Perhaps the most serious aftershock of Asia's 1997–98 financial crisis has been a growing burden of bad debt that threatens the region's banks and national economies. Private estimates suggest that nonperforming loans now total a staggering $2 trillion—equivalent to almost 30 percent of the region's GDP. Yet governments have yet to recognize the full extent of the problem: their own reports peg the amount at a fraction of that level (Exhibit 1).¹

With so many bank assets failing to produce income, profits are suffering mightily. In fact, many banks would be insolvent if their balance sheets reflected the true value of their loan portfolios. Since Asian governments explicitly or implicitly protect depositors, the debts could well become yet another liability for taxpayers, who have already paid out $370 billion to mop up the 1997–98 mess.²

Worse still, bad debt is dampening economic growth: capital that could be used productively is tied up in defaulted borrowers—thus dragging down national productivity—and insolvent companies continue to operate rather than face liquidation. Moreover, as the nonperforming loans of banks have mounted, they have turned risk averse, preferring to invest in government securities and foreign markets instead of stepping up lending to local businesses (Exhibit 2). A regionwide corporate credit crunch is being created.

Resolving these difficulties won't be easy, because Asian banks have historically rated personal relationships higher than the imperatives of running a market-oriented business and because these institutions will undoubtedly take a hit to their balance sheets as they write down the value of distressed assets. But such banks could alleviate the sting by acting quickly, since the value of debt recovery in Asia—already low as a result of legal systems that favor borrowers—falls sharply over time. Our experience indicates that Asian banks could double or triple their recovery rates by tackling problem lending sooner rather than later. But if these banks continue to ignore the problem, they are at increasing risk for another collapse of the financial system, not to mention years of slower growth.

Governments too must act. Their job is to encourage the nascent secondary markets for distressed bank assets by loosening restrictions on the markets' operation and nurturing the state-owned asset-management companies (AMCs) set up to resolve bad debts. Bank regulators will have to toughen the requirements for reporting troubled loans, and bankruptcy courts must be overhauled—tough prescriptions but necessary ones if Asia's banks are to make the transition to a more market-oriented system that is in line with global norms.

One step in a long journey

And the good news? There are signs of progress. The few banks that have rigorously revamped their loan procedures and created effective and autonomous loan workout units have been surprisingly successful. And almost all Asian governments have now set up AMCs to take over and resolve nonperforming loans from banks. In a promising first step, these AMCs have already acquired $350 billion of bad debt from banks and recovered about $110 billion of it.

Still, many AMCs were established as an immediate response to the 1997 crisis and lack a mandate to resolve newer credits that have gone bad. Furthermore, in many cases the underlying causes of that crisis persist: the cozy relations between Asia's bankers and borrowers continue to ensure that if borrowers run into trouble, banks will respond either by rolling over their loans—though most Asian countries now require banks to classify as nonperforming any loan that is 90 days past due—or by granting concessions on interest rates.

Account officers at one Chinese bank were too embarrassed to telephone delinquent borrowers to find out why payments were late

A hallmark of this lending culture is the absence, by and large, of effective workout departments for nonperforming loans. Officers of commercial banks are not only involved in the decision to grant loans but also responsible for collecting them, a combination that creates a conflict of interest in a culture in which declaring a borrower in default is akin to blaming the loan officer. At one Chinese bank, account officers were too embarrassed to telephone delinquent borrowers to inquire why payments were late. The notion that Asian creditors might go further and demand corporate restructuring and management changes was unheard of until creditors outside the region began to agitate after the 1997 crisis. Their local counterparts have yet to follow suit.

Senior bank executives are equally disinclined to crack down on deadbeat borrowers. In the absence of pressure from shareholders to boost earnings—banks are owned by governments or controlled by family or conglomerate interests—and given the captive base of retail depositors to provide liquidity, institutions tend to ignore nonperforming assets. A true valuation of the loan portfolios of these banks would leave many in breach of their regulatory-capital requirements, and some would be found insolvent. Without external pressure, senior executives will be reluctant to face these realities.

