The Covid-19 shock and the subsequent lockdown measures have led to a collapse in corporate cash flows, especially in economic sectors where physical proximity among workers and customers is unavoidable. In contrast to a traditional liquidity shock, firms are not subject to a sudden change in the cash flow distribution over time, but are instead experiencing a short-term output loss due to a temporary halt of economic activities. In this respect, the shock should not compromise their long-term viability. As a result, it also differs from a solvency shock, at least at this stage.
The speed at which the economic activity will recover (once health restrictions are eased) depends crucially on how the measures adopted by governments and other authorities affect the allocation of losses among different agents (firms, banks, households, governments and central banks), as well the timing of the measures themselves.
Main government measures adopted so far
Governments have already taken several policy actions aimed at supporting firms, households, and banks. Some measures involve a direct transfer of current losses from the private sector to the government balance sheet, including direct cash transfers to households and firms, temporary lay-off assistance (including the recently announced SURE programme by the European Commission), and higher unemployment subsidies. Some measures, on the other hand, do not change the allocation of losses among agents, but instead provide liquidity at subsidised conditions to postpone and smooth their impact over a longer time horizon. These measures include targeted temporary loan guarantees, temporary tax waivers, the temporary suspension of loan instalments, and the extension of loan maturities.
Measures such as temporary loan guarantees play a prominent role in the Governments’ policy responses because they represent a fast way to incentivise banks to accommodate the liquidity needs faced by firms during the Covid-19 crisis. In some of the key jurisdictions (the US, Germany, France, Italy, Spain), the guarantee covers at least 80% of the loan value to small and medium-sized enterprises (SMEs). The strong reduction in the expected losses faced by the bank provides substantial incentives to grant new loans (or roll over existing ones) in a situation of heightened credit risk. Loan guarantees can be seen as an effective tool for the ‘evergreening’ of loans to help keep businesses running, as advocated by Brunnermeier and Krishnamurthy (2020).
The medium-term loan foreclosure incentive created by guarantees
However, temporary loan guarantees may have an unintended effect which has been overlooked in the analysis so far. Once within close proximity to the guarantee scheme expiration date, banks will have incentives to foreclose maturing loans that benefit from such a guarantee that will be removed in the near future. Indeed, when the guaranteed loan expires, and guarantees are about to stop being available, the bank would prefer not to roll over the debt if the expected return from continuing the client relationship without guarantees is lower than the expected recovery value of the loan (an amount at least equal to the public loan guarantee that still protects the loan).
Put differently, the introduction of public guarantees increases the collateral value of the loan above its stand-alone value, encouraging bank lending. By the same token, the removal of guarantees will reduce collateral values, encouraging loan foreclosure. Foreclosure incentives (in proximity to the guarantee removal) will, all else being equal, be stronger (i) the higher the guaranteed amount per unit of loan face value, and (ii) the higher the probability of default and loss, given default of the loan.
Debt reduction policies to avoid foreclosure waves in the medium-term
Temporary public guarantees might introduce a trade-off between current and future availability of credit to firms. In order to avoid a loan foreclosure ‘wave’ ahead of the removal of guarantees, it is crucial to ensure that firms return to their long-term economic viability and achieve a sustainable risk profile before that date.
A fraction of the output losses suffered by firms during the Covid-19 crisis will not be recovered, and the additional guaranteed debt piled up by firms to cope with the shock will inevitably lead to an increase in their financial leverage. It is therefore crucial to complement public loan guarantees with other policy actions that allow firms to maintain their debt at (or at least close to) pre-crisis levels. Debt reduction policies will not only avoid foreclosure waves down the road, but also avoid debt overhang problems that might hamper investment when it will be needed most in order to speed up economic recovery.
Three possible complementary policy options, different in terms of timing of implementation and level of disbursements by governments, are conceived as follows:
- Short-term implementation: Additional direct government transfers to firms to compensate for the short-term loss of revenue and to cover operating costs (Drechesel and Kalemli-Ozcan 2020). During a lockdown that reduces many firms’ sales down to zero, the already-adopted temporary lay-off assistance measures (and the short-term adjustment of other operating costs) reduce, but do not eliminate, firms’ cash outflows. Additional transfers to firms to substitute for the missing demand (Saez and Zucman 2020) would further reduce the need for firms to take on extra loans to overcome the Covid-19 shock, preserving their net worth. These transfers would also insulate banks from short-term losses. However, they would entail a large immediate expense for the government, the circumvention of substantial legal issues, the rapid definition of eligibility criteria for firms, and bring with them the related controversies among different economic sectors.
- Medium-term implementation: Establishment of a vehicle with public equity for the restructuring of debt of medium and large sized companies. Governments could set up a special purpose vehicle that would purchase from banks the loans granted to meet firms’ liquidity needs during the lockdown phase. The vehicle would be funded with equity provided by each Government (or, in the case of an EU-wide initiative, by supranational agencies) and with long-term debt placed in capital markets. The amount of equity provided by public authorities should be sufficient for the long-term debt issued by the vehicle to meet the eligibility criteria of some of the ECB asset purchase programmes.
- Medium-term implementation: Introduce strong incentives to inject equity into firms. Governments could introduce strong tax incentives to inject private capital into firms in the form of equity. For example, this could be implemented through a ‘reinforced’ allowance for corporate equity (ACE). In comparison to policy option 1, there is no need to compute the ‘right’ amount of direct transfers to each firm, and no engagement in controversies over eligible industries and firms. This mechanism also avoids an immediate (and very large) disbursement for the government, linking its implicit tax liability to the effective survival of the firm. However, budget constrained SME owners may not participate in this programme, unless willing to allow new equity partners to join the company. In this respect, corporate governance seems to be a key factor for the success of this type of policy programme.
Conclusion
Governments have responded promptly to the urgent liquidity needs faced by firms during the initial phase of the Covid-19 emergency. In order to ensure access to liquidity, a prominent role has been given to the introduction of temporary public guarantees for corporate loans. While effective in the short-term, this column alerts that, in proximity of the guarantee expiration date, there could be a wave of loan foreclosures, unless further measures aiming at private debt reduction are also adopted.
Authors' note: Authors’ note: The opinions expressed are those of the authors and do not necessarily reflect the views of the Bank of Italy.
References
Brunnermeier, M and A Krishnamurthy (2020), “COVID SME Evergreening Proposal”, Inverted Economics, Mimeo.
Saez, E and G Zucman (2020), “Keeping Business Alive: The Government as Buyer of Last Resort”, Mimeo.
Drechsel, T and S Kalemli-Ozcan (2020), “Standard macro and credit policies cannot deal with global pandemic: A proposal for a negative SME tax”, VoxEU.org , 24 March.