3 Dealing with Bad Debts: The Case of Poland

Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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Stefan Kawalec, Slawomir Sikora and Piotr Rymaszewski 

We would like to present to you the principles of the bank restructuring program designed at Poland’s Ministry of Finance. We will concentrate on the distinctive characteristics of the program as well as its controversial features, which were the subject of the most heated disputes.

Before presenting the program itself, however, we would like to say a few words about the environment in which it is being implemented. The bank restructuring program was introduced as part of the broadly instituted reform of the Polish financial sector. This reform started in early 1989 with the creation of a two-tier banking system and has gained momentum since the stabilization program of 1990 brought to the Polish economy macroeconomic stability and microeconomic liberalization, and when interest rates became positive in real terms.

The main elements of the financial sector reform are (1) introducing the proper regulatory framework; (2) improving the quality of supervision of the banking sector; (3) introducing, through corporatization and privatization, internal incentives for the more efficient performance of banks; (4) strengthening competition by opening the market to newcomers, including foreign banks; and (5) developing a modern clearing and settlement system. All of these elements are being vigorously implemented and significant progress has been achieved over the past four years.

Banks Affected by the Program

The Polish restructuring program concentrates on the nine state-owned commercial banks that were separated from the National Bank of Poland in 1989 as part of the creation of a two-tier banking system. In 1991, the Government decided that these banks should be privatized. As the first step, the banks were transformed into joint-stock companies, with the State Treasury remaining the sole shareholder. The members of the banks’ supervisory boards were selected by the Ministry of Finance, primarily from professionals in the fields of finance, law, and other relevant subjects. Thus, even before their privatization, the banks were forced to operate as quasi-private institutions. To improve their internal operations, they entered into long-term technical assistance contracts with a number of reputable foreign banks. These so-called twinning arrangements were set up with the assistance of the World Bank and the International Finance Corporation.

In April 1993, the first of these nine banks, WBK of Poznan, was privatized with a capital injection from the European Bank for Reconstruction and Development and huge oversubscription by domestic and foreign investors. Another one, Silesian Bank of Katowice, will be privatized later this year, without the prior injection of new capital being necessary. The remaining seven banks will be privatized between the beginning of 1994 and the end of 1996, having been recapitalized in 1993.

The Polish Government came to the conclusion that it could not privatize a bank unless it was confident that the bank was financially stable and its organizational structure met the necessary standards. It desperately wanted to avoid having to bail out any recently privatized institutions. Although we are very enthusiastic about bank privatization, we want to privatize each bank only once.

In 1991, the Ministry of Finance commissioned a financial portfolio analysis of the nine commercial banks. The audits, carried out by international auditing firms, revealed that although the financial situation of individual banks differed, the percentage of substandard loans was on average very high. This was true not only for loans inherited from the centralized economy, but also for loans in the private sector credit portfolio. The creation of sufficient loan-loss provisions (100 percent for “loss” category and 50 percent for the “doubtful” category) in most of the banks would result in a decrease in the banks’ capital adequacy ratio (Cook’s ratio) to much below the 8 percent level required by Polish prudential regulations.

Choice of Restructuring Method

The Polish Government turned to the World Bank, the International Finance Corporation, and the European Bank for Reconstruction and Development with an invitation to engage in the preparation of the bank restructuring program and the financial support needed for the recapitalization of the banks. The international financial institutions had agreed with the concept of recapitalization, but had initially had many doubts about the methodology of restructuring proposed by the Ministry of Finance.

During the discussions, most experts representing the international financial institutions proposed the standard approach to the bank restructuring process, which can be described as a centralized, onetime solution that aims at improving banks’ assets by transferring their bad loans to a specially created loan-recovery institution and replacing them with interest-bearing treasury bonds. We in the Government rejected such an approach.

First of all, we did not believe that a centralized, government-sponsored agency could vigorously and effectively recover bad debts. We did not believe in our ability to create, within a reasonable time, a strong institution in terms of the high quality of its staff and internal organization. Nor did we believe in the possibility of devising an adequate incentive system that would ensure the institution’s active approach toward the indebted enterprises. We also did not believe that such an institution could resist political pressure.

Second, we felt that the centralized solution did not address the causes of the problem, which we believed lay primarily in the banks’ lack of experience and expertise in handling credit activities in a market environment. By painlessly removing the burden of bad debt from the banks, the centralized approach creates a danger that a bad loan portfolio will re-emerge in the near future. It does not contribute to the growth of the banks’ experience and expertise in conducting credit operations and resolving bad debt problems.

We proposed an alternative solution, which may be called a decentralized approach. It consists of recapitalizing the banks to such a level that they will be able to create adequate provisions for the bad loans and of introducing mechanisms that will encourage and even force the banks to undertake specific actions with respect to the bad debtors. The amount of ex ante recapitalization is not dependent on the amount of bad loans to be recovered by the individual banks. This creates incentives for the bank to recover as much of the bad debt as possible.

