| Abstract: | This article presents a taxonomy of financial restructuring strategies that have been used by national policy makers to manage financial crises in the past. The goals of financial restructuring are to preserve or, if necessary, restore the debtor‐creditor relationships on which the economy depends for efficient allocation of capital, and to do so at minimal cost. Costs include not only the direct costs to taxpayers of financial assistance, but also—and likely more important—the indirect costs to the economy that stem from misallocations of capital and incentive problems resulting from the restructuring. Countries typically apply a combination of tools, including decentralized, market‐based mechanisms as well as government‐managed programs. Market‐based strategies generally aim to strengthen the capital base of financial institutions and borrowers using some mix of debt forgiveness and capital infusions. Government‐led restructuring strategies include the establishment of entities to which non‐performing loans are transferred as well as government‐assisted sales of domestic financial institutions, often to foreign entrants. Market‐based mechanisms can provide low‐cost ways of resolving the coordination problems faced by countries in the wake of massive debtor and creditor insolvency, particularly when those mechanisms are effective in achieving the desirable objective of selectivity—that is, devoting taxpayer resources only to those borrowers and banks that, with temporary assistance, will be capable of sustaining themselves in the future. But limiting their range of application mainly to developed economies, such market‐based mechanisms also depend on an efficient judicial system, a credible supervisory framework and authority with sufficient enforcement capacity, and lack of corruption in implementation. Although government‐managed programs may not seem to depend as heavily on well‐functioning legal and regulatory institutions, such approaches—especially the transfer of assets to government‐owned asset management companies—also rely to some extent on such institutions. Asset management companies are less likely to achieve their goal of resolving the overhang of debt at reasonable cost when legal and political institutions are weak and ownership of domestic creditors and debtors is highly concentrated. Especially in such cases, complexity and failure to consider incentive problems when designing specific rules governing financial assistance can aggravate moral hazard problems, unnecessarily raising the costs of resolution. Resolution mechanisms tend to be most successful when—like across‐the‐board debt forgiveness programs implemented through redenominations of debt—they are simple in design and afford quick resolution of outstanding debts, offering little discretion to governments while providing incentives for the private sector to work down the remaining debt overhang. |
