Infrastructure Requirements in the Area of Bankruptcy Law

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Infrastructure requirements have long played an important role in the development debate. Until recently these requirements referred to the need for improvements in roads, railways, electricity supply, telecommunications and the like. Lack of such infrastructure was seen as an important cause of a country's relative poverty. Investments in physical infrastructure seem not to have had the desired growth effects in developing countries, however. The search for the root cause of economic development has led the mainstream of economists to the system of rules for economic activity. The attention to rules and institutions became wide-spread only after the fall of communism, although Nobel prizes had been awarded to Friedrich Hayek and Gunnar Myrdahl in 1974, and Ronald Coase in 1983 for their contributions to institutional and political economics. These prices represented a recognition that institutional and political economics help explain important aspects of the organization of economic activity, but few economists took the additional step to analyze institutional factors as root causes of development and growth. An exception was Douglas North, who received the Nobel prize in 1993 after the fall communism and a renewed interest in institutional economics. This interest was to a large extent sparked by the formerly centrally planned economies' failure to start growing. Economic research began to focus on social institutions in general, and the legal system in particular, defining and securing property rights, enabling trade, and providing incentives for economic activity. Among social institutions the legal system is most directly subject to change, at least with respect to the letter of the law. Thus it is natural that policy-oriented economists would emphasize legal reform to enhance incentives leading to economic growth. Economic growth requires that old activities are phased out to make room for new ones, and that economic resources are reallocated from activities that are no longer profitable. This reallocation can occur within a variety of organizational structures, but the failure of projects and firms must be seen as an inherent aspect of growth process. The Asian crisis and a large number of more or less severe banking crises in a variety of countries during the last decades have led to questions about the ability of economic systems to deal with wide-spread failure of firms. Caprio and Klingebiel (1996) refer to the lack of procedures for banks to settle and recover claims on distressed firms as a cause of lingering and recurring banking crisis in many countries. Krugman (1994) noted before the crisis that investments kept flowing to projects of questionable value in many Asian countries. A mechanism for abandonment of non-profitable projects seemed to be missing. In the Eastern European transition economies state-owned enterprises or formerly state-owned large enterprises producing negative value could not be closed down in an orderly fashion. Laws, procedures, and court capacity was missing. Bankruptcy law was implemented in several of countries with mixed results as will be discussed below. While there may have been too few bankruptcies in Asia and Eastern Europe the argument in the Swedish policy debate after the banking crisis in the early 90s was that there were too many bankruptcies of viable firms, and that the recession therefore became unnecessarily deep. These experiences indicate that the procedures for dealing with insolvent firms may affect economic growth, and the depth and duration of crises. These procedures, and the institutions and organizations involved are viewed as the "infrastructure for bankruptcy" in this paper. At the center of the discussion stands insolvency law for firms and the court systems supporting the law, but the bankruptcy infrastructure could be considered to be much broader including or relating to a broad array of formal law and informal procedures. Informal procedures for insolvency are as important as the law and they necessarily involve banks as the major creditors. Therefore, law and regulation for financial institutions may be considered an aspect of the infrastructure for bankruptcy. From banks' point of view insolvency procedure is only one aspect of debt recovery. The procedures for debt recovery include security enforcement, which depend on property rights registration and enforcement. Other stakeholders than banks are also affected by a firm's insolvency. Employees, customers, suppliers, the state, and of course shareholders may have a stake and some kind of claim on a firm's assets. Insolvency essentially means that formal and informal contractual relations with some or all of the firm's stakeholders must be breached. Thus the variety of laws regulating contractual relations among stakeholders interact with insolvency procedures. Although bankruptcy is not a criminal offense, and debtors' prisons have been abandoned in most countries, criminal law relating to civil fraud and corruption has a bearing on insolvency procedures. Finally, personal bankruptcy procedures may affect insolvency procedures for firms even under limited liability, because a firm's owners' personal guarantees may be required by creditors. We will not cover all these aspects of the "bankruptcy-related" infrastructure but we focus, as noted on formal and informal insolvency procedures. Insolvency law will be used as a term covering both bankruptcy law and explicit law for restructuring of firms without change of ownership. Thus, bankruptcy always implies that a firm as a whole, or its assets, are offered for sale to new owners. While lawyers often focus on fairness and equity in their discussion of insolvency law, economists are concerned with economic efficiency, growth, and business cycle fluctuations. Wood (1995) notes that there are wide differences in insolvency law among countries based on differences in legal doctrines, but there is no obvious relation between legal doctrine and economic growth or economic wealth. Insolvencies happen everywhere but practices vary with respect to law, informal procedures, effectiveness, and predictability of procedures. Lack of bankruptcies does not necessarily mean lack of insolvency procedures. Informal work-outs are common, and informal procedures are well established in many countries. On the other hand, the existence of insolvency law does not necessarily imply that it has much influence on procedures, and in some countries procedures are neither well established nor predictable. Legal traditions and cultural factors affect the attitude to bankruptcy, and procedures for dealing with insolvency. Political factors affecting objectives of formal law and informal procedures vary, as well, across countries and time. Political influences on the banking system, and concentrated ownership of corporations forming strong vested interests can affect the allocation of credit and state subsidies in such a way that insolvency procedures are seriously undermined. We return to these issues. The paper proceeds in Section 2 with a discussion of the economic role of insolvency procedures for efficiency of resource allocation, economic growth, and the depth and duration of crises. Efficiency of procedures are discussed further in Section 3 where a distinction is made between ex ante (at the time financial commitments are made) and ex post (at the time of insolvency) efficiency. The purpose of Section 4 is to classify procedures in an economically meaningful way. It is common to distinguish between creditor-and debtor oriented procedures. More interesting from an economic viewpoint is whether procedures tend to lead to "excessive survival" or "excessive shut-downs" of firms. These distinctions do not necessarily coincide. In Section 5, we look at the wide differences in restructuring laws across countries. Stylized facts about the performance of laws in different countries in terms restructuring vs shut-down, and survival vs shutdown are presented in Section 6.. Stylized facts from developing countries point to the important issue of enforcement of law. Two aspects of enforcement are discussed in Section 6. First, the legal system may be ineffective in its application of existing law. Second, political influences on the banking system in particular may render insolvency procedures irrelevant. The strongest policy implications refer to enforcement. This and other aspects of design of formal insolvency procedures and their associated infrastructure are discussed in Section 8. The basic question whether or why insolvency law is needed at all is also asked.


This article was originally published in the Brookings-Wharton Papers on Financial Services in 2001.

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