The pressure should come from governments, but in most cases they too have failed to agitate for serious change, because they view banks as funding vehicles for economic growth rather than profit-making entities. Indeed, many currently bad loans were provided at the behest of governments or corporate parents, with little thought to credit risk. Cutting off distressed borrowers or demanding restructuring could threaten politically important companies and, in some cases, push unemployment to unacceptable levels. And if governments can't make up their minds to cut off insolvent companies, neither will banks.

Most banks have tried to grow their way out of this quandary by expanding retail lending. But this is a strategy born of wishful thinking: Japanese banks have tried it for almost a decade without success. Even if the proportion of nonperforming loans should decline, their absolute value won't—and is likely to increase as further questionable loans are made. Business lending still accounts for the largest part of bank balance sheets in most of Asia, and institutions will eventually need to engage in profitable business lending to grow. Actually doing so will require a significant change in the way these institutions approach their work.

The best from the bad

To begin whittling away the mountain of bad debt, banks must first break the link between the origination and the collection of loans by establishing independent workout units. The banks would then have three options: to resolve bad loans in-house, to sell them to private workout specialists, or to transfer them to state-owned AMCs. Most banks will find that a combination of all three of these strategies works best to manage their portfolios of nonperforming loans.

Any of these choices would undoubtedly be more challenging to execute in Asia than in developed markets elsewhere. Despite laudable reforms in many Asian countries, bank workout departments, third-party workout specialists, and national AMCs face legal systems that can still make it hard for creditors to obtain and enforce claims on debtors. Loan documentation and credit-risk assessments are often poor, and loans are frequently backed by collateral of dubious value. Well-connected companies turn to political friends for protection. Nevertheless, it is possible to undertake successful loan workouts in Asia.

Working out in-house . . .

Even if a bank's strategy is to sell most of its distressed assets, an independent workout unit—and not just a onetime attempt to solve a current problem—is vital. Such units are a permanent fixture of every world-class credit business because loans can go bad at the best banks. A good workout function can also enhance the overall return from lending and provide valuable information to improve future credit-risk assessments.

Independence and autonomy are the defining features of any true workout unit, whether set up as a bank department or as a separate asset-management subsidiary. They are particularly important in Asia, where it is essential to break with the lending culture of the larger bank and create a staff focused on loan restructuring and collections. To avoid interference from account officers, banks should set strict rules to govern the timing of the transfer of loans to workout—a common standard is 90 days after pay-ments of principal or interest are overdue—at previously agreed prices. Banks should be encouraged to deal with deteriorating loans as soon as trouble appears, however, since recovery rates can be up to eight times higher for loans that have yet to go bad.³

In some countries foreign workout specialists now train local staff whom local banks could hire away

Employing staff of the right caliber is vital as well: all too readily, banks push problem lending onto their poorly performing employees, though the job really requires their very best talent. Hiring experienced practitioners is difficult in Asia, but in some countries foreign workout specialists now train local staff whom local banks could hire away. Current employees could also be retrained, perhaps with the help of outside experts. One Chinese bank created a workout unit in just nine months and staffed it largely with branch employees familiar with the bad-loan portfolio. Workout agents underwent extensive training and, despite China's many legal and cultural constraints, boosted recovery rates to levels three times higher than usual, reclaiming $500 million in cash in the process.⁴ In some cases, merely calling a borrower and asking for delinquent payments was enough to spur action. In others, workout teams found unused equipment and other assets to liquidate for cash.

Besides assigning a staff of sufficient quality, a bank must develop financial incentives to compensate its members for undertaking this difficult job. In some cases, collection agents are paid up to 12 percent of the total cash recovered, with additional awards for those who secure extra collateral or tackle the hardest cases. It isn't uncommon to find successful employees quadrupling their base salaries through recovery bonuses.

