This note investigates the likelihood of corporate insolvency and the potential implications of debt overhang for non-financial corporations associated with the Coronavirus (COVID-19) outbreak. Based on simple accounting exercises, it evaluates the extent to which firms may deplete their equity buffers and increase their leverage ratios in the course of the crisis. Next, relying on regression analysis and looking at the historical relationship between firms’ leverage and investment, it examines the potential impact of higher debt levels on investment during the recovery. Against this background, the note outlines a number of policy options to flatten the curve of crisis-related insolvencies, which could potentially affect otherwise viable firms, and to lessen the risk of debt-overhang, which could otherwise slow down the speed of recovery.
OECD Economic Outlook, Volume 2020 Issue 2
Issue Note 2. Insolvency and debt overhang following the COVID-19 outbreak: Assessment of risks and policy responses
Introduction
A swift and decisive response of policymakers across OECD countries has helped businesses to bridge short-term liquidity shortfalls due to the economic shock following the COVID-19 outbreak, avoiding immediate and widespread insolvency crises. However, following the post-lockdown period, many countries have now entered a second wave of the health crisis. With a shock of such unprecedented scale, firms are forced to deplete their cash and equity buffers as well as to raise new financing; the situation is likely to translate into an enduring risk of a wave of corporate insolvencies and in a significant increase in leverage, depressing investment and job creation for a long time.
Building on earlier work (OECD, 2020a), which focused on the short-term risk of a liquidity crisis, this note assesses two key medium and long-term risks:1
Widespread distress and rising leverage. The number of non-financial corporations in distress, i.e. firms that are anticipated to have a negative book value of equity and therefore a high risk of insolvency, is increasing worldwide. An accounting exercise is performed based on a sample of almost one million firms located in 14 European countries to assess the decline of net profit over a one year period, the associated decline in equity and the increase in leverage ratios.
The negative effect of debt overhang on investment. Higher levels of corporate debt require businesses to reduce investment in the aftermath of economic crises, thereby slowing the speed of the recovery. Relying on regression analysis and looking at the historical relationship between investment and the financial leverage ratio at the firm level as well as this relationship during the global financial crisis (GFC), a calculation is made of the potential implications of the projected increase in leverage for investment ratios in the recovery from the COVID-19 crisis.
Against these risks, the note discusses options for policymakers to prevent widespread insolvencies and support firms without further increasing debt and leverage across firms. The exceptional magnitude of the crisis and the high levels of uncertainty that firms still face are likely to make the distinction between viable and non-viable firms more difficult. The risk of supporting potentially non-viable firms needs to be balanced against the risk of forcing viable and productive firms into premature liquidation. This is because insolvency frameworks tend to become less efficient during a crisis, especially when courts are congested, potentially leading to liquidation of a higher number of viable firms than desirable, with adverse effects on growth (Iverson, 2018).
To get around the necessity of identifying non-viable firms at an early stage, policy support needs to preserve optionality, i.e. helping firms weather the COVID-19 crisis but regularly re-assessing their viability. More broadly, one potential strategy for governments would be to adopt a multidimensional cascading approach. At first, policymakers could aim at “flattening the curve of insolvencies” by providing additional resources and restoring the equity of distressed firms. Next, if those additional resources are not sufficient, they could encourage timely debt restructuring to allow distressed firms to continue operating smoothly. These two steps should reduce the number of viable firms that would be otherwise liquidated. Finally, to deal with firms that would still be non-viable despite public support and debt restructuring, governments could improve the efficiency of liquidation procedures to unlock potentially productive resources. Over time, policymakers will acquire new information on what the “post-pandemic” normal will look like and policy may need to facilitate the “necessary” reallocations implied by the COVID-19 crisis.
