A guest post by Niall McGeever (Central Bank of Ireland) on new company registrations and corporate insolvency in Ireland during the pandemic. [Disclaimer: This blog represents the author’s views and not those of the Central Bank of Ireland]
The severity of the COVID-19 shock
and the modest liquid asset holdings of many Irish firms (Financial Stability Review 2020 I; McGeever et al., 2020) raises the
question of how the pandemic is affecting business dynamism and failure rates. A
marked reduction in new firm formation or a spike in insolvencies could lower
the productive capacity of the economy and negatively affect output and
employment.
There’s lots of economic research
showing the importance of new firms for productivity and employment growth. Lawless (2013),
for example, shows that young firms contribute disproportionately to employment
growth in Ireland.
While a certain level of insolvency over time is inevitable
and even desirable to ensure resource re-allocation to productive firms, the
failure of otherwise viable firms due to the pandemic could reduce output and
productivity growth. See Lambert
et al. (2020) for more discussion on this point.
The chart below, Figure 2 from the Letter, shows the new company registration rate between January 2001 and September 2020. The rate averages around 9.5 per cent per annum and is broadly pro-cyclical.
The initial Covid-19 shock coincided with a sharp decline in new
company registrations, with the rate falling to 5.3 per cent in April and 6.1
per cent in May. The Companies Registration Office tell us that over 90
per cent of applications to register a new company are made online, so the
decline in April and May cannot be explained by procedural delay due to the
pandemic. Instead, it likely reflects a temporary decline in both new
enterprise formation and stalled investment decision-making by pre-existing
corporate groups.
The largest declines during this period were, perhaps
unsurprisingly, in Accommodation and Food and in Arts, Entertainment and
Recreation. New registrations in these sectors were down 50 per cent on the
same period in 2019.
Whilst the number of registrations in the first nine months of
2020 were down around 12 per cent on the same period of 2019, new company
registrations rebounded quite strongly over the summer and had returned to
roughly pre-pandemic levels by September. An emerging trend in the
Wholesale and Retail trade category is the consistent increase in new
registrations in “retail sales via mail order houses or via internet” and in
“other retail sales not in stores, stalls or markets” between June and
September relative to the same period in 2019. This trend is also reflected
internationally. US
Census Bureau data, for example, shows higher new business applications by
non-store (e.g., internet sales) retailers during 2020.
We next look at insolvent liquidations. The next chart (Figure 4 in the Letter) shows the insolvent liquidation rate from January 2001 to September 2020. The rate generally tracks macroeconomic conditions very closely and it is worth noting that it rose notably rose with the unemployment rate in early 2008.
The
immediate impact of Covid-19 shock was to sharply reduce insolvent liquidations. The annualised rate was
exceptionally low at 0.07 per cent in April 2020 and only a touch higher at
0.10 per cent in May. This is due principally to the inability of company
directors to safely convene creditors’ meetings. Prior to the pandemic, it was
a requirement to hold a physical meeting with creditors to initiate a
creditors’ voluntary liquidation. This became impractical during the acute
phase of public health restrictions and so the main channel for insolvent
liquidations was blocked. This procedural issue was quickly resolved and the
Oireachtas passed a company law amendment to facilitate creditors’ meetings by
electronic means.
The insolvent
liquidation rate reverted to pre-pandemic levels in June and showed no signs of
a marked increase up to September. At a sectoral level, Accommodation and Food
and Wholesale and Retail Trade show signs of higher liquidations both during
the pandemic and relative to 2019. These patterns are aligned with the negative
labour market shocks in both sectors.. To a lesser extent, we also see the Arts
and health sectors recording higher numbers.
Despite the
clear evidence of financial distress facing many firms, there is no evidence yet
of a marked increase in corporate insolvencies. The striking contrast between
the insolvent liquidation rate and current labour market conditions is unusual
and points to the significant role of government supports, loan payment breaks,
and forbearance from other creditors in helping firms to stay cash-flow
solvent.
A guest post by Fergal McCann (Central Bank of Ireland) on SME finances and firm supports during the pandemic.
The Central Bank has published a Financial Stability Note, written by Derek Lambert, Fergal McCann, John McQuinn, Samantha Myers and Fang Yao, entitled “SME finances, the pandemic, and the design of enterprise support policies”. The Note estimates the likely losses that are being experienced in the SME sector over from March 2020 to year end, introduces a model of SME financial distress which can be used to evaluate the effect of announced SME support policies, and discusses policy implementation issues in the current climate.
