ESRB published a report that reviews the risks to economic and financial stability of a potential large wave of insolvencies and the possibilities for mitigating these risks. The report also discusses how a steep rise in insolvencies could be prevented and how insolvency frameworks can mitigate the disruptive impact of a large number of simultaneous corporate insolvencies, notably through the swift identification of fundamentally viable firms and their restructuring. The report also suggests that, as current support measures are withdrawn, governments should have strategies in place to address solvency issues, enabling fundamentally viable companies to thrive again once the COVID-19 pandemic is over.
The report highlights that the longer non-financial corporations have to rely on liquidity support measures such as debt moratoria, loan guarantees, and public loans, the greater their solvency problems might become as their debt accumulates. In most member states, corporate debt levels have already risen by several percentage points relative to the pre-COVID GDP levels. This debt overhang increases the risk of a large wave of insolvencies and a protracted, slow recovery. The policy mix, therefore, needs to evolve from addressing immediate liquidity needs toward providing more solvency support to viable firms. The shift from liquidity to solvency support implies higher costs to public budgets. Solvency support measures, therefore, need to be more targeted than liquidity support measures, through focus on the hardest-hit sectors and use of stricter eligibility criteria, subject to State aid controls. According to the report, governments now have to strengthen their additional lines of defense against the destabilizing impact of insolvencies.
The first priority for member states must be to create the right conditions for successful debt restructuring. Through public loans and loan guarantee schemes, the public sector has acquired a significantly larger stake in the non-financial corporate sector than it had before the pandemic. Successful debt restructuring for the large number of firms that benefited from such schemes is likely to be key to sound public finances in the medium term. Recent changes to the Temporary State Aid Framework of EC allow governments to convert public loans and guarantees into grants (up to a certain ceiling) to help companies weather the COVID-19 crisis. Governments can use such measures to contribute to debt restructuring while providing restructuring incentives to private creditors and banks, to put viable businesses on a sound financial footing for the recovery phase by harnessing the expertise of the financial sector in assessing business viability.
To avoid moral hazard, it is important to ensure that the interests of public authorities and banks are aligned when debt is restructured, to put companies on a sound financial footing for the recovery after COVID-19 pandemic. This will require banks to bear some of the restructuring costs and downside risks. Efficient insolvency procedures should be used or, if unavailable, developed for companies that are found to be unviable in the post-COVID economy. By eliminating judicial bottlenecks, assets of businesses that have to be wound up can be reallocated swiftly to more productive uses, thereby contributing to economic recovery and mitigating the impact of non-performing loan ratios on banks’ lending capacity. Cooperation at the EU level should support the efforts of national authorities in tackling the economic and financial stability risks stemming from corporate insolvencies. This should include information sharing on expected insolvency developments and on the development of policies to prevent and deal with insolvencies. ESRB is already committed to monitoring the financial stability implications of fiscal measures to protect the real economy from the COVID-19 pandemic.
Keywords: Europe, EU, Banking, COVID-19, Credit Risk, Corporate Insolvency, Debt Restructuring, Loan Moratorium, State Aid Rules, NPLs, ESRB
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