27 April 2020

SAFE: Corona and Financial Stability 4.0: Implementing a European Pandemic Equity Fund

I. Introduction
This