Equity, leverage and debt overhang: An empirical assessment
Evaluating the impact of the pandemic on firm financial conditions
Using a simple accounting exercise, as in Carletti et al. (2020), the impact of the pandemic on firms’ long-term viability is evaluated quantitatively. The economic shock is modelled as a change in firms’ operating profits, resulting from a sharp reversal in sales and from firms’ inability to fully adjust their operating expenses. After calculating the decline in profits, taking into consideration governments job support schemes implemented during the first phase of the crisis, the model predicts the evolution of financial conditions along two dimensions.2 First, it calculates the new hypothetical value of net equity (i.e. the difference between the book value of assets and liabilities) one year after the implementation of containment measures. Firms whose net equity is predicted to be negative are classified in this framework as distressed, and thus at risk of being insolvent. This exercise provides information about the amount of equity that would be needed to restore firms’ pre-crisis financial structure. Second, the model quantifies the increase in firms’ leverage ratios caused by the reduction in equity relative to a “No-COVID-19” scenario.
To proxy the magnitude of the sectoral drop in sales, the analysis relies on the first-round demand and supply shocks computed at a detailed sectoral level by del Rio-Chanona et al. (2020), who account for the large heterogeneity in the ability to telework across sectors.3 With respect to the duration of the shock, the model presents two alternative scenarios. An “upside scenario”, which foresees a sharp drop in activity lasting two months (equivalent to the average duration of the shock most countries experienced in the second quarter of 2020), followed by a progressive but not complete recovery in the remaining part of the year. A “downside” scenario, which initially overlaps with the “upside” scenario, but then has a slower recovery due to more widespread further outbreaks of the virus accompanied by stricter mobility restrictions.
The analysis of firms’ financial vulnerabilities relies on financial statements of non-financial corporations from the latest vintage of the Orbis database. After applying cleaning procedures, the final sample consists of 872 648 unique firms, operating in both manufacturing and non-financial business services industries, for 14 European countries.4 Importantly, as the objective of the exercise is to investigate the extent to which solvent firms may become distressed due to the COVID-19 shock, the sample excludes firms that would have been distressed (e.g. firms with negative book value of equity at the end of 2018) and would have experienced negative profits even in normal times. It follows that the findings show an incremental – rather than total – effect following the COVID-19 shock.
The sharp decline in profits reduces equity buffers
The estimated decline in profits is sizeable, on average between 40% and 50% of normal-time profits (depending on the scenario considered). Following this sharp reduction, 7.3% (9.1%) of otherwise viable companies would become distressed in the upside (downside) scenario (Figure 2.7) and, accordingly, 6.2% (7.7%) of previously “safe jobs” would be endangered. The highlighted incremental effect following the COVID-19 shock implies that the total number of distressed firms would double compared with “normal times”, as approximately 8% of firms are estimated to already be endangered in a No-COVID-19 scenario.
The results differ across sectors and type of firms. The share of otherwise viable companies becoming distressed reaches 26% (32% in the downside scenario) in the “Accommodation and food service activities” sector, while it is almost zero in the “Information and communication” and “Professional services” sectors (Figure 2.7). The “Transports”, “Wholesale and retail trade”, as well as “Arts, entertainment and recreation” and “Other services activities” sectors are also severely hit by the crisis.5 The share of distressed firms in manufacturing is below average. More broadly, and consistent with the diverse ability of firms to use innovative technologies and teleworking arrangements, tangible investment-intensive sectors are relatively more affected than intangible investment-intensive ones (Figure 2.8, Panel A). Similarly, more productive companies are relatively less impacted than low-productivity firms; yet, the estimated percentage of firms in the top quartile of the productivity distribution becoming distressed is not negligible (Figure 2.8, Panel B). In addition, old and large firms are better positioned to face the shock compared to their younger and smaller counterparts (Figure 2.8, Panels C and D).
Figure 2.7. A substantial portion of otherwise viable firms is predicted to become distressed
Note: The figure shows the percentage of distressed firms in the upside (red triangles) and downside (green and blue bars) scenarios for the whole economy and at the sector level (1-Digit NACE Rev2 classification). Firms are defined as distressed if their book value of equity is predicted to be negative one year after the implementation of containment measures. The sample is restricted ex-ante to firms having both positive profits and book value of equity in the 2018 reference year.
