervision of the full that is in financial ranking of claims procedure distress but not yet established by law in a technical state of insolvency E.g., the London E.g., Republic of E.g., US Chapter E.g., Germany’s pre- E.g., France’s judicial E.g., UK liquidation; Approach; INSOL Korea’s Corporate 11 prepackaged insolvency scheme reorganization; Republic of Principles Restructuring bankruptcies; French (“StaRUG”); French US Chapter 11 Korea’s bankruptcy Agreement; conciliation safeguard procedure reorganization; UK proceeding Thailand’s CDRAC; administration Istanbul Approach Level of distress: financial difficulty or imminent insolvency Level of distress: Level of distress: imminent or actual actual insolvency insolvency Source: World Bank Insolvency & Debt Resolution Team. 76. The World Bank’s (2022) A Toolkit for Corporate Workouts includes a detailed description of different forms of restructuring procedures and their benefits and addresses practical considerations relevant to workouts. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 55 Variations of the London Approach were implemented guidance of the 2014 Recommendation by the European in countries affected by the Asian Financial Crisis of Commission80 and the 2019 Restructuring and Second 1997 and the global financial crisis of 2007–2008. During Chance Directive.81 The procedures prescribed by the this period, a new generation of informal CDR frameworks directive can be considered “formal procedures aimed at emerged, adapting the London Approach. Where necessary, restructuring viable enterprises that are not in a technical state they were often enhanced with intercreditor agreements, of insolvency, with a stay on creditor action from initiation of the including binding elements, such as a mechanism under which procedure (if requested by the debtor, and subject to limitations) agreements reached among a majority of financial institutions but a limited role for the court” (Menezes et al. 2022). could be imposed on dissenting financial institutions and the use of formal arbitration to resolve disputes, as well as 3. Formal Reorganization penalties for failure to meet deadlines. Some of the examples Corporate reorganization procedures have their roots include the Republic of Korea’s Financial Institutions’ in the nineteenth-century United States, when the first Agreement for Promotion of Company Restructuring of 1998; major restructurings of railroads engaged in interstate Thailand’s CDRAC Framework of 1999; and Turkey’s “Istanbul commerce were attempted. (For more information, see, for Approach” in the early 2000s (see Table 3.1). example, Lubben 2004 or Craven and Fuller 1936.) Equity receiverships that involved adjustments to railroad companies’ 2. Hybrid and Preventative Hybrid Workouts financial structures were commonplace at that time, although Hybrid and preventative hybrid workouts effectively their effectiveness was questionable (Lubben 2004). In 1933, complement informal workouts and formal insolvency during the Great Depression, the value of business rescue procedures. Prepackaged, prearranged, and preventive procedures was formally recognized by incorporating more restructuring procedures all fall within the spectrum of orderly, court-supervised business restructuring procedures workouts, although with variable levels of formality (see Table into the US Bankruptcy Act of 1898.82 Business rehabilitation 3.1). Compared to formal restructuring procedures, less formal became the key feature of US bankruptcy legislation and laid or hybrid workouts are often characterized by less stringent the groundwork for the Chapter 11 reorganization procedures access requirements (no need to meet the insolvency test) as we know them today. and minimal or reduced procedural formalities, including limited reliance on court systems or administrative authorities. In the United Kingdom, a significant transformation The UNCITRAL Legislative Guide describes informal and toward rehabilitative procedures took place in the 1980s. hybrid workouts as a “means of introducing flexibility into In 1982, a review committee on insolvency law and practice an insolvency regime” that reduce the burden on courts, published a report referred to as the “Cork Report” (Finch encourage early action by debtors and creditors, and 2009). The report proposed groundbreaking reforms to the UK reduce the stigma associated with the publicity of the formal insolvency regulation, including the introduction of business procedures.77 Since the adoption of the US prepackaged reorganization procedures and the concept of an administrator and prearranged bankruptcy procedures (in the context of with the role of managing companies’ affairs during the initial the Chapter 11 reorganization procedure), the rise of hybrid grace period (Finch 2009). The recommendations of the Cork restructuring procedures78 globally has erased the dividing Report were transposed into UK legislation four years later line between the judicial (formal) reorganizations and out- with the passage of the Insolvency Act of 1986 (Finch 2009). of-court restructurings. Variations of hybrid processes have Unlike the US Chapter 11 reorganization procedure, in which been adopted in Colombia, France, the Netherlands, Peru, a corporate debtor usually retains control over the operations Singapore, the United Kingdom, and other countries.79 of its business (the “debtor-in-possession”), in the United Kingdom, a licensed insolvency practitioner usually takes over Recently, the European Union placed the focus on the management of the debtor company’s business. preventive restructuring procedures following the 77. The UNCITRAL Legislative Guide on Insolvency is available at https://uncitral.un.org/en/texts/insolvency/legislativeguides/insolvency_law; see pages 21–22. 78. As defined in Table 3.1, “hybrid” broadly refers to any CDR procedure that involves private negotiation of a restructuring agreement and provides for a court role short of supervision of the full procedure. 79. For more detailed descriptions of these examples, see Menezes et al. 2022. 80. European Commission, “Commission Recommendation of 12.3.2014 on a New Approach to Business Failure and Insolvency,” (EU) 2004/1500; available at http://ec.europa.eu/justice/civil/files/c_2014_1500_en.pdf. 81. Directive (EU) 2019/1023 of June 20, 2019, on preventive restructuring frameworks, discharge of debt and disqualifications, and measures to increase the efficiency of procedures concerning restructuring, insolvency, and discharge of debt, and amending Directive (EU) 2017/1132; available at https://eur-lex.europa.eu/legal-content/EN/ TXT/?uri=celex:32019L1023. In addition, Article 3(1) of the directive requires member states to “ensure that debtors have access to one or more clear and transparent early warning tools which can detect circumstances that could give rise to a likelihood of insolvency and can signal to them the need to act without delay.” 82. US Bankruptcy Act, section 77, 47 Stat. 1474 (1933), as amended, 11 U. S. C. section 205. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 56 > > > BOX 3.2 CDR Frameworks for Micro and Small Enterprises (MSEs) Financially distressed MSEs face specific challenges in accessing formal and informal restructuring procedures. In many parts of the world, easy-to-access, flexible, fast restructuring procedures are unavailable to MSEs, whereas formal reorganization procedures are prohibitive due to their complexity and cost (see, e.g., McGowan and Andrews 2018). MSEs, the majority of which are sole proprietorships and single-employee businesses, face many other specific challenges that hinder their restructuring prospects. These include the inability to detect financial distress at an early stage, social stigma, information gaps due to the informality of MSEs, and lack of access to post-filing and post-commencement financing (Martinez and Uttamchandani 2017). Specific restructuring procedures are needed to deal with MSE financial distress. Recognizing the magnitude of the challenges faced by MSEs, in 2021, the World Bank Principles were updated to include specific principles for the insolvency of micro- and small-sized enterprises, in addition to the principles aimed at both small businesses and large corporate debtors.83 Principle C18 (Key Objectives and Policies) states that effective insolvency systems for micro- and small-sized enterprises should aim to lower the barriers to access and encourage early use of out-of-court restructuring procedures, hybrid procedures, and in-court simplified insolvency proceedings (World Bank 2021, Principle C18). Principles B4.1 (Informal Workout Procedures) and D5.4 (MSEs Simplified Proceedings) further promote the use of mediation, conciliation, and other alternative dispute resolution techniques when dealing with MSEs’ financial distress or insolvency (World Bank 2021, Principles B4.1 and D5.4). In practice, the use of alternative dispute resolution tools to support negotiations between debtors and creditors has been growing.84 The EU Directive on Insolvency and Second Chance also promotes adoption at the national level of small-business-specific, low-cost, and low-complexity debt restructuring procedures and early warning tools to enable debtors to act early.85 83. In World Bank Principles for Effective Insolvency and Creditor/Debtor Regimes (2021), see especially, Principle C18 (Key Objectives and Policies); Principle C19 (Simplified Insolvency Proceedings); Principle C20 (Discharge); Principle D1.6 (Small and Micro Enterprises Insolvency Proceedings); and Principle D5.4 (Simplified Proceedings). 84. For more information on the use of alternative dispute resolution in pre-insolvency and insolvency situations, see Pavlova and Shah 2017. 85. European Commission (2019), EU Directive on Preventive Restructuring Frameworks and Second Chance; available at https://eur-lex.europa.eu/legal-content/EN/ TXT/?uri=CELEX:32019L1023. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 57 III. An Empirical Description of The World Bank worked with INSOL International87 and the International Association of Insolvency Regulators Legal Frameworks for CDR (IAIR)88 to distribute the survey to experienced insolvency professionals around the world, who were asked to provide answers for their countries. Contributors from 135 A survey was designed to better understand the economies were contacted,89 with at least three independent availability and characteristics of CDR frameworks contributors contacted in a hundred jurisdictions. Responses globally. As discussed above, CDR frameworks are important were obtained from 114 economies,90 including multiple to a well-functioning economy, especially during times of crisis, responses in 71 percent of those economies (see Figure 3.1).91 such as the current pandemic. Yet, CDR systems vary widely When multiple responses were provided for a single jurisdiction from country to country (and sometimes within a country). To and discrepancies were found, direct communication clarified further understand the tools available to firms in distress in the matters of contention. The analysis that follows is based different jurisdictions, as well as their main features, a survey on the answers provided in the survey.92 of CDR tools was designed, primarily examining what is provided in a jurisdiction’s laws and regulations. The survey was conducted during March and April 2021 and focused on the following three types of restructuring mechanism: (i) out- of-court workouts, including enhanced ones; (ii) restructuring procedural tools for noninsolvent debtors, such as the hybrid tools described above; and (iii) formal reorganizations.86 > > > F I G U R E 3 .1 Jurisdictions Covered by the Survey (in yellow) Source: World Bank-INSOL-IAIR CDR Survey. 86. See the annex below for definitions of the terms as used in the survey. 87. INSOL International is a worldwide federation of national associations of accountants and lawyers who specialize in turnaround and insolvency, with over 10,500 members around the world. For more information, see https://www.insol.org/. 88. The International Association of Insolvency Regulators (IAIR) is an international body of government insolvency regulators from jurisdictions around the world. For more information, see https://www.insolvencyreg.org/. 89. The experienced insolvency professionals were identified through their membership in INSOL International or IAIR or through their prior experience collaborating in insolvency-related World Bank Group projects. 90. For a full list of the jurisdictions from which contributions were received, see Annex 3A. 91. In all but one jurisdiction, a private sector insolvency professional submitted a response. 92. The authors have not independently verified the contributors’ answers. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 58 While the survey’s coverage is wide in terms of GDP limited or no judicial involvement between a debtor and and population, more responses tended to come from creditors, with the aim of easing the debtor’s debt burden economies with more robust insolvency systems. The so that it can maintain its operations. The existence of an CDR mechanisms described below are from economies that out-of-court workout framework agreement,96 indicative of represent over 84 percent of global GDP and 86 percent of enhanced workouts and/or out-of-court workout guidelines the global population.93 In terms of existing evaluations of the such as the London Approach, is reported in only 33 percent insolvency systems of these jurisdictions, the sample in this of the economies in our sample (see Figure 3.2). Of those study includes 87 percent of the economies with an outcome jurisdictions, 77 percent report having banks that participate of “going concern”—that is, not liquidated piecemeal—in the regularly in out-of-court workouts. Banks are reported to resolving insolvency indicator of the Doing Business Report also regularly participate in out-of-court workouts in a few 2020.94 The average recovery rate of the economies included jurisdictions (see Figure 3.3).97 In these cases, sophisticated in this study (46.4 cents on a dollar) is close to twice that of banking sectors with “repeat players” (e.g., in Canada or the the economies that were left out (24.7 cents on a dollar).95 United States) or experience from previous crises (e.g., in These facts suggest that economies from which reports were Argentina or Iceland) may suffice to develop an informal out- not returned may have weaker CDR mechanisms in place. of-court workout practice. Tax authorities also often participate as company creditors in many countries. While their role A. Out-of-Court Workouts and can be important to restructuring efforts, tax authorities are Enhanced CDR Frameworks reported to regularly participate in out-of-court workouts in only 12 percent of the economies in this study’s sample, a The survey shows that out-of-court workouts remain result most likely affected by government preferences and relatively uncommon. For the purposes of this study, out- legal or regulatory restrictions.98 of-court workouts were defined as private agreements with > > > > > > F I G U R E 3 . 2 Out-of-Court Workout Framework F I G U R E 3 . 3 Economies Where Banks Reportedly Agreements and Guidelines Around the World Participate Regularly in Out-of-Court Workouts 80% 17% 29% No OCW OCW framework or framework guidelines agreements 60% 40% 20% 17% 37% OCW OCW framework guidelines 0% agreements & Frame & guide Framework Guidelines Nothing guidelines Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. 93. The sample contains information on 21 percent of low-income economies, 44 percent of lower-middle-income economies, 52 percent of upper-middle-income economies, and 83 percent of high-income economies. 94. See https://www.doingbusiness.org/en/doingbusiness. 95. These figures also come from the Doing Business Report 2020. 96. By an OCW framework agreement, we mean an agreement between participating creditors seeking to establish the terms governing collective out-of-court restructurings with a set of debtors. 97. Of the economies where no out-of-court workout framework agreement or guidelines exists, only 33 percent report regular bank participation in multi-creditor out-of-court workouts. 98. Contributors’ responses show that in only a quarter of the jurisdictions in our sample does the legal and/or regulatory framework allow tax authorities to participate in out-of-court workouts where a haircut of the principal owed to them is permitted. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 59 > > > F I G U R E 3 . 4 Out-of-Court Workout Framework Agreements and Guidelines by Region 100% 80% 60% 40% 20% 0% Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing Frame & guide Framework Guidelines Nothing E AST AS I A E U ROP E & HIGH L AT I N M I D D L E E AST SOU TH SUB- & PACI FI C CENTRAL I NCOM E : A M E R ICA & NORT H AS I A SAHARAN AS I A OECD & A FR ICA A FR ICA CA R I BBE A N Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. Out-of-court workout framework agreements and out- workout. While out-of-court workouts are often focused of-court workout guidelines are distributed across all on large debtors, only 4 percent of out-of-court workout regions (Figure 3.4). Out-of-court workout guidelines tend framework agreements reported on appear to preclude the to be relatively more prominent in the East Asia and Pacific participation of small- and medium-sized enterprise debtors. region, perhaps given their development during the Asian Nonbank creditors, in turn, were precluded from participating Financial Crisis, while they tend to appear together with out- in 17 percent of the jurisdictions in this study. of-court workout framework agreements in the Middle East and North Africa and South Asia regions (though the sample The most commonly reported feature of out-of-court size is relatively small for the latter regions).99 Latin America workout framework agreements (Figure 3.5) is the and the Caribbean appears to be the region where out-of-court possibility to bind dissenting creditors (83 percent of the workout infrastructure is least common, as over 80 percent economies in this study). Other common features of the out- of the economies in this study’s sample are reported to lack of-court workout framework agreement are the availability of a guidelines or framework agreements. mandatory standstill (63 percent) and the support provided by a government office, such as the central bank or the Ministry Out-of-court workout framework agreements provide of Finance (58 percent). The feature reported to be included potential participants with further certainty of what to in the fewest cases was the appointment of a lead creditor expect if they engage in a multi-party workout. As such, (35 percent). These figures suggest that there is justified it is not uncommon for banks in developing countries to see emphasis on providing tools to address potential holdout these types of frameworks as a necessary condition before problems, though the tools to facilitate obtaining out-of-court they can evaluate participating in any specific multi-creditor workout agreements differ importantly. 99. The sample size of economies in South Asia is four, while in the Middle East and North Africa it is seven. The next lowest sample size is from East Asia and Pacific, with 10 economies. The sample in the rest of the regions consists of at least 18 economies. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 60 > > > F I G U R E 3 . 5 Relative Frequency of Features in Out-of-Court Workout Framework Agreements Binding nature 83% Standstill 63% Agency support 58% Confidentiality 50% Information sharing 46% Dispute resolution 42% Lead creditor 35% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. Informal means of restructuring often run into difficult B. Hybrid and Preventative hurdles. Even where out-of-court workout framework Hybrid Procedures Addressing agreements are in place, breakdowns in negotiations can Noninsolvent Debtors occur for a myriad of reasons. Empirical evidence suggests To analyze the CDR options accessible to noninsolvent that the probability of completing out-of-court workouts can be debtors, contributors were asked about two mechanisms: lower when the proportions of intangible assets and secured prepackaged restructurings and preventive restructurings debt are smaller.100 Further, out-of-court workouts tend to (otherwise known as hybrid and preventative hybrid be less prevalent when debtors have more distinct classes workouts). As these tools differ from jurisdiction to jurisdiction, of debt outstanding and a smaller proportion of bank debt the former was defined as a procedure that allows for court relative to long-term debt.101 In these situations, other means ratification of a plan agreed on by a debtor and its creditors of restructuring, either hybrid or even fully formal ones, can prior to the initiation of formal proceedings.103 The latter was be helpful. The next subsection deals with hybrid restructuring defined as a type of pre-insolvency procedure that affords a procedures available for noninsolvent corporate debtors.102 debtor with protection while negotiating with its creditors on an agreeable path forward to avoid insolvency. Taken together, procedures for noninsolvent corporate debtors are more prevalent than out-of-court workout framework agreements or guidelines. Indeed, 65 percent of the jurisdictions in this study’s sample are reported to have at least one of these procedures, with about 15 percent having both in their insolvency regimes (Figure 3.6).104 100. See Gilson, Kose, and Lang (1990) and Asquith, Gertner, and Scharfstein (1994). This evidence is consistent with greater value depreciation in firms having more intangible assets. 101. Gilson, Kose, and Lang (1990); Asquith, Gertner, and Scharfstein (1994). In those situations, conflicts of interest among creditors would tend to be less manageable, and the main creditors (banks) would have less and worse information. Potential holdout problems would also tend to be larger. 102. For the purposes of this study, insolvency refers to a situation in which a debtor is generally unable to pay its debts as they mature and/or where its liabilities exceed the value of its assets. See also World Bank 2021. 103. Prepacks were developed as a way to bind dissenting creditors that could not be bound out of court. 104. Specifically, contributors were asked if there was a special provision, section, or title in the bankruptcy legislation containing any of these procedures. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 61 > > > F I G U R E 3 . 6 Procedures for Noninsolvent Corporate Debtors 40% 30% 20% 10% 0% Prepack & preventive Prepack Preventive No system Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. CDR mechanisms must address the specific needs arising from the underlying business and financial environment. While in many countries cash flow-based finance can be an option, asset-based finance is the prevalent form of financing available in most countries. Even when cash flow finance is available, different forms of security are often used to facilitate operational and financial transactions. Given the ubiquity of collateral-based financing, contributors were asked if secured creditors are allowed to vote in the procedures for noninsolvent debtors without previously renouncing their collateral.105 Focusing on the economies that have these procedures, Figure 3.7 shows, by region, a high rate of positive responses to this question in both prepackaged (86 percent) and preventive restructuring procedures (77 percent). > > > F I G U R E 3 . 7 Secured Creditor Participation in Prepacks (in yellow) and Preventive Restructurings (in blue) Across Regions 100% 75% 50% 25% 0% No Yes No Yes No Yes No Yes No Yes No Yes No Yes E AST AS I A E U ROP E & HIGH L AT I N M I D D L E E AST SOU TH SUB- & PACI FI C CENTRAL I NCOM E : A M E R ICA & NORT H AS I A SAHARAN AS I A OECD & A FR ICA A FR ICA CA R I BBE A N Prepacks Preventive restructurings Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. Note: Economies without a prepack or preventive restructuring procedure appear as Not Applicable. 