Banks, Firms, Bad Debts and Bankruptcy in Hungary 1991-4

The paper examines Hungary's experience with banking and bankruptcy reform in the period 1992-94. The first part of the paper uses enterprise-level data to show that in 1992, the same year in which the amount of classified loans in the state-owned commercial banks grew enormously, the proportion of total bank credit held by highly-unprofitable firms hardly changed. The inference from this is that the rapid growth of bad debt in 1992 was not the result of a "flow problem" (new bad lending) but rather represented the emergence of an inherited "stock problem" (pre-existing loans to inherited troubled clients). The paper then considers Hungary's 1992 bankruptcy reform, and in particular the novel "automatic trigger" which required firms to file for bankruptcy if they had a payable of any size, owed to anybody, overdue 90 days or more. The paper argues that the bankruptcy experiment was flawed on two counts. First, one of the key motivations for introducing the automatic trigger - a perceived problem with financial discipline and with interenterprise credit in particular - was largely unfounded. Second, the automatic trigger experiment was costly because the impact on firms which were forced to file for bankruptcy led to chains of disrupted trade relations which rippled through the economy. Evidence from a 1994 survey of 200 manufacturing firms shows that a majority of the surveyed firms had been involved in bankruptcies as creditors, and had lost not only sales but also suppliers as a result. The last part of the paper looks at the Hungarian government's bank recapitalization and enterprise bailout programs, arguing that they were poorly structured, overly bureaucratic, and susceptible to lobbying by firms looking to be "rescued". The paper concludes with a number of lessons: don't "shake things up" without being sure of the possible consequences; don't overestimate the capacities of bureaucratic procedures and undeveloped asset markets when designing debt workout programs; and don't underestimate the ability of market agents (banks and firms) to enforce financial discipline on each other if incentives are properly structured.