Financial Sector Inefficiencies and Coordination Failures : Implications for Crisis Management

In a country where financial intermediation is highly inefficient (with the enforcement costs of loan contracts very high, for example), or in one experiencing great volatility and large adverse shocks in output, the likelihood of an inefficient equilibrium is great. In East Asia it may be in the interests of both debtors and creditors to collectively reduce the face value of debt, to reduce inefficiencies in the financial sector.Agenor and Aizenman analyze the implications for crisis management of inefficient financial intermediation in a country (such as Indonesia or the Republic of Korea) where firms are highly indebted.They base their analysis on a model in which firms rely on bank credit to finance their working capital needs and loan contracts entail high state verification and enforcement costs for lenders.They find that higher volatility of output, lower productivity, or higher costs for contract enforcement and verification may shift the economy to the inefficient portion of the debt Laffer curve - with potentially sizable losses in employment and output.What implications does this have for the policy debate on crisis management in East Asia? Debt reduction, in addition to debt rescheduling, may be required to reduce employment and output losses in the presence of inefficiencies in the financial sector.In practice this may be difficult to coordinate among a large group of creditors because of the free-riding problem: Each creditor has an incentive to refrain from offering debt relief on its own claims and wait for others to do so, thereby raising the expected value of its own claims.This paper - a product of Economic Policy and Poverty Reduction, World Bank Institute - is part of a larger effort in the institute to explore the real effects of financial sector inefficiencies. The authors may be contacted at pagenor@worldbank.org or j.aizenman@dartmouth.edu