105. Such an option may allow for flexibility in reaching different types of agreements with a firm’s creditors, and it may pave the way for finding workable solutions to financial distress problems. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 62 While room is often made to incorporate secured In terms of the frequency of the feature, prepacks and creditors within these hybrid procedures, the availability preventive restructuring show similarities (Figure 3.9). of special procedures for noninsolvent MSME debtors The most common feature included in prepackaged and appears to be a bit of a rarity. Indeed, only in 11 percent preventive restructuring procedures is reported to be of cases do contributors report the availability of a separate allowing the debtor to remain in control of the business (i.e., section containing an MSME prepackaged procedure. In debtor-in-possession) while undergoing the proceeding turn, a separate section containing an MSME preventive (89 and 79 percent, respectively). Requiring a minimum restructuring procedure is reported in only 2 percent of the payoff to unsecured creditors as a requirement for a plan to economies in this study’s sample. be approved/ratified was the least reported feature (14 and 10 percent, respectively). The low frequency of this feature For those jurisdictions where CDR procedures for implicitly raises flexibility in the agreements to be reached.108 noninsolvent debtors exist, entry into the system can be a contested matter. Contributors report that in about three- quarters of the economies where prepackaged or preventive restructuring procedures are in place, a filing by a debtor triggers a procedure to verify that substantive commencement standards—not merely formal requirements—have been met (see Figure 3.8).106 These preliminary procedures implicitly raise the barriers to entry.107 > > > F I G U R E 3 . 8 Substantive Review to Initiate Prepacks (in yellow) and Preventive Restructuring (in blue) Procedures by Region 100% 75% 50% 25% 0% No Yes No Yes No Yes No Yes No Yes No Yes No Yes E AST AS I A E U ROP E & HIGH L AT I N M I D D L E E AST SOU TH SUB- & PACI FI C CENTRAL I NCOM E : A M E R ICA & NORT H AS I A SAHARAN AS I A OECD & A FR ICA A FR ICA CA R I BBE A N Prepacks Preventive restructurings Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. Note: Economies without a prepack or preventive restructuring procedure appear as Not Applicable. 106. Formal commencement requirements refer to the set of affidavits and other documents required to initiate a case, for instance, a balance sheet and other financial statements of the debtor or a list of known creditors. Substantive commencement standards refer to the legal tests that must be met for a debtor to be eligible for a given procedure, for instance, that the debtor is not insolvent. 107. The figures are 83 percent in the case of prepacks and 72 percent in the case of preventive restructurings. 108. The other features included in the graph are first-day orders (defined as court orders requested immediately after filing to facilitate the management of the case as well as the operations of the debtor), a standstill of actions and executions against the debtor on a prepack or preventive restructuring filing, and cross-class cramdown (the imposition of a restructuring plan on dissenting creditors despite the dissent of a class of creditors). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 63 > > > F I G U R E 3 . 9 Features in Prepacks and Preventive Restructuring Procedures 100% 89% 79% 80% 60% 55% 50% 45% 40% 41% 39% 40% 20% 14% 10% 0% First-day order Debtor-in-possession Standstill Cross-class cramdown Minimum payoff Prepacks Preventive restructurings Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 64 C. Formal Reorganization Mechanisms Jurisdictions also differ in terms of procedural specialization in formal reorganization. Separate procedures geared toward The central role formal reorganization procedures play has the formal reorganization of MSME debtors, in turn, are led most jurisdictions in each region to incorporate them available in only 10 percent of the economies in this study’s in their insolvency systems (Figure 3.10). Nevertheless, sample. While the survey did not enquire into the quality of contributors report that 11 percent of the jurisdictions in this such MSME reorganization procedures—that is, whether they study’s sample lack formal reorganization procedures.109 Some are compliant with international standards—it highlights the of the economies lacking formal reorganization procedures ample opportunity for reform in this area, especially for those are at an early stage in the development of their insolvency economies lacking specialized procedures.111 systems. Others have various reasons for the absence of such procedures. Greece, for instance, recently repealed its formal Variation in procedural features is also common reorganization procedure in favor of a procedure referred to as in formal reorganization. To complement information a prepack rehabilitation.110 already available from other sources,112 contributors were asked about management and plan approval features in Formal reorganization procedures vary significantly from formal reorganization (Figure 3.11). The results show a jurisdiction to jurisdiction, with one important difference similar pattern to that observed for procedures addressing arising in terms of structure. So-called unitary systems noninsolvent debtors. Indeed, debtor-in-possession is the provide a unique initiation mechanism to a procedure that most common feature in formal reorganization procedures, later may become a reorganization or a liquidation. Separate- though it is less prominent (66 percent). Requiring a minimum entry systems, in turn, provide for separate reorganization payoff to unsecured creditors as a requirement for a plan to be and liquidation procedures. In this study’s sample, 72 percent approved/ratified was the least reported feature (18 percent), of the jurisdictions are said to have separate-entry systems. allowing for flexibility in the agreements to be reached. > > > F I G U R E 3 . 1 0 Availability of Formal Reorganization Procedures 40 30 20 Frequency 10 0 No Yes No Yes No Yes No Yes No Yes No Yes No Yes E AST AS I A E U ROP E & HIGH L AT I N M I D D L E E AST SOU TH SUB- & PACI FI C CENTRAL I NCOM E : A M E R ICA & NORT H AS I A SAHARAN AS I A OECD & A FR ICA A FR ICA CA R I BBE A N No Yes Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. 109. For the purposes of this report, “reorganization” refers to a process through which the financial well-being and viability of a debtor’s business may be restored so that the business can continue to operate, through means that may include debt forgiveness, debt rescheduling, debt-equity conversions, and sale of the business (or parts of it) as a going concern. 110. See Greek Law 4738/2020. 111. Particularly for micro- and small-sized enterprise insolvency, see World Bank 2021, Principles C18 to C20. 112. For instance, the Doing Business Strength of Insolvency Framework reports on the availability of several formal insolvency features for a large sample of economies. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 65 > > > F I G U R E 3 . 1 1 Features in Formal Reorganization Procedures 80% 66% 60% 53% 40% 32% 18% 20% 0% First-day order Debtor-in-possession Cross-class cramdown Minimum payoff Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. IV. Survey Data and the Role of How creditors fare in an insolvency proceeding is a key indicator of the system’s performance and its ability to CDR Frameworks facilitate CDR. The broadest measure of creditors’ recovery rates in different countries comes from Doing Business. It assesses how secured creditors fare after a debtor becomes Insolvency systems face the challenge of taking insolvent.115 Specifically, it measures creditors’ ability to into account diverse stakeholders’ interests within a recoup their claims through the use of the local legal system— procedure and providing efficient outcomes. Robust by foreclosure, formal reorganization, or liquidation. We used systems protect debtors’ and creditors’ rights and facilitate this measure to explore recovery rates under single- and an efficient resolution of financial distress. As mentioned separate-entry insolvency procedures. Bivariate analysis above, evidence suggests that robust insolvency systems are suggests that separate entry procedures are associated with associated with increased recovery rates, increased access higher recovery rates (50.6 cents versus 37.1 cents on a dollar, to credit, higher levels of entrepreneurship, and improved on average). While this difference is noteworthy, Figure 3.12 resolution of NPLs.113 Yet in cross-country analysis, the CDR shows important variations in recovery rate distributions by evidence has been largely restricted to the very useful yet type of procedure, with separate-entry distribution appearing limited insolvency measures provided by Doing Business.114 to be bimodal. Future multivariate analysis may provide insight In this section, the additional procedures and features covered on this issue. by the newly constructed dataset are used to further explore some of these relationships. 113. See, among others, Menezes 2014 and Menezes and Muro 2020. 114. Doing Business provides the most comprehensive information at a global scale and has been repeatedly used in comparative insolvency empirical studies (Consolo, Malfa, and Pierluigi 2018; McGowan and Andrews 2018; Fu, Wennberg, and Falkenhall 2020; among others). While it has proven fruitful, this data—by design—is limited to insolvent debtors and asks about the procedures most likely to be used in such situations, as well as about some of the features of the formal insolvency system. As such, important elements relevant to assessing the breadth and robustness of a CDR framework—such as the existence of informal or hybrid restructuring tools—are outside its scope. 115. See https://www.doingbusiness.org/en/methodology/resolving-insolvency. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 66 > > > F I G U R E 3 . 1 2 Recovery Rate by Type of Reorganization Entry System Separate-entry Single-entry 10 Frequency 5 0 0 50 100 0 50 100 Recovery rate (cents on the dollar) Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. To further explore the relationship between the recovery Access to credit suffers when insolvency and creditor rate and the strength of the reorganization system, a new rights are weak. Credit constraints can lead to borrower variable—strength of formal reorganization—was created. discouragement and, in turn, to large negative effects on This new variable was constructed by combining insolvency investment, employment, and asset growth. (See Ferrando framework answers from Doing Business116 and reorganization and Mulier 2015; García-Posada Gómez 2019 (though it finds answers from the survey. Specifically, the strength of formal no effect of credit constraint on employment); and Kuntchev reorganization variable incorporated responses to the survey et al. 2013.) Robust CDR mechanisms, as a subcomponent questions on procedural barriers to entry, management of the of insolvency and creditors’ rights, can ease access to credit case, and reorganization plan requirements and approvals.117 by improving creditors’ prospects in bad scenarios (Armour et The new variable was then normalized to take values between al. 2015). 0 and 1, with 0 representing the weakest reorganization system and 1 the strongest. Figure 3.13 shows a positive association of Regular bank use of out-of-court workouts is strongly this novel measure with recovery rate (as measured by Doing related to higher levels of access to credit. To further Business Report 2020)—despite high dispersion—a relationship explore the relationship between CDR and access to credit, that is statistically significant at the 0.1 percent level.118 The this section examines the link between banks’ regular results under this expanded measure of good international participation in out-of-court workouts and the share of domestic practices provide further evidence of the positive relationship credit to the private sector (as a percentage of GDP).119 Figure between robust insolvency frameworks and efficient creditor 3.14 shows that the share of domestic credit to the private outcomes. Moreover, they emphasize the ability of robust sector in economies where banks are reported to participate CDR frameworks to mitigate some of the negative effects of a regularly in out-of-court workouts is substantially larger debt overhang by attenuating creditors’ losses. (median of 72 percent) than in the economies where banks do not (median of 46 percent). This difference is statistically significant at the 1 percent level. 116. Specifically, the score on the strength of insolvency framework from the Doing Business Resolving Insolvency Index was added to the value of the questions on automatic stay and priority in insolvency (taking value 1 if yes and 0 if no) from the Doing Business Getting Credit Index. 117. That is, two questions were added on first-day orders and cross-class cramdown from our survey (taking value 1 if yes and 0 if no), and two questions were added on substantive commencement review after a debtor files for reorganization and on whether there is a minimum amount that needs to be offered to unsecured creditors for a plan to be approved/ratified by the court (taking value 0 if yes and 1 if no). 118. The variables show a moderate correlation: 0.39. 119. This information was obtained from https://data.worldbank.org. For this exercise specifically, we used data from 2019. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 67 > > > F I G U R E 3 . 1 3 Strength of Formal Reorganization and Recovery Rates 75 Recovery rate (cents on a dollar) 50 25 0 0.2 0.4 0.6 0.8 Strength of formal reorganization East Asia High income: Middle East & Sub-Saharan Europe & Latin America South & Pacific OECD North Africa Africa Central Asia & Caribbean Asia Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. > > > F I G U R E 3 . 1 4 Distribution of Domestic Credit to Private Sector (as percentage of GDP), by Banks’ Regular Participation in Out-of-Court Workouts 200 Domestic credit to private sector (% GDP) 150 100 50 0 0 1 Bank regular participation in OCWs Source: World Bank-INSOL-IAIR CDR Survey; authors’ calculations. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 68 Banks’ regular use of out-of-court workout agreements These novel results emphasize the importance of supporting is associated with having supportive tools within a given the development of out-of-court workout agreements with legal system. To understand banks’ regular use of out-of-court the right institutional tools. Moreover, they point to the value workouts, binomial (logit) regression models were developed. of using flexible means for restructuring, not just under the Table 3.2 shows the results, with banks’ regular use of out- current pandemic environment but also longer term (World of-court workouts as the dependent variable. The existence Bank 2017). of either an out-of-court workout framework agreement or guidelines—appearing as OCW frame or guide in the table— These results highlight the importance of developing is positively associated to banks’ regular use of out-of-court robust CDR mechanisms and, more broadly, insolvency workouts, a result that is highly statistically significant in each systems. While the survey’s limitations did not offer the of the models (p-value < 0.01). The result remains even after opportunity to delve into other important development factors controlling for an economy’s recovery rate (also positively directly related to CDR mechanisms, such as entrepreneurship associated to the regular bank use of out-of-court workouts, or the resolution of NPLs, the evidence presented in this p-value < 0.05) or the strength of its formal reorganization section further supports strengthening CDR mechanisms. system. To investigate the robustness of our results, model Policy makers must understand the impact of CDR frameworks 4 repeats model 3, but limits the sample to jurisdictions from as well as the practical considerations in implementing them which multiple contributions were received, giving the team and preparing for potential challenges. For that reason, the the opportunity to check for any discrepancies. Again, the next section sets out some of the key lessons learned in main results remain statistically significant (p-value < 0.05). implementing reforms in this area. > > > TA B L E 3 . 2 Banks’ Regular Participation in Out-of-Court Workouts120 Dependent variable: Bank regular OCW use = 1 (1) (2) (3) (4) OCW frame or guide 1.877*** 1.642*** 1.612*** 1.635** (0.482) (0.507) (0.534) (0.673) Recovery rate 0.025*** 0.026** 0.037*** (0.010) (0.011) (0.013) Strength of formal reorganization 0.478 0.340 (1.628) (2.231) Constant -0.738*** -1.792*** -2.174** -2.614** (0.259) (0.524) (0.938) (1.332) Observations 101 95 83 60 Log likelihood -61.083 -54.250 -46.906 -31.961 Akaike inf. crit. 126.167 114.500 101.812 71.922 Note: *p<0.1; **p<0.05; ***p<0.01. Coefficients in log-odds. 120. Table 3.2 was created using software from Hlavac (2018). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 69 V. Lessons Learned from Implementing CDR Frameworks in EMDEs Having CDR frameworks in place does not necessarily mean they will work successfully in practice. It is essential that these frameworks be effectively implemented with wide stakeholder support and buy-in. The following lessons aim to provide policy makers with a better understanding of how to develop and implement CDR frameworks in practice. The lessons are based on experiences and observations from more than 20 years working in the development of insolvency systems in EMDEs. For reasons of confidentiality and the sensitivity of some topics, the names of the country or countries implicitly referred to in each lesson are not mentioned in most cases. > > > TA B L E 3 . 3 Lessons Learned from Implementing CDR Frameworks Lessons Designing a CDR 1. A CDR framework should respond to the specific needs of each country. Framework 2. Evaluating the degree of development of the business rescue culture of each country is indispensable. 3. Mitigating the stigma associated with financial difficulties or business insolvency is essential for developing a CDR culture. 4. It is important to address financial difficulties in a timely and effective manner. 5. Effective insolvency procedures promote the extensive use of CDR mechanisms, as well as related tools and incentives. 6. Legal and regulatory impediments that affect corporate debt restructurings should be identified and removed. 7. Tax claims’ super-priority and the ability of tax authorities to compromise debt must be carefully considered by policy makers. 8. In most EMDEs, improving insolvency legislation is essential but may not be sufficient for effective implementation. 9. Absent a robust business rescue culture, informal workouts based on nonbinding guidelines and lacking regulatory support and other incentives often face an uphill challenge. 10. In countries with effective courts and the ability to “cram down” creditors, hybrid and preventive restructuring procedures are often key to successful corporate debt restructuring. 11. CDR frameworks with an out-of-court component could also benefit financially distressed SMEs. Implementing a 12. CDR reforms must be supported by an authoritative local champion. CDR Framework 13. The quality of financial information and easy access to it are crucial elements to effectively implement corporate debt restructuring. Confidentiality facilitates informal restructurings. 14. 15. Tax policy plays a key role in facilitating and incentivizing financial restructurings. 16. Excessive formalities and unnecessary court involvement should be avoided in informal and hybrid restructuring procedures. 17. Formal insolvency frameworks must be strengthened because out-of-court restructurings are more effective “in the shadow of the law.” 18. Creating a legal priority to protect new money is important, but it does not ensure that financing in the context of a restructuring will flow easily. 19. Results of CDR frameworks are difficult to assess. 20. Corporate debt restructurings rely on sound institutional frameworks. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 70 A. Designing a CDR Framework LESSON 2 Evaluating the degree of development of the business Many factors determine whether workouts will be achievable rescue culture of each country is indispensable. Any and efficient. These include not only legislative and regulatory CDR reform requires a proper diagnosis of a country’s frameworks but also many intangible elements. The latter business rescue culture, including an assessment of multi- include a good faith negotiation culture and use of a framework party negotiations and ease of sharing information between that addresses the level of distress and is appropriate for the creditors, which could support CDR frameworks. There are institutional fabric in the country (as discussed in Section II). several cultural aspects and business practices that must The following are some lessons learned from developing an be identified up front, even before analyzing the problems or enabling environment that facilitates workouts. obstacles presented by the legal and institutional framework. In particular, it is key to identify if (and how frequently) debtors LESSON 1 and creditors negotiate arrangements aimed at restructuring A CDR framework should respond to the specific needs debts in default using out-of-court mechanisms or judicial of each country. Due to numerous legal, institutional, and proceedings. cultural differences, CDR procedures work differently across countries: there is no “one-size-fits-all” approach. Countries LESSON 3 address restructuring in different ways, according to the Mitigating the stigma associated with financial difficulties various choices embedded in legislative policy. For example, or business insolvency is essential for developing a CDR in countries such as Mexico and Peru, some provisions of culture. If insolvency is not seen as a business contingency the national constitution condition the restructuring of labor but rather as a moral failure or, worse, a crime, one of the claims. Because these claims enjoy significant constitutional biggest challenges is changing the mindset of stakeholders. protection, their restructuring is severely restricted: either they This has happened in several countries in which even the cannot be included in general restructuring plans, or the plans name of a CDR program or legislation initially had to break must establish super-priority payments for labor credits. The the association of insolvency and fraudulent behavior. evolution of laws and institutions produces a particular local Increasingly, words with a negative connotation, such as juridical culture that should be understood when assessing “bankruptcy” or “insolvency,” have been replaced by other the system and suggesting reform recommendations. terms that suggest solutions and not failure: for example, Recommendations that are significantly alien to the legal “financial difficulties,” “business rehabilitation program,” or culture of a country are generally counterproductive. For “business rescue.” Sometimes, the stigma is also fueled by the example, some insolvency laws adopted in the 1990s by so-called nonpayment culture, when debtors expect solutions certain countries of the former Soviet Union were perceived as to their financial difficulties to come from the state and not from partial transplants of foreign legal regimes. The results were debt negotiation efforts with creditors. In such an environment, not positive, and significant reforms—based on the experience creditors tend to view debtors’ payment difficulties—without gained—had to be introduced shortly afterwards. On the distinction—as deliberate defaults, and consequently, they other hand, there is a noticeable focus on a harmonization refuse to negotiate amicable debt restructuring solutions. of regional CDR frameworks in some countries, characterized by having strong economic ties or integrating commercial LESSON 4 or economic unions. For instance, many countries in the It is important to address financial difficulties in a timely Caribbean have been inspired by the Canadian proposal and effective manner. Debtors generally deny the seriousness process;121 all 17 countries in the OHADA trading bloc have of business difficulties, taking refuge in optimistic thoughts that adopted the same French restructuring model; and the are not conducive to solving debt problems. This has been European Commission has issued EU Directive 2019/1023 on repeatedly verified in countries that have a weak business preventive restructuring frameworks, discharge of debt and rescue culture. The consequence is certainly negative, since disqualifications, and measures to help strengthen a regional no CDR mechanism has a chance of success if it is used too approach to restructuring procedures. This harmonization late to rescue a business that has lost viability due to delay. can encourage economies of scale and closer ties between Sometimes creditors also deny the existence or underplay the countries’ judiciaries. 