Asian finance and the role of bankruptcy

The degree to which bankruptcy is permitted to play a role in the allocation of capital is a key distinction between the Asian state-directed financial regime and the Western market-directed version. The paper discusses the two approaches to finance and argues that a major problem with the bank finance model used in many Asian countries is its minimization of bankruptcy risks. A three-sector development model (agriculture, manufacturing, and financial sector) is developed and simulated to compare the outcomes of the two approaches separately and then to evaluate the transition costs of switching from a state- to a market-directed financial regime. The simulation results suggest that the market approach results in a higher long-run growth path because it eliminates inefficient firms through bankruptcy. The results also suggest that switching from a state- to a market-directed model can be very costly to the economy, though the transition costs can be lowered somewhat by a delayed and phased-in liberalization. At the same time, a delayed and phased-in approach may induce other difficulties not considered in the model. Several policy implications are drawn from the model and simulation results; for example, development of an infrastructure to provide for orderly bankruptcy and the development of money and capital markets should be given high priority in the liberalization process.