Source: OECD calculations based on Orbis® data.
Figure 2.8. The impact of the shock is heterogeneous across types of sectors and firms
Note: The figure shows the percentage of distressed firms in the upside (blue bars) and downside (red bars) scenarios: by sectoral intangible intensity (Panel A); by productivity levels (Panel B); by firms’ age (Panel C); by firms’ size (Panel D). Details on the construction of the intangible intensity, productivity, age and size variables are in OECD (2020b). Firms are defined as distressed if their book value of equity is predicted to be negative one year after the implementation of containment measures. The sample is restricted ex-ante to firms having both positive profits and book value of equity in the 2018 reference year. For the sake of exposition, the vertical-axis scale varies among panels.
Source: OECD calculations based on Orbis® data.
The crisis will leave firms highly indebted and with a lower ability to service debt
The reduction in equity relative to normal times has immediate consequences on firms’ leverage ratios: the ratio of total liabilities to total assets would increase by 6.7 percentage points in the upside scenario and 8 percentage points in the downside scenario for the median firm in the sample (Figure 2.9, Panel A). Importantly, while leverage ratios are estimated to substantially increase due to the COVID‑19 shock over the whole range of the pre-crisis distribution, the new distribution of firms according to their leverage ratio shows a larger portion of firms with very high leverage ratios, underlying the likelihood of large-scale over-indebtedness (Figure 2.9, Panel B).
Similarly, the sizeable decline in profits relative to the business-as-usual scenario may impair firms’ ability to service their debt. Figure 2.10 shows that, despite assuming no increase in interest payments compared to normal times, 30% (36%) of the companies are not profitable enough to cover their interest expenses in the upside scenario (downside scenario) – i.e. they have an interest coverage ratio lower than unity. In line with this, the interest coverage ratio is estimated to be approximately halved due the COVID-19 outbreak for the median firm. Figure 2.10 also disaggregates results at the sector level, showing once again large heterogeneity across sectors and that a consistent portion of firms in the “Accommodation and food service activities”, the “Arts, entertainment and recreation” and “Transport” sectors will find it difficult to service their debt. Unsurprisingly, young, small and less productive companies are also predicted to be hit more severely by the crisis according to this metric.
Figure 2.9. Firms’ leverage is expected to increase in the aftermath of the crisis
Note: Panel A shows the percentage points increase in the liabilities-to-total assets ratio for the median firm of the leverage distribution following the COVID-19 outbreak in the upside (blue bar) and downside (red bar) scenarios. Panel B shows the levels of the liabilities-to-total assets ratio in the no-COVID (green bars), upside (blue bars) and downside (red bars) scenarios at different points of the leverage distribution. The sample is restricted ex-ante to firms having both positive profits and book value of equity in the 2018 reference year. Further details are in OECD (2020b).
Source: OECD calculations based on Orbis® data.
Figure 2.10. A large portion of otherwise viable firms will find it hard to service their debt
Note: The figure shows the percentage of firms whose interest coverage ratio falls below unity due to the COVID-19 outbreak in the upside (red triangles) and downside (green and blue bars) scenarios, both for the whole economy and at the sector level (1-Digit NACE Rev2 classification). The sample is restricted ex-ante to firms having both positive profits and book value of equity in the 2018 reference year.
Source: OECD calculations based on Orbis® data.
A high level of debt combined with a high risk of default could undermine recovery
The increase in the level of indebtedness and the risk of default can push firms towards the so-called “debt overhang” risk. When a firm has a high outstanding debt with a high likelihood of default, the reduced ability to invest and limited access to new credit generate pressure to deleverage by cutting costs and downsizing, even in companies with profitable investment opportunities, potentially slowing down the recovery. As shown in the early part of the crisis, a combination of negative pressure on sales, high uncertainty about future sales and profits, and growing debt burdens has increased the risk of default, have led to downgrades of corporate credit ratings. For example, in March 2020, 389 non-financial corporations across OECD countries saw a decrease in their credit rating, compared to 61 downgrades in March 2019. In turn, the deterioration in the quality of loans may impair banks’ balance sheets, reducing lending towards firms with good growth opportunities.
