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WHO SHOULD MANAGE THE BAD ASSETS

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Arguments for leaving the loans in ... The AMC should be an independent agency. The AMC staff must have incentives to achieve a quick resolution of the crisis ... – PowerPoint PPT presentation

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Title: WHO SHOULD MANAGE THE BAD ASSETS


1
WHO SHOULD MANAGE THE BAD ASSETS?
  • Should the resolution of bad loans be managed by
    a separate agency or by the banks themselves?
  • Two views
  • -- Leave the management of bad loans to the
    banks
  • -- Move all problematic loans to a separate
    agency

2
  • Arguments for leaving the loans in the banks are
  • -- Banks know their customers better and can
    resolve any problems
  • -- It is desirable for the bank to get some
    experience with loan resolution (e.g. banks keep
    some small problematic loans)

3
  • But, there are also arguments for removing bad
    loans from banks
  • -- Banks may be less objective and may continue
    lending to delinquent borrowers (e.g. Japanese
    case)
  • -- Banks may become very risk-averse and
    restrict new lending when trying to resolve bad
    debts

4
  • -- It is easier to find a buyer for a troubled
    bank in this case
  • Should the asset management agency be centralized
    or decentralized?
  • -- In a decentralized approach, a troubled bank
    is divided into a bad bank and a good bank
  • -- In a centralized approach, there is a bad
    bank for the whole system

5
CENTRALIZED vs. DECENTRALIZED ASSET MANAGEMENT
  • The decentralized approach works well when there
    are a few troubled banks
  • It also works well when it is important that
    bank-customer relationships are maintained (e.g.
    C I loans)
  • In this case, the bad bank should not end up
    with the bad staff, as well

6
  • In a centralized approach, there is an Asset
    Management Corporation for the whole system (e.g.
    RTC in the SL crisis in the US)
  • This approach is preferable when there are
    several troubled banks and the problematic assets
    are homogeneous (e.g. real estate loans)
  • The AMC should be an independent agency
  • The AMC staff must have incentives to achieve a
    quick resolution of the crisis

7
LESSONS FROM SYSTEMIC BANK RESTRUCTURING
  • Diagnosis is a very important component of a
    restructuring program
  • A successful program must have a comprehensive
    approach and address shortcomings in
  • -- accounting framework
  • -- legal framework
  • -- regulatory framework

8
  • Prompt action is very important
  • Operational restructuring is a necessary
    condition for future profitability of banks
  • Systemic restructuring must be implemented by a
    designated lead agency
  • Continuous monitoring of the restructuring
    process is necessary

9
  • Central bank must stand ready to provide
    liquidity support
  • Exit policies must be an integral part of the
    process
  • The principle of loss-sharing between the state,
    the banks, and the depositors is an integral part
    of a successful strategy

10
  • Problems with state-owned banks can be addressed
    through privatization
  • Macroeconomic policy that will stimulate growth
    can support the restructuring efforts

11
CORPORATE GOVERNANCE
  • Corporate governance deals with ways in which
    suppliers of finance to corporations assure
    themselves of getting a return on their
    investment
  • -- How do suppliers of finance get managers to
    return some of the profits to them?
  • -- How do they make sure that managers do not
    steal the capital they supply or invest it in bad
    projects?

12
  • -- How do suppliers of finance control managers?
  • Less developed and developing economies can
    significantly improve their corporate governance
    systems
  • Corporate governance mechanisms are economic and
    legal institutions that can be improved through
    political decisions

13
  • Couldnt the product market solve any corporate
    governance problems?
  • In other words, shouldnt inefficient firms fail
    or experience a decrease in the amount of capital
    supplied to them?
  • Yes, but the product market still does not
    prevent managers from expropriating funds after
    the amount of capital is invested

14
THE AGENCY PROBLEM
  • The main issue in corporate governance is to
    address the agency problem
  • Suppliers of finance (shareholders/owners) are
    the principals who need to monitor the
    managers, who are the agents, to ensure that
    they receive the return on their investments

15
  • This agency problem is referred to as the
    separation of ownership and control
  • -- principals own the firm, but
  • -- agents may have more control on the
    decision-making process
  • Most modern corporations are organized in this
    way shareholders are not the managers
  • In some cases, owners are also the managers
    (family business)

