Financially Distressed Firms in the Korean Manufacturing Sectors: Bank Loan, Innovations, and Reorganization

Abstract

This research investigates the effectiveness of rescue given to financially distressed firms through looking at the cases of Korean manufacturing companies in the three following ways. The first study uses data from the 1980s until 2010 to observe how bank behaviors have changed in giving additional loans to financially distressed firms. The second and third research analyzes the effect of rescue provided to financially distressed firms on firm performance. More specifically, the second research examines whether a financially distressed firm, if it possesses potential for growth and is motivated to pursue long term growth, achieves technological innovation if additional bank loans are provided. In the cases that long term investments are required for the technological innovation, financial difficulties may occur due to temporary liquidity problems until profitability is secured. Therefore, this research studies companies that were in such situations to assess whether additional financial aid to such companies has a significant positive effect on the realization of the technological innovation. The third research focuses on evaluating the effectiveness of rescue for financially distressed companies by investigating the validity of workout programs. More specifically, it evaluates whether the workout program, the autonomous restructuring agreement between financially distressed firms and its creditors, successfully keeps the firm from going bankrupt. While the second research focuses on the internal characteristics of companies, the third research looks at the institutional arrangement to analyze the validity of its function to rescue financially distressed firms. This research has found the following three main results. First, we found that South Korean banks had been giving additional loans to troubled firms before and during a decade after the Seoul Olympics of 1988. However, no additional lending to financially distressed firms was observed after the Asian Financial Crisis of 1997. Especially after the Global Financial Crisis of 2008, banks proved not to provide additional loans to companies if they encountered risks of bankruptcy. Such results imply that banks screening process has been functioning properly after the Asian Financial Crisis of 1997. Second, a positive correlation between additional loans to financially distressed firms and technological innovation was shown using the data after the year of 2000. More specifically, the more competitive the market conditions were and the higher the performance-based bonus was, the more likely were technological innovation. In general, financially distressed firms fail to innovate their technologies because of liquidity constraints and because they need to avoid further risks. However, amongst those financially distressed, appropriate motives to pursue growth such as being placed in competitive market conditions or given performance-based bonus are likely to increase the probability of innovations. Such results bear significant implications in that it has been presented that the positive firm characteristics play crucial roles in mitigating the negative effect of bank loans to distressed firms on technological innovation. Third, the analysis on the efficacy of the workout system, which was introduced in 1998, found that firms which underwent debt to equity swap experienced improved corporate performance after the completion of workout program. In particular, it has been observed that the banks decision to swap debt to equity is made contemplating the future growth potential that the company possesses. In other words, it has been found that if potential for growth is recognized within companies undergoing workout, main creditor banks decide to swap debt to equity. Workout firms adjusting its debt structure through debt to equity swap meets the intention of swapping debt to equity, and thus it is found to yield a positive long term corporate performance. Such results imply that the banks screening system for growth potential amongst workout firms functions effectively.