To assess formally how the rising tide of debt associated with the COVID-19 outbreak would affect investment and the potential magnitude of the effect, two separate empirical exercises are undertaken:6
A panel data analysis, similar in spirit to Barbiero et al. (2020), examines the historical relationship between indebtedness and investment over the 1995-2018 period. Results suggest that an increase in the ratio of debt to total assets comparable to the one predicted by the accounting model would imply a decline in the ratio of investment to fixed assets of 2 percentage points (2.3 percentage points) in the upside (downside) scenario (Figure 2.11, Panel A).
A cross-sectional analysis similar in spirit to Kalemli-Ozcan et al. (2019) examines the specific features characterising this relationship during the GFC. The results strengthen the previous findings, showing that the relationship holds also in the presence of a large shock such as the GFC and that the effect of a change in debt on investment is heterogeneous across firms. Firms that entered the GFC with a higher financial leverage ratio experienced a sharper decline in investment. In contrast, an increase in debt could foster investment in firms with very low initial indebtedness levels (Figure 2.11, Panel B).
Overall, the analysis confirms that a debt overhang could hamper investment and impede a fast recovery following the COVID-19 outbreak, given the record-high debt levels at the beginning of 2020 and the ongoing and expected rise in corporate debt due to the economic consequences of the pandemic.
Figure 2.11. High financial leverage decreases investment
Note: Panel A shows the predicted decrease in the investment-to-fixed assets ratios under the hypothetical increase in the debt-to-total asset ratios shown in Figure 2.9 (Panel A) for the median firm. Estimates on the correlation between debt and investment ratios are based on column (7) of Table A.3 in OECD (2020b). Panel B shows the predicted percentage growth in the change in the ratio of investment to fixed assets following a one-standard deviation increase in the (post- minus pre-GFC) change in financial leverage, at different pre-crisis indebtedness levels. To interpret the size of the effect, the vertical-axis is scaled by the absolute value of the mean of the change in the investment ratio, hence obtaining the effect of a one standard deviation increase in the explanatory variable of interest on the average value of the dependent variable. Estimates are based on specification 2 of Table A.4 in OECD (2020b).
Source: OECD calculations based on Orbis® data.
Policy options
The empirical analysis stresses that the rise of corporate debt could threaten the recovery, suggesting that governments should be careful when designing support packages. In the initial phase of the COVID-19 crisis, temporary deferral or repayments of loans either by private agents (e.g. banks in the Netherlands) or public sources (e.g. loans by the Ministry of Tourism in Spain) played a key role in relieving financially distressed businesses and preventing early insolvency. Loan guarantees also helped distressed firms to meet their immediate financial commitments, avoiding widespread defaults (e.g. the Überbrückungskredite – loan guarantees for short-term credits – processed by specialised Austrian banks). However, such support may not address the issue of their long-term viability due to the associated rise in indebtedness. The rest of this note sheds light on various policy options to support distressed firms without compromising their ability to invest. First, it focuses explicitly on the design of crisis-related measures and on the necessity of favouring equity-type financing over debt to recapitalise distressed firms. Second, it considers the potential role of debt resolution mechanisms in mitigating debt overhang and in sorting out viable and non‑viable firms.
Flattening the curve of insolvency while reducing the debt overhang risk
Increasing equity capital provides a way to support viable businesses without raising corporate debt. Relative to increases in debt, additional equity improves leverage ratios and reduces interest coverage ratios, thereby reducing corporate refinancing costs and helping a potential recovery. In times of high uncertainty over future sales growth, equity financing may also be desirable from the viewpoint of entrepreneurs, given that equity acts like an automatic stabiliser. Governments have various policy options to expand equity financing to support viable businesses.
