Preparing for the post-pandemic rise in corporate insolvencies

ASC Insight

No 2 / January 2021

Preparing for the post-pandemic rise in corporate insolvencies

by

Bo Becker Martin Oehmke

Note: The views expressed in ASC Insights are those of the authors and do not represent the views of other members of the Advisory Scientific Committee, the official stance of the ESRB or of its member organisations. In particular, any views expressed in the ASC Insights should not be interpreted as warnings or recommendations by the ESRB as provided for in Article 16 of Regulation (EU) No 1092/2010 of 24 November 2010, as those are subject to a formal adoption and communication process.

Contents

Abstract	3
1	Introduction	4
2	The economics of financial distress and insolvency	5

2.1 The trade-off between inefficient liquidation and inefficient

		continuation	5
	2.2	The ex ante versus ex post trade-off	6
	2.3	The cost of formal insolvency procedures	7
	2.4	Formal versus informal insolvency procedures	7
3	The impact of COVID-19 on corporate insolvencies	8
	3.1	The macroeconomic shock	9
	3.2	Default and bankruptcy	9
	3.3	Insolvency and distress	11
	3.4	Heterogeneity	13
4	Short-term policy options	15
5	Conclusion and longer-term structural issues	18
References		20
Imprint and acknowledgements	23

ASC Insight No 2 / January 2021

Contents

2

Abstract

Preparing for the post-pandemic rise in corporate insolvencies

The coronavirus (COVID-19) pandemic has severely affected economic activity around the world. The reduction in business activity during the pandemic will leave many firms highly indebted. Some face long-lasting or even permanent changes to their economic environment, and recovery may take a long time in the most affected industries. As a result, many firms are likely to be insolvent or close to insolvency when the public support measures that are currently in place are withdrawn. This ASC Insight provides an economic perspective on the trade-offs involved in dealing with a potential post-pandemic rise in corporate insolvencies.

Based on a brief summary of the economics of insolvency, we argue that the key challenge in dealing with post-pandemic corporate insolvencies will be to distinguish between viable firms and those which, owing to structural changes in their economic environment, have become non-viable "zombie" firms. Targeting of intervention measures is therefore essential. For viable firms, policy should aim to facilitate debt restructuring, relying on formal or informal insolvency procedures. For non-viable firms, policy should seek to facilitate the reallocation of resources to more productive uses.

In facilitating efficient restructuring and the reallocation of productive assets, the nature of the COVID-19 shock raises a number of specific issues.

• Small firms have been particularly affected by the COVID-19 shock. Yet, formal insolvency procedures often do not deal efficiently with small firms, in particular when it comes to restructuring.
• Policy should be mindful of congestion in formal and informal insolvency procedures. This includes the court system, banks' ability to restructure their loans, as well as labour and asset markets through which resources are being reallocated. Policy should aim to increase capacity.
• Given the nature of European capital markets, banks play a central role in the restructuring of corporate debt. Potential regulatory and accounting disincentives to restructuring should be kept low. Restructuring by banks and landlords could be incentivised, for example, via tax credits.
• During restructuring, viable firms need access to liquidity. There may be a role for policy to ensure such liquidity provision, particularly outside of formal insolvency procedures (for example, via liquidity facilities directed at banks that restructure loans).

ASC Insight No 2 / January 2021

Abstract

3

1 Introduction

The COVID-19 pandemic threatens not just health and life, but has also had a severely adverse impact on economies worldwide. The pandemic has complicated any type of business activity requiring face-to-face interaction. Some industries are set to face permanently lower demand. Dealing with these challenges, firms have drawn on available reserves and funding options, and unprecedented policy measures have been implemented to support these businesses. As support measures are withdrawn, as firms run out of funding options, and as some industries struggle to adjust to long-term demand shifts, a key policy concern is how to handle the likely increase in financial distress and corporate insolvencies (see, for example, Blanchard, Philippon, and Pisani- Ferry, 2020).

In this note, we provide an assessment of the current outlook for corporate insolvencies and the key trade-offs faced by policymakers, with a particular focus on macroprudential issues. We first provide a brief summary of the economics of insolvency. We then summarise the current economic situation. Based on this analysis, we discuss the trade-offs faced by policymakers in dealing with a potential wave of corporate insolvencies (although we do not attempt to assess each policy currently in place, or all of the national insolvency systems). We conclude with a brief discussion of longer-term structural issues related to insolvency law in the EU.

ASC Insight No 2 / January 2021

Introduction

4