BANK RESTRUCTURING AND SOFT BUDGET CONSTRAINTS IN FINANCIAL TRANSITION

This paper analyzes in a formal model the problem of achieving financi al discipline in a transitional economy with bank-intermediated financ e. Even if banks have no intrinsic interest in refinancing unprofitabl e firms, they may still exploit the softness of government. By gamblin g for government bailouts, banks contribute to softening the budget co nstraints of enterprises. We show that the poor quality of loan portfo lios, the absence of collateral, and low bank capitalization are key e lements explaining soft budget constraints and repeated bank bailouts in transitional economies. Bank reserves help in hardening budget cons traints, but high initial levels of capitalization are necessary to mi tigate potential negative effects of a credit crunch for enterprises. We demonstrate that the trade-off between hardness and enterprise liqu idity is more severe when loan portfolios are of poor quality. A simil ar trade-off arises if a bank invests in screening or monitoring proje cts to improve the quality of portfolios. Under certain conditions, th e government should make capitalization contingent on banks investing in monitoring and screening in order to obtain hard budget constraints rather than to let banks use reserves for such investments. Wr furthe r show that transfers of all nonperforming loans to a separate institu tion, a hospital agency, is never optimal, whereas partial transfers m ay serve to harden budget constraints. (C) 1995 Academic Press, Inc.