121. Grenada, Jamaica, Saint Kitts and Nevis, Saint Vincent and the Grenadines, and Trinidad and Tobago have insolvency laws inspired by the Canadian Bankruptcy and Insolvency Act. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 71 severity of debt repayment problems (see Chapter 1). In some difficult to implement in many EMDEs because bank creditors countries, especially at the beginning of the global financial are subject to regulatory constraints that restrict them from crisis of 2008, it was observed that bank officers and directors taking shares or limit the amount of equity they are allowed to failed to appreciate and acknowledge the magnitude and accept as payment of debts. In many jurisdictions, banks—in extent of growing payment performance problems, given the particular, state-owned financial entities—encounter problems incentives to avoid signaling an increase in credit losses and in writing off debts due to statutory constraints. In a few but weakening in the bank’s financial position. Creditors’ stances extreme cases, all-encompassing embezzlement provisions of denial exacerbate effects of debtors’ inaction. Drastic in the Criminal Code may affect debt write-offs, as bank restructuring measures that might be necessary, such as debt officers may fear being exposed to criminal liability if write-offs write-offs, are postponed. Instead, debt maturity is simply are interpreted as embezzlement. Assignment of claims is extended and payment profiles rescheduled. This creates also problematic in many instances. In some EMDEs, the law an illusion of restructuring that only delays the application of requires the debtor’s consent when the loan to be transferred is CDR mechanisms until, inevitably, they may not be effective in subject to dispute in litigation. Banking regulations sometimes rescuing the no longer viable insolvent business. do not allow assignment of loans that are not fully accelerated or, worse, the transfer is allowed but the bank creditor will LESSON 5 remain jointly and severally liable with the debtor for the Effective insolvency procedures promote the extensive payment of the debt to the assignee. Consumer protection use of CDR mechanisms, as well as related tools and laws may add another impediment to the assignment of a incentives. In some countries, creditors’ general preference consumer debt, forbidding transfer of the borrower’s data to for individual enforcement procedures (as opposed to the assignee. Tax laws may subject assignment of claims to collective insolvency procedures) prevents extensive use of VAT, sometimes over the face value of the debt, which acts CDR mechanisms. Extensive use of individual enforcement as a disincentive for such transactions. This was the case, for procedures against a financially distressed business example, in Montenegro, where it was unclear whether NPL undermines the ability to maximize asset values and impairs assignments were subject to VAT and the Ministry of Finance equitable distribution among creditors. Several factors help had to clarify that a sale of bad debts to a third party should not explain creditors’ preference for individual enforcement be considered VAT taxable. proceedings in many EMDEs. In countries where this has been observed, negotiation and mediation are not established LESSON 7 practices; arbitration is rarely used or has a poor reputation; Tax claims’ super-priority and the ability of tax authorities and domestic judicial proceedings are lengthy and generally to compromise debt must be carefully considered by unattractive. Lending practices also play a role: in countries policy makers. This is an area where policy change is very where all or most loans are over-secured, creditors typically difficult to achieve in most countries. Outstanding tax claims resort to collateral enforcement and have little incentive to can be significant—where the tax authority has outstanding participate in a collective negotiation aimed at restructuring tax claims for many years, this can amount to a large a plurality of debts from a distressed business. Ineffective proportion of the debtor’s liabilities. In some countries, tax reorganization procedures discourage the creation of a claims are given a super-priority ahead of secured creditors in business rescue culture based on negotiation, reinforcing the waterfall payment structure. If these claims are significant, creditors’ preference for individual enforcement proceedings this can negatively affect the recovery of creditors, both to recover their loans. Maximizing credit recovery through secured and unsecured, and affects creditors’ willingness to stronger reorganization frameworks is necessary to change engage in a restructuring process. In fact, it often exacerbates this bias toward individual enforcement and encourage the the likelihood of creditors attempting to enforce their collateral rehabilitation of viable businesses through informal and formal through individual proceedings, which can impede an effective collective procedures. restructuring. In certain countries, tax authorities are often not able to forgive debt, not even penalties or interest rates. Even LESSON 6 if they can legally forgive debt, tax authorities are usually risk Legal and regulatory impediments that affect corporate averse and do not have incentives to compromise on their debt restructurings should be identified and removed. claims. In the Dominican Republic, a useful power in the Regulatory and some legal obstacles should be addressed, law allows the tax authority to compromise on tax claims. It as they are likely to inhibit creditors’ ability to participate in remains to be seen whether officials will actually make use of a restructuring. Debt-to-equity swaps are rarely used and that power. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 72 LESSON 8 it has helped to improve the overall business rescue culture in In most EMDEs, improving insolvency legislation East Asia. Similarly, in the wake of the global financial crisis is essential but may not be sufficient for effective of 2008, a number of European countries (Albania, Austria, implementation. Sound insolvency and related laws, Hungary, Latvia, Montenegro, Portugal, Romania, Serbia, effectively implemented by efficient institutions (such and Slovenia) also adopted such guidelines. The results are as insolvency regulators or commercial courts), are the difficult to assess accurately as there is no recorded data on foundations that must be firmly established to build a legal corporate debt restructuring based on guidelines endorsed by environment conducive to corporate debt restructuring. a government authority. Although this approach clearly has However, other elements should also be taken into account not been a panacea, anecdotal evidence suggests that when when assisting a country to improve its CDR frameworks, workouts have been provided with legal or administrative including the following: support through the creation of hybrid or enhanced procedures, their effectiveness appears to increase.122 • Understanding how credit relationships work among the relevant players. In this regard, the effectiveness of credit LESSON 10 information through the development of credit information In countries with effective courts and the ability to “cram bureaus, as well as credit protection and enforcement down” creditors, hybrid and preventive restructuring mechanisms, should be evaluated. procedures are often key to successful corporate • Enabling the creation of security interests in movable debt restructuring. Effective hybrid and preventative property and implementing a reliable collateral registry. procedures often contemplate at least three tools: (i) a stay of enforcement for a short time period; (ii) a cramdown effect • Strengthening the capacity of commercial courts, of the restructuring plan (i.e., a restructuring plan approved insolvency regulators, and associated institutions to by a legally defined majority of creditors will bind minority administer restructurings efficiently, with minimal delays. creditors); and (iii) priority for new financing. In many EMDEs, it has been proved that without a cramdown provision in the • Identifying and removing, to the extent possible, cultural, legal framework, restructuring procedures can be ineffective. legal, and institutional obstacles to distressed debt In hybrid procedures, cramdown typically is an effect of restructuring and business reorganization. judicial confirmation of a preapproved agreement or plan. It • Creating incentives for CDR and educating the relevant facilitates informal restructuring by discouraging holding out players on how to use the new CDR frameworks. or obstructive attitudes to negotiation by creditors. In some countries that have adopted hybrid procedures, it has not LESSON 9 even been necessary to use them in many cases. The mere Absent a robust business rescue culture, informal possibility that a debtor and its main creditors agree by majority workouts based on nonbinding guidelines and lacking to a debt restructuring plan, and that this may also bind minority regulatory support and other incentives often face an creditors who did not sign it, in practice discourages creditors uphill challenge. The dissemination of guidelines to conduct from adopting obstructionist attitudes during the out-of-court informal debt restructuring—including the basic principles of phase of a workout negotiation. In the wake of Argentina’s cooperation between a debtor and its creditors, information 2002 crisis, out-of-court debt restructuring was encouraged sharing, stay of enforcement, and priority for new financing—as and supported by a hybrid restructuring proceeding (known as recommended by the London Approach, the INSOL Principles, APE, for its Spanish name Acuerdo Preventivo Extrajudicial). and the Asian Bankers’ Association Workout Guidelines, is a APE provides that an out-of-court restructuring plan may bind positive first step, but it often proves insufficient for creating or dissenting creditors, following a very short in-court procedure, developing a robust business rescue culture. This development once a judge approves the plan agreed to by the majority takes time, often years or even decades. The adoption of such of creditors. APE was successfully used in 2003 and 2004, guidelines as a code of conduct endorsed by an authority (the allowing debtors and creditors to negotiate and restructure the central bank or a ministry or other government agency) was distressed debt of the largest corporations. Using out-of-court the path chosen to improve the effectiveness of workouts by workouts and in some instances the new hybrid procedure, many Asian jurisdictions during the Asian Financial Crisis of the corporate and financial sectors were able to save time 1998–2001 (e.g., Hong Kong, Indonesia, Japan, the Republic and avoid costs and the destruction of value that the massive of Korea, Malaysia, and Thailand), and over the last 20 years use of formal insolvency proceedings would have brought 122. These hybrid procedures add a certain amount of formality to corporate debt restructuring but allow more successful results to be obtained. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 73 about in a systemic crisis environment. After the Argentine LESSON 13 experience, other Latin American countries (including Brazil, The quality of financial information and easy access to it Chile, Colombia, Dominican Republic, Mexico, and Uruguay) are crucial elements to effectively implement CDR. This is introduced provisions into their insolvency laws contemplating particularly relevant in informal restructuring mechanisms in hybrid restructuring proceedings. which creditors must primarily rely on information provided by the debtor to properly evaluate any proposals made as part of LESSON 11 the restructuring. A drawback of such informal mechanisms, CDR frameworks with an out-of-court component seen in numerous jurisdictions, is that many debtors lack could also benefit financially distressed MSMEs. Purely reliable financial information or provide out-of-date information. informal out-of-court workouts are rarely used with MSMEs In some countries with unreliable credit information systems, in most EMDEs. Several reasons may explain this minimal some financial creditors refuse to share information with their use: (i) MSMEs frequently borrow from one lender only, so competitors. These creditors reject collective workouts and financial difficulties are negotiated over bilateral (bank-client) prefer bilateral negotiations with the debtor. discussions, and there is no need for multi-creditor workouts; (ii) MSMEs’ financial information is not always reliable or LESSON 14 readily available, so creditors prefer to negotiate in court, Confidentiality facilitates informal restructurings. Informal where the debtor’s obligations are formally verified; and (iii) restructurings are more private processes than formal the costs of attempting a workout (in particular, remuneration reorganization proceedings. As informal restructurings are of financial advisors, auditors, and lawyers) may be too high less prone to unwanted publicity and speculation, they are for many MSMEs. Increasingly, many countries are looking at perceived to cause less reputational damage and to carry less implementing hybrid or formal, but simplified reorganization stigma than formal insolvency processes. Requirements to proceedings for MSMEs. This trend is expected to be provide information must be balanced against confidentiality strengthened by the World Bank’s new principles on micro concerns. As such, this element should be preserved as and small enterprises’ insolvency123 and by the upcoming text much as possible. In Turkey, the so-called Istanbul Approach of UNCITRAL on simplified insolvency regimes. Enhanced initially required directors of corporate groups to disclose CDR frameworks, such as Iceland’s joint rules on the financial personal assets before participating in the restructuring. This restructuring of companies, which targets SMEs with liabilities requirement was subsequently removed because it deterred of less than ISK 1 billion (US$8 million), have also provided companies from seeking restructuring under the framework. useful standardized models for addressing large volumes of SME debt. LESSON 15 Tax policy plays a key role in facilitating financial B. Implementation of CDR Frameworks restructurings. In most EMDEs, a write-off of debt is typically treated as a taxable gain for the debtor; conversely, the LESSON 12 creditors’ ability to deduct the losses when offering concessions CDR reforms must be supported by an authoritative local is commonly limited. In both cases, a restructuring based on champion. Ministries of finance and central banks play a a debt write-off may become prohibitively expensive for all the central role in implementing and promoting CDR frameworks. participants. Ideally, the legal framework should not discriminate Other influential stakeholders can play a similar role, including against debt restructuring in workouts and reorganization banking associations and chambers of commerce, although plans. Moreover, during periods of high levels of corporate in some EMDEs with little experience with insolvency these distress or NPLs in the financial system, the law could provide institutions first need to be educated in basic elements of tax incentives for the parties that participate in arrangements financial distress resolution through CDR mechanisms. In or plans that will render a restructured business viable. For India, the government made the Insolvency and Bankruptcy example, in the wake of the Asian Financial Crisis of 1997, Code the sole route for dealing with NPLs (repealing earlier the Thai regime for restructuring activities established special measures, such as the CDR framework). This resulted in very tax provisions distinguishing between formal restructuring strong take-up by the financial institutions and the corporate processes and informal, out-of-court restructurings. For any insolvency resolution process is now entrenched in financial formal process, it was specified that (i) no personal and creditors’ approach to handling NPLs. corporate income taxes are payable by debtors on income 123. The World Bank Principles for Effective Insolvency and Creditor/Debtor Regimes was revised in 2021 to include new principles on micro and small enterprise insolvency. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 74 derived from the release of debts, a composition agreement under the Shield 4.0 Act. Court involvement was reduced to (or negotiated creditor arrangement) under application, or a confirming the restructuring plan. In the new procedure, the reorganization plan approved by the court in accordance with courts are notified virtually at the initiation of the negotiations. An the Bankruptcy Act; and (ii) no personal and corporate income automatic four-month stay is applied, and new money is given tax, value-added tax, special business tax, or stamp duty is priority. An insolvency practitioner facilitates the restructuring payable by debtors and creditors on income derived from negotiations. In the first six months since enactment, at least the transfer of assets, sale of goods, provision of services, 60 cases were processed through the new restructuring or execution of instruments in consequence of implementing procedure (as opposed to the few cases in the accelerated an application for composition or a reorganization plan as arrangement proceeding since its introduction in 2016). approved by the court in accordance with the Bankruptcy Act. LESSON 17 Regarding informal restructurings, substantially similar tax Formal insolvency frameworks need to be strengthened advantages have applied for debtors and creditors; but because out-of-court restructurings are more effective unlike the situation of formal restructurings, these have been “in the shadow of the law.” Informal mechanisms in place only on a temporary basis for specific periods. The do not replace, but rather complement, formal or full Uruguayan Law on Insolvency provides for two tax incentives, insolvency proceedings. In particular, informal or alternative applicable to insolvency proceedings though not to informal reorganization mechanisms have generally been found to debt restructuring agreements, namely: (i) from the date of work well in countries where formal insolvency proceedings the declaration of the insolvency proceeding, all credits filed and debt enforcement pose a credible threat. The presence against the debtor shall be considered unrecoverable for tax of the “shadow” of legislation that establishes efficient formal purposes; and (ii) the debtor may postpone up to five fiscal processes of insolvency and individual enforcement of debts years the gross income generated by write-offs obtained in is an important condition for the frequent and successful use an insolvency proceeding. In Montenegro, the deduction of a of informal CDR mechanisms. For this reason, some countries write-off as bad debt was not allowed as there was no proof have prioritized improving the formal insolvency framework— that efforts to collect the entire loan had been unsuccessfully when it is manifestly ineffective—and leaving reforms related exhausted. However, the Voluntary Debt Restructuring Law to informal restructuring to a later stage. (known as the “Podgorica Approach”), among other tax incentives, allowed the creditor to immediately deduct the LESSON 18 write-off as a loss. Although the deduction continued to be Creating a legal priority to protect new money is considered a taxable gain of the debtor, the practice was important, but it does not ensure that financing in the established of dividing payment of the resulting tax into six context of a restructuring will flow easily. This has been or 12 installments (according to the amount). Many countries repeatedly observed in many EMDEs where amendments may present other situations in which an unexpected taxable to the law on priorities have been introduced to protect new event complicates the restructuring operation. Therefore, financing. Additional work is necessary to persuade lenders— all countries require a complete analysis of the relevant tax financial institutions in particular—to provide fresh money to regime to identify potential obstacles to debt restructurings. a corporate debtor in financial distress. Brazil has recently amended its insolvency law, dedicating a detailed chapter to LESSON 16 the protection of post-commencement financing. It remains to Excessive formalities and unnecessary court involvement be seen whether this major reform will have the desired effect should be avoided in informal and hybrid restructuring of increasing the supply of loans to debtors in financial distress. procedures. Minimal formalities in out-of-court negotiations lead parties to reach restructuring agreements faster and at LESSON 19 lower cost. The limitation of unnecessary court involvement Results of CDR frameworks are difficult to assess. also creates an environment for spontaneous negotiation Quantitative and qualitative data on restructuring are essential between the parties and allows for a collaborative climate that for evidence-based policy making. In most EMDEs, however, simplifies the resolution of problematic debts. In Poland, a getting complete and reliable data on restructurings is difficult. 