Introduction

The development of financial institutions, and the establishment of capital markets in particular, is central to the transition from a centrally planned, non-market economy to a market economy. This paper concerns the importance of bankruptcy in the process of financial reform. Specifically, it focuses on a problem with the implementation of bankruptcy in the early stages of reform that has the potential for bringing financial reform to a halt. This problem is a lack of aggressiveness of creditors in the reforming socialist economies (RSEs) in seeking satisfaction of their claims. That is, when debtors default on their debt, creditors passively accommodate by taking such actions as extending the payment period for loans and capitalizing unpaid interest rather than pursuing their claims through bankruptcy or other means.

Bankruptcy laws and other (non-bankruptcy) laws governing default serve crucial roles in market economies. The general purpose served by default law is that it helps to complete very incomplete debt contracts by specifying contingencies in the event of default. More precisely, default law stipulates whether control over assets is transferred in the event of default, how control is transferred, and also defines rights to future income streams either directly through provisions governing payment of creditors' claims or indirectly through the provisions on transfer of control. In brief, default law directs the reallocation of claims to a debtor's assets in the event of default.

By resolving some of the uncertainty associated with default, bankruptcy and other default laws achieve three beneficial types of outcomes. First, they define more precisely the property rights of creditors and thereby lower the cost of writing debt contracts.