A central objective of economic reforms in the former socialist economies has been to improve the financial discipline of firms by decentralizing credit allocation decisions to banks. The problem with such decentralization is that banks may not have adequate incentives to harden budget constraints of firms because their own budget constraints are soft. In Discussion Paper No. 1250, Research Affiliate Erik Berglof and Programme Director Gerald Roland stud y the incentives of banks in an environment characterized by undercapitalized banks, poor loan portfolios and political pressure to refinance unprofitable firms. They focus on soft budget constraints, that is, a situation where investors cannot commit ex ante not to refinance a firm ex post. This dynamic commitment problem arises because capital contributions are viewed as sunk at the time of the refinancing decision. Banks in their model have no intrinsic financial incentive to refinance bad loans ex post, but they may want to exploit the softness of the government. Since the government has an interest ex post in keeping unprofitable firms afloat, banks could commit capital to such firms beyond their current liquidity in order to trigger a government bailout. The softness of the government thus gives rise to softness by banks, which in turn results in soft budget constraints in enterprises.

The authors show that the poor quality of loan portfolios, the absence of collateral and low bank capitalization are key elements explaining soft budget constraints and repeated bank bailouts in transitional economies. Bank reserves help in hardening budget constraints, but high initial levels of capitalization are necessary to mitigate potential negative effects of a credit crunch for enterprises. They show that the trade-off between hardness and enterprise liquidity is more severe when loan portfolios are of poor quality. A similar trade-off arises if a bank invests in screening or monitoring projects to improve the quality of portfolios. Under certain conditions , the government should make capitalization contingent on banks investing in monitoring and screening in order to obtain hard budget constraints rather than let ting banks use reserves for such investments. They further show that transfers of all non-performing loans to a separate institution, a hospital agency, is never optimal, whereas partial transfers may serve to harden budget constraints.

Bank Restructuring and Soft Budget Constraints in Financial Transition
Erik Berglöf and Gérard Roland

Discussion Paper No. 1250, November 1995 (FE)