For a newly established workout unit, the first task is to decide which loans to resolve in-house and which to sell. Internal workouts have several advantages: the bank itself often knows the borrowers best, for example, and, with the right workout skills, can squeeze the highest value from distressed assets; third parties demand lower prices to compensate for this information asymmetry. Internal workouts helped one Chinese bank generate recovery rates of 55 percent of face value, compared with market disposal rates of 20 percent by other financial institutions in the country.

Building a world-class workout function is hardly without its challenges. A new focus on collection rather than origination requires a huge cultural shift. Incomplete or inaccurate loan files, inadequate or overvalued collateral, opaque financial statements from borrowers—all hamper recovery. Units might be forced to employ hundreds of people, particularly to undertake collections from retail borrowers and small businesses. Workout specialists for large corporate debts need to have strong negotiation skills and the ability to coordinate activities with other creditors. The salary inequalities created by additional financial incentives for workout experts can spark controversy. Given these realities, any smaller financial institution or bank that isn't interested in collecting loans as a long-term business should consider disposing of bad loans instead of creating a large workout unit.

. . . and with outside specialists

The market for distressed debt is still small in most of Asia, but it is growing. So far, investors have purchased nonperforming Asian loans with a face value of about $340 billion. US and European loan workout specialists—including Deutsche Bank, GE Capital, Goldman Sachs, Lone Star Funds, and Morgan Stanley—have operations (some through joint ventures) in many Asian countries.

Japan and South Korea have the largest and most active markets (Exhibit 3); by contrast, the Philippines and Taiwan have yet to see significant sales. In China, Indonesia, Malaysia, and Thailand, the state-owned AMCs have so far been the main sellers of distressed debt: the Indonesian Bank Restructuring Agency (IBRA), for example, reckons it will sell bad loans with a face value of $15 billion this year, boosting the local market.

The advantage of selling bad debt externally is that it offers banks a relatively quick, guaranteed return on nonperforming assets; the disadvantage is that prices can be low, since private workout specialists look for an annual return of 25 to 35 percent. But if a specialist's workout skills and recovery rates surpass those of the bank, a sale can produce a "win-win" outcome—though some banks might balk at taking the large write-downs these sales generate: in Taiwan, one foreign bank estimated that certain loans were worth just 10 cents on the dollar.⁵ To get around this problem, sellers can dispose of their bad loans slowly or bundle together loans of differing quality. The South Korean experience shows that prices can rise once workout specialists gain local experience.

In Thailand, DBS Thai Danu Bank had to accept a low price when it resolved to dispose of $200 million in bad loans—a decision that reduced its nonperforming-loan ratio to 10 percent, from 35 percent, in a single transaction.⁶ The bank was happy with the outcome, since it felt that its internal resources could be better deployed elsewhere, and equity markets rewarded it with a 6 percent rise in its share price after the transaction was announced.

Creative deal structures can circumvent the problem of large write-downs. Instead of requiring the buyer to assume all of the risks and benefits, for example, deals can be designed to share them. In a landmark transaction in China, a consortium led by Morgan Stanley purchased $1.3 billion of nonperforming loans from China Huarong, the asset-management subsidiary of the Industrial and Commercial Bank of China. The consortium paid a small amount up front and agreed to share its recovery proceeds 50–50 with Huarong after it earned back the purchase price plus a fixed return.⁷ Another possibility is a joint venture with a foreign institution. South Korea's state-owned AMC, for instance, set up separate joint ventures with, among others, Deutsche Bank, Goldman Sachs, and Lone Star. The South Koreans provided the distressed loans; the partners, capital and expertise. Both parties shared the recovery proceeds.

Making national AMCs work

Although the secondary markets for Asia's distressed assets are expanding, they will always refuse to touch some loans. Effective state-owned AMCs are therefore the final piece of any solution to Asia's debt mess. A national AMC can not only achieve greater scale than most private operators but also consolidate loans from several creditors to a single borrower, thereby increasing the AMC's bargaining power. But to date, the disposal and recovery rates of these AMCs vary enormously, and many need to be revamped (Exhibit 4).