Favouring equity and quasi-equity type of public financing
Equity injections can help viable firms, which suffer from financial difficulties solely due to the COVID‑19 pandemic but are likely to return to profitability afterwards, to raise much-needed cash to finance their working capital while keeping assets free for raising debt in the future. Hybrid instruments like preferred equity appear particularly well‑adapted as they provide a senior claim to dividends and assets in case of liquidation while they entail no voting rights and hence do not require governments to be involved in management. However, the authorities need to ensure that losses for taxpayers are minimised, competition in markets is not overly distorted and that equity injections do not crowd out other investors (OECD, 2020h). It is hence important to ensure that such support is state-contingent and includes mechanisms to incentivise all parties to wind down support when economic conditions improve (OECD, 2020c; OECD, 2020d). Temporary forms of preferred equity, e.g. retractable preferred equity, would also help to formulate an exit strategy in advance.
Supporting the financing needs of SMEs and start-ups may require a different and more comprehensive approach, as equity markets for small and medium-sized, as well as young, firms are thinner and often lacking altogether.7 This makes the valuation of equity capital and thus the design of the injection more difficult. Besides direct equity injections, policymakers could revert to indirect measures. For instance, loan repayments could be linked to businesses’ returns: firms that recover most robustly would pay back more, in the form of future taxes, while those that struggle longer would pay back less. Such support would have several advantages. It could help to flatten the curve of bankruptcies. In addition, agreements to pay higher taxes in the future against guaranteed credits would be easier to monitor than a potentially large number of equity injections in a large number of single entities.
While subject to the existence of sufficient fiscal space, another useful measure to address SME funding needs without raising debt consists of converting government (crisis-related) loans into grants. For instance, in the United States, loans obtained through the “Paycheck Protection Program” could be turned into grants conditional on the recipient firm spending at least three-quarters of the loan on payroll expenses and the rest on rent and utility bills. Similarly, the German government launched the “Immediate Assistance Programme” (Soforthilfeprogramm) to provide grants to small businesses, the self-employed and freelancers, conditional on using the funds to mainly cover rental and leasing expenses; applications should be filed directly with regional governments, and the maximum amount of the grant is set proportional to firm’s size.
Stimulating the uptake and provision of equity capital
One way for policymakers to leverage on the need for equity in the post-COVID-19 world would be to grant an allowance for corporate equity (ACE). Such an allowance would partially or totally offset the tax benefits of using debt financing and make equity financing more attractive. Their design should however ensure that multinationals do not exploit ACE for tax-planning and that their fiscal cost is acceptable, for instance by granting them to new equity capital only. In the OECD area, a few countries (such as Italy and Belgium) have already introduced ACE or experimented with it in the past and their experience can serve as an example (Zangari, 2014; Hebous and Ruf, 2017). Moreover, deductions on income taxes and reliefs on the taxation of capital gains for eligible investments can foster the provision of private equity capital. Such tax incentives are often used to stimulate investment in high-risk, early-stage businesses, e.g. as in the UK’s Enterprise Investment and Seed Enterprise Investment scheme, but could potentially also be extended to a wider set of firms, such as smaller companies facing tight financing frictions.
Debt-equity swaps constitute a further tool to address high leverage. They involve the conversion of outstanding debt that cannot be repaid into equity of an otherwise viable company. Debt-equity swaps may appear attractive in theory, but raise some implementation issues. A debt-equity swap requires the estimation of the market value of debt and equity, and an agreement between shareholders and debtholders about the exchange ratio. The lack of equity markets for SMEs, in particular smaller ones, impedes a cost-efficient estimation of the market value of equity. Consequently, debt-equity swaps appear more appropriate to address elevated leverage in circumstances where agreements on underlying terms are more likely to be reached, such as subsidiaries of a large firm, than as a more general policy tool.