Many experts have cautioned about the danger resulting from the fact that our proposal does not terminate the financial ties between the banks and the bad debtors. The danger consists of the possibility of the debtors financing the old debt with the new loans, and that the bank preoccupied with the old debt may be unable to introduce new standards for its credit operations. We therefore attempted to introduce safeguards against these dangers.

The Polish Program

Preliminary Steps

In early 1992 the nine banks were required by the Ministry of Finance, acting as their owner, to (1) separate the loans classified by the auditors as being in the “doubtful” and “loss” categories, and (2) set up new internal organizational units (workout departments) to manage bad loan portfolios. The managers of these departments were selected through managerial contests between candidates who had not previously been involved with the credit activities of the bank whose department they would head. All of them are members of their bank’s management board. The workout departments were made responsible for developing the bad debt restructuring strategy and are obliged either to sell or to restructure—according to predetermined procedures—the loans classified as substandard.

At the same time the Ministry began work on the new Law on Financial Restructuring of Enterprises and Banks, which would serve as an administrative tool for facilitating the restructuring process. This law, which became effective in March 1993, established a framework for the restructuring program and introduced instruments permitting its effective implementation.


The program requires the banks to create recapitalization provisions at 100 percent for “loss” category loans and 50 percent for “doubtful” category loans. The recapitalization amount was calculated ex ante on the basis of the credit portfolio analysis as of December 1991, and was set at a level sufficient to ensure that on creating the necessary provisions the banks will reach a Cook’s capital adequacy ratio of 12 percent. Because the banks have no liquidity problem, the recapitalization will be performed by means of the treasury bonds transferred to the banks in the fiscal year ended December 31, 1993.

Duties and Limitations on Banks Subject to Recapitalization

The Law on Financial Restructuring of Enterprises and Banks imposes on banks subject to recapitalization certain duties and limitations on the loans separated from the total loan portfolio according to the audit for December 1991. These loans constitute the basis for calculating the amount of recapitalization.

The banks are obliged to complete the restructuring of these loans by end-March 1994—the deadline set by the Minister of Finance as authorized by the law. Until this deadline, the banks are not allowed to extend new credit to enterprises whose debt has been placed in the bad debt portfolio unless such credit is given in connection with a conciliation agreement. Such an agreement may be obtained as the result of a conciliation proceeding (similar to the U.S. Chapter 11 bankruptcy procedure) introduced into Polish law by the Law on Financial Restructuring of Enterprises and Banks. This provides that creditors of an enterprise unable to pay its debts can work with the management to draw up a financial and business restructuring plan. Under the conciliation agreement to implement such a plan, the creditors may reschedule claims, write off part of them, or convert them into equity in the firm. The conciliation agreement, upon signature by the debtor and creditors holding at least 50 percent of the claims of the debtor, becomes binding on all creditors.

The law requires the banks to ensure that before the March 1994 deadline one of the following events takes place:

  • the loan is recovered in its entirety;
  • a conciliation agreement with the bad debtor has been reached (or alternatively an arrangement agreement according to the old Polish Law on Arrangement Proceedings has been reached);
  • the debtor’s bankruptcy has been declared by the court;
  • liquidation of the debtor has been initiated either under the privatization law or under the Law on State Enterprises; or
  • the debtor has regained its creditworthiness, which has been proved by at least a three-month record of servicing the debt.

If the bank fails to restructure the debt through any of the above-mentioned alternatives or decides that none of these methods is feasible, the Law on Restructuring obliges it to sell the loan in the open market before the March 1994 deadline. Public debt sale is a procedure also introduced by the Law on Restructuring that in effect suspends the bank secrecy regulations with respect to the loans in the bad loan portfolio that are offered for sale.

Incentive Mechanism

The structure of the program described shows a two-tier incentive mechanism. The first tier is provided through the creation of a quasi-private, profit-driven institution. Transformation of the banks into joint-stock companies with market-oriented supervisory boards, the creation of workout departments operating as separate profit centers, and the prospect of privatization are all expected to stimulate appropriate responses by the banks to the restructuring program.

The second tier of the incentive mechanism is provided by the administrative supervision of the banks’ compliance with the Law on Financial Restructuring of Enterprises and Banks.

Conciliation and Debt Sale

It might be useful to concentrate on one of the choices that the banks taking part in the restructuring program will have to make—the choice between a conciliation proceeding and the public sale of debt made in the context of timely obligatory debt restructuring.

Banks are, by nature, very cautious when it comes to conciliation involving significant debt reduction. Thus, without special incentives the banks would be unwilling to negotiate debt reduction even with those debtors that could generate a reasonable level of operational profit after the reduction.

