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Mon, 3 August 2020

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Could coronavirus trigger a corporate debt crisis?

Could coronavirus trigger a corporate debt crisis?

TheCityUK estimates that unsustainable corporate debt could reach c.£100bn by next March, writes Maria Busca. | PA Images

Maria Busca | Dods Monitoring

5 min read

It is hard to see if TheCityUK’s new corporate recapitalisation proposals would benefit the public purse. Ultimately, it comes back to the old debate on whether to save failing companies or instead let the natural restructuring happen.

The early stages of the Covid-19 pandemic were marked by a harsh warning from the Governor of the Bank of England, Andrew Bailey, who told banks to carry on lending, warning that withdrawing credit provision would trigger bigger losses for banks on existing corporate loans by pushing unemployment higher.

Heeding the advice, or more likely encouraged by the government guarantees, the banks have done exactly so. According to statistics published on 28 July, the banking and finance industry has approved more than £50bn to over 1.17m businesses via government-backed coronavirus lending schemes. The bounce-back loans account for the biggest share, having provided a total of £33.7bn to 1.1m businesses.

High unsustainable debt taken during the Covid-19 crisis threatens economic recovery

TheCityUK estimates that unsustainable corporate debt could reach c.£100bn by next March, of which c.£35bn would stem from Government loan schemes. The debt risks impeding firms’ ability to invest and grow and causing a significant drag on the recovery and in turn on the finance sector as well.

The financial industry warned that three million jobs across the UK and 780,000 SMEs are at risk once interest rates on government guaranteed loan are due for repayment starting in March 2021.

In a recent committee session, Richard Hughes, appointed head of the OBR, said the longer the crisis goes on, the guaranteed loans become more of a burden than a facilitator of recovery. Many MPs and the opposition had called for grants as opposed to loans at the beginning of the crisis, to avoid the challenge of deleverage instead of fuelling recovery. However, the Chancellor opted for partially or fully guaranteeing the loans to the banking sector.

So what’s the solution?

With many of these loans given without credit assessment, and the country facing an uncertain economic recovery, ensuring struggling borrowers are treated fairly will be no easy task. Banks also face a reputational risk; the backlash against RBS over their treatment of small business during the previous crisis is still fresh in the memory. That is why the industry is calling for clear guidelines to agree when the Government guarantee can be called, and an oversight process to reduce conduct risks and avoid disputed cases.

To address the risk of massive deleveraging, some have called for making obligations to pay contingent to firms’ affordability and extending the maturity to give businesses more time. For instance, Richard Hughes has previously advocated making repayment of this debt contingent on revenues, and writing off the debt after a period of time.

A similar but far more complex proposal came from the finance industry – theCityUK’s led Recapitalisation Group. Under the plan, smaller companies that are unable to pay back their debt would convert their obligations into means-tested tax liabilities. Larger companies that have taken bigger loans would be able to convert their debt into a long-term subordinated unsecured loan or a preferred share capital.

The proposal is somewhat akin to the concept behind student loans, where the obligations to pay are parcelled up and sold to investors. But it differs in the concerns it raises such as the risk of subsidising unsuccessful companies that in fact may need restructuring. It also introduces the risk of moral hazard – many more firms would be tempted to take these loans under far better terms of repayment following the conversion, a risk which the Treasury is very concerned with.

Shifting responsibility to the Government and reducing taxpayers’ exposure to losses – a win-win?

The plan shifts the responsibility of managing these debts to a new government funded entity – UK Recovery Corporation. It makes it less costly to administer and less reputationally risky for the banks, but also provides the banks the opportunity to earn fees on arranging the conversion of obligations to pay and structuring of debts.

As agreed when the loans schemes were created, the lender will be paid in full for the Government guaranteed portion. In turn, the complex financial instruments under the proposal, created with a view to attracting investors, would gradually reduce the Government’s exposure.

Much of the industry’s proposal rests on attracting private sector capital to reduce the Government’s exposure. But in order to do so the industry needs more guarantees from the Government and rules to allow some investors to make such risky investments. Due to the sheer complexity of the proposal, it is hard to see if it would bring benefits to the public purse.

Ultimately, it boils down to the old debate on whether to prop up failing companies, and in so doing save jobs and maintain human capital, or instead let the natural restructuring happen hoping new and more productive companies and jobs will be created. However, there is no guarantee that ‘creative destruction’ works during such uncertain economic times. 

Maria Busca is the Dods Political Consultant for Financial services. To download the complementary report on the Financial Challenges of the Pandemic click here. 

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