Besides immediate short-term measures aimed at dealing with the economic consequences of the COVID‑19 pandemic, there are options to ensure that equity markets continue to develop, including by widening access to equity markets for smaller firms by e.g. reducing costs and streamlining listing requirements (Kaousar Nassr and Wehinger, 2016). For instance, COVID‑19-related equity programmes could speed up the implementation of the Capital Market Union in EU countries, which in turn could help to address intra-EU segmentation along national boundaries. Similarly, policymakers can improve the development and attractiveness of equity markets by using financial literacy as a tool to boost stock market participation and the financial knowledge of entrepreneurs.
Ensuring the restructuring of viable firms in temporary distress and liquidation of unviable ones
Equity and quasi-equity injections might prove insufficient to allow firms to operate normally if leverage ratios and the risk of default remain high. For those firms, reducing the debt burden through debt restructuring can change both the timing of a potential default and their possibility of investing (Frantz and Instefjord, 2019). Most countries have already modified their insolvency framework to give insolvent firms a chance to survive in the short run, for instance by relaxing the obligation for directors to file for bankruptcy once insolvent (e.g. France, Germany, Luxembourg, Portugal and Spain) or by relaxing creditors’ right to initiate insolvency proceedings, as done in Italy, Spain, Switzerland and Turkey (OECD, 2020e; INSOL International-World Bank Group, 2020). However, more structural changes to features of insolvency regimes, which can be a barrier to successful restructuring, could help to coordinate creditors’ claims in a manner that is consistent with preserving the viability of the firm. The crisis can provide an opportunity for such reforms.
Favouring new financing
Continuity of firm operations during restructuring increases the chances of a successful restructuring but often requires firms to have access to bridge financing. However, access to new funds may be difficult when debt levels are already high and the risk of default is significant, leading to debt overhang. Across the OECD, new financing can have either no priority at all over existing creditors or priority over only unsecured creditors or else priority over both secured and unsecured creditors. In normal times, insolvency regimes have to balance incentives for debtors to invest and take risks with incentives for creditors to supply funds. Therefore, new financing should be granted priority ahead of unsecured creditors but not over existing secured creditors since this would adversely affect the long-term availability of credit and legal certainty (Adalet McGowan and Andrews, 2018). Yet, several OECD countries currently do not offer any priority to new financing, so granting it over unsecured creditors would be beneficial. Further, in the context of the current crisis and assuming that the extensive guarantees and liquidity injections reach the right firms, the blocking of the “credit channel” might not be the main concern. An alternative but more controversial option to improve access to new financing is to temporarily suspend the priority enjoyed by secured creditors in favour of new investors when they invest in distressed firms (Gurrea‑Martínez, 2020).
Promoting pre-insolvency frameworks
Efficient pre-insolvency frameworks and debt restructuring could help to address debt overhang by lowering the negative impact of deleveraging on GDP growth and speeding up the resolution of non‑performing loans (Carcea et al., 2015; Bricongne et al., 2016). While a majority of OECD countries have some type of pre-insolvency legislation, until recently they were generally missing in non-European OECD countries (Adalet McGowan and Andrews, 2018). A number of countries have strengthened out‑of‑court procedures in recent years. For example, in 2018, Belgium granted the courts the ability to endorse a settlement between a debtor and two or more of its creditors to make it enforceable. Lithuania overhauled the insolvency regime in 2020, accelerating timely initiation and resolution of personal and corporate insolvency proceedings and increasing returns for creditors, bringing them among the countries with the most efficient insolvency regimes according to the OECD indicator (OECD, forthcoming). In addition, several countries have encouraged lenders to reach out-of-court agreements with debtors materially affected by the COVID-19 crisis, especially when these agreements just involve a deferral of loan repayments (Australia, China, India, Malaysia and Singapore). More generally, introducing preventative restructuring or pre-insolvency frameworks, for instance as in the EU Directive on Preventive Restructuring Frameworks and Second Chance, could be accompanied by other incentives for private creditors to restructure debt, such as tax incentives (e.g. tax exemption for creditors who forgive part of debt). Effective design of such policies can be based on existing guidelines, such as the World Bank’s “Toolkit for Out‑of‑Court Restructuring” (World Bank, 2016).
