67804 NOTE NUMBER 328 viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY SEPTEMBER 2011 Saving Viable Businesses Leora Klapper The Effect of Insolvency Reform Leora Klapper (lklapper@ The 2008 financ i a l c r i s i s a n d c o n s e q u e n t r i s e i n c o r p o r a t e i n s o l v e n c i e s worldbank.org) is a lead economist in the World highlight the cle a r n e e d f o r e f f i c i e n t b a n k r u p t c y s y s t e m s t o l i q u i d a t e Bank’s Development unviab le f irms a nd r e o r g a niz e v ia b le o ne s — a nd t o d o s o in a w a y t h a t Research Group. maximizes the p r o c e e d s f o r c r e d i t o r s , s h a r e h o l d e r s , e m p l o y e e s , a n d This Note was written as part other stake holde r s . T his N o t e s um m a r iz e s t he e m p ir ic a l lit er a t u r e o n of the Investment Climate the ef f e ct of inso lv e nc y r e f o r m s o n e c o no m ic a nd f ina nc ia l a c t i v i t y . Impact Project, a joint effort of the World Bank Group’s O verall, researc h s ug g e s t s t ha t e f f e c t iv e r e f o r m s inc r e a s e t im e l y Investment Climate repayments, red u c e t h e c o s t o f c r e d i t , a n d l o w e r t h e r a t e o f Department, IFC’s Investment Climate liq uid ation among d is t r e s s e d f ir m s . Business Line, and the World Two important goals of a bankruptcy system are research. First, reforms that improve insolvency Bank’s Development Research to weed out the bad (unviable) businesses from regimes have a real effect on credit. Second, new Group, in collaboration with IFC’s Development Impact the good (viable) ones and to keep viable busi- mechanisms to encourage debt restructuring or Department, the Development nesses in operation. Unsuccessful companies ide- reorganization decrease the duration and cost of Impact Evaluation Initiative, ally should be taken over by more capable owners bankruptcy proceedings and reduce the failure the FPD Chief Economist’s or liquidated through asset sales, so that only rate of insolvent firms. Finally, evidence from high- Office, and the Global the most efficient users of economic resources income countries suggests that reforms to indi- Indicators and Analysis continue to operate as active companies. In most vidual bankruptcy laws can increase household Unit. The project is funded by cases, however, keeping the business alive is the credit, which may also benefit entrepreneurs. THE WORLD BANK GROUP the U.S. Agency for Interna- most efficient outcome: creditors get a chance to Worldwide, debt enforcement mecha- tional Development and the recover a larger part of their credit, more employ- nisms vary enormously in efficiency (figure 1). World Bank Group’s ees keep their jobs, and the network of suppliers Bankruptcy procedures are in general extremely Investment Climate and customers is preserved. Saving viable busi- time consuming, costly, and inefficient. In 2010 Department. nesses becomes especially important in times of the cost of bankruptcy proceedings averaged recession. Indeed, crises have been used as an more than 30 percent of the value of the estate in opportunity to improve insolvency laws.1 Cameroon, the Dominican Republic, Liberia, the Many bankruptcy regimes around the world Philippines, and Thailand—but approximately perform poorly. But there is evidence that reform- 1 percent in Colombia, Kuwait, Norway, and ing bankruptcy systems can improve economic Singapore (World Bank 2010a). A cross-country activity. Three key findings emerge from existing study shows that higher bankruptcy costs hamper A A v I N G Tv I AGB L E I BHUOSwI NME S S E D O E S E I NEVFEFSETCMT E N TF CI L ISM AL TV EE NM A T T E R ?O R M S TTRAc IN FD uCH S TH O N O CY REF Estimated average cost to resolve insolvency by country income group and that they increase the probability of timely repay- Figure type of proceeding, 2006 ments, reduce the cost of debt and interest rates, 1 and increase the aggregate level of credit (table High income Upper middle income Lower middle income 1). Common to these reforms is an assurance that Cost as % of total value of debtor’s estate creditors will recover a larger part of a troubled 0 4 8 12 16 20 loan. This results in savings that are passed on to borrowers in the form of cheaper credit. Foreclosure One study uses a loan-level data set to analyze the effect of new debt recovery tribunals in India that speeded up the resolution of debt recovery Liquidation claims and allowed lenders to seize greater values of collateral on defaulting loans (Visaria 2009). The study exploits the random rollout of debt Reorganization recovery tribunals in different states at differ- ent times between 1994 and 1999. The author Source: Djankov and others 2008. finds that the reform increased the probability of timely repayments by 28 percent (for loans entry by new firms, especially in industries that with overdue amounts averaging US$5,000) and naturally should have high entry rates (Klapper, significantly lowered interest rates on large loans Laeven, and Rajan 2006). (those of around US$200,000). The recent financial crisis highlighted the In Brazil a broad 2005 bankruptcy reform