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Is a Wave of Bankruptcies About to Hit the Global Banking System?

by internationalbanker

By John Manning, International Banker


As the pandemic swept across the world early last year, many anticipated that a surge in insolvencies would materialise from the prolonged shutdowns, which severely curtailed economic activity. But with most governments acting quickly to implement business-contingency measures, the number of realised bankruptcies during the COVID-19 era thus far has drastically undershot what was widely expected. This gap, therefore, continues to beg the question of whether an imminent tidal wave of bankruptcies is about to hit the global banking sector, as those contingency measures are gradually removed in the face of steady economic recovery.

The pandemic has seen companies take on considerable debt to survive the long and frequent periods of lockdown that often led to dramatic slowdowns in sales. Such decisions have undoubtedly been helped by the provision of state guarantees and central bank stimulus. Earlier this year, for example, Spain’s government approved an €11-billion plan to help companies pay down debts accumulated during the pandemic, including €7 billion for direct aid to companies and €4 billion for potential debt restructuring. But now, as authorities attempt to wean them off this support, the very real likelihood of bankruptcies could well put banking sectors under severe strain.

While state support has certainly boosted liquidity for firms, moreover, it remains unclear just how much it has done to stave off insolvency. As the International Monetary Fund (IMF) wrote in April, the abundant liquidity assistance via loans, credit guarantees and moratoria on debt payments may have protected many small and medium-sized enterprises (SMEs) from the immediate risk of bankruptcy, but such schemes cannot address solvency problems. “As firms accumulate losses and borrow to keep carrying on, they risk becoming insolvent—saddled with debt well over their ability to repay.”

Indeed, the IMF expects that the pandemic will boost the share of insolvent SMEs from 10 percent to 16 percent this year across 20 mostly advanced economies in Europe and the Asia-Pacific region. “The increase would be on a magnitude similar to the rise in liquidations in the 5 years after the 2008 global financial crisis, but it would take place over a much shorter period of time,” the IMF wrote in April. “Projected insolvencies put about 20 million jobs at risk (i.e., over 10 percent of workers employed by small and medium enterprises), roughly the same as the total number of currently unemployed workers, in the countries covered by the analysis.” The Fund also anticipates that 18 percent of SMEs may become illiquid in that they may not have enough cash to meet their immediate financial obligations.

As such, business insolvencies and eventual defaults could end up causing substantial write-offs, which would severely test banks’ capital buffers. The IMF sees banks’ Tier 1 capital ratios in the hardest-hit European countries, mainly in the south of the continent, declining by more than two percentage points this year, if not more. “Smaller banks would be hit even harder, as they often specialize in lending to smaller businesses: a quarter of them could experience a drop of at least 3 percentage points in their capital ratios, while 10 percent could face an even larger fall of at least 7 percentage points.”

So, is a wave of insolvencies all but guaranteed, then? Many seem to think so. An EU (European Union) document obtained by Reuters in February, for instance, showed that the bloc would face a surge in bankruptcies and bad loans once the post-pandemic economic recovery starts to take hold and governments begin withdrawing state schemes that are keeping many firms on life support. “Once the unprecedented public support measures expire, a number of businesses are likely to default on their debt obligations, leading to higher non-performing loans and insolvencies,” the note stated. It also included a calculation that national liquidity-support measures of almost €2.3 trillion are helping governments in the eurozone stave off a rise in insolvencies. Without such assistance and additional bank lending, the note also observed, nearly one-quarter of EU companies would have had liquidity problems by the end of 2020, having exhausted their cash buffers to contain the economic havoc wreaked by the pandemic.

The European Central Bank (ECB) has similarly acknowledged the potential “zombification” of the region’s economy, with many firms existing thanks only to state assistance implemented during the pandemic. The bank recently admitted that policy measures aimed at supporting corporates and the economy through the coronavirus pandemic “may have supported not just otherwise viable firms but also unprofitable but still operating firms—often referred to as ‘zombies’”. With such pressing concerns in the offing, EU leaders have discussed the issue with the ECB’s president, Christine Lagarde; specifically, what happens when such business-support measures are removed, and how will a potential wave of corporate insolvencies impact the banking sector? “It is a very significant risk for us,” said Paschal Donohoe, the Irish minister who leads meetings of euro area finance chiefs.

Indeed, given the support measures still in place, the currently subdued number of bankruptcies seems almost certain to be disguising a major surge further down the road. At the end of March, for instance, official data from Germany showed that the number of corporate insolvencies fell last year to its lowest level since 1999, which is more a reflection of the government’s decision to allow ailing businesses to delay filing for bankruptcy than any fundamental improvement in operating conditions in the country. “It’s a paradox: Despite one of the biggest economic crises in Germany last year, insolvencies fell by 15 percent,” Ron van het Hof, chief executive officer of credit insurer Euler Hermes in Germany, Austria and Switzerland, told German international media outlet Deutsche Welle (DW). “This shows how strongly the insolvency trend is decoupled from the actual overall economic condition and the current state of the companies.”

Similarly, the United States experienced a 30-percent decline last year in personal and business bankruptcy filings compared with 2019 figures. Official data showed that company insolvencies in England and Wales also fell to their lowest levels in more than 30 years in early 2021, again thanks mainly to the government-support measures in place. And the number of EU bankruptcies declined last year vis-à-vis 2019 levels, again thanks in no small part to the suspension of loan repayments and the easing of bankruptcy rules in the region.

But not everyone is expecting bankruptcies to soar in the near future, the Bank of England (BoE) included. According to the United Kingdom’s central bank’s outgoing chief economist, Andy Haldane, much of the accumulated business debt is spread over long durations, “which increases the chances of them being able to be paid back and therefore bankruptcy is not picking up very much from current relatively subdued levels”. Nonetheless, Haldane acknowledges that risks remain and that the BoE will “need to track them through”.

The Bank for International Settlements (BIS), meanwhile, remains undecided on what the future holds in terms of the coming insolvency wave—or lack thereof. “The extension of credit to loss-making firms has clearly helped prevent the initial liquidity crunch from quickly morphing into widespread solvency problems. However, it remains uncertain whether this transition has been cancelled or postponed,” BIS economists Ryan Banerjee, Joseph Noss and Jose Maria Vidal Pastor wrote in March. “Ample credit has resulted in sharp increases in firm indebtedness over the past year. For example, in the airline and hotel, restaurant and leisure sectors, the median leverage in loss-making firms has increased by nearly 20 and 15 percentage points respectively.” As such, the BIS expects that the path of future cash flows will play a key role in determining whether this mounting indebtedness ultimately makes firms vulnerable to insolvency.

As for banks, it would seem to be a case of remaining cautious for the time being, especially given that the current problems corporates face are not being reflected in the levels of nonperforming loan ratios. “While it is clear that the debt-servicing capacity of the private sector has been adversely affected by the pandemic, government credit guarantees and loan repayment moratoria have so far prevented a rise in loan defaults,” the EU note read. “Thus, the headline NPL ratios—based on a rather stable NPL stock and the increasing loan denominator—do not yet reflect the underlying deterioration in the credit profile of borrowers.”

Whether the global banking sector can emerge from the crisis unscathed, however, is more difficult to assess at this stage, not least given how fragile the global economic recovery remains at present and how susceptible it is to further restrictive measures. According to the European Commission (EC), banks in the region had largely been in strong health prior to the crisis, but corporate and economy-wide risks may well have grown since then. “According to the ECB’s Bank lending survey, banks expect to further tighten credit conditions and raise collateral requirements,” the Commission stated.

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