The Challenges of Bankruptcy Reform

The 2008 financial crisis precipitated a global economic downturn, credit crunch, and reduction in cross-border lending, trade finance, remittances, and foreign direct investment, which all adversely affected businesses around the world. The increase in the number of distressed firms has made policymakers more concerned about the effectiveness of existing bankruptcy regimes, including both the laws that address reorganization and liquidation, as well as improved enforcement of laws in court.

In a recent paper with Elena Cirmizi and Mahesh Uttamchandani, my co-authors and I summarize the theoretical and empirical literature on designing bankruptcy laws; discuss the challenges of introducing and implementing bankruptcy reforms; and present examples of the most recent reforms in this area from around the world. As policymakers use the current recession as an opportunity to engage in meaningful reform of the bankruptcy process, it is important to assess experiences from previous crises.

To summarize, we find a consensus in the literature that effective bankruptcy laws that allow viable firms to reorganize and unviable ones to liquidate or be sold is a necessary condition for economic growth. Such laws encourage new firms to enter and surviving firms to become more efficient. In the alternative scenario where bankruptcy is costly, timely, and recovery rates are low, inefficient firms tend to be reluctant to file for bankruptcy and continue to operate at a financial loss.

Although firm closure is a frequent occurrence, we also observe substantial differences between countries in the use of legal procedures because of differences in legal traditions, accounting standards, regulatory frameworks, capital market structure, and macroeconomic factors. For instance, bankruptcies are less common in countries with concentrated banking relationships, and are more common in countries with firms that have more complex capital structures. The resolution of insolvency also depends on local social norms and stigmas about responsibility.

Finally, we discuss examples of recent bankruptcy reforms introduced by policymakers around the world. For example, popular trends among reformers include the introduction of shorter time limits on bankruptcy procedures (Lithuania, Tajikistan) and the establishment of reorganization procedures or pre-packaged arrangements (Italy, Kuwait, Czech Republic, Poland, Estonia, Mauritius, Uruguay, Rwanda, Sierra Leone, Philippines, and France). Countries also introduced new professional requirements for bankruptcy administrators; for example, Albania, Columbia, and Russia introduced new licensing requirements for bankruptcy receivers and training courses to improve professional qualification standards.

Studies on the impact of improved insolvency regimes—particularly efforts to speed up the resolution of debt recovery claims—find that reforms increase the probability of timely repayments, reduce the cost of debt, and increase aggregate levels of credit (e.g. India and Brazil). In addition, studies on the impact of reforms that introduce new mechanisms to encourage debt restructuring and organization (and lower liquidation rates) find a reduction in the duration of reorganization and a drop in SME failure rates (e.g. Columbia and Belgium). Reforms introduced in response to the recent financial crisis highlight that governments recognize the importance of bankruptcy reform in preserving businesses as going concerns for as long as possible, as well as providing a framework for speedy and efficient liquidations and reallocation of assets.

Further Reading:

Cirmizi, Elena, Leora Klapper, and Mahesh Uttamchandani, "The Challenges of Bankruptcy Reform," World Bank Policy Research Working Paper 5448, October 2010.