Bank-Led Restructuring in Poland: Its Impact on Enterprises

by Cheryl W. Gray and Arnold Holle

Since 1993 Poland has been considered a model of commercial banking reform among transition economies. Poland's Enterprise and Bank Restructuring Program (EBRP), adopted by parliament in early 1993, aimed to rehabilitate and lay the groundwork for privatizing seven of the nine commercial banks that had been created in 1989 out of the National Bank of Poland. Under the banks' command, the EBRP planned to restructure and privatize a group of financially troubled state enterprises. The program required the banks to establish workout units and to take action by March 1994 to recover loans that had been classified as losses (or those in doubt of being repaid) as of end-1991 (the "base portfolio") through one of several resolution paths stipulated in the law—repayment, bank conciliation, court conciliation, bankruptcy, state enterprise liquidation, or sale of debt.

How effective has the EBRP been in fostering the restructuring or closure of problem firms? To answer that question, the World Bank surveyed 139 of the 787 firms that had been through the program. Sixty-two of the firms had signed a bank conciliation agreement; 45 had gone into court conciliation, bankruptcy, or state enterprise liquidation, 22 had repaid or become current on their loans, and the debt of 10 had been sold.

The survey confirmed that the EBRP had a positive impact on balance, but that its benefits fell far behind the high expectations set for it. The reform program was clearly innovative and well designed. In general, banks and enterprises took the program seriously, and it appears to have been free of fraud or corruption. Compliance with its prescriptions was high but not perfect. For example, both the 1992 government stance and the 1993 law required that banks stop new lending (including rollovers of previous loans) to firms with debts already classified international accounting firms as losses or indoubt of being repaid. Yet, contrary to these directives, about one-eighth of the firms in the sample received new loans or rollovers. The EBRP also envisioned that enterprises entering bank conciliation would be commercialized (that is, transformed into joint stock companies). Seventy-five percent of firms were com-mercilized, but the rest were not.

Furthermore, the EBRP was very useful as a catalyst in forcing otherwise passive creditors to take action against bad debtors. Although the debts in question turned bad in 1991, creditors took no action at all in more than 80 percent of the survey's sixty-two conciliation cases until the law was passed in early 1993. Even after the law was adopted, nothing happened in more than 60 percent of cases until bank conciliation was initiated, on average ten months later. By then, the debt had been in arrears more than two years. The signing dates of most agreements cluster closely around March 1994, the original EBRP's deadline .

Finally, the division of firms among resolution paths appears to have followed economic logic (see figure). Better-off firms tended to enter conciliation, while weaker performers tended to go into bankruptcy or liquidation. Profitability was not all that mattered, however. Size also appears to have been important, with larger firms tending to enter conciliation regardless of profitability. This is not surprising; politically, these firms are more difficult to close.

Despite these strengths, the survey results suggest that the EBRP may have had limited power to promote necessary restructuring in firms. Furthermore, the program focus on the new and temporary bank conciliation process resulted in neglect of other more fundamental and longer-term workout and exit processes. The exit processes continue to be poorly designed for the needs of a market economy.

Bank Conciliation

Bank conciliation agreements appear to have been unsophisticated. They dealt primarily with financial conditions—mostly large debt write-offs and renegotiation of payment dates—and included very few tangible requirements for operational or management change. Weaker banks (that is, those with lower capital and higher bad debt ratios) were willing to undertake significant debt-equity swaps, but stronger banks undertook very few. Restructuring plans that were actually prepared for firms, appear to have greatly overestimated future profitability, particularly when weaker banks (the three banks to be consolidated with Pekao S.A.) were in the lead.

Given these features, it is not surprising that the agreements have resulted in little restructuring to date. The first two years of the agreements' implementation saw a slowdown in the rate of layoffs from previous years, an increase in the average wage rate (after adjusting for inflation), and a decline in average operating profitability and cash flow. (Reported net profits soared, but this was because loan write-offs were booked as income.) The main effect of the conciliation process was to provide firms with breathing room. Weak operating performance in 1994 and 1995 suggests that many firms continued to have problems and that financial discipline was perhaps still somewhat soft. Indeed, booking write-offs as profit may have given a misleading impression of higher post-conciliation profitability, may lead to further pressure for wage increases or more debt forgiveness in the future.

Debt-equity swaps were not used as widely as originally hoped, and the conciliation process did not lead to extensive ownership change. Of the sixty-two state-owned enterprises in the sample, majority stakes in no more than one-fifth will eventually be in private hands if the banks themselves are privatized. The fact that most debt-equity swaps were concluded by the weaker banks (those last to be privatized)—and that the equity went proportionately to other, often passive, creditors (including the government)—heightens the concern that it may be a long time before these swaps translate into effective private ownership and governance.