Aggregate revenue shortfalls We begin by updating an aggregate model of SME revenue shortfalls. McGeever, McQuinn and Myers (‘MMM’, 2020) used a first variant of this model to estimate three-month initial liquidity needs for SMEs of €2.4bn to €5.7bn. We update this model to account for reported reductions in wage and non-wage costs, using both PUP/TWSS take-up rates and CSO surveys on the business impact of COVID-19. Firstly, we show that, using observed data, our estimates for Q2 are at the very high end of the MMM estimates, suggesting the effect of the COVID-19 shock is about as severe as we were willing to project back in March/April when the initial MMM work was being carried out. Revenue shortfalls for 2020 are estimated between €10.3bn and €11.7bn across the SME sector, which are of course subject to significant uncertainty, both due to the uncertain outlook and the use of firms’ survey responses during the pandemic.
We highlight in the paper that such aggregate revenue shortfall estimates are not necessarily estimates of the size of required government support. These shortfalls already account for wage cost reductions through the TWSS. In aggregate, these shortfalls can be met by a combination of utilisation of pre-existing cash reserves, draw-down of existing credit commitments, new borrowing, additional cost reductions or loss-sharing, or if necessary governmental non-wage grants, reliefs and guaranteed loans. In this vein, we also model that across the board non-personnel cost reductions of 30 per cent could have large effects in reducing the overall shortfalls, suggestive of the importance of burden-sharing and cost efficiencies, along with fiscal support, in addressing the crisis.
Protection or liquidation We outline considerations for designing policy responses to
SME financial distress. Some enterprises entered the COVID-19 shock with
unsustainable business models and during a typical downturn the closure of such
companies can be seen as part of the overall process of economic restructuring
and dynamism. However, identification of such firms is difficult given the
nature of the COVID-19 shock.
There is a risk that, if traditional financial signals were being used, widespread liquidation could arise in the short run. We also point out that there are employee, supplier and customer relationships tied up in all firms, with relationship-specific capital on the line as firms are liquidated. Blanchard, Philippon and Pisani-Ferry (2020) summarises much of our thinking in this area:
“In normal times, policies should help the reallocation process, letting some firms fail and others expand, and helping the reallocation of workers across sectors. These are not normal times, however: many firms may fail because they are insolvent even if they are viable. Given the very high uncertainty, banks may be reluctant to advance credit. Unemployment is extremely high, making it difficult for laid off workers to find other jobs. For these reasons we think that protection (of workers) and preservation (of firms) should be given a higher priority than in normal times.”
Despite the above, we of course acknowledge that those designing SME supports must do whatever feasible to use taxpayer funds as efficiently as possible, given the nature of deficit dynamics during the pandemic. Targeting is difficult, especially in the current climate, but it is not fiscally or economically sustainable for supports to be provided without regard to viability, particularly as the likely duration of the pandemic period elongates.
Firm supports: loans, grants or equity? Outside of the over €5bn that will be used to support wages
through the TWSS and EWSS, there is a 60/40 split between debt and grants in
the announced SME support packages. If tax warehousing is accounted for as a
debt, this rises to 70/30. We point out that the amounts announced are committed funds – in the case of
debt-based supports in particular, final take-up rates are unknown.
We highlight the risk that debt-based supports may have weak
demand from firms wary of borrowing, may lead to debt overhang issues over the
medium term and face implementation issues when channelled through lenders. However,
debt-based supports benefit from lenders’ access to information and incentives
to screen credit risk, in cases where banks retain appropriate levels of risk
(such as the 80-20 split embedded in the Irish Credit Guarantee Scheme).
Direct fiscal supports, such as grants or tax or rate waivers, provide liquidity and support the economy but raise issues regarding costs, targeting and moral hazard. Relative to a guaranteed loan, where costs only arise as defaults occur, grant funding is far more expensive up-front for the taxpayer. One potential option to address this drawback is for the State is to provide equity-like or “conditional grant” injections to SMEs which involve an element of clawback or potential return, lowering the cost of intervention relative to a direct grant. In this light, the proposal of Boot et al. (2020) is worthy of further consideration, where higher future tax rates are agreed in exchange for up-front aid.
A model of financial distress Finally we present key results from a forthcoming model of SME financial distress (McCann and Yao, 2020). The financial distress (FD) indicator is based on SMEs’ capacity to meet losses through cash holdings, or to service interest expenses during the shock. We calibrate 2018-2019 data on SME balance sheets to the revenue and cost reductions reported by SMEs in 2020, and use the model to assess the role of various policy support options.
