What is needed to make the AMC solution work?

The government wants to form a public asset management company (PAMC) to buy distressed loans from banks. A special law is reportedly being prepared to empower the PAMC to purchase non-performing loans (NPLs) from banks, restructure and sell them to individuals or corporate entities. This is intended to get around the legal complexities to recovering NPLs. The AMC option is reportedly being crafted after conducting an extensive analysis of seven Southeast Asian countries on how they handled large amounts of default loans in the aftermath of the Asian financial crisis (1997-99).

Indeed, countries having fragile banking systems due to high NPLs have turned to asset management companies (AMCs) as a central strategy for cleaning their bad loans. Indonesia, South Korea, Malaysia, and Thailand established centralised AMCs soon after the onset of the financial crisis in 1998. Kazakhstan, Kyrgyz Republic, and Mongolia, which experienced bank runs and financial instabilities in the early 1990s, did the same. The United States, Sweden and Mexico have used centralised AMCs to solve their big and small financial crises.

A few other countries adopted a decentralised approach to the bad loans problem. Argentina, Norway, and Poland adopted private individual workout units, instead of centralised AMCs, but the motivations—that of unburdening banks and facilitating credit intermediation—are the same as those of centralised AMCs. India, Philippines, and Taipei, China have enacted laws, or provided for fiscal incentives, for the establishment of private entities that can help unload bad loans from banking institutions.

Do AMCs lead to improved behaviour and performance of the banking system? This is the most fundamental question. The answer depends on whether they come with reforms that address the root cause of the problem. The evidence is mixed at best. No surprise there since the AMCs varied very significantly in their design and performance.

The use of AMCs in various banking system resolution strategies to deal nationally with the 1997-98 crisis generally proved effective and efficient in managing NPLs in the East Asian region. At the height of the crisis, AMCs were important tools in cleansing bank balance sheets, ensuring capital adequacy, and safeguarding financial stability in the banking sector. This helped banks resume private lending and catalyse recoveries in economies gravely hit by the crisis.

The Chinese government set up four asset management corporations in 1999. In their early days these AMCs made a limited contribution to the resolution of the NPL problem. They acquired well over half of the NPLs of the big four banks and resolved no more than half of those acquired. However, the AMC losses surpassed the financial contributions to the AMCs from both the Ministry of Finance and the People's Bank of China. With their cash recoveries lagging the interest obligations, they faced cash flow pressures. In response, the Chinese government offered investment banking business licenses as incentives for the AMCs to meet the deadlines and recovery targets of their NPL resolution. The AMCs were allowed to diversify.

The AMCs in China were initially capitalised with 10-year bonds. It was generally anticipated that the bad banks would complete the task of cleaning up the financial system within that period, at which point they would be wound down. Instead, after 10 years the bonds were rolled over, giving the AMCs a new lease of life. After spending a decade diversifying, the big four AMCs returned to their core competence and dedicated more resources and energy to resolving NPLs. Chinese commercial banks' NPL ratio hit a 10-year high of 1.89 percent at the end of 2018 amid an economic slowdown. Separate from NPLs, "special mention" loans, or lending potentially at risk of becoming non-performing rose to 3.16 percent of the total loan volume for commercial banks. The NPL reached an all-time high of 12.4 percent in March 2005 and a record low of 0.9 percent in September 2011.

The AMC path is saddled with challenges. Asset management companies can trigger moral hazard induced bank lending when the NPL transfer to the AMC entails little cost to banks. Empirical examination of Thai AMCs found that moral hazard-induced bank lending resulted in creating newer NPLs under the public AMC regime. The public AMCs allowed the transfer of bad assets from state-owned banks (SOB) at inflated prices. In contrast, the Thai Asset Management Company regime was able to decrease the new NPL ratio, presumably due to better control measures addressing potential moral hazard effects on banks.

Financial and corporate sector weaknesses played a major role in the Asian crisis in 1997. Weaknesses in bank and corporate governance, lack of market discipline and weak enforcement of prudential regulations allowed excessive risk taking. Corporate sector problems represent the flip side of banks' nonperforming loans. Close relationships between governments, financial institutions, and borrowers worsened the problems. More generally, weak accounting standards, especially for loan valuation, and disclosure practices helped hide the growing weaknesses from policymakers, supervisors, market participants, and international financial institutions. Available indicators of trouble were largely ignored. Sounds familiar?

Political independence is key to accounting for the varied AMC performance across the world. This includes the AMC's ability to exercise ownership rights, restructure assets, and apply commercial, rather than political, criteria in pricing the acquired assets. Appropriate pricing provides the proper benchmark with which to assess the performance of the asset management companies. For instance, recovery values may be deemed too low compared to book values of assets, but not when compared to market values at the time of acquisition of purchased assets. Political insulation allows professional approach in the management of AMCs.

The legal framework largely determines the AMCs' ability to exercise ownership rights. Korea and Malaysia had more modern bankruptcy laws and relatively efficient judicial systems, unlike Indonesia, Philippines, and Thailand. Restructuring and asset disposal face long delays when the legal framework has a strong bias toward debtors who refuse to pay. It causes uncertainty in determining the price of the collaterals and the ability and timing of seizing the collaterals. Extrajudicial powers to overcome debtor resistance in such cases help only if it can be used without bowing to political pressure that protect well-connected debtors.

AMCs cannot work without a supporting environment enabling the market to carry the asset resolution process without depending too much on government-led initiatives. The essential ingredients of a supporting environment include an effective legal system defining the rights of ownership and the legal obligations between debtors and creditors; a sound regulatory and supervisory framework facilitating rational decision making in the management of NPLs; a neutral tax framework promoting both financial transactions and restructuring; and good governance to safeguard the effective operation of PAMCs with a sufficiently independent board capable of resisting political interference and pressure from borrowers.  An AMC is not the most suitable framework to tackle large exposures to wilful defaulters. A high concentration of NPLs and problem assets in SOBs and the dominance of large loans in the NPL stock warrant targeted bank-level solutions.

Zahid Hussain is an economist.