Court Conciliation and Bankruptcy

Court conciliation cases in the survey were concluded on average in about six months—about the same time required for bank conciliation cases. Firms in court conciliation received smaller debt write-offs but greater extensions in debt maturity than firms in bank conciliation. On a net present value basis, the extent of debt relief under the two processes appears to have been similar. In contrast to bank conciliation, the extent of debt write-off in the court conciliation cases was positively correlated with two other economic variables: the firm's operating profitability and its level of indebtedness. With regard to outcomes, the subsequent performance of firms in court conciliation did not improve, and in eight of ten cases, firms in our survey continue to have problems servicing their debt.

Poland's bankruptcy and the related legislation have major weaknesses in design and implementation, most notably the low priority given to secured creditors, the institutional weakness of bankruptcy courts and related professions, and the difficulty that judges and trustees have in identifying and curbing fraudulent behavior. Bankruptcy is inevitably a slow process, and in the twenty-three survey cases the process was expected to take on average about three years. Creditors have little involvement in the bankruptcy process and in the sample, creditors were expected to recover little of their original claims (on average 17 percent of claims for banks and 7 percent for suppliers).

As currently designed, neither bankruptcy nor court conciliation gives creditors sufficient control over firms in financial distress. Both could work much better if redesigned, if supported by institutional development in the courts and related professions, and if better systems of collateral and debt collection were developed. Court conciliation could be redesigned in several ways to increase flexibility. Government claims should be included in the process. A smaller majority should be required for approval of a workout agreement—not varying with the extent of debt write-offs proposed. All creditors should be allowed to vote (whether present or not). And more financial and operational restructuring options could be available for inclusion in restructuring agreements. Creditors' rights under bankruptcy should be strengthened by rearranging priorities to put secured creditors first, by reducing up-front fees, and by giving courts and trustees greater powers and resources to uncover and to punish fraudulent transactions. Any design improvements need to be complemented by strong economic policies that give banks and other creditors powerful incentives to use these debt- collection mechanisms.

State Enterprise Liquidation

State enterprise liquidation is the most problematic of the three formal processes. It is almost entirely controlled by debtors. In most cases debtor management chooses the trustee—and in some cases even serves as trustee! In the cases surveyed, state enterprise liquidation is proving to be significantly slower than bankruptcy. Firms continue to operate far longer than in the bankruptcy process, and more assets eventually end up under the control of managers and employees of the original firm. The process, though on paper designed for solvent firms, is often used as a way to get around bankruptcy and keep debtor management in control of assets for as long as possible. Creditors are the big losers. They have no power. In the cases surveyed creditors were expected to recover almost nothing (6 percent of claims for banks and 3 percent for suppliers). The loophole of state enterprise liquidation needs to be plugged if the other formal processes are to work as intended. It should be strictly limited to solvent firms. If this is not feasible, the process should be eliminated altogether because of the abuse it invites.

Sale of Debt and Repayment

The EBRP included a nonbureaucratic market-based alternative to these formal processes—sale of debt. This alternative appears to have played a very limited role, however. Few sales were attempted and even fewer concluded. Tax disadvantages and debtor antipathy appear to have undercut banks' incentives to sell, and the difficulty of using debt to "pay" for purchases or swapping debt into equity appears to have undercut potential purchasers' incentives to buy. A secondary market for debt can be an effective and nonbureaucratic means to increase financial discipline in problem firms, but it will take some time—and probably a change in tax and other rules—to build such a market in Poland.

The EBRP also allowed firms to repay or become current on debt and thereby avoid other resolution paths. A large number of firms (about 40 percent) did repay. Almost 40 percent of the cases surveyed used retained earnings to repay, while 28 percent have borrowed new money to pay back old debt—a result not necessarily in accord with the goals of the EBRP.

Therefore initial evidence suggests that the outcome of Poland's first experiment with bank-led restructuring is decidedly mixed. The EBRP forced banks to confront their problems, helped them build institutional capacity in their workout units (though not necessarily in their credit units), and furthered the difficult task of weeding out and closing clearly unviable firms. Loans could be written down without creating an environment of general debt forgiveness. These are important achievements in transition, and the in many ways approach in Poland serves as a model for other transition economies.

The process, however, does not appear to have rapidly imposed strong restructuring mandates on problem debtors, and its success in privatizing them has been limited. The EBRP was a good start, but continued work is needed to build strong banks that can impose effective corporate governance on enterprises in times of financial distress. Now that bank conciliation has expired as an option, the Polish government should shift its energies to improving the traditional exit processes—formal and informal workouts and bankruptcy—fundamental to any well-functioning market economy.

Detailed results of the survey are available in two World Bank Policy Research Working Papers by Cheryl W. Gray and Arnold Holle: "Bank-Led Restructuring in Poland: An Empirical Look at the Bank Conciliation Process" (1650) and "Bank-Led Restructuring in Poland: Bankruptcy and Its Alternatives" (1651), September 1996. (See page 33 for ordering information). Shorter versions are forthcoming in Economies of Transition.

Cheryl W. Gray, Principal Economist, Finance and Private Sector Development Division, Policy Research Department.

Arnold Holle, former consultant to the World Bank currently with Boston Consulting Group, London, U.K.