Relative to a no-policy scenario, we implement firms’ lowering of wage costs, both through TWSS wage supports and the transition of employees to the Pandemic Unemployment Payment (PUP), as well as non-wage policies worth €7.5bn, capturing the role of the credit guarantee, other lending, tax warehousing and enterprise grant policies. When the full package of policies announced in 2020 are included in the model, distress rates fall from 18.7 to 15.8 per cent (or 25.9 to 14.9 per cent when weighting firms by their debt balances outstanding).
Why does a cohort of SMEs remain in financial distress (FD) after policy supports are modelled? There are a number of factors at play. Firstly, the schemes’ total availability of €7.5bn means there is an aggregate maximum on the number of SMEs that can access funds. Secondly, specific schemes have specific maximum amounts, which in the cases of those experiencing the most severe financial effects of the pandemic, may not suffice to alleviate FD. Thirdly, the schemes have reasonably wide eligibility criteria, often related to firms experiencing a fall in revenues of a certain amount. This means that many firms that were never at risk of entering FD by our definition are just as entitled to draw down funds as firms experiencing the greatest losses. This issue of widespread access to funding was a necessary feature of scheme designs across the globe in response to the pandemic.
The latter finding on debt-weighted distress suggests that support schemes will have more beneficial financial stability effects than are visible when looking at a simple share of enterprises falling into financial distress. The greater efficacy of policy in lowering debt-weighted distress relates to the tendency of larger SMEs to have larger debts, implying that these firms draw down larger amounts of total scheme funds available, as well as to the concentration of SME debt among affected sectors such as the accommodation, food, wholesale and retail sectors. The table below reports the impact of the sequential addition of specific policy supports, highlighting that the effects of lowering wage bills through PUP and TWSS are larger than the effect of other supports.
Scenario
Financial Distress (%), by firm count
Financial Distress (%), by debt balance
No Policy
18.7
25.9
+ Income and Wage Supports
16.4
18.9
+ Grants
16.0
18.3
+ Tax Warehouse
15.9
17.4
+ Credit
15.8
14.9
Finally we show that, relative to currently calibrated support policy, a hypothetical “viability-based” grant system that targets firms based directly on the size of their operating losses, supporting firms closest to viability first, would reduce distress rates to about half the levels modelled under currently-designed policy (comparing the middle and right hand side sections of Figure 1). Such a hypothetical system would prioritise solely the minimization of the financial distress rate, for a given fiscal outlay, and is therefore not intended as a specific recommendation but rather to illustrate the effect of current supports relative to a benchmark model. In practice of course, policy must take on board sector-specific, regional and longer-run considerations that go beyond solely the minimization of financial distress rates.
Source: Model-based estimates from McCann and Yao (2020). Notes: “Targeted Grants” replicate payroll supports modelling from the “Current Supports” scenario, but replace the grant, credit and tax components with a €7.5bn grant that provides support to firms in order of their viability (with firms closest to exiting financial distress receiving support first). By construction, the debt-weighted exercise relates only to firms with debt balances above zero in the 2018-19 data
Conclusions and wider policy issues The model suggests that existing policy supports are likely to have mitigated SME financial distress in some cases, but challenges will remain for a relatively large group of SMEs. From a policy perspective many of the firms modelled as being in financial distress may be viable over the medium term – the identification of FD does not imply enterprise liquidation. This points to the importance of a dual approach to policy for SMEs, where targeted and effective financial support is required in the first instance, but a focus is also placed on the system-wide capacity to restructure the liabilities of potentially-viable firms. This latter step will ensure that the set of firms with the greatest prospects of survival over the medium term are given a chance to trade through the current challenges posed by the pandemic. The Central Bank is a key stakeholder in this process, with oversight of lenders’ approach to loan restructuring as SMEs’ payment breaks begin to expire. The Central Bank’s approach to this process was outlined by Deputy Governor Ed Sibley on Monday September 28th and can be accessed here.
References McCann, Fergal and F. Yao (2020, forthcoming), Modelling financial distress in SME sectors during the Covid-19 pandemic – from liquidity to solvency, Central Bank of Ireland, Mimeo. McGeever, Niall, John McQuinn, and Samantha Myers (2020). SME liquidity needs during the COVID-19 shock. Central Bank of Ireland Financial Stability Note, 2020 No. 2
