F&d 6/96/22-37

OTH FINANCIAL sector reform and private sector development have received considerable attention in developing and transition economies in recent years. But the critical nexus between banks and firms—not only for financing but also for efficiency and ultimate survival—has been underemphasized. Banks and other creditors have an extremely important role to play in fostering efficiency in medium and large private or state-owned firms. Creditors, in turn, rely for their survival on debt repayment by their borrowers. Without dependable debt collection, no amount of supervision or competition can make banks run efficiently. Debt appears to be slowly emerging as a device for exerting control over medium and large enterprises in some transition economies. The powers and incentives of creditors in these countries are still weak, however, compared with their counterparts in more mature market economies. Strong creditors are as critical to the efficient functioning of enterprises as are strong owners. External financing for private firms comes essentially from two sources: debt and equity. While control by equity holders is appropriate in profitable times (when entrepreneurial risk taking is needed), creditor monitoring and control become binding in times of financial distress, particularly when tight controls on spending and investment are needed. Indeed, foreclosure and bankruptcy laws typically shift control of firms to creditors at such times. Thus, the development of effective creditor controls is a crucial element in successful economic transition. The requirements for good control, or “corporate governance,” by owners have been extensively analyzed. The legal and institutional requirements for effective debt monitoring have not been as thoroughly analyzed but are no less important. Like equity holders, creditors can monitor firms either actively or passively. The active mode involves hands-on evaluation of a firm’s operations, investment decisions, and capacity and willingness to repay. The passive mode depends on collateral for security. To the extent analysis is carried out before a lending decision is made, the value of the firm’s collateral is what is analyzed rather than the operations of the firm. There are three crucial underpinnings to creditor monitoring and control in market economies: adequate information, marketoriented creditor incentives, and an appropriate legal framework for debt collection. The experiences of Hungary and Poland in the first half of the 1990s provide fascinat ing lessons about how—and how not—to strengthen creditors as agents of governance and restructuring for medium and