2016 law introduced an accelerated arrangement proceeding To some extent, the absence of data could be explained by the (akin to a preventive insolvency procedure). It did not achieve confidentiality with which informal restructuring negotiations wide acceptance in practice partly due to an overreliance on are conducted. But even for hybrid or formal restructuring courts. In 2020, in the context of the COVID-19 pandemic, the procedures, the data that is usually collected is scarce. When Polish government introduced a new restructuring procedure data is collected, it is generally limited to the number of EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 75 proceedings (initiated, ongoing, and concluded), the statistics two main commercial centers. Second, in 2017 the require- of which are compiled by judicial authorities or insolvency ments to act as insolvency administrators were regulated in regulators. It is very rare to find other relevant data such as detail, and supervision of these professionals was entrusted to the most frequently implemented restructuring measures, the the Chambers of Commerce and Production. The World Bank average rate of recovery of secured or unsecured credits, and and INSOL International have developed a capacity-building the percentage of enterprises that effectively resolve their program to assist judges in developing technical expertise in financial difficulties using debt restructuring mechanisms. This restructuring. was partly the rationale for conducting the survey described above. As a rare example, the Turkish Banking Association tracks monthly data on the number of debtors in restructuring VI. Conclusion and cases approved under the Istanbul Approach. Regarding formal insolvency proceedings, Latvia has a sophisticated The pandemic’s broad economic effects have heightened data collection system. The Latvian Insolvency Control the need for robust CDR systems to help deal with the Service (the insolvency regulatory agency) gathers abundant ensuing corporate debt overhang and the expected rise data from the insolvency administrators’ reports and compiles in the number of businesses in financial distress. This comprehensive statistical reports on the insolvency system, chapter has described how well-developed CDR systems which are published at the Insolvency Register. The court often provide several different tools to facilitate saving viable information system provides additional information and allows businesses and resolving NPLs. Unfortunately, this chapter for the verification of information reported by insolvency has also shown that most economies still lack mechanisms administrators. In countries where insolvency data is collected to facilitate out-of-court workouts, that about a third of the by different entities, the integration of all sources of information jurisdictions in the sample lack special tools for restructuring could further improve the data collection system. noninsolvent debtors, and that a few still lack mechanisms for the formal reorganization of insolvent debtors. Even when LESSON 20 these tools are available, special rules to deal with MSMEs in CDRs rely on sound institutional frameworks. Though financial distress—often the great majority of the firms within an institutional weaknesses take a long time to change, the economy—seldom exist and are particularly critical in contexts success of restructuring mechanisms is often linked to appro- such as that created by the COVID-19 pandemic. Moreover, priate institutional setup and capacity. Courts and insolvency the novel analysis has shed light on the link between regular administrators are key stakeholders in this area. Weak court use of out-of-court workouts by banks and higher access to systems are characterized by a number of shortcomings, credit, while also providing further evidence supporting the including (i) inadequate selection and training of judges; (ii) positive relationship between robust formal reorganization appointing judges unfamiliar with financial/business practices; systems and creditor recovery. Yet, CDR—and, more broadly, (iii) having an overall bench lacking judicial specialization insolvency reform—is a complex exercise. Many intangible or expertise in commercial and insolvency law; (iv) having and tangible elements are needed for these frameworks to an excessive number of cases in courts with jurisdiction on be successful, including the enabling environment, the right insolvency, but only a few, if any, insolvency cases at all; choice of tools, and effective implementation. In recognition of (v) inefficient case administration practices; (vi) a lack of this complexity, a practical set of “lessons learned” has been transparency or inconsistency in judicial decision-making; and distilled from significant practical experience to help guide (vii) frequent procedural abuses. The insolvency profession policy makers in navigating this process. is typically underdeveloped, with unqualified people acting as insolvency administrators. It needs significant improvement to or creation of institutions and procedures to license, qualify, and supervise insolvency administrators. For example, before 2015 the Dominican Republic had no professional insolvency administrators or judges with this specialization. The restruc- turing of corporate debt, under the old legal and institutional framework, was practically nonexistent. When a completely new restructuring and liquidation law was passed, reform of the legal framework was accompanied by two indispensable institutional developments. First, jurisdiction in insolvency matters was assigned to specialized judges in the country’s EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 76 >>> References Andrews, D., and F. Petroulakis. 2019. “Breaking the Shackles: Zombie Firms, Weak Banks and Depressed Restructuring in Europe.” ECB Working Paper No. 2240, European Central Bank, Basel, Switzerland. Araujo, A. P., Rafael V. X. Ferreira, and Bruno Funchal. 2012. “The Brazilian Bankruptcy Law Experience.” J. Corp. Finance. doi: 10.1016/j.jcorpfin.2012.03.001. 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EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 79 >>> Annex 3A > > > T A B L E 3 A . 1 List of Contributors to the CDR Survey Albania Bermuda Olsi Coku // Kalo Associates Rachelle Frisby // Deloitte Ltd Angola Benjamin McCosker // Walkers (Bermuda) Limited Leniza Sampaio and Fernanda Mualeia // Manuel Gonçalves & Botswana Associados Nigel Dixon-Warren // DWP Advisory (Pty) Ltd Argentina Chipo Gaobatwe // Administration of Justice Javier Lorente // Lorente & López Abogados Brazil Sebastian R. Borthwick // Richards, Cardinal, Tutzer, Zabala & Frederico A. O. De Rezende // F. Rezende Consultoria Ltd Zaefferer Antonio Mazzucco // Mazzucco & Mello Advogados Fernando Daniel Hernández // Marval O’Farrell Mairal Isabel Picot and Rodrigo Garcia // Galdino & Coelho Advogados Armenia Liv Machado and Flavia Cristina Moreira Campos Andrade // Makar Yeghiazaryan // Yeghiazaryan & Partners Law Firm TozziniFreire Advogados Artur Hovhannisyan // “Concern Dialog” CJSC British Virgin Islands Australia Tameka Davis and Rachael Pape // Conyers Dill & Pearman Farid Assaf SC // Banco Chambers Grant Carroll and Nicholas Brookes // Ogier David Dickens and Ann Watson // Hall & Wilcox Rosalind Nicholson and Gareth Murphy // Walkers Orla McCoy and Tom Gardner // Clayton Utz Bulgaria Scott Atkins, Alex Mufford, John Martin, and Noel McCoy // Norton Angel Ganev, Simeon Simeonov, and Galin Atanasoff // Djingov, Rose Fulbright Gouginski, Kyutchukov & Velichkov Austria Hristina Kirilova and Ivo Alexandrov // Kambourov & Partners Markus Fellner // Fellner Wratzfeld & Partners Attorneys at Law Burkina Faso Susanne Fruhstorfer // TaylorWessing Jean Jacques W. Ouedraogo // Deputy Attorney General, Court of David Seidl // Graf & Pitkowitz Attorneys at Law Appeal – Ouagadougou Georg Wabl and Gottfried Gassner // Binder Grösswang Attorneys Cambodia at Law Guillaume Massin and Chuan How Tan // DFDL Azerbaijan Heng Chhay, Ly Sopoirvichny, Prom Savada, Chum Socheat, and Delara Israfilova // BM Morrison Partners LLC Ouk Lungdy // Rajah & Tann Bahamas, The Canada Vanessa L. Smith // McKinney, Bancroft & Hughes Elisabeth Lang // Office of the Superintendent of Bankruptcy Barbados Solange de Billy-Tremblay // de Billy-Tremblay & Associés Inc Taylor Laurayne // Lex Caribbean Evan Cobb // Norton Rose Fulbright Canada LLP Lisa Taylor, Craig Waterman, and Dave Collins // PWC Gavin Finlayson // Miller Thomson LLP Belarus Jane Dietrich and Jeffrey Oliver // Cassels Brock & Blackwell LLP Maria Rodich, Aliaksei Sialiun, and Valeriya Dubeshka // Sorainen Cayman Islands Law Firm Liam Faulkner // Campbells Belgium Jennifer Fox // Ogier Dorothée Vermeiren // Clifford Chance LLP EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 80 Chile Mari Karja and Rety Estorn // Sorainen Law Firm Pablo Valladares Ljubetic // Superintendencia de Insolvencia y Ethiopia Reemprendimiento Yosef Fekadu and Deborah Haddis // Mesfin Tafesse & Associates Diego Rodríguez Gutiérrez // Kramm y Rodríguez Law Office Francisco Cuadrado // Cuadrado Abogados y Cia Finland Ricardo Reveco Urzúa // Carey Matti Engelberg // Engelberg&Co Ltd Rodrigo Novoa, Pablo del Campo, Jeannette Rojas, and Ignacio Tomi Kauppinen and Lasse Parkkamäki // Merkurius Attorneys Ltd Rojas A. // SIV Abogados France China Catherine Ottaway, Georges-Louis Harang, and Hadrien de Lingqi Wang // Fangda Partners Lauriston // HOCHE Avocats Li Shuguang // China University of Political Science and Law Emmanuelle Inacio // ULCO Chen Lau // PWC Philippe Hameau // Norton Rose Fulbright Colombia Sébastien Normand // CBF ASSOCIES Susana Hidvegi Arango // Superintendencia de Sociedades Germany Nicolas Polania-Tello // DLA Piper Frank Grell // Latham & Watkins LLP Croatia Friedrich von Kaltenborn-Stachau // BRL Insolvenz GbR Jelenko Lehki // Lehki Law Office Regina Rath // Norton Rose Fulbright LLP Josipa Jurčić // Josipa Jurčić, attorney-at-law Ghana Cyprus Audrey Naa Dei Kotey and Samuel Alesu-Dordzi // AudreyGrey Rennos Ioannides // KPMG Limited Greece Christakis Iacovides and Andriane Antoniou // Corporate Recovery Yiannis Sakkas // Bazinas Law Firm & Insolvency Ltd Georgios Nikopoulos-Exintaris // N Solution Consultants Michalis Loizides // KPMG Limited Konstantinos Issaias and Zaphirenia Theodoraki // Kyriakides Grigoris Sarlidis // A.G. Erotocritou LLC Georgopoulos Law Firm Czech Republic Stefanos Charaktiniotis, Mariliza Myrat, and Danai Falconaki // Zepos & Yannopoulos Law Firm Tomáš Jíně // White&Case Zacharopoulos Georgios // Andreas Angelidis and Associates – Veronika Strizova and Zuzana Mihalikova // PWC Attorneys at Law Denmark Guatemala Anne Birgitte Gammeljord // Rovsing & Gammeljord Jorge Luis Arenales, Cindy Gabriela Arrivillaga, and Andrés Ernesto Michala Roepstorff // Plesner Advokatpartnerselskab Marroquin // Arias Law (Guatemala) Piya Mukherjee // Hortens Rodrigo Callejas and Paola Montenegro // Carrillo & Asociados Dominican Republic Guernsey Fabiola Medina, Melissa Silie, Patricia Alvarez, and Carla Alvarez // Andy Wood // Deloitte LLP Medina Garrigó Abogados Adam Cole // Walkers Mary Fernandez // Headrick Honduras Ecuador Evangelina Lardizábal // Arias Law Fabricio Davila // LEXVALOR Abogados Sergio Bendaña López and Jorge López Loewenberg // López Patricio Peña // Noboa, Peña & Torres Law Firm Rodezno & Asociados Egypt, Arab Republic Hong Kong SAR, China Gamal Abou Ali // Hassouna & Abou Ali Law Firm Lillian Chow // Official Receiver’s Office Hazim Rizkana and Farida El Baz // Rizkana Partners Eddie Middleton // Alvarez & Marsal El Salvador Camille Jojo, Daniel Ng, and Michael Lam // Norton Rose Fulbright Rommell Sandoval Victor Jong // PWC Rafael Mendoza and Jairo Gonzalez // Espino Nieto Helena Huang and Edmund Wan // King & Wood Mallesons Estonia Hungary Paul Varul, Peeter Viirsalu, and Silvia Urgas // Law firm TGS Baltic Zoltan Tenk // TENK Law Firm EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 81 Gabriella Pataki and Nóra Nagy // Dentons Réczicza Law Firm Kenya Zoltan Fabok and Mark Seres // DLA Piper Posztl, Nemescsói, George Weru // PwC Ltd Györfi Tóth & Partners Law Firm Joyce Mbui and Vruti Shah // Bowmans Kenya Braner Torsten // TaylorWessing Hungary Sonal Sejpal and James Njenga Mungai // Anjarwalla & Khanna LLP Ágnes Ábrahám // Lakatos, Köves and Partners Law Firm Latvia Iceland Naira Anfimova // Ministry of Justice of the Republic of Latvia Pall Eiriksson // Borgarlogmenn – Holm & Partners Edvins Draba // Sorainen Einar Baldvin Árnason // BBA // Fjeldco Janis Esenvalds and Ieva Kalniņa // Rasa, Esenvalds and Radzins Gudmundur Ingvi Sigurdsson // LEX Law Offices Law Office Heiðar Ásberg Atlason // LOGOS Legal Services Lebanon India Abir Al Khalil // Attornis Law Firm Pulkit Gupta // EY Restructuring LLP Rana Nader // Nader Law Office Dhananjay Kumar // Cyril Amarchand Mangaldas Liechtenstein Sawant Singh // Phoenix Legal Alexander Amman // Amann Partners Indonesia Judith Hasler and Corinna Kelz // Ospelt & Partner Attorneys at Law Ltd Cornel B. Juniarto // Hermawan Juniarto & Partners (Member of Deloitte Legal Network) Lithuania Erie Hotman Tobing // Soemadipradja & Taher Advocates Frank Heemann // bnt attorneys in CEE Ireland Paulius Markovas // Law Offices COBALT David Baxter and Eoin Mullowney // A&L Goodbody LLP Ieva Strunkienė // CEE Attorneys Vilnius Office Fergus Doorly // William Fry Vincas Sniute // Law firm SORAINEN Simon Murphy // Beauchamps LLP Luxembourg William Greensmyth // Walkers Alex Schmitt and Nicolas Widung // Bonn & Schmitt Isle of Man Melinda Perera // Linklaters LLP Andy Wood // Deloitte LLP Malawi Israel Elton Jangale // PFI Partnerships Joseph Benkel and Jonathan Ashkenazi // Shibolet & Co. Law Firm John Kalampa // Ritz Attorneys-At-Law Italy Malaysia Paolo Vitale // Studio Legale Vitale Stephen Duar and Tzai Ming // EY Giorgio Cherubini // EXP LEGAL Lee Shih // Lim Chee Wee Partnership Luigi Costa and Tiziana Del Prete // Norton Rose Fulbright Lim San Peen // PWC Japan Malta Hideyuki Sakai // Anderson Mori & Tomutsune Kevan Azzopardi // Malta Business Registry Shin-Ichiro Abe // KILO Mauritius Hajime Ueno, Shinnosuke Fukuoka, Yuri Sugano, and Kotaro Fuji // Gilbert Noel and Manissa Dhanjee // LX Legal Nishimura & Asahi Ashvan Luckraz and Vishakha Soborun // Venture Law Ltd Naoki Kondo // Oh-Ebashi LPC & Partners Shankhnad Ghurburrun // Geroudis Ltd Yoshinobu Nakamura // KPMG Rajiv Gujadhur // Bowmans Jersey Mexico Jeremy Garrood // JTC Law Patricia Cervantes and Elias Mendoza // Guerra, Hidalgo y Andy Wood // Deloitte LLP Mendoza, S.C. Nigel Sanders // Walkers Rosa M. Rojas Vértiz // Rojas Vértiz Jordan Diego Sierra // Von Wobeser y Sierra, S.C. Lana Msameh // Andersen Moldova Kazakhstan Dan Nicoară // Gladei & Partners Shaimerden Chikanayev // GRATA International EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 82 Morocco Peru Abdelatif Laamrani // Laamrani Law Firm Daniel Schmerler // Diez Canseco Law Firm Fahd El Mjabber // CAPITAL EXPERTS Renzo Agurto // Miranda & Amado Abogados Mozambique Fernando Martinot // Estudio Martinot Miguel-Angelo Almeida // MA Solutions Guillermo Puelles // Rodrigo, Elías & Medrano Abogados Jorge Salomao and Geral Maputo // FL&A Advogados Michelle Barclay // CMS Grau Myanmar Philippines Rodney Bretag // Norton Rose Fulbright Simeon Marcelo, Ramon Manolo Alcasabas, and Kristine Ann Venzuela // Cruz Marcelo & Tenefrancia Namibia Poland Ahg Denk // Denk Law Chambers Lech Giliciński and Joanna Gąsowski // Wolf Theiss Taswald July // First National Bank of Namibia Limited Karol Czepukojć // Baker McKenzie Krzyzowski i Wspolnicy sp.k. Axel Stritter // Engling, Stritter & Partners Paweł Bartosiewicz and Maciej Wisniewski // Allen & Overy, A. Netherlands Pędzich sp.k. Ferdinand Hengst and Wies van Kesteren // De Brauw Blackstone Tomasz Rogalski and Daniel Popek // Norton Rose Fulbright Westbroek Portugal Koen Durlinger // Norton Rose Fulbright Miguel de Almada, Bertha Parente Esteves, and Duarte Manoel // Krijn Hoogenboezem // Dentons Cuatrecasas Sigrid Jansen // Allen & Overy Nuno Líbano Monteiro, Catarina Guedes de Carvalho, Nuno New Zealand Ferreira Morgado, Martim Valente, André Abrantes, Ana Varela Costa, and Eva Freitas // PLMJ Scott Abel // Buddle Findlay Nuno Azevedo Neves // DLA Piper Russell Fildes // Insolvency and Trustee Service Qatar Nicaragua Chafic Nehme, Danah Mohamed, and Claudia el Hage // Rashed R. Ernesto Rizo and Gerardo González // BLP Abogados al Marri Law Office Minerva Bellorín // ACZA Law Dani Kabbani // Eversheds Sutherland Norma Carolina Jaen Hernández // Alvarado y Asociados Simon Chan and Khaled Al-Assaf // K&L Gates LLP Nigeria Romania Anthony Idigbe, SAN // Punuka Attorneys & Solicitors Dana Buscu // Muscat & Asociatii Victor Akazue Nwakasi // Legalfield Partners Nicoleta Mirela Nastasie and Vlad Nastase // Bucharest Tribunal / Ayodele Musibau Kusamotu // Kusamotu & Kusamotu Concilium Consulting Perenami Momodu and Odinaka Okoye // Aelex Partners Russian Federation Norway Andrei Mitrofanov // KPMG Siv Sandvik // Schjødt Law Firm Dmitry Konstantinov // Ilyashev&Partners Ellen Schult Ulriksen // Advokatfirmaet Haavind AS Julia Zagonek and Pavel Boulatov // White & Case LLP Oman Pavel Novikov // Baker McKenzie Erik Penz and Hussein Amzy // Al Busaidy Mansoor Jamal, Senegal Barristers & Legal Consultants Aboubacar Fall // AF Legal Pakistan Serbia Altaf Qureshi // Ijaz Ahmed & Associates Jelena Todic // Bankruptcy Supervision Agency of Republic of Serbia Panama Aleksandar Milosavljevic // Attorney at law David Mizrachi, Marlyn Narkis, and Donald Saez // MDU Legal Ivan Todorovic // Zajednicka advokatska kancelarija Todorovic Scott Cohen // CLC PARTNERS Jelena Bajin // ŠunjkaLaw Elizabeth Heurtematte, Alejandro Fung, and Christopher Glasscock Sierra Leone // LOVILL Henrietta Cole // Basma and Macaulay Legal Practice Paraguay Miguel Saguier // FERRERE Abogados EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 83 Singapore Turks and Caicos Boon Heng TAN // Insolvency Office, Ministry of Law Yuri Saunders // Prudhoe Caribbean Jonathan Ong Shyue Wen // Krys Global Uganda Sheila Ng // Rajah & Tann Singapore LLP Turyasingura Rogers Terry // Innochem International LLC Chew Kei-Jin and Samantha Ch'ng // Ascendant Legal LLC Kabiito Karamago and Rita Birungi Mwesige // Ligomarc Advocates Shaun Langhorne and Robert Child // Clifford Chance Ukraine Debby Lim // BlackOak LLC Anton Molchanov // Arzinger Law Firm Slovak Republic Olena Stakhurska and Vasyl Pop-Stasiv // TaylorWessing Kyiv Ivan Ikrényi // IKRÉNYI & REHÁK, s.r.o. Hanna Smyrnova // Baker McKenzie Katarína Čechová // Čechová & Partners s.r.o. Oleg Malinevskiy and Dmytro Tylipskiy // Equity Law Firm Dávid Oršula // bnt attorneys in CEE United Arab Emirates Ondrej Majer // HAVEL & PARTNERS Bruno Navarro // Ipso Facto Ltd Slovenia Shagun Dubey // EY Marko Zaman // Law firm Zaman and Partners Ltd Nicky Reader // Clifford Chance LLP South Africa United Kingdom Nastascha Harduth // Werksmans Attorneys Steven Chown // Insovlency Service South Korea Nick Middleton and Andrew Eaton // Burges Salmon LLP Jungeun Ko // Kim & Chang Joshua Dwyer // AlixPartners Spain Mark Craggs // Norton Rose Fulbright Mariano Hernandez Montes // M&M Abogados Partnership United States Javier Castresana and Oscar Guinea // Allen & Overy Laura Hall // Allen & Overy LLP José Carles Delgado // CARLES | CUESTA Abogados y Asesores Howard Seife // Norton Rose Fulbright US LLP Financieros, S.L.P. Tim Brock, Jarret Hitchings, Rick Hyman, and Malcolm Bates // Sri Lanka Duane Morris LLP Niranjan Abeyratne and Rukshala Goonetileke // Commercial & Uruguay Maritime Law Chambers Alejandro Pintos // Ferrere St. Vincent and the Grenadines Agustina Silva // Hughes & Hughes Mikhail Charles // Mikhail A. X. Charles Barrister Mariana Arena // Hughes & Hughes Sweden Venezuela, RB Bill Kronqvist and Peter Törngren // Törngren Magnell & Partners Roland Pettersson // D’Empaire Erik Selander // DLA Piper Rubén Eduardo Luján and Ramón Alvins // Despacho de Abogados Switzerland miembros de Dentons, S.C. Roman Sturzenegger // Niederer Kraft Frey Ltd Ibrahim Garcia Carmona // GHM Abogados Sabina Schellenberg // Froriep Legal AG Vietnam Tajikistan Nguyen Hung Quang // NHQuang&Associates Azim Ishmatov // ABG L.A. LLC Zambia Tanzania Nitesh Patel // Cotswold Consult Ltd Shemane Amin and Bupe Kabeta // A&K Tanzania Yosa Yosa // Musa Dudhia & Company Trinidad and Tobago Zimbabwe Karen Seebaran-Blondet // Office of the Supervisor of Insolvency Bulisa Mbano // Grant Thornton Turkey Claudious Nhemwa // C Nhemwa and Associates Çağlar Kaçar // Kaçar, Attorneys at Law Orçun Çetinkaya // Çetinkaya Attorneys at Law Yonca Fatma Yücel // Yiğit Yücel Int. Law Firm EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 84 > > > T A B L E 3 A . 2 Glossary of Terms Used in the Survey Meaning Automatic stay A measure that prevents the commencement, or suspends the continuation, of judicial, administrative, or other individual actions concerning the debtor’s assets, rights, obligations, or liabilities, including actions to make security interests effective against third parties or to enforce a security interest, and prevents execution against the assets of the insolvency estate, the termination of a contract with the debtor, and the transfer, encumbrance, or other disposition of any assets or rights of the insolvency estate. Avoidance actions A set of insolvency actions targeting the voidance of prefiling transactions detrimental to creditors or preferential to some creditors. Collateral An encumbered asset. Commencement of The effective date of insolvency proceedings, whether established by the law or by a decision of the court. proceedings Commencement standards The standard to be met for insolvency proceedings to be commenced. Court A judicial or other authority competent to control or supervise insolvency proceedings. Cramdown The imposition of a restructuring plan despite the dissent of a class of creditors (sometimes referred to as cross- class cramdown). Creditor A natural or legal person that has a claim against the debtor that arose on or before the commencement of insolvency proceedings. Debtor Any natural or legal person in financial difficulties that is the subject of an insolvency or pre-insolvency procedure. Discharge The release of a debtor from claims that were, or could have been, addressed in the insolvency proceedings. Encumbered asset An asset in respect of which a creditor has a security interest. Estate Assets of the debtor that are subject to insolvency or pre-insolvency proceedings. First-day order Court orders requested immediately after filing to facilitate the management of the case as well as the operations of the debtor. Insolvency A situation where a debtor is generally unable to pay its debts as they mature and/or where its liabilities exceed the value of its assets. Insolvency procedures Collective proceedings, subject to court supervision, either for reorganization or liquidation. Insolvency representative A person or body (including one appointed on an interim basis) authorized in insolvency proceedings to administer the reorganization or the liquidation of the insolvency estate. Liquidation A process through which the assets of the debtor are sold and disposed of for the collective distribution of the proceeds among its creditors. MSME The “national” definition of a micro-, small-, and medium-sized enterprise according to the legal framework in question. OCW or out-of-court Private agreements with limited or no judicial involvement between a debtor and its creditors, with the aim of easing workouts the debtor’s debt burden so that it can maintain its operations. OCW framework agreement An agreement between participating creditors seeking to establish the terms governing collective out-of-court restructurings with a set of debtors. Pre-insolvency procedures A collective proceeding that enables the debtor to restructure at an early stage with a view toward preventing its insolvency. For the purposes of this study, pre-insolvency procedures are divided into prepack and preventive restructuring procedures. Prepack procedure A procedure that allows for court ratification of a plan agreed on by a debtor and its creditors prior to the initiation of insolvency proceedings. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 85 > > > T A B L E 3 A . 2 Glossary of Terms Used in the Survey (cont...) Meaning Preventive restructuring For the purposes of this study, preventive restructuring procedures are a type of pre-insolvency procedure that procedures afford a debtor protection to negotiate with its creditors for an agreeable path forward that avoids insolvency. Priority The right of a claim to rank ahead of another claim where that right is stipulated by the law. Reorganization A process through which the financial well-being and viability of a debtor’s business may be restored so that the business can continue to operate; means may include debt forgiveness, debt rescheduling, debt equity conversions, and sale of the business (or parts of it) as a going concern. Restructuring plan A plan by which the financial well-being and viability of the debtor’s business can be restored. Sale as a going concern The sale or transfer of a business as a whole or in substantial parts, as opposed to the sale of separate assets of the business. Secured claims A claim assisted by a security interest in an asset taken as a guarantee for a debt enforceable in case of the debtor’s default. Secured creditor A creditor holding a secured claim. Wrongful trading Rules by which directors of insolvent companies may be made personally liable for certain acts or omissions in the lead-up to the commencement of insolvency proceedings. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 86 4. >>> The Role of Capital Markets in Dealing with the Corporate Debt Overhang I. Introduction This chapter focuses on the role that capital market solutions can play in helping nonfinancial corporations (NFCs) in EMDEs deal with debt overhang as the COVID-19 crisis continues to evolve. The solutions covered are relevant for both NFCs already using market-based solutions124 to fund themselves as well as those that could potentially use them as part of their funding mix. For the purposes of this chapter, the focus is on solutions that can (i) help NFCs improve their balance sheets and financial position to deal with already high levels of leverage, and (ii) help lower-leveraged NFCs improve their performance and probability of survival, given the severe adverse shock of the pandemic. Furthermore, while accessing international capital markets is an option for many large NFCs in EMDEs, the main focus is on possible local currency financing options and other market-based solutions. Given the impact of the current pandemic on MSMEs in EMDEs, the chapter also discusses the role of capital markets in helping them as the recovery takes hold. This chapter uses the Corporate Vulnerability Index (CVI) introduced in Chapter 1 as well as a proprietary World Bank capital market development indicator to assess, at a country level, the role that domestic capital markets can play in helping NFCs manage the corporate debt overhang. In addition, the chapter assesses if domestic capital markets could play a greater role in corporate funding markets in the medium term, using another World Bank capital market indicator, the capital market potential indicator. This assessment could help policy makers decide if it is worth intensifing efforts to develop various segments of the local capital maket. Experience from previous crises, such as the Asian Financial Crisis in 1997–2000 and the dynamics in the United States and the euro area125 after the global financial crisis in 2007–2008, underline that local capital markets can make a key contribution to supporting an economic recovery. 124. The term “market-based solutions” is used because many of the solutions presented do not fit neatly into a traditional definition of capital markets but can be considered nonbank financing alternatives that leverage financing from capital market investors. 125. A factor behind the slower recovery in the euro area after the global financial crisis was the region’s underdeveloped corporate bond market. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 87 Potential capital market solutions to the corporate debt enabling environment for a corporate bond market is not overhang in the aftermath of COVID-19 are a complex always present. These preconditions can be grouped into three issue. The type of financial problem differs across firms, main categories: (i) a stable macroeconomic environment; making identifying appropriate solutions important, but also (ii) a relatively developed financial sector; and (iii) a solid difficult. Capital market solutions for NFCs suffering from a institutional environment. The development of public equity debt overhang should focus primarily on increasing the equity markets requires similar preconditions. Such preconditions base of the corporate to address its high leverage, while debt are necessary but not always sufficient. For example, for bond solutions may be more appropriate for firms facing liquidity markets, the level of banks’ liquidity (and consequently their problems or that are less leveraged. willingness to lend to corporates) can affect capital market development, as well as other factors such as taxation and The level of capital market development dictates the even the international macroeconomic environment. Figure role that capital market solutions could potentially play 4.1 illustrates the level of domestic capital market development in dealing with corporate debt overhang. For domestic globally, with capital markets in countries displaying either a capital market solutions, a certain level of capital market nascent or a basic level of development unlikely to be able development is needed. Only a limited number of NFCs have to play a meaningful role in dealing with the corporate debt used domestic capital markets to fund themselves, as most overhang. EMDEs’ financial sectors remain bank-centric, and the basic > > > F I G U R E 4 . 1 Overview of Domestic Capital Market Development <0.046 0.046 – 0.124 0.124 – 0.300 0.300 – 0.392 0.392 – 0.676 > 0.676 No data available Choropleth clusters are based on the Financial Market sub-index of the IMF’s Financial Development index Nascent Basic Intermediate Advanced 78 countries 54 countries 36 countries 15 countries Depth Very shallow Shallow Less deep Very deep Access Inaccessible Less accessible Accessible Very accessible Efficiency Inefficient Less efficient Very efficient Source: World Bank. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 88 Accessing international capital markets is an option Section V describes some guiding principles for policy makers for larger NFCs. The global policy response has supported assessing capital market solutions. Section VI provides NFCs in EMDEs in accessing international capital markets, an overview of public sector interventions, and Section VII but it is often only the larger NFCs that have the necessary sketches a non-exhaustive list of capital market solutions for capacity to issue debt or equity instruments in this way. A dealing with corporate debt overhang. Section VIII concludes tightening of financial conditions could see some lower-rated the chapter discussion. Annex 4A provides some background NFCs lose access to international debt markets as borrowing information, and Annex 4B provides a graphical overview costs become prohibitively expensive or investor risk appetite of capital market solutions for dealing with corporate debt subsides. For NFCs based in countries with more developed overhang. domestic capital markets, the local market may provide a complementary funding source. But in many cases, local capital markets are not adequately developed, and some form II. The Type of Corporate of public sector support may be needed to ensure continued Financial Problem market access to the international market, particularly if the Dictates the Solution NFC in question is of systemic importance to the domestic economy. In such circumstances, governments will need to carefully weigh the fiscal implications of such support as well The appropriateness of capital market solutions depends as any implication for sovereign borrowing costs. on the type of corporate financial problem. Equity solutions are best for firms facing corporate debt overhang. Box 4.1 This chapter proceeds as follows: Section II distinguishes provides an overview of the importance of equity for dealing between the types of problems faced by NFCs and the main with this type of problem. However, although NFCs with low capital market approaches to this problem, while Section III leverage before the pandemic do not necessarily face a provides a review of the academic literature on the topic. threatening debt overhang, they may still experience liquidity Section IV assesses where NFCs’ vulnerabilities are highest problems, and well-designed debt solutions could suffice to and whether capital market solutions could play a role, while address their current financial problems. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 89 > > > B OX 4 .1 A Stylized Illustration of Dealing with the Debt Overhang Corporate debt and leverage were already worryingly high in many EMDEs going into the COVID-19 pandemic due to cheap access to finance over the past decade. This stylized example shows how a company’s equity could be affected by COVID-19 and outlines two economically very different options for restoring lower leverage. Corporate debt has increased for many companies as they have borrowed to cover losses (see (1) in the figure). Losses erode companies’ equity. Higher debt and lower equity mean higher leverage. In addition, certain assets may have declined in value, for example, because of a worsened economic outlook or as a result of having become redundant due to disruptions caused by COVID-19. This is illustrated by a decline in assets (labeled (2) in the figure). A decline in assets reduces equity and increases leverage even though no cash flow is involved. Issuing equity and equity-like assets and using the proceeds to repay debt will work to reduce the corporate leverage (see (3) in the figure). Another solution is to deleverage by shrinking the company’s assets (shown in (4) in the figure). That can be a feasible approach for some companies. However, a sector- or country-wide corporate deleveraging will likely delay an economic recovery and hamper employment. Thus, raising equity where possible should generally be considered a good option to address the higher leverage following COVID-19. > > > F I G U R E 4 . 1 . A Dealing with Debt Overhang (2) Options to delever to pre-COVID leverage Eqt 50 Eqt 30 (4) Eqt 45 Assets 100 (3) Assets 90 Assets 90 Debt 30 Assets 60 (1) Debt 60 Debt 50 Debt 45 (4) Debt 30 2019 2021 II: Deleveraging by I: Deleveraging by pre-COVID post-COVID raising equity scaling down Source: Authors’ illustration. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 90 III. Literature Review the debt overhang.126 Díez et al. (2021) analyze the financial situation for MSMEs in advanced economies and policy options after COVID-19. They find that providing MSMEs with access The role of capital markets in dealing with corporate debt to new credit will not address the underlying solvency problems overhang in EMDEs has not generated a large strand of but can address liquidity shortfalls. A large efficiency gain can academic literature. One reason for this may be that there are be made by targeting the credit injection only to the firms with few episodes of corporate debt overhang in countries where clear post-COVID-19 recovery prospects but that would face the domestic financial markets have played a prominent role insolvency without the additional liquidity provision. Díez et in dealing with the problem. In cases where financial markets al. (2021) also find that the quasi-equity injections should be were a part of the solution over an extended period, the complemented with a comprehensive set of MSME insolvency episodes have not attracted much academic attention. and debt restructuring tools. A well-developed capital market can sustain economic Government efforts should focus on equity solutions and recovery. Filardo et al. (2010) note that the existence of limit the use of debt. Díez et al. (2021) stress, given fiscal well-developed bond markets in Asia after the Asian Financial constraints, the importance of targeted measures for viable Crisis could have mitigated the full impact of the crisis. By firms while limiting government support to situations in which a the time of the global financial crisis in 2007–2008, local market failure would lead to an adverse outcome. For EMDEs, currency Asian corporate bond markets provided an important foreign investment could be a particularly important source of backstop to the decline in bank-based lending. The European funds. The Group of 30 (2020) recommends that countries Central Bank (2012) analyzes the bank deleveraging in with strong banking sectors and well-developed private the euro area after the global financial crisis and identifies capital markets should use the private sector to target and elevated funding costs for banks as one source potentially deliver support. Some EMDEs have significant public sector driving the disintermediation of credit supply from bank credit investment capability through sovereign wealth funds and to market-based finance. Since then, the euro area corporate development banks that could cooperate with private financial bond market has grown in importance for corporates relative market participants to support viable firms. to bank finance, as documented by De Fiore and Uhlig (2015). The European Central Bank (De Santis et al. 2018) shows that Distressed corporates find challenges in issuing new market-based financing increased for NFCs in the euro area in equity due to misaligned incentives between existing the years after the sovereign debt crisis, while bank financing and new investors, but studies suggest that these contracted until 2015. impediments can be overcome. By construction, when new equity is issued, the existing owners are diluted. New International organizations generally align on the role investors, on the other hand, typically require a premium to that debt instruments have played in supporting NFCs’ inject new capital, in part to address the risk that the information liquidity, while the use of equity instruments is more provided to them is incomplete and that the problems of the important over the medium term. The IMF (2021) shows company are more severe than were stated to them by the that total debt and equity raising for advanced economies and original owner. Some empirical analyses suggest, however, a number of large EMDEs reached record high levels in the that equity markets can play an important role in supporting the post-COVID-19 world. It finds that the increase in corporate recovery of distressed companies. Kim, Ko, and Wang (2019) debt puts medium-term growth at risk and impacts the capacity find for Korea from 2000 to 2013 that equity was primarily of many firms to service debts. It also finds that solvency stress issued to help restructure debt and recapitalize existing assets in several large EMDEs is prevalent across different firm sizes rather than for financing new assets. They propose that equity but is more pronounced for smaller firms that still rely heavily issues in general may be an important channel to facilitate debt on policy support and bank financing. An OECD working paper restructuring in bank-centered EMDEs, as potential conflict (Demmou et al. 2021) highlights that the increase in leverage between banks and public bondholders is less of an issue than affects corporate debt servicing capacity and reduces the in other jurisdictions, such as the United States. In practice, level of investment. The authors conclude that debt financing however, while certain types of equity injections, such as from has been decisive in solving immediate liquidity problems, but family members or strategic investors, may be viable in many that equity financing could play an important role in mitigating EMDEs, public equity offerings would be much more difficult. 126. Concretely, they propose a cascade approach to govern policy intervention. First, policy should aim at restoring the equity base of corporations and supporting continued development of equity markets, particularly for small firms. Second, policy should ease debt restructuring procedures. Third, liquidation frameworks should be strengthened and improved. Some of these considerations are also pertinent for more developed EMDEs. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 91 IV. Analytical Mapping level of a country’s capital market is correlated across countries, meaning that countries with a less developed capital market also tend to have a less developed local bond This section maps corporate vulnerabilities of listed market and that the NFCs in those countries also tend to issue NFCs vis-à-vis (i) an assessment of a country’s current less debt in international bond markets (Table 4.1). However, level of domestic capital market development, and (ii) as the pairwise correlations for market developments are an assessment of a country’s domestic capital market far from 1, there are also important exceptions where one potential. The objective of this mapping exercise is to establish of the markets shows a higher degree of development than whether the local capital market displays an adequate level others; this highlights that, while not all instruments may be of development to support market-based solutions to assist available for a specific country, NFCs may still take advantage firms during the recovery. The CVI introduced in Chapter of accessing options that may be available to them despite 1 tracks financial conditions of the NFC sector based on an overall low level of market development. The development four key aspects of financial vulnerabilities that have been of individual markets is also closely correlated with the depth identified by the literature as leading indicators of corporate of the domestic investor base, underlining the importance of financial distress.127 This vulnerability index is mapped against a domestic investor base for the development of domestic the World Bank’s proprietary capital market development financial markets. indicators,128 which are used to provide an assessment of a country’s current level of capital market development as The countries with the highest corporate vulnerabilities well as its capital market development potential based on tend to have the least developed financial markets an assessment of the existence of key preconditions. This is (Figure 4.3). However, the CVI indicator does not include the important, as any intervention supported by the government or debt of unlisted NFCs or MSMEs. Countries with few listed a multilateral development bank should generally be limited to firms, and thus not included in the CVI, tend to belong to the situations with the potential for a catalytic development impact. group of countries with undeveloped markets. Notwithstanding this, in some cases, even if the local capital market is not developed or if the size of the economy does Most of the vulnerable debt included in the CVI is in not support market development, accessing international debt countries with relatively developed capital markets. This markets or attracting foreign capital to support market-based reflects that large countries tend to have more developed solutions may be an option for larger, more sophisticated NFCs. capital markets and that there are larger NFCs in those countries (Figure 4.4). It follows that capital market solutions For the immediate relevance of domestic capital markets could be relevant in dealing with a large part of the total listed to support solutions to the current NFC debt overhang, debt at risk in these EMDEs. Countries not included in the CVI, the initial level of capital market development matters. and MSMEs or other firms with unlisted debt in the countries The initial state of capital markets cannot be considered in the CVI, may still have challenges with corporate debt sufficiently developed to a level that is supportive of capital overhang, particularly from bank loans. These countries and market solutions to NFC debt overhang on a significant scale borrower segments may have the most difficulties accessing in around 90 percent of EMDEs (Figure 4.2). The development capital in financial markets. 127. Debt service capacity, leverage, rollover risk, and profitability/market value. The Corporate Vulnerability Index (CVI) tracks financial conditions of the nonfinancial corporate sector listed on the local stock exchange. Using readily available balance sheet information of 17,284 listed nonfinancial firms in 74 countries (for 2020Q4), the CVI is based on seven indicators that capture four key dimensions of firms’ financial vulnerabilities. The four dimensions are debt service capacity, leverage, rollover risk, and profitability/market valuation. The seven indicators are interest coverage ratio, leverage ratio, net debt to EBIT ratio, current liabilities to long-term liabilities ratio, quick ratio, return on assets, and market to book ratio. For methodological details, see Feyen et al. (2017). 128. The indicator is composed of four pillars: macroeconomic stability, level of financial sector development, strength of institutions, and current level of capital market development. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 92 > > > > > > F I G U R E 4 . 2 Initial State of Development by TA B L E 4 .1 Correlation Matrix of Depth of Income Group of Countries Private Sector Markets and Depth of Domestic Investor Bases 35 1 2 3 A B C 30 1. Equity market 1.00 25 capitalization 20 2. Domestic 0.54 1.00 No. of countries debt securities 15 3. International 0.63 0.54 1.00 10 debt securities 5 A. Mutual 0.57 0.61 0.55 1.00 fund assets 0 Undeveloped Little Medium Relatively B. Insurance 0.66 0.46 0.52 0.53 1.00 developed developed developed company assets C. Pension Upper middle Lower middle Low 0.59 0.44 0.43 0.56 0.54 1.00 fund assets income income income Source: World Bank. Source: World Bank. Note: Excludes high-income countries. Note: Excludes high-income countries. Correlations are based on development scores for the countries for specific financial market aspects. The development scores for indicator (1), (2), and (3) are based on the level of outstanding amounts, and indicator (A), (B), and (C) are based on AUM. > > > > > > F I G U R E 4 . 3 Vulnerability vs. Initial Market F I G U R E 4 . 4 Vulnerability vs. Initial Market Development—Number of Countries Development—Debt at Risk 24 400 3 22 20 8 9 18 300 16 11 No. of countries 14 6 12 6 200 US$ bn 10 2 8 2 4 6 100 4 8 7 6 2 0 0 Most Medium Least Most Medium Least vulnerable vulnerable vulnerable vulnerable vulnerable vulnerable Undeveloped Little Medium Relatively Undeveloped Little Medium Relatively developed developed developed developed developed developed Source: World Bank. Source: World Bank. Note: Only includes countries for which there is data for the CVI. Split of Note: Only includes countries for which there is data for the CVI. Split of countries into thirds based on the CVI. countries into thirds based on the CVI. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 93 The extent that capital market solutions can play a role capital markets with participation from local investors provide in helping NFCs deal with corporate debt overhang some insulation from swings in global financial markets and varies significantly across countries. In some countries, may help reduce the risks from reversal of capital flows, for capital market development is at a level where capital market example, from global monetary policy contractions, such as solutions are already relevant to explore (Figure 4.5). In others, during the taper tantrum in 2013. based on the country’s institutional features, macroeconomic stability, and financial sector features, scope exists to In geographic terms, the corporate debt of countries in develop capital markets. The countries with the highest Europe and Central Asia, East Asia and Pacific, Sub- debt vulnerability (names in red in Figure 4.5) are present Saharan Africa, and South Asia is most vulnerable. Sub- throughout the development spectrum. Currently, a limited Saharan Africa stands out for having the least capital market number of countries have the potential to achieve a stage potential, but in dollar terms also the least total value of where a capital market solution becomes promising, based vulnerable debt (Figure 4.6). Figure 4.7 illustrates the still high on the current characteristics of the countries’ preconditions. percentage of USD borrowing in several countries by NFCs. The current economic crisis has shown the value of developed The highlighted box shows a group of countries that have a capital markets, as many issuers were able to access markets relatively high score on the capital market potential indicator despite the severity of the economic situation. As a lesson and that have high USD borrowings. For these countries, from this, countries should work on the preconditions for developing a more stable domestic capital market would financial market development, helping to develop local capital reduce vulnerabilities. markets to reduce the risks in future crises. Further, domestic > > > F I G U R E 4 . 