Establishing specific procedures for SMEs
SMEs may warrant different treatment from other firms in a debt restructuring strategy, as complex, lengthy and rigid procedures, necessary expertise and the high costs of insolvency can be demanding for this category of firms. Indeed, SMEs are more likely to be liquidated than restructured, since they have to bear costs that are disproportionately higher than those faced by larger enterprises. In the current juncture with a high risk of insolvency among SMEs, the social cost of inefficient debt restructuring for SMEs could be very large.
Against this background, formal procedures can be simplified for SMEs and informal procedures, which typically avoid the procedural complexities and timelines of court proceedings and are often associated with better outcomes for SMEs, can be adopted relatively quickly (World Bank, 2020). A number of countries have taken measures to simplify insolvency procedures for SMEs in response to the COVID‑19 pandemic. The new COVID-19 moratorium in Switzerland provides SMEs with a simple procedure to obtain a temporary stay of their payment obligations. Brazil has proposed to implement simplified insolvency rules for SMEs (during judicial restructuring plans, they can be allowed to pay debt in up to 60 monthly instalments instead of 36 months, as is currently the case). In the United States, the threshold required to access the simplified insolvency rules of the Small Business Reorganisation Act of 2019 has been increased to allow more companies access to simplified proceedings. Introduction of such simplified rules and flexibility with payment plans could increase the likelihood that non-viable SMEs exit and viable ones in temporary distress are restructured immediately.
Dealing with systemic debt restructuring of large companies
In-court debt restructuring for large firms appears broadly efficient in normal times, but during systemic crises case-by-case restructuring can become difficult, availability of private capital is limited and co-ordination problems become more serious. In these conditions, court-supervised restructuring can be too time-consuming. Against this background, government agencies could prioritise out-of-court renegotiations whenever possible, a strategy that proved to be successful after the GFC (Bernstein et al., 2019; Hotchkiss et al., 2012). When out-of-court restructuring is difficult due to too many creditors, a centralised out‑of‑court approach might be desirable; such as the centralised out-of-court debt restructuring approach (the so‑called “London approach”) developed by the Bank of England in the 1990s or the “super Chapter 11” developed in the United States designed to deal with systemic crises.
Strengthening the efficiency of the liquidation framework to improve resource allocation
Providing equity support for distressed firms and ensuring debt restructuring should reduce a build-up of undesirable bankruptcies, but some firms will still remain non-viable in the post-COVID-19 world (e.g. due to their business model, their financial situation or their product specialisation). Against this risk, policymakers need to address several challenges to ensure that the liquidation process of such firms is efficient.
Ensuring the highest possible recovery rate for creditors. When the number of distressed firms is too large, the courts become overwhelmed, standard insolvency procedures work less effectively, and the recovery rates for creditors can be reduced, potentially at fire-sale prices. Any reforms that can simplify and speed up in-court processes would help in this respect. In the short term, increasing resources for the court system, for instance by adding new temporary judges on insolvency procedures or reallocating judges depending on the busiest jurisdictions, would improve the recovery rate of creditors.
Ensuring that liquidation is established by an independent broker. Public agencies such as public development banks in charge of loan guarantees may not be well placed to negotiate liquidation given their own exposed balance sheets (Bertay et al., 2015).Therefore, one challenge for policymakers is to establish an independent organisation to ensure that decisions with respect to liquidation and debt restructuring are not distorted (Hege, 2020).
Reducing specific barriers to market exit for small firms. The corporate versus personal distinction in assets and liabilities is often blurred for small firms. In that context, the type of personal insolvency regime matters for reducing the scars from the crisis, in particular by enabling a post-insolvency second chance for entrepreneurs and the availability of a “fresh start” – i.e. the exemption of future earnings from obligations to repay past debt due to liquidation bankruptcy. Many countries are already lowering time to discharge to three years to be in line with the EU Directive on Insolvency and Second Chance (e.g. Germany), but they could try to expedite this part of the reform, which can facilitate reallocation (e.g. Spain is considering this option).
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