importance of effective insolvency frameworks. that established greater creditor protection led In 2009 Japan had 13,306 corporate bankruptcies to a 22 percent reduction in the cost of debt (up 5 percent from 2008), the United Kingdom and a 39 percent increase in the aggregate level 94,135 (up 6 percent), Germany 32,687 (up 11 of credit (Funchal 2008).3 A necessary caveat is percent), and the United States 60,837 (up 40 that the study measures the effect as simply the percent).2 At the same time, the quality of banks’ change between the pre- and postreform periods, loan portfolios worsened: the average ratio of although firm borrowing patterns might have nonperforming loans to total gross loans for com- been affected by other, unobservable factors. An mercial banks in these four countries rose from ongoing randomized evaluation of the effect of 1.6 percent in 2007 to 2.2 percent in 2008 and new restructuring guidelines in Romania aims to 3.5 percent in 2009 (World Bank 2010b). use improved methodology to isolate the effect This Note summarizes empirical studies on the of the reform on borrower behavior. effect of reforms in insolvency and restructuring on economic activity. Overall, research suggests that Lower failure rates, shorter proceedings effective reforms improve economic activity. Studies on the effect of introducing new mecha- nisms to encourage debt restructuring or reorga- More timely repayments, cheaper credit nization (and to lower liquidation rates) find that Studies on the effect of reforms that improve such reforms also reduce rates of failure among insolvency regimes, particularly efforts to speed small and medium-size enterprises, particularly up the resolution of debt recovery claims, find the liquidation of stronger firms (table 2). Table Effect of insolvency reforms on aspects of credit 1 Country Study Reform Effect on repayment rates Effect on cost of credit Effect on aggregate credit India Visaria 2009 Introduction of debt 28 percent increase in 1.36 percentage point smaller recovery tribunals timely repayments increase in interest rates Brazil Funchal 2008 Introduction of creditor- 22 percent decrease in cost 39 percent increase friendly rulesa of debt a. 2005 Bankruptcy Law. failure rates and Table Effect of insolvency reforms on aspects of credit duration of proceedings 2 Country Study Reform Effect on liquidations Effect on reorganizations Other effects Belgium Dewaelheyns and Introduction of new 8.4 percent reduction in Van Hulle 2006 restructuring mechanismsa number of liquidations Colombia Giné and Love Introduction of a new Decrease in duration from Decrease in duration 2008 reorganization codeb 49 months to 33 from 34 months to 12 Thailand Foley 1999 Introduction of a legal Decrease in nonperforming loans framework for workoutsc Decrease in expected costs of financial distress a. 1997 bankruptcy reform. b. Law 222 (1995) and Law 550 (1999). c. 1998 bankruptcy reform. A 1997 bankruptcy reform in Belgium intro- firms (table 3). In the United States, for example, duced mechanisms to encourage corporate the creditor-friendly 2005 personal bankruptcy rehabilitation as an alternative to liquidation. reform may have contributed to the subsequent The reform increased protection from creditors increase in the supply of credit and in credit card for companies that are granted reorganization debt. In the year following the reform, revolving protection. One study finds that this reduced debt per household rose by a five-year high of 5.3 liquidation-type bankruptcies among small percent in nominal terms (White 2007). and medium-size enterprises by 8.4 percent An important caveat is that while entrepreneurs (Dewaelheyns and Van Hulle 2006). might benefit from an increase in the supply of In Colombia a new reorganization code, Law credit and start-up capital, the comparatively 550 (1999), streamlined the reorganization pro- anti-debtor bankruptcy laws may also discourage cess by tightening statutory deadlines for reor- self-employment and personal risk-taking (White ganization plans and reducing opportunities for 2009). This effect will ultimately depend on the appeal by debtors. This reform improved the quality and credibility of judicial enforcement, selection of viable firms into reorganization and however. For example, in environments where reg- shortened the duration of reorganization from istering a limited liability firm is costly or difficult 34 months to 12 (Giné and Love 2008). (because of, say, high minimum capital require- In Thailand the introduction of a legal frame- ments), the threat of stronger personal bankruptcy work for rehabilitation led to a decline in the level laws might reduce the total number of new firms. of nonperforming loans as well as in the costs of But the quality of firms should improve—because insolvency. But the pace of restructuring remained only high-quality entrepreneurs would be willing slow: nonperforming loans still amounted to more to take on personal liability. than 20 percent of total bank loans more than 18 months after the reform (Foley 1999). conclusion Strong insolvency laws that provide an efficient Greater household credit resolution of financial distress are associated with Evidence from high-income countries suggests a more dynamic private sector. Evidence from that reforms to individual bankruptcy laws can empirical studies shows that reforms to improve increase household credit, which might also the bankruptcy system can strengthen economic benefit entrepreneurs and non-limited-liability activity—by increasing the probability of timely Table Effect of reforms to individual bankruptcy laws 3 Country Study Reform Effect on filing costs Effect on credit supply United States White 2007, 2009 Introduction of creditor-friendly 50 percent increase in cost of 5.3 percent nominal increase in revolving mechanismsa individual bankruptcy filings debt per household a. Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCP). SAvING vIABLE BUSINESSES THE EFFECT OF INSOLVENCY REFORM repayments, reducing the cost of debt, increas- Working Paper 0607, Department of Accountancy, ing the level of credit, lowering failure rates, and Finance and Insurance, Katholieke Universiteit shortening the time to resolve bankruptcies. But Leuven, Belgium. these studies are limited to specific reforms in a Djankov, Simeon, Oliver Hart, Caralee McLiesh, and few countries. Additional evidence is needed, par- Andrei Shleifer. 2008. “Debt Enforcement around the ticularly from well-designed randomized evalua- World.� Journal of Political Economy 116 (6): 1105–49. viewpoint tions to identify the effects of insolvency reforms Foley, C. Fritz. 1999. “Going Bust in Bangkok: Lessons on credit decisions and firm survival. from Bankruptcy Law Reform in Thailand.� Harvard is an open forum to Business School, Cambridge, MA. encourage dissemination of Funchal, Bruno. 2008. “The Effects of the 2005 Bank- public policy innovations ruptcy Reform in Brazil.� Economics Letters 101 (1): for private sector–led and Notes 84–86. market-based solutions for The author would like to thank Elena Cirmizi, Asli Giné, Xavier, and Inessa Love. 2008. “Do Reorganiza- development. The views Demirgüç-Kunt, Leonardo Aleixo Lemes, Marialisa tion Costs Matter for Efficiency? Evidence from a published are those of the Motta, Mahesh Uttamchandani, Massimiliano Santini, Bankruptcy Reform in Colombia.� Policy Research authors and should not be and Asli Togan Egrican for their valuable inputs and Working Paper 3970, World Bank, Washington, DC. attributed to the World comments. Klapper, Leora, Luc Laeven, and Raghuram Rajan. Bank or any other affiliated 1. For a longer discussion on insolvency reform during 2006. “Entry Regulation as a Barrier to Entrepre- organizations. Nor do any financial crises, see Cirmizi, Klapper, and Uttamchan- neurship.� Journal of Financial Economics 82 (3): of the conclusions represent dani (forthcoming). 591–629. official policy of the World 2. The data for Japan are from Teikoku Databank Statistisches Bundesamt Deutschland. 2009. Statistisches Bank or of its Executive (2010); for the United Kingdom, from U.K. Ministry of Jahrbuch für die Bundesrepublik Deutschland 2009. Directors or the countries Justice (2010); for Germany, Statistisches Bundesamt Wiesbaden, Germany. they represent. Deutschland (2009); and for the United States, Ameri- Teikoku Databank. 2010. “Bankruptcy Report for 2009.� can Bankruptcy Institute (2010). Online edition. To order additional copies 3. The new law increased creditors’ rights through two U.K. Ministry of Justice. 2010. “Quarterly National contact Ryan Hahn, channels: it increased creditors’ priority in bankruptcy, Statistics.� London. managing editor, and it allowed them to actively participate in bank- Visaria, Surata. 2009. “Legal Reform and Loan Repay- Room F 4P-252A, ment: The Microeconomic Impact of Debt Recovery The World Bank, ruptcy procedures. The cost of debt for each firm is Tribunals in India.� American Economic Journal: 1818 H Street, NW, measured as total annual interest expense divided by Washington, DC 20433. the firm’s mean debt over the current and lagged pe- Applied Economics 1 (3): 59–81. riod. Total credit is measured as the sum of short- and White, Michelle J. 2007. “Bankruptcy Reform and Telephone: long-term debt plus accounts payable. Credit Cards.� Journal of Economic Perspectives 21 (4): 001 202 473 4103 175–200. Fax: References ———. 2009. “Bankruptcy: Past Puzzles, Recent 001 202 522 3480 American Bankruptcy Institute. 2010. “Annual U.S. Reforms, and the Mortgage Crisis.� American Law Email: Bankruptcy Filings.� Alexandria, VA. and Economic Review 11 (1): 1–23. rhahn@worldbank.org Cirmizi, Elena, Leora Klapper, and Mahesh Uttamchan- World Bank. 2010a. Doing Business 2011: Making a Differ- dani. Forthcoming. “The Challenges of Bankruptcy ence for Entrepreneurs. Washington, DC: World Bank. Produced by Carol Siegel Reform.� World Bank Research Observer. ———. 2010b. World Development Indicators database. Dewaelheyns, Nico, and Cynthia Van Hulle. 2006. http://data.worldbank.org/indicator. Printed on recycled paper “Legal Reform and Aggregate Small and Micro Business Bankruptcy Rates: Evidence from the 1997 Belgian Bankruptcy Code.� K.U. Leuven AFI This Note is available online: http://www.worldbank.org/fpd/publicpolicyjournal