National AMCs are sometimes granted extralegal powers to cut through ineffective legal systems—an approach that can be particularly helpful in Asia. The Thai Asset Management Corporation of Thailand, for example, has full legal authority to seize and dispose of assets and to set conditions for restructuring companies, without going through the country's normal court bankruptcy proceedings. This special authority will give the AMC a stronger bargaining position with debtors and speed up loan workouts.

AMCs also play a crucial role in developing secondary markets for distressed assets. In the past four years, the Korea Asset Management Corporation (KAMCO), a leader in this area, has sold $15 billion of nonperforming assets, about one-third of its portfolio. The most active seller of distressed debt in Asia, it has fueled a market that private South Korean banks now tap into directly and moved to increase its returns by creating new asset-backed securities from bad debts, thereby providing an example for banks.⁸

As government-owned organizations, however, AMCs are subject to intense political and social pressures; in particular they are expected to favor borrowers with political connections. Such problems can be prevented if key policy decisions, such as the degree of debt forgiveness granted to large debtors and the amount and type of assets that can be sold to foreigners, are made in a public and transparent way.

In return for independence, national AMCs must be transparent and accountable; for example, the US Resolution Trust Corporation (RTC), established to resolve the savings-and-loan crisis that roiled the United States during the 1980s, dealt with political pressures by making its asset-disposal processes public and communicating frequently with Congress. AMCs should regularly disclose their financial and operating performance, ideally through public monthly reports, and clearly communicate their workout processes and asset-disposal methods. To minimize corruption, an independent audit unit should report directly to the AMC's board, which should have an audit committee made up entirely of outside directors. Finally, governments must hold AMCs accountable for meeting their performance targets (such as the level of funds recovered and loans successfully restructured) and must demand changes when they fall short.

Calling all governments

If Asia's debt is to be reduced, governments can no longer sit on the sidelines. First and foremost, regulators must crack down on loans designated as nonperforming. As long as dying state-owned enterprises in China and nonviable conglomerates in South Korea can obtain credit, the classification of loans is amiss. Rigor in designating loans as nonperforming would create an incentive to fix the problem by directly hitting the profita-bility and the capital of banks. Where such moves could threaten the solvency of the entire banking system—as in China, Japan, Taiwan, and Thailand—a temporary forbearance on capital-adequacy requirements while new bank capital was raised might be necessary.

Simultaneously, governments should encourage the development of second-ary markets for distressed assets by expanding national AMCs and removing procedural and financial obstacles to the sale and transfer of assets. (These obstacles include stamp taxes, registration fees, and capital gains taxes, which in some cases can raise the cost of an asset transfer in Asia by 10 percent or more of the book value.) Restrictions on the right of specialist firms to establish themselves in the market should also be relaxed; months after the landmark Morgan Stanley transaction with China Huarong, Morgan Stanley was still battling red tape to set up operations.

Commercial and bankruptcy law must be reformed to make it easier for creditors to seize assets and take over companies in default

Finally, commercial and bankruptcy law must be reformed to give creditors the right to seize assets and take control of defaulted companies more easily. For years, debtors across Asia have exploited weak legal systems to avoid honoring debts; in Thailand, for instance, creditors must go to court to prove insolvency before borrowers are forced into arbitration—a process that can take years. And court orders mean little without enforcement; even after Thai courts granted creditors control of Thai Petrochemical Industries, the founder and former CEO continued to show up for work every day, telling employees that he was still in charge.⁹ In China, banks estimate that only 5 percent of all court judgments are actually enforced, while in many countries commercial courts are clogged with cases and additional judges and enforcement officials are desperately needed. Reforming such entrenched legal traditions will take time, but governments could help in the short term by granting special legal authority to AMCs and by bringing in foreign legal support.

Asia's debt poses a serious problem, and resolving it might seem daunting. But if bankers and policy makers can find the will to tackle it now, they could be generating years of economic prosperity to come.