5 The Current Level and Potential Capital Market Development and Corporate Vulnerability of Individual EMDEs Red: Highest corporate debt vulnerability India, Thailand, White: Medium Indonesia, Peru, Philippines, Brazil, Green: Lowest Poland, Turkey, Chile, Israel, Malaysia, Saudi Arabia, Russia, Mexico, Montenegro, Kenya, Egypt, Colombia, Czech Republic, Hungary, Higher current capital market development Argentina, Ukraine, Panama, China, South Africa Croatia, Slovenia, Vietnam, Tunisia, Bulgaria, Pakistan, Nigeria, Mauritius, Kuwait, Morocco, Sri Lanka, Ghana, Bahrain, United Arab Emirates, Qatar, Oman, Jamaica Venezuela, Cote d’Ivoire, Kazakhstan, Zambia, Costa Rica Estonia, Botswana, Trinidad and Tobago Tanzania, Lao PDR, Bosnia and Herzegovina, Zimbabwe, Uganda, Serbia, Uruguay, Romania, Mozambique, Bolivia, Mongolia, Ecuador, Paraguay, Bangladesh, Georgia, Macedonia, Latvia, Malawi, Cambodia Bahamas Lithuania Higher capital markets potential Source: World Bank staff estimate. Note: Based on the Corporate Vulnerability Index and the capital market potential indicator. Only includes countries included in the Corporate Vulnerability Index. Countries not included in the index tend to be small and to display a small degree of capital market development. For the x-axis, if the potential is less than the current level, the current level is used, as it is likely a good representation of the short-term potential for capital market solutions; therefore, the upper triangle is empty. Boxes from left to right and from bottom to top correspond to “Undeveloped,” “Little developed,” “Medium developed,” and “Relatively developed” in the previous charts. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 94 > > > F I G U R E 4 . 6 Geographic Vulnerabilities and Capital Market Development Potential Vulnerability, country average 0.18 Europe & Sub-Saharan Central Asia, 52 East Asia & Africa, 6 Pacific, 346 0.16 0.14 South Asia, 224 Middle East & North Africa, 60 0.12 Size of bubble: debt at Latin America & risk, US$ bn Caribbean, 88 0.1 Capital market development potential, country average 0.08 Little developed Development potential Source: World Bank. Note: “Development potential” corresponds to “medium development” for the level of the initial indicator. > > > F I G U R E 4 . 7 NFCs in Some Countries with Higher Capital Market Development Potential Still Focused on USD Borrowing 4.00 MYS 3.50 Capital market potential indicator THA ZAF CHN 3.00 CHL POL MEX CZE HUN IND RUS SAU 2.50 TUR COL PEU PHL BRA VNM 2.00 PAK UKR NGA ARG GHA EGY LBN KEN 1.50 0% 20% 40% 60% 80% 100% % of USD denominated NFC debt (bonds + loans) Source: World Bank. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 95 V. Assessing Capital First, any capital market solution must be feasible. Feasibility will depend on both demand and supply factors. For Market Solutions the former, the factors included in the capital market potential indicator are a sufficient investor base that can be attracted and having the necessary financial infrastructure in place. On The following section provides guiding principles for the supply side, the structure of the corporate sector is equally policy makers when considering implementing capital important for the relevant types of capital market instruments. market tools. Appropriate and possible capital market tools For example, firm size, sectoral specialization, corporate depend on a large number of factors. Therefore, a decision culture, and ownership structure will be important. For issuing tree directly applicable in all cases is out of scope. Instead, debt in international markets, careful consideration should overall guiding principles are presented to help steer policy especially be given to the relative cost of the borrowing, the makers toward appropriate and possible solutions, if any. foreign exchange risk, and the term of the borrowing. Capital market solutions for corporate debt overhang can Second, any capital market solution must be appropriate, be grouped into three broad categories: debt instruments, as liquidity and solvency problems require different equity instruments, and hybrid instruments. Before solutions. Figure 4.9 suggests which type of solutions should presenting a generalized discussion on these three categories, be the primary avenue to explore to find an economically this section sets out guiding principles for assessing a solution appropriate solution. and general principles for adequate public sector intervention, if needed. If capital market solutions are considered, they should meet the following guiding principles: feasible; appropriate; market-based, if possible; and proportionate (if any) public sector involvement (Figure 4.8). > > > F I G U R E 4 . 8 Capital Market Solutions to Corporate Debt Overhang: Guiding Principles Address the Supported by nature of the the level of problem and capital market provide the development Feasible Appropriate economically best solution Benefiting from Public market signals Market based Proportional involvement and preserving should be public funds proportionate Source: Staff illustration. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 96 > > > F I G U R E 4 . 9 Map of Economically Appropriate Solutions Depending on Corporate Condition Corporate financial situation Viable corporate with Viable corporate with Nonviable healthy finances financial issues Solvency issues Liquidity issues Business as usual Equity type instruments Debt type instruments Default Source: Staff illustration. Increasing the equity base of a company can address support measures. For companies that only face liquidity solvency issues and thus provide support so the issues and not solvency issues, debt solutions will suffice to company has the financial flexibility to undertake solve their immediate problem, although equity solutions can profitable investments. The high uncertainty regarding the also suffice. This could particularly be true for those MSMEs next stages of the COVID-19 pandemic and the strength, that did not have well-established access to financial markets type, and timing of any economic recovery also favor or the banking system before COVID-19 and thus were running increasing equity capital. Finally, increasing equity provides their business based on internally generated cash. Box 4.5 a permanent injection of funds, whereas debt is subject to in Section VII discusses capital market solutions for MSMEs coupon payments, redemptions, and potentially withdrawals. in more detail. For companies with solvency issues, positive Hybrid equity solutions may also have coupon payments and steps include debt solutions such as extending maturity and a redemption date, but the full payback in cash, and thus the lowering interest rates to reduce risks from existing debt (e.g., drain on corporate liquidity, is contingent on developments. On the rollover, interest rate, and foreign exchange risks), but that basis, equity solutions are generally appropriate avenues further accumulation of debt and higher leverage is generally to explore for viable firms. Hybrid solutions should also be not advisable. considered and may help strike a balance between equity and debt solutions, although such solutions are likely only viable in Out-of-court restructuring can be considered on a case- the most developed EMDE capital markets. by-case basis as it may in some instances be a good solution to address the liquidity or solvency problem of the firm, as Debt solutions can address liquidity issues and reduce highlighted in Chapter 2 of this report. A special purpose AMC the risk of cliff effects of widespread defaults, as well as or distressed debt fund may play a facilitating role. Finally, if address risks on the existing debt stock. Debt solutions a firm is not viable in the medium or long term, equity or debt may help to avoid widespread defaults of companies that risk market solutions are not advisable. Instead, the advisable spilling over to the financial system and the economy. Provision solution is restructuring or liquidation, depending on the of liquidity both from financial markets and the banking system severity of the financial situation and the firm’s importance. is therefore crucial while governments phase out liquidity EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 97 Third, market-based solutions are generally preferred. Last, public involvement should be proportionate. If public Such a solution will benefit from the market’s assessment sector involvement is needed to facilitate a solution, some of the company’s economic situation and preserve public extra considerations should be made. Generally, public sector funds for use where they are needed more. As a general involvement serving as a catalyst to attract private capital principle, policy makers should let the market play its role in on market terms can be considered in cases where there allocating capital to the most productive and needed places, are failures preventing a market-based solution. Initiatives for example, by letting the market distinguish between viable to support the development of markets are also generally and nonviable companies. Still, there can be instances where advisable. More direct involvement, such as co-investment/ the allocation of capital is suboptimal from society’s point guarantee solutions, should be considered carefully and of view. That could be the case for certain strategic sectors evaluated against all other alternative solutions, including the if spillovers and contagion risks to other companies and option of not acting. If public intervention is indeed warranted, the broader economy are high or in some cases if financial solutions should be designed so that the public purse is markets are underdeveloped. As a starting point in all these rewarded from any economic recovery. The design of public cases, the public sector strategy should focus on facilitating sector involvement should be carefully considered. Box 4A.1 the companies’ access to markets and addressing the market in Annex 4A provides more detail on considerations for policy failure instead of playing the role of the market. In this way, the makers in providing public policy support for capital market use of public capital is reduced, and concerns related to public solutions. interventions are lowered. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 98 VI. Types of Public Multilateral development banks such as the World Bank Group and the Inter-American Development Bank Sector Interventions also offer partial financial guarantees to some EMDE borrowers. The guarantee can be tailored to meet the needs of both borrower and creditors. Guarantees should be limited Credit guarantees and other risk reduction methods to the minimum amount necessary to facilitate a successful protect bondholders against the bond issuers’ defaults transaction. Guarantee facilities have many benefits, such as or any other kind of mutually agreed “credit event.” As enabling corporate market access, diversifying the investor a result, these instruments upgrade the credit quality of the base, and contributing to capital market development. bond issuer. Providers of such risk reduction mechanisms can Notwithstanding these benefits, operationalizing a guarantee be private companies, government agencies, or international program in practice can be challenging, as guarantees are financial institutions. Guarantees, in particular, will constitute a sometimes not efficiently priced in the market. One driver of contingent liability for the provider. However, in most EMDEs, this is the heterogeneity of terms, conditions, and coverage the economics for private insurers of providing risk reduction events. However, neither guarantees nor credit-enhanced mechanisms to individual NFC issuers is not yet compelling,129 borrowings may represent the most efficient way to use capital and it normally requires some kind of public intervention. from multilateral development banks and would need to be evaluated on a case-by-case basis. Governments could set up agencies to provide risk reduction mechanisms to targeted borrowers. Box 4.2 Debt or equity co-investments by local development provides an example of a government-supported credit fund. banks, strategic investment funds, sovereign wealth If these agencies do not use market pricing, they provide a funds, or state pension funds may be considered. Such government subsidy to the beneficiaries, that is, the local NFCs. investors are often well placed to invest in local viable This, in turn, raises issues of transparency, fairness, potential corporates in strategic sectors and to help support an for corruption, and potential fiscal costs to taxpayers. In economic recovery, especially in circumstances where the addition, while they may relieve pressure for NFC restructuring, banking system is not providing such funding. However, they also delay the strengthening of the corporate sector. For such public-level involvement needs to be carefully weighed issuance in international financial markets, the credit rating of by policy makers. The current unprecedented crisis calls for the guarantor will likely have a significant effect on the market extraordinary measures. In some circumstances, it may make pricing of the guarantee, and as a result, guarantees issued by economic sense to use local pools of liquidity to support the lower-rated sovereigns may be less efficient. corporate/MSME sector. Such investment could be via either debt or equity and could be on market terms. > > > BOX 4.2 Credit Funds Supported by Governments and Multilateral Development Banks Credit funds, supported by multilateral development banks, could (i) expand financing to mid-market companies; and (ii) help countries deal with the many problems that arise from corporate debt overhang, including lack of bank financing. The fund could be structured in various ways to attract institutional and/or retail investors. The authorities would need to define the characteristics of the fund, including: • Type of assets that can be included in addition to direct loans (such as acquisition of loans up to a certain percentage and receivables) • Maximum concentration per debtor to the total portfolio • Maximum participation as financier for the total debtor’s indebtedness • Type of loans accepted (minimum and maximum amount, tenor, index, and guarantees) • Minimum and maximum administration fees 129. In many EMDEs, the credit market infrastructure (such as credit registries and volumes of financial disclosures) is often underdeveloped, which means that there is not enough industry-specific credit information to accurately price credit risk. This results in a high premium that makes it prohibitively expensive for NFCs, and especially MSMEs, to enhance their bond issues. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 99 In more systemic cases of corporate debt overhang One potential solution would be a debt fund supported by of sizable NPLs that threaten financial stability, policy the private sector or a multilateral development bank. The makers must consider the merits of establishing a fund would purchase the securities from the affected firms, public AMC to take responsibility for resolving NPLs, thus alleviating their liquidity problem. The fund would then as outlined in Chapter 2. Such an AMC may be established manage the debt portfolio and sell the securities to institutional by the government or with multilateral development bank investors over time. A relatively active secondary market as support. Policy makers should be cognizant that government well as a mix of institutional investors would be required for interventions on such a scale increase the bank-corporate- such a proposal to work efficiently. Furthermore, as the risk sovereign nexus and may also have implications for sovereign of crowding out would be large, coordination between the borrowing costs and overall country risk premium. fund and the country’s debt management office would be very important as any lack of coordination would result in volatile Government arrears to NFCs (for services provided borrowing costs for the government. Moral hazard is also high to the government) can be a major liquidity problem in with such funds, as the government may be less willing to pay some EMDEs. While a portion of these arrears relate to the arrears, especially if there is multilateral development bank COVID-19 shock, they have been an ongoing issue in some support. Given these constraints, such a fund would likely be a Sub-Saharan African countries, such as Angola. In some solution worth considering in only a small number of EMDEs. of these countries, governments have tried to manage the Some other formats could also be worth considering, such arrears problem by issuing government securities to affected as changes to collateral rules or allowing corporates to offset firms. Due to a lack of depth in the financial sector, it may be their tax liabilities. This could also help develop a secondary difficult for the relevant firm to sell the security in the market. market for these securities over time. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 100 VII. Instrument Overview A. Debt Instruments When facing a crisis or uncertain outlook, corporates should aim to reduce inherent risks in their debt portfolios, This section outlines a non-exhaustive list of capital such as overreliance on foreign currency borrowing market solutions for dealing with a corporate debt or short-term debt. Since the onset of the COVID-19 overhang. Figure 4.10 provides an overview of the main types pandemic, many NFCs have used the benign financial market of capital market instruments. The relevance of each solution environment, supported by the extraordinary policy response, will need to be considered in more detail and adjusted to the to good effect by issuing debt in both the domestic and the specificities of each country, corporate, or corporate sector international market (Figure 4.11). and to the nature of the problem at hand. Solutions should also be assessed by whether they complement or work against Debt instruments are often preferred by NFCs over equity each other and by the extent to which public sector involvement instruments. Many NFCs are more comfortable with debt is necessary, as well as its effect on other aspects of market instruments given the familiarity with loans and credit lines from functioning. Other, more innovative instruments could work in the banking sector. Moreover, issuing debt in the domestic or certain circumstances, but the type of instruments used will be international market can often be a more flexible and cost- dictated largely by the level of capital market development. The effective funding tool than a bank loan. For example, an NFC use of more bespoke instruments is likely only at the margin. can lock in fixed borrowing costs over a relatively lengthy time horizon, compared to a bank loan, and be subject to fewer The feasibility of the solutions should be determined on borrowing conditions. Certain markets may have more of an a case-by-case basis guided, for example, by analysis equity culture, and in these cases, the domestic debt market of the current state of the market and by assessing for corporates may be relatively less developed. prerequisites and enabling factors for specific solutions in a country. No recipe indicates when a capital market exists or has the potential to be developed. However, a number of enabling factors can be assessed. Many are common for different capital market solutions, although each solution may also require considering more specific prerequisites. The next section discusses three main types of instruments and highlights necessary preconditions. > > > F I G U R E 4 . 1 0 Capital Market Instruments to Address NFC Solvency and Liquidity Issues Solvency issues Liquidity issues Equity type instruments Debt type instruments Quasi-equity, e.g. preference Listed Private International Domestic bond shares, convertible equity equity bond issuance issuance bonds, and profit participating bonds Source: Staff illustration. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 101 > > > F I G U R E 4 . 1 1 NFC Issuance Trends in Domestic and International Debt Markets Local currency markets also saw an increase, but remain small and fragmented outside the largest EMDEs 300 250 200 150 100 50 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 INB MYR TRY ZAR BRL THB RUB CLP IDR MXN PLN ILS COP ARS CZK PEN UAH HUF KZT PHP Others Source: Bloomberg. Record year of NFC issuance in international State-owned enterprise issuances contribute a large capital markets dominated by China share to NFC international issuance 50 175 14 80 158 12 40 152 160 70 145 10 143 30 140 139 139 145 60 133 135 8 130 130 131 6 20 130 50 4 10 115 40 2 0 100 0 30 Jan 20 Feb 20 Mar 20 Apr 20 May 20 Jun 20 Jul 20 Aug 20 Sep 20 Oct 20 Nov 20 Dec 20 Jan 20 Feb 20 Mar 20 Apr 20 May 20 Jun 20 Jul 20 Aug 20 Sep 20 Oct 20 Nov 20 Dec 20 Source: IMF. Source: IMF. SE Asia (ex China) SSA 12m issuance SE Asia (ex China) SSA Pemex Europe MENA pace ex China (rs) Europe MENA 12m issuance LAC China LAC China pace (rs) Some EMDE corporates have significant bond redemptions in the next three years 180 40% 160 35% 140 30% 120 25% 100 20% 80 15% 60 10% 40 5% 20 0% 0 India Russia Brazil Mexico Thailand Malaysia Israel Indonesia South Africa Saudi Arabia Chile UAE Singapore Argentina Nigeria Colombia Philippines Peru Czech Republic Turkey Ukraine Poland Ghana Hungary Vietnam Kenya Source: IIF. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 102 Issuance in the domestic market. Corporate issuance indices, which is another important consideration. Corporates of domestic currency bonds is low in most countries with that issue in international capital markets are exposed to a underdeveloped capital markets. This is mainly because of turn in the EMDE financial cycle. Lower-rated sovereigns and the lack of financial sector depth and the culture of continued NFCs are most exposed to higher interest rates and a change heavy dependence on bank funding in many EMDEs. In many in international risk perceptions as the global economic cases, issuing in the local market can be more expensive than recovery takes hold. A sudden reversal of capital flows, like the bank funding. Foreign investor demand is also generally low. one experienced during the taper tantrum episode in 2013, will Factors such as taxation, currency risk, thin liquidity, limited put access to lower-rated sovereigns and corporate issuers at access to information on the issuer, and lack of coverage by risk. Furthermore, in a more systemic scenario of corporate rating agencies are key barriers to increased foreign investor distress, the corporates’ respective sovereign market involvement. As a result, many foreign investors favor the access would also likely be affected—a manifestation of the more diversified and liquid international corporate bond sovereign-corporate nexus (European Central Bank 2021) market. Given this backdrop, it is likely that the domestic that could also be exacerbated by high debts in state-owned debt market can only act as an important corporate funding enterprises. In such cases, issuing debt in the international source in the most developed EMDE capital markets, where market would not likely be an option. International issuances the institutional investor base is large. Box 4.3 explores one are skewed toward countries with more developed markets, possible solution for public sector involvement to support local but less so than domestic issuance. currency corporate bond markets. Liability management operations can occur in both the In international markets, debt issuance in hard currency domestic and international capital market. A decline in can cater to a broader group of investors and be more the secondary market prices of existing debt presents an liquid. On the downside, the access to the market depends opportunity for the company to restructure its debt on more more heavily on global financial developments, and the risk favorable terms. By repurchasing their debt for cash or perception of the investor base is often more volatile. Issuance exchanging the debt for new securities, the company can in international markets should be of a large size to attract reduce its indebtedness as well as the related interest cost. investors and reduce the premium that the issuer pays if the A company that decides to restructure its outstanding debt bond liquidity is low. In addition, only bonds with a certain securities can do so with or without the use of cash. Before a minimum outstanding amount are included in the relevant bond company embarks on a debt restructuring, it should carefully > > > BOX 4.3 A Local Currency Corporate Bond Platform A local currency guaranteed fund could provide a mechanism for corporates to access funding in local currency. Such a fund could be operationalized via a guarantee from a multilateral development bank, as well as by private debt funds. This public sector involvement is quite likely to prove attractive to foreign investors. The fund, modeled on the CGIF Asian Bond Markets initiative platform,130 could invest in local currency bonds of viable nonfinancial corporates and offer investors a cost-effective way to gain diversified exposure to relatively high-yielding assets with contained risk. The CGIF provides guarantees on bonds denominated in local currency and issued by NFCs in the ASEAN + 3 region. The aim of the CGIF is to help NFCs that otherwise would have difficulty issuing in local bond markets to secure longer-term financing and reduce their dependency on short-term foreign currency borrowing to mitigate currency and maturity mismatches. A local currency fund would be attractive to smaller NFCs that would otherwise find it difficult to access a wide investor base. However, funded NFCs would require relatively sound fundamentals to make the fund attractive to institutional investors. The bundling of assets in this way may require substantial operational and financial involvement of the sponsoring institution. Experience suggests that such an initiative may require a sustained effort over several years. It is not clear whether the fund could be expanded to a macro-relevant scale in time to make a difference in the aftermath of the COVID-19 pandemic. 