16
HOW DOES THE AGENCY PROBLEM ARISE?
  • Suppose an entrepreneur has a great idea and
    raises money from investors to implement it
  • Investors need the entrepreneur (also manager) to
    run the business due to her knowledge of the
    idea
  • Suppose also that the manager does not have
    enough funds and needs the investors

17
  • How can the investors be sure that their funds
    will not be wasted on unprofitable projects?
  • One solution is for the two parties to write a
    contract that says
  • -- what the manager does with the funds
  • -- how the returns from the investment are
    divided between the manager and the investors

18
  • The problem with this solution is that, in an
    incomplete world, there is uncertainty about all
    possible future states of the world
  • E.g. if the company can expand into a new market
    overseas due to favorable demand conditions, who
    will make the decision?
  • Thus, the owners and the manager must allocate
    residual control rights

19
  • This means that they must agree, a priori, as to
    who will have the right to make decisions as to
    what the firm can and cannot do
  • Other examples may involve the way the company
    will raise additional funds or allocate its
    profits
  • One way to solve the problem of residual control
    rights is for the owners to keep these rights (to
    be the ones who make the decisions)

20
  • The problem is that the manager knows a lot about
    the business and the owners need the managers
    knowledge
  • Thus, the manager ends up having a lot of those
    residual controls and, as a result, discretion
    as to how funds will be allocated
  • Another problem is that any contract between the
    owners and the manager must be simple enough to
    be enforced by courts

21
  • Also, if the funds are collected from many
    investors, they may be too small and poorly
    informed to deal with the manager
  • Managers can then expropriate funds by, for
    example,
  • -- transfer funds to businesses of their
    relatives
  • -- consume perquisites (drive fancy cars and
    have fancy offices, etc.)

22
  • -- try to expand the business beyond its scope
    for personal benefits (e.g. empire-building
    through mergers, etc.)
  • -- expropriate investors by making it difficult
    for owners to replace them

23
HOW CAN WE SOLVE THE AGENCY PROBLEM?
  • Corporate governance deals with finding optimal
    mechanisms that
  • -- will give managers incentives to put
    constraints on themselves
  • -- will allow owners to put constraints on the
    managers
  • In this case, owners funds will not be
    misallocated ex post

24
  • Thus, owners will have an incentive to supply
    funds ex ante
  • A few such mechanisms are
  • -- Performance-based pay for the CEO
  • -- The role of the Board of Directors
  • -- The role of major shareholders
  • -- Takeovers

25
  • Shareholders often do not know what actions the
    CEO can take or which of these actions will
    increase shareholder wealth
  • In this case, the CEO compensation can be
    designed in a way to give the CEO incentives to
    maximize shareholder wealth
  • Note that CEOs will decide on taking certain
    action by comparing their private costs and
    benefits only

26
  • Some mechanisms that align the CEOs incentives
    with those of shareholders are
  • -- performance-based salary and bonuses
    revisions
  • -- stock options
  • -- performance-based dismissal decisions

27
  • The Board of Directors should represent the
    interests of shareholders and monitor the CEO and
    top management
  • The BOD plays a governance role by
  • -- writing top managements employment contracts
  • -- evaluating and ratifying proposals for major
    decisions of strategic importance

28
  • -- replacing top management
  • However, CEOs participate in the BOD and, often
    times, have considerable influence on who sits on
    the board and how the members decide
  • There are three types of directors on the board
  • -- inside directors

29
  • -- gray directors
  • -- outside directors
  • The corporate governance role of the board
    improves with more outside directors
  • Also, major shareholders (controlling 10 or 20
    percent of the firm) can play a role in corporate
    governance and they often sit on the BOD

30
  • Large shareholders have an incentive to collect
    information about the firm and the CEO and
    monitor the managements activities
  • Large shareholders can exercise their role only
    if their voting rights are legally protected
  • This corporate governance mechanism is stronger
    in countries with strong legal systems

31
  • In countries where large shareholders are
    uncommon (US and UK), another corporate
    governance mechanism is hostile takeovers
  • Hostile takeovers typically target poorly
    performing firms and their management is replaced
  • Thus, the threat of a hostile takeover will
    convince managers to align their decisions with
    shareholders interests
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