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Effects of the Bankruptcy Laws Reform on Banks : The examination of recent Japanese experience

Listed author(s):
  • Sumio Hirose

    (Associate Professor, Shinshu University)

Registered author(s):

    Making the legal system more advantageous to debtors could contribute to improvement in efficiency. For example, under DIP, the existing management team would be allowed to remain and obtain incentives to start the reconstruction of their companies through bankruptcy proceedings before the company's value is significantly damaged. On the other hand, the revisions favorable to debtor could incur inefficient outcome. The revisions, favorable to debtors, could be unfavorable to creditors. It subsequently could reduce the amount expected to be recoverable by financial institutions upon bankruptcy. Consequently, the revisions could make financial institutions more reluctant to lend. This paper attempts to examine whether the above possible effects are caused by the recent reform of the bankruptcy laws in Japan, focusing especially on the introduction of the Civil Rehabilitation Law. The reform was intended to encourage reconstruction of distressed firms. For this purpose, the Civil Rehabilitation Law applies the provisions supporting incumbent managers to stay in business at the expense of creditors' benefits. Firstly, the possibility of the efficiency improvement is analyzed using the technique of an event study, focusing on the share price changes of main banks of bankrupt firms at the time when legal procedures were applied for. Secondly, the possible inefficient effect is examined by comparing borrowing amounts from financial institutions before and after the enforcement of the Civil Rehabilitation Law. The results of the event study show that applications for legal bankruptcy procedures had a significant negative impact on share prices before the enforcement of the Civil Rehabilitation Law. After the Law came into effect, however, the negative impact on the share price of main banks is no longer observed, therefore, the market did not necessarily perceive of filing legal reorganization as a negative factor any more. Moreover, after the second half of FY2001, applications for legal bankruptcy procedures turned to a significantly positive impact on the share price of the main banks. This was when the Financial Services Agency made bank inspections more rigor than before. Particularly, they carefully inspected lending to large borrowers, which could have an impact on the soundness of main banks. At least, the main banks enjoy the effects of improved efficiency caused by the revisions of bankruptcy laws together with more rigor bank inspections by the supervisory authority. On the other hand, the comparison of corporate borrowing from financial institutions before and after the enforcement of the Civil Rehabilitation Law shows a decrease in ratios of borrowing amounts from financial institutions against total debt amounts, mainly among smaller firms with a capitalization of 10 million to 1 billion yen. Thus, it is possible that lending by financial institutions has become passive. In this way, the amendments to bankruptcy proceeding legislation led conflicting effects. Therefore, the system needs to be designed in awareness of this kind of trade-off.

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    Article provided by Policy Research Institute, Ministry of Finance Japan in its journal Public Policy Review.

    Volume (Year): 5 (2009)
    Issue (Month): 2 (November)
    Pages: 201-228

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    Handle: RePEc:mof:journl:ppr006b
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    1. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 473-494.
    2. Ricardo J. Caballero & Takeo Hoshi & Anil K. Kashyap, 2008. "Zombie Lending and Depressed Restructuring in Japan," American Economic Review, American Economic Association, vol. 98(5), pages 1943-1977, December.
    3. Hiroyuki Seshimo & Fukuju Yamazaki, 2004. ""Perverse Incentives of Loan Supply and the Violation of Absolute Priority Rule in Japan--Credit Crunch and Excessive Additional Loan--"(in Japanese)," CIRJE J-Series CIRJE-J-103, CIRJE, Faculty of Economics, University of Tokyo.
    4. Gertner, Robert & Scharfstein, David, 1991. " A Theory of Workouts and the Effects of Reorganization Law," Journal of Finance, American Finance Association, vol. 46(4), pages 1189-1222, September.
    5. White, Michelle J, 1989. "The Corporate Bankruptcy Decision," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 129-151, Spring.
    6. Berglof, Erik & Roland, Gerard, 1997. "Soft budget constraints and credit crunches in financial transition," European Economic Review, Elsevier, vol. 41(3-5), pages 807-817, April.
    7. Elazar Berkovitch & Ronen Israel, 1998. "The Bankruptcy Decision and Debt Contract Renegotiations," Review of Finance, European Finance Association, vol. 2(1), pages 1-27.
    8. Berkovitch, Elazar & Israel, Ronen & Zender, Jaime F., 1997. "Optimal bankruptcy law and firm-specific investments," European Economic Review, Elsevier, vol. 41(3-5), pages 487-497, April.
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