130. Credit Guarantee and Investment Facility, https://www.cgif-abmi.org. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 103 review the terms of its outstanding debt. In many situations, Issuers of bonds trading at distressed prices may find covenants in bank or other debt agreements will restrict the that none of these methods are realistic because each company’s ability to redeem its debt securities. Waivers of requires a significant amount of cash, which is generally these covenants may not be available while the company is in in short supply for troubled corporates. In addition, most financial distress. In most situations, there will be some limited senior credit agreements limit or prohibit repurchases of junior exceptions to this restriction, and the company will need to debt (whether unsecured, subordinated, or secured on a junior ensure that the terms of any proposed restructuring fit within lien basis) ahead of its scheduled maturity. As a result, often the limited exceptions. Companies also need to consider the the only viable option outside bankruptcy for many distressed tax consequences of debt buybacks and exchange offers. low-rated issuers is an exchange offer, typically coupled with Figure 4.12 illustrates common corporate liability management an exit consent that removes most of the protective covenants techniques. from any non-exchanged bonds. Annex 4A considers some of the approaches to restructuring corporate debt. > > > F I G U R E 4 . 1 2 Overview of Key Liability Management Techniques • Depends on terms of debt CASH REDEMPTION • Availability of cash for redemption • Redeems at par; often higher than market price • Buyback of debt in the open market/privately negotiated CASH PURCHASES • Often at discount to par amount • Needs enough cash CASH TENDER • Public offer to purchase some or all of outstanding debt • Often at discount to par • No cash available • Offer to holders to exchange current securities for EXCHANGE OFFER newly issued debt or equity • Often at market discount Source: Davis, Polk, and Wardwell 2008. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 104 Preconditions for NFCs’ Issuance the market. The primary market framework also needs to be of Debt Instruments appropriate for issuers while ensuring investor protection. Such a framework can include a streamlined registration Developing the local corporate bond market generally process and issuance regulation; reduced approval time and requires (i) a stable macroeconomic environment; (ii) fast-track options such as shelf registrations for seasoned a relatively developed financial sector; and (iii) a solid issuers; integrated disclosure; and e-prospectuses. institutional environment (Figure 4.13). As a result, only a limited number of EMDE NFCs have issued debt in domestic NFCs from EMDEs with underdeveloped local capital capital markets. In addition, many NFCs in EMDE countries markets or more international balance sheets could lack the financial sophistication to actively engage with consider issuing in international debt markets. Corporates corporate bond markets, often viewing this funding route as that access international capital markets generally need too complicated, costly, and difficult to explain to shareholders. to meet certain requirements, and their ability to do this will depend on their balance sheet size, financial situation, credit Issuance in the domestic debt market requires a relatively history, industry, and geographic location. In some cases, in well-developed government bond market. A developed less developed EMDEs, only the largest NFCs in the country government bond market provides a foundation for the will have the ability and scale to access international capital development of a local corporate bond market. For example, markets. Issuance in international debt markets normally the government bond yield curve serves as an important requires a credit rating; there may also be many other fees, reference point for capital market activity, while the existence which can be nontrivial and should be factored into decision- of robust market infrastructure supports the development of making. > > > F I G U R E 4 . 1 3 Preconditions for Debt Issuance Debt type instruments Preconditions International Domestic bond issuance bond issuance Enabling conditions such as macroeconomic conditions, large enough Prerequisites economy, financial sector soundness Credit rating, issuance program Developed and liquid market with (e.g. EMTN), market access, established yield curve, domestic level of sophistication investor base, market infrastructure Source: World Bank. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 105 > > > F I G U R E 4 . 1 4 Domestic Corporate Bond Markets 4 ZAF ISR THA CHL MYS BRA IND PHL RUS 3.5 POL Level of capital market development CZE COL MEX IDN 3 HUN PER 2.5 2 KAZ 1.5 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000 Average domestic NFC issuance (2018 to 2020) Source: Staff illustration. Potential for Debt Instuments Where there is a public domestic equity market, both listed firms and nonlisted firms can, in principle, raise new Only a limited number of EMDEs have active domestic equity. Nonlisted firms can go public in initial public offerings. corporate bond markets (Figure 4.14). As a result, NFC debt However, the expensive administrative requirements behind options are most promising in these markets. This assessment public listing make it less attractive for many firms. Furthermore, is based on average NFC issuance volumes in the domestic the process of listing is long and costly, and success is subject market over the period 2018–2020. Notwithstanding this to having stable market conditions over longer periods. Listed assessment, and as illustrated in Figure 4.14, which also firms can do follow-on issuances (sometimes referred to as considers capital market development potential, policy makers seasoned equity offerings). These can take the form of rights should be cognizant that the current environment may present offerings, where existing shareholders receive a right to buy an opportunity to begin developing the local corporate bond new shares, or issuance to new investors. For investors, market, based on local specificities. Finally, the potential for equities are well-known and straightforward financial products crowding out is an important consideration when developing with a high risk and reward and offer a voting right. They are a corporate bond market, particularly in economies with less tradeable in small sizes and on a continuous basis, which financial depth. makes public equity particularly attractive to a broad investor base, including retail investors. As illustrated in Figure 4.15, B. Equity Solutions since the beginning of 2020, NFCs in countries with the The choice between debt and equity as the source of highest level of initial capital market development were able to financing can vary depending on a firm’s life cycle, issue the most equity, apart from a few outliers. The figure also market conditions, and company preferences. Equity suggests that equity issuances only take place in significant solutions can provide firms with patient capital, promoting volumes in countries with relatively developed capital markets long-term innovation, risk taking, and growth. The decision is (i.e., a score of 3 or above)131 and deeper investor bases. relevant, especially for growth companies that want to shift from being a small-to-medium company to being a large one with the potential to affect the real economy and boost overall economic growth (Isaksson and Çelik 2013; OECD 2019). 131. Based on the capital market development indicator. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 106 > > > F I G U R E 4 . 1 5 Equity Markets in EMDEs Equity issuance by level of initial EMDEs with a deeper investor base capital market development have a more developed equity market Equity issuance since 2020 in % of GDP 2.5 80% 70% 2.0 60% 50% 1.5 40% 30% 1.0 20% 10% 0.5 0% Malaysia China Brazil Turkey Costa Rica Lebanon India Mexico South Africa Indonesia Thailand Philippines Venezuela Iran Argentina Bangladesh Colombia Peru Nigeria St. Lucia Pakistan Dominican R. Vietnam Botswana Russian F. Cabo Verde Morocco Maldives Egypt 0 0 1 2 3 4 Initial level of capital market development Stock market capitalization / GDP (%) Investor base (% of GDP) Source: Bloomberg and World Bank. Source: World Bank. Private equity (PE)132 funds are pooled sources of Preconditions for Equity Solutions capital that are used to invest in the equity ownership of Preconditions for equity market solutions share many companies. Investors buy equity/quasi-equity securities in similarities with those needed for the domestic bond companies that are not publicly traded, and in exchange for market to develop. For some markets, depending on local the capital they take an ownership stake in the company, with specificities, equity appears first, and the market for corporate an expectation that the company will be more valuable and will debt develops later. The experience of the World Bank generate profit when the investor exits in three to seven years. Group in the field suggests that in practice there is no rigid Most funds are structured as partnerships, but other legal sequencing between equity and corporate bond markets; structures exist, such as trust and limited liability companies. rather these two markets tend to develop in parallel (due to PE funds can leverage their strategic and operational know- their complementarity) albeit at different speeds—depending how to help companies navigate the COVID-19 crisis and post- on local context. crisis re-adjustments. Unlike other financial intermediaries, PE funds do not just provide capital; they also provide firms with operational capabilities that will be critical in helping Equity market development is often curtailed when the them navigate the major trends that will shape economies in preconditions for market development are not present. the post-COVID-19 world.133 The PE business model is well Raising capital through the equity market is much more difficult suited to help navigate companies out of economic crises, than from the corporate bond market. Corporate governance as companies can benefit from the strategic and operational is a big challenge for small equity issuers. The level of know-how of investors. PE solutions could be particularly disclosure requested by corporate governance requirements useful for MSMEs, for which public equity listings are unlikely is costly; transparency requirements make equity issuance and tighter lending conditions make securing debt financing more expensive than debt issuance. In small economies, more difficult. equity issuers may face another challenge: protection of the 132. https://www.ifc.org/wps/wcm/connect/2099c86a-0f99-404f-b407-0691869bc00e/202008-COVID-19-Impacts-PE-EMs.pdf?MOD=AJPERES&CVID=ngxmslN. 133. These include (i) shifts in global supply chains; (ii) digital transformation; and (iii) increased demand for environmental, social, and governance investing and related impact-oriented investment opportunities. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 107 minority stakeholders. Those markets contain a lot of family- However, the literature suggests that these problems can be owned companies, the current owners of which might be overcome and that the equity market is used to some extent reluctant to give control and/or monitoring rights to people by distressed companies to raise new capital. Incentives to outside the family. This reluctance may prevent the company use equity finance are also affected by corporate tax codes, from going public. as interest rate payments on debt are tax deductible. Box 4A.2 in Annex 4A explains ways to address this debt bias to support In many EMDEs, large companies have the choice of equity financing, but such attempts may come at a fiscal cost. listing on a domestic or a foreign exchange (either a larger exchange in the region or an international exchange), PE solutions involve some prerequisites, including a which may offer more investors, prestige, and liquidity. minimum level of private investment and an enabling tax/ This can be beneficial for the domestic capital market as it regulatory environment (see Figure 4.16). Successful allows foreign investors to get comfortable and familiar with PE funds require experienced fund managers with an companies from that market, making them more likely to established presence on the ground and a proven ability to participate in the domestic market once any legal and regulatory source a proprietary deal-flow. Relevant country and industry barriers for foreign investors are removed. On the other hand, experience are also important. A clear investment strategy, a strong regional markets can attract issuers, investors, and demonstrated successful track record, and a certain level of liquidity away from the domestic market. diversification will also likely make a PE fund more investable. In underdeveloped markets, PE funds may require high levels A challenge for equity market solutions is whether existing of support from multilateral development banks, particularly investors have incentives to support the issuance of new in International Development Association/fragile and conflict- equity and whether new investors have incentives to affected situations markets, to demonstrate the viability of the inject capital. By construction, when new equity is issued, PE business model in unproven situations, establish a track the existing owners are diluted, that is, their ownership share record, and give comfort to other investors, encouraging them of the company goes down if they do not inject new capital to enter into follow-on funds (Box 4.4). Multilateral development into the company. New investors, on the other hand, typically banks go beyond providing capital; they also demonstrate that require a premium to inject new capital, in part to address the it is possible to invest in nascent markets by providing stable risk that the information provided to them is incomplete and funding, improving fundraising, and promoting environmental, that the problems of the company are more severe than were social, and governance standards.134 stated to them by the original owner (asymmetric information). > > > F I G U R E 4 . 1 6 Preconditions for Equity Solutions Equity type instruments Preconditions Quasi-equity- Listed equity Private equity debt intruments Enabling conditions such as macroeconomic Prerequisites conditions, large enough economy, financial sector Developed, liquid markets, Developed, liquid markets, Domestic investor base soundness, equity domestic investor base, domestic investor base, and market infrastructure, culture financial market infrastructure. financial market infrastructure. enabling tax and regulatory Corporate culture; willingness to Corporate culture; willingness environment. Good exit dilute ownership share and give to dilute ownership share and opportunities for funds up part of control give up part of control Source: Staff illustration. 134. For example, multilateral development banks back more than 50 percent of PE funds in Sub-Saharan Africa and the Middle East and North Africa—regions where the market is still highly underdeveloped—and they back more than 70 percent of the MSME funds critical for nurturing these funds to scale. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 108 Potential for Equity Solutions Equity solutions will be an option in markets with a more developed capital market. Figure 4.17 illustrates where equity markets could be a viable option now, with markets with a market development indicator of 3 or above showing most promise. PE is a small but relatively established asset class across many EMDEs. Funding in EMDEs continues to show varying levels of activity, with almost 75 percent occurring in China and India. The macroeconomic impact of the COVID-19 pandemic presents a challenging backdrop for continuing to grow this financing source in many EMDEs. The uncertainty from the pandemic built onto already significant challenges in investing in EMDE PE funds, such as weak enabling environments; lack of experienced, quality fund managers; shortage of deal availability; and limited exit opportunities. Another challenge is that most global investors do not invest in local PE and prefer regional offerings with coverage across several corporates and countries. Considering this difficult backdrop, PE is likely to be only a marginal solution in the majority of EMDEs. > > > F I G U R E 4 . 1 7 Domestic Equity Markets ZAF THA 4 MYS CHN BRA IND TUR PHL 3.5 Level of capital market development PER COL MEX IDN JOR 3 LBN MAR EGY VNM KEN PAK 2.5 IRN LKA UKR IDN NGA JAM BGR 2 PNG GHA NAM 1.5 0 5 10 15 20 25 30 35 40 45 50 Number of firms adjusted for equity market capitalization Source: Staff illustration. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 109 > > > BOX 4.4 International Financial Institutions Supporting PE Funds in More Nascent Markets Co-investments are important, especially in the EMDE COVID-19 context. Multilateral development banks have a significant role to play in supporting funds in less developed private equity markets and in scaling up needed MSME financing.135 These institutions go beyond providing capital by demonstrating that it is possible to invest in nascent markets by providing stable funding; improving fund raising; and promoting environmental, social, and governance standards.136 Development finance institution partnerships remain vital since their investments still play a prominent role in nascent/basic private equity markets. The increased convening efforts brought about by the involvement of these institutions also helps raise the overall profile of the PE asset class among private companies, institutional investors, and government agencies. Africa has a nascent PE and venture capital market.137 The main sectors for funds in these markets are consumer goods/services, financial services (including fintech), and health care. Education is a low volume but promising future business. There is a trend toward “buy and build platforms,” especially where North African companies expand into Francophone West Africa. African companies are struggling to raise finance for their new funds, and multilateral development banks are increasingly stepping in to cover the shortfall. Capital has been flowing back to the United States and to other more developed markets where the returns have improved and risks have been lowered. C. Hybrid Solutions vanilla equity instruments, they entail a higher risk of default than other debt instruments, and the dilution from conversion takes Hybrid instruments (preference shares, convertible place when the value of the company increases and dilution bonds, and profit participating bonds) can raise new, is most costly for the existing shareholders. For investors, equity-like capital with a smaller degree of dilution for convertible bonds are attractive particularly for periods with existing owners, but at the cost of a higher strain on future elevated uncertainty and for risky corporates with clear upside cash flows to pay coupons on such instruments (whereas potential but where the safety of having a claim to debt instead dividend payments on regular equity are decided on a of equity is significant. On the other hand, the bond market is case-by-case basis). Hybrid instruments’ terms can also often illiquid, and prices can be volatile. vary significantly, which further limits depth and liquidity. These factors, combined with the complexity and lack of Prerequisites for Hybrid Solutions understanding and standardization of the treatment of hybrid instruments, result in relatively low overall issuance volumes Preconditions for hybrid solutions share many similarities of hybrid instruments over recent years and low numbers with those needed for the domestic bond market to develop. of specialized funds that focus on these instruments. Their In addition to the preconditions already discussed under debt complexity also means that the cost of issuance tends to be and equity solutions, a sophisticated investor base is particu- higher, once the issuance cost premium, liquidity premium, larly important. Given the bespoke nature of these instruments, and complexity premium are accounted for, in turn reinforcing a robust regulatory and legal framework is also paramount. the low overall volumes. Potential for Hybrid Solutions One type of hybrid instrument that could be relevant in larger To date, hybrid instruments have only been used EMDEs is convertible bonds. Convertible bonds are flexible marginally in EMDEs. Notwithstanding their limited use so financing instruments for the issuer and pay a lower interest far, they could play a role in the recovery for some larger NFCs rate than regular debt; the trade-off is that they give up upside that access international markets. In some cases, bonus potential to the investors. In addition, the coupon payments are warrants could be included to make these instruments even often tax deductible to the company. However, compared to plain more attractive to investors. 135. IFC is heavily involved in the private equity space in emerging markets and often co-invests in funds. IFC (2020) expects fundraising for PE to become more challenging in the next two to three years, especially for funds targeting MSMEs. However, IFC PE funds had sizable cash reserves going into the COVID-19 pandemic, which allowed it to continue investment activity. 136. For example, development finance institutions back more than 50 percent of funds in Sub-Saharan Africa and the Middle East and North Africa—regions where the market is still nascent—while they back more than 70 percent of the SME funds, which are critical in nurturing these funds to scale. 137. The key PE market on the continent is East Africa (Kenya, Ethiopia, Uganda); in West Africa, Nigeria is the main market, followed by Ghana and Côte d’Ivoire; in Southern Africa, South Africa is the main market; in North Africa, Egypt and Morocco are the key markets. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 110 > > > BOX 4.5 Capital Market Solutions for MSMEs The pandemic has particularly affected MSMEs, which often play a key role in EMDE economies and are central to economic recovery. Adian et al. (2020) showed that MSMEs were particularly affected by the COVID-19 shock for several reasons. First, MSMEs are prevalent in countries and sectors more affected by the crisis. Second, MSMEs are more vulnerable to some of the pandemic’s channels of impact than larger firms within the same country and sector, and, finally, MSMEs may have fewer avenues to respond and manage the impact. These include thinner equity cushions, lower liquidity buffers, limited financing, and less diversified revenue streams. Given a greater reliance on bank financing, MSMEs may be a particular source of vulnerability for small and regional banks with significant asset concentration in lending to such firms; see Chapter 1 of this report. Capital markets have played a limited role in mobilizing private sector funding to MSME financing in EMDEs. The pandemic is causing countries to re-evaluate the role that capital markets could have, in both the recovery phase and longer term. What solutions should be pursued is country dependent, because (i) countries’ objectives differ in focus in addressing immediate working capital needs, more medium-term needs, or even growth financing; (ii) the role of the banking sector and its ability/willingness to provide MSME loans varies; and (iii) the state of development of capital markets and the investor base differs, as does the macroeconomic environment. Investment funds could play an important role in the recovery phase in EMDEs, as they allow pooling of exposures to MSMEs and provide diversification and expert management. However, they are not suited to all countries, and their use would require a more clinical deep dive into the specificities of each market. • Equity funds. PE encompasses a range of investment strategies, including growth equity, buyouts, and venture capital. PE venture capital is most important in the context of MSMEs. • Debt funds. This is a new but growing asset class across EMDEs. Depending on the type, these funds could provide short- and medium-term capital to support MSMEs’ financial conditions, as well as longer-term debt financing for capital investments. Debt funds require an asset management industry already in place, as well as a reasonable domestic institutional investor base (at least 10 percent of GDP). Mobilizing capital market solutions for the MSME sector may need some type of government intervention to foster investor mobilization, such as co-investments. Some form of profit/loss arrangement, guarantees, or co-investments increases investor confidence, particularly in MSME financing where information asymmetries may be large. • Several other solutions could help mobilize capital markets to MSME financing, but they must be analyzed from a broader context and with the objective of expanding the mechanisms for MSME financing, rather than with the lens of the recovery, which requires more ready solutions. In considering adoption of such solutions, policy makers should consider if they are scalable and implementable relatively quickly. Different types of platforms that can connect SMEs with investors can be considered (lending platforms, equity crowdfunding platforms, receivable platforms). For a more in-depth overview of SME solutions, see the recent World Bank Group Capital Markets and SMEs report.138 138. https://openknowledge.worldbank.org/handle/10986/33373. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 111 VIII. Conclusion and Policy For many countries, the low depth of local capital markets limits corporates’ access on a significant scale to equity Recommendations or debt markets and limits their ability to develop other capital market solutions, such as PE solutions. Research and experience suggest that several preconditions need to be The role of capital markets in resolving the current met for capital markets to develop. These preconditions can be corporate debt overhang depends on several factors. grouped into three main categories: (i) a stable macroeconomic First, to play a role it is necessary either that the NFCs seeking environment; (ii) a relatively developed financial sector; financing can access the international capital markets or that and (iii) a solid institutional environment. In addition, many the level of development of the local capital market is supportive corporates in EMDE countries lack the financial sophistication for a domestic capital market solution. The corporate financial to engage with financial markets, often viewing this funding situation and the type and size of the corporate also play key route as too complicated and costly; existing owners may also roles. In some cases, other types of financing, such as PE be very averse to the dilutional effect of new equity issuance. or debt, or risk-sharing schemes provided by the government Countries with less developed markets should aim to improve or multilateral development banks may make capital market the preconditions for developing a domestic capital market. solutions more viable. In most cases, the domestic market will Even though capital market solutions will only have a marginal only play a role in larger economies with more developed capital impact on the current situation, they could play a larger role in markets. These markets generally display a well-functioning similar situations in future. local currency government bond market, a broad and diversified investor base, and the presence of foreign investors. Even in larger EMDEs, there are limits to the role that capital markets Public intervention should be targeted at supporting the can play in resolving the debt overhang problem. survival of long-term viable firms while avoiding cliff effects from too quickly unwinding broad support for the economy. Public resources are scarce in EMDEs. In that Historically, the issuance of equity and equity-like respect, capital market solutions, if feasible, are in principle instruments has been on a small scale compared to suitable to support the recovery to the extent they are on the debt levels of NFCs. While the issuance of equity or market terms or constitute a method to foster flows of private equity-like instruments, to the extent possible, is important to funding or to leverage public money by raising private funding. reduce the potential effects of a broad corporate deleveraging Leveraging money can be in the form of co-investment, for that could delay and dampen the economic recovery, there example, in mezzanine tranches or by providing partial are often barriers such as low investor risk tolerance and a guarantees. Public intervention can be aimed at building a poorly diversified investor base. Issuance of new debt does good foundation for corporates to access stable, long-term not address the problem of higher leverage, but debt issuance investors from abroad and at home. For example, sustainable and debt restructuring efforts by corporates should be aimed at development goals financing is a growing field and has the reducing the risks on their existing debt and taking advantage potential to attract capital from sources that would otherwise of the windows of opportunity in the financial markets to not be available. improve terms through refinancing. Finally, it is important that potential public interventions The potential of capital market solutions also depends on do not distort market competition or keep unviable firms the types and sizes of firms and the state of corporate or sectors alive. Distinguishing between viable and nonviable health. Access to listed debt and equity markets is primarily an companies is particularly difficult due to the uncertainty that option for the largest companies, as listings entail issuance and COVID-19 has created. Market signals can be helpful in this listing costs and stricter disclosure requirements. Countries respect. Governments should also be aware of contingent should seek to have robust but proportionate requirements for liabilities from the corporate sector, for example in the form public offering and listing, potentially differentiating between of guarantees and other financial support policies. Public large and small firms. Particular attention is needed to intervention should also consider the effects of crowding out in address the financial problems of MSMEs without access to local capital markets and the implications for borrowing costs capital markets and with no close banking relationship. Few and market functioning. capital market solutions are of relevance in this respect, but facilitating PE flows and freeing up lending capacity in the banking sector will nonetheless be supportive. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 112 >>> References Adian, I., Doumbia, D., Gregory, N., Ragoussis, A., Reddy, A., and Timmis, J. 2020. Small and Medium Enterprises in the Pandemic: Impact, Responses and the Role of Development Finance. Policy Research Working Paper No. 9414. World Bank, Washington, DC. Çelik, S., G. Demirtaş, and M. Isaksson. 2019. Corporate Bond Markets in a Time of Unconventional Monetary Policy. OECD Capital Market Series. OECD Publishing, Paris. Çelik, Serdar, and Mats Isaksson. 2013. “Institutional Investors as Owners: Who Are They and What Do They Do?” OECD Corporate Governance Working Papers 11. OECD Publishing, Paris. https://ideas.repec.org/p/oec/dafaae/11-en.html. Dallari, P., End, N., Miryugin, F., Tieman, A. F., and Yousefi, S. R. 2018. Pouring Oil on Fire: Interest Deductibility and Corporate Debt. IMF Working Paper WP/18/257. IMF. Davis, Polk, and Wardwell. 2008. Restructuring Debt Securities: Options and Legal Considerations. November 2008. De Fiore, F., and Uhlig, H. 2015. “Corporate Debt Structure and the Financial Crisis.” Journal of Money, Credit and Banking 47: 1571–1598. De Santis, R., Geis, A., Juskaite, A., and Vaz Cruz, L. 2018. The impact of the corporate sector purchase programme on corporate bond markets and the financing of euro area non-financial corporations. European Central Bank Economic Bulletin No. 3. European Central Bank. Demmou, L., Calligaris, S., Franco, G., Dlugosch, D., McGowan, M. A., and Sakha, S. 2021. Insolvency and debt overhang following the COVID-19 outbreak: Assessment of risks and policy responses. OECD Working Papers No. 1651. OECD. Díez, F. J., Duval, R., Fan, J., Garrido, J., Kalemli-Özcan, S., Maggi, C., Martinez-Peria, S., and Pierri, N. 2021. Insolvency Prospects Among Small and Medium Enterprises in Advanced Economies: Assessment and Policy Options. IMF staff discussion note 2. IMF. European Central Bank. 2012. EU Bank Deleveraging—Driving Forces and Strategies. Financial Stability Review Special Feature A. European Central Bank. Feyen, Erik H. B., Norbert M. Fiess, Igor Esteban Zuccardi Huertas, and Lara Alice Victoria Lambert. 2017. Which Emerging Markets and Developing Economies Face Corporate Balance Sheet Vulnerabilities?: A Novel Monitoring Framework. World Bank Policy Research Working Paper No. 8198. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 113 Filardo, Andrew, Jason George, Mico Loretan, Guonan Ma, Anella Munro, Ilhyock Shim, Philip Wooldridge, James Yetman, and Haibin Zhu. 2010. “The international financial crisis: Timeline, impact and policy responses in Asia and the Pacific.” BIS Papers chapters, in: Bank for International Settlements (ed.), The International Financial Crisis and Policy Challenges in Asia and the Pacific 52: 21–82. Bank for International Settlements. Group of Thirty. 2020. Reviving and Restructuring the Corporate Sector Post-Covid. Group of Thirty. International Finance Corporation. 2020. Asset Management Company 2020 Annual Report. IFC. International Monetary Fund. 2021. Global Financial Stability Report, April 2021. IMF. Kim, W., Ko, Y., and Wang, S. 2019. “Debt restructuring through equity issues.” Journal of Banking and Finance 106: 341–356. Zangari, E. 2014. Addressing the Debt Bias: A Comparison between the Belgian and the Italian ACE Systems. European Commission Taxation Working Paper No. 44. European Commission. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 114 >>> Annex 4A > > > B O X 4 A . 1 Public Policy Support for Capital Market Solutions and What Policy Makers Should Consider During the current crisis, government policy responses have been critical. The policy toolkit included fiscal and monetary tools and incentives. Governments swiftly launched broad-based measures to support firms, including transfers, tax cuts and payment deferrals, and provision of loan guarantees. At the same time, central banks supported bank lending to firms by providing ample liquidity with favorable conditions, while prudential authorities encouraged use of available capital and liquidity buffers to provide support. Other decisive policy responses, such as payment moratoria, allowed firms to defer payments of interest and principal to banks and to draw down their credit lines to finance their working capital. A World Bank tracker of initiatives benefiting the MSME sector can be found at https://dataviz.worldbank.org/views/SME-COVID19/Overview?%3Aembed=y&%3AisGuestRedirectFromVizportal=y. While public sector support has the advantage of potentially avoiding cliff effects and systemic corporate stress, it comes with disadvantages over and above direct fiscal implications. Such interventions can create concerns about market distortion. Concerns are particularly strong if the public support involves direct recapitalization measures. Another concern is whether public support keeps alive sectors or companies that are not viable or productive, potentially creating a “zombie” firm problem that misallocates capital and impedes economic growth. The design of public intervention is key to alleviating such negative effects. Possible public sector efforts to support capital market solutions should be guided by the following eight common principles. Common Principles for Public Crisis Solution Mechanisms • Provide optionality and proportionality. Potential support instruments should be proportional to, and aligned with, the actual and foreseeable corporate sector challenges. A degree of optionality should be preserved in cases of direct public sector involvement to ensure, inter alia, that only viable firms are receiving help. • Enable adequate incentives for borrowers and lenders. Solutions should entail the right incentives. For example, viable firms without liquidity or solvency issues but facing higher leverage post-COVID-19 should have incentives to access private funding markets where possible. Potential measures should be aimed at facilitating that access and developing the capital base available to them. • Avoid moral hazard and adverse selection. When introducing public sector intervention in capital market solutions, the risks should be considered. Moral hazard occurs when the incentives for corporate owners or managers change because they are not held accountable for their prior actions. Adverse selection occurs when conditions in financial markets or in supported schemes are such that only nonviable companies or industries access them. Policy makers must monitor such dynamics carefully. • Create transparency and develop a level playing field for access. Transparency is critical so that all creditors and borrowers can take informed decisions and support well-functioning capital markets. It will also help to alleviate concerns about unfair competition. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 115 • Consider feasibility. Solutions that could be scaled up in the short term without triggering distortions in financial markets would be preferred, and proposals should not take too long to implement. Otherwise, they could be irrelevant. • Leverage capital. Public sector support should aim at attracting capital from both domestic and foreign sources to leverage scarce public capital. Furthermore, it is important to assess whether there is potential to attract foreign capital that would otherwise be unavailable to that country—for example, sustainable development goals and impact funds or project financing. • Minimize risks and maximize upside potential for taxpayers. Risks are associated with most support schemes to develop capital market financing. The government may incur losses, but its efforts may also have upside potential, depending on the future economic development and the design of the supported scheme. Especially if considering co-investments in (hybrid) equity instruments, the public sector’s risk should be rewarded. Grants, subsidies, or tax credits come at a fiscal cost with no direct upside, so the use of these should be considered carefully, especially when the immediate impact of the COVID-19 pandemic is over. Guarantees will not require liquidity up front, but they will create a contingent liability that rating agencies and investors will consider when assessing the guarantor’s creditworthiness. • Consider crowding out and the sovereign-corporate nexus. Facilitating the access of corporates to domestic markets may result in competition for the sovereign’s own issuances, particularly in countries with limited investor capacity. Furthermore, public support resulting in higher debt or large-scale explicit or implicit contingent liabilities may weaken the sovereign’s own access to markets and potentially reduce other domestic private issuers’ access to the capital markets. > > > B O X 4 A . 2 Debt-Equity Biases from Corporate Taxation Schemes The deductibility of interest rate costs in corporate tax codes is one factor influencing corporate leverage (Dallari et al. 2018). The phenomenon arises because there is no tax deductibility for returns on equity financing. The IMF documents a debt bias effect on leverage for MSMEs without access to capital markets as well as for large firms. It found that the debt bias can explain somewhat more than 5 percentage points of the average corporate leverage of 20 percent in its sample of firms, thus about one-quarter. Tax policies in many countries currently encourage leverage. With the goal of putting equity and debt financing on an equal footing, debt bias can be addressed in two ways: (i) by reducing or eliminating interest deductibility, or (ii) by creating a tax incentive for equity financing. It is not straightforward to implement a tax system that treats equity on equal terms with debt without eliminating debt deductibility. One such approach has been adopted by both Belgium and Italy, which introduced corporate tax systems in 2006 and 2011, respectively, that aimed to incentivize equity financing by introducing a deduction of a notional return to equity (Zangari 2014). The systems are known as allowance for corporate equity. For example, the Belgian allowance for corporate equity has been effective in reducing the debt bias and has reduced the indebtedness of corporates, likely contributing to strong growth of foreign direct investment. A reduction of the debt bias can incentivize corporates to raise equity to reduce leverage, but this may come at a fiscal cost. Providing tax credits for equity financing comes at a fiscal cost and therefore must be considered on a case-by-case basis. Reducing tax deductibility for debt has a positive fiscal effect, although the implications of a higher tax on corporates’ investment behavior should be considered. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 116 > > > B O X 4 A . 3 The Carrot-and-Stick Approach for Restructuring Debt of Distressed Corporates Often existing holders are encouraged to tender139 their bonds through a combination of carrots and sticks. Carrots may take the form of a higher interest coupon and/or a more senior ranking in the new bonds’ capital structure, while sticks may involve impairment of the terms of the existing bonds. Failure to tender in the exchange could leave a holder with a bond that has basically no covenant protection, is effectively subordinated to the new bonds, has a reduced principal amount, and/or only accrues payment-in-kind interest. Bondholders—often through an organized group—will assess these proposed new terms against retaining the payment terms of their old bonds in light of the issuer’s prospects, with a close eye on terms being agreed to by other creditors to the extent that a broader restructuring is in process. (See Chapter 2 for a deeper discussion of corporate debt restructuring.) Disincentives to remaining in the old bonds include the looming threat of a bankruptcy filing, being structurally or effectively subordinated to new bonds, or being subjected to an accompanying exit consent. If requisite consents are obtained in the exchange offer, an accompanying exit consent would strip the old bonds of most of their protective covenants and, if the old bonds are secured, their collateral. When common equity is offered as consideration, exchanging bondholders may require high minimum participation conditions to avoid having holdouts remain in a senior position (i.e., as debt holders rather than equity holders) if the issuer eventually enters bankruptcy. Consensual amendments occur when corporate issuers facing debt distress seek to amend the terms of their existing bonds, via maturity extentions, coupon reductions, or similar approaches. The terms of most bonds will have a clause that sets out how amendments can be made to the indenture or trust deed. For most EMDE high-yield bonds, the nonfundamental terms can be amended with the support of a simple majority of bondholders. But in a restructuring, the changes are likely to affect the fundamental terms: principal amount, interest, and maturity. Those terms are subject to a higher threshold—often 90 percent for bonds issued by a non-US company and governed by New York law, and 75 percent for multilateral development banks’ bonds governed under English law. Another approach would seek to exploit investors’ “natural hedges.” For example, some institutional investors are very averse to reductions in principal, but they may be less concerned about the risk of maturity extensions. They might be attracted by an extendable bond or a bond with an extendable grace period contingent on recovery from COVID-19-related shocks. 139. A debt tender offer is when a company retires all or a portion of its outstanding bonds or other debt securities. This is accomplished by making an offer to its debt holders to repurchase a predetermined number of bonds at a specified price and during a set period. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 117 >>> Annex 4B: Overview of Capital Market Solutions for Corporate Debt Overhang Solvency issues Liquidity issues Quasi-equity, e.g. preference Listed Private International Domestic bond Instrument shares, convertible equity equity bond issuance issuance bonds Developed, liquid Domestic investor Developed, liquid Credit rating Developed and markets, domestic base and market markets, domestic issuance program liquid markets investor base, infrastructure, investor base, (e.g. EMTN). with a sovereign financial market enabling tax financial market benchmark curve, infrastructure. and regulatory infrastructure. domestic investor Prerequisites Corporate culture; environment. Good Corporate culture; base, and market willingness to dilute exit opportunities willingness to dilute infrastructure. ownership share for funds. ownership share and give up part and give up part of control. of control. Liquid market with Comes with strategic Lower dilution Liquid and deep Possibly captive possibilities to access and operational than equity, markets with investor base. Pros finance once listed. know-how. lower interest access to broad Financing in rate than debt. investor base. domestic currency. Mostly relevant for Subject to investor’s Low liquidity. Only relevant Limited investor largest corporations. plans and financial Strain on cash for large and low-risk and liquidity. Does Onerous listing situation, e.g. for flow and higher corporations. Subject not address Cons and reporting extracting capital or default risk to global financial solvency issues. requirements, exiting investment. than equity. cycles. Possible high listing costs. foreign exchange risk for issuer. Available and Small but relatively Likely to remain Large capital base Available in some liquid market in developed in some a marginal and easy to scale larger and more some larger, more countries. Difficult solution for some but limited to a few developed markets. developed markets. to scale up in short companies in a companies. Liquid if investor Potential Typically low term due to delivery few markets. base is strong. issuance volumes structure, and even in liquid difficult to start up markets. in new markets. Source: Staff illustration. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 118