Because the Law on Financial Restructuring of Enterprises and Banks fixes a specific timetable for the restructuring or sale of the debt, the banks in many cases will have to choose between a substantial reduction in the debt’s value under a conciliation agreement and a significant discount under a compulsory public debt sale. In a public sale of a nonperforming debt, the banks can be expected to deal with two potential groups of debt purchasers. The first group consists of firms with financial obligations to the bank debtors. They may be interested in purchasing the debt to set off the claims. According to the Polish Civil Code, the mutual claims may be automatically set off against each other, without the need for either side’s consent. The second group of purchasers are investors buying the debt to demand the conversion of the debt purchased for the equity of the indebted enterprise (through a new mechanism introduced by the Law on Financial Restructuring of Enterprises and Banks).

Nevertheless, when a bank offers nonperforming debt for sale, it should expect a significant discount, forcing it seriously to consider sound restructuring proposals from the debtors. The bank may conclude, for example, that a 30 percent reduction under a conciliation agreement is a better alternative than a sale at a 60 percent discount. The bank may also decide that a cash sale of a bad debt at a 60 percent discount of face value is more reasonable than accepting a 30 percent reduction under a financially dubious restructuring plan. Thus, we hope that this mechanism will encourage the banks to enter into conciliation agreements offering good prospects for the recovery of the debtor. At the same time, the mechanism will discourage the banks from entering into economically unfeasible arrangements.

Subsidiary Government Intervention

The program, as described above, requires the banks to cease any financial cooperation with the debtor if the bank is not persuaded that such cooperation is based on sound commercial grounds. Strict implementation of the program will result in the termination of financial cooperation with a number of enterprises that are regarded by the Government as sensitive and important from the socioeconomic perspective. The goal of subsidiary government intervention is to address the situations in which sudden and unstructured liquidation of such enterprises would cause severe negative macroeconomic and social consequences of a scale that would be intolerable to the Government.

The intervention mechanism introduced will permit the Government to support the restructuring or cushion the liquidation of enterprises that are regarded by the Government as important from the sociopolitical perspective and that have been unable to reach a conciliation agreement with their creditors. Access to the mechanism is strictly limited.

To qualify for government help, an enterprise must prepare a sound restructuring proposal that envisages profound organizational and financial restructuring, or alternatively, it must prepare a liquidation plan. If the debtor submits a restructuring proposal, it must apply for corporatization; the creditors must have agreed to conduct conciliation or arrangement proceedings; and the qualifications of the incumbent management will be reassessed and appropriate actions taken.

The intervention mechanism itself will consist of financing and monitoring the restructuring or liquidation of the qualifying enterprises. The financing of this mechanism is provided for in a line item in the budget and will be supported in its entirety by the enterprise and financial sector adjustment loan that was approved by the World Bank Executive Board in April 1993 for the purpose of supporting the Government’s enterprise and bank restructuring program.

We view the subsidiary government intervention as an indispensable element of the financial restructuring program. Its main goal is to isolate the banks and enterprises participating in the restructuring program from political pressure, thus facilitating the establishment of sound commercial practices in the economy.

Budgetary Cost and Sources of Financing

In addition to the expenses of subsidiary government intervention, the Government will bear the cost of recapitalizing the banks. Even though the Government realizes that the cost of ex ante recapitalization may theoretically be greater than the cost of ex post capitalization, it is convinced that the incentives the proposed mechanism creates will result in improving the banks’ financial situation and achieving a better price for the banks when they are privatized.

The total recapitalization amount for the seven banks covered by the program will reach 11 trillion zlotys (approximately $630 million). Since the banks possess sufficient liquidity, the Government will capitalize them with 15-year redeemable treasury bonds. These will be denominated in Polish currency, indexed to a basket of foreign currencies, and will bear an interest rate close to the market level. Until the privatization of the banks, the bonds will be serviced and redeemed by use of budgetary resources. After the privatization, both the interest payments on the bonds as well as their redemption will be financed through the Polish Bank Privatization Fund, which presently amounts to over $600 million. This fund is financed through grants and loans originally extended by foreign governments to support the stabilization of the Polish zloty.


Under the Polish program described, in contrast with the centralized approach that we mentioned, the “cleaning” of banks’ assets is not accomplished overnight, but is performed in a limited time frame by the banks themselves. In addition, it is the banks that undertake the active restructuring and that adjust their organizational structure so that they will be able to deal with the problems of bad debt in the future. In the process, the banks’ personnel will acquire invaluable experience in debt recovery. They will learn how better to assess credit risk—an experience that they will find of use in future credit operations. The painful experience of losses also acts as a positive incentive for more cautious and calculated activities in the future. For all of these reasons, we believe that the method chosen by the Polish Government is superior to the centralized approach, which in our view fails to affect the banks at their operational level.

By combining enterprise restructuring with bank rehabilitation, we hope to speed up privatization of both industrial companies and banks, and ensure that this is a “once-and-for-all” operation leading to the elimination of bad borrowers and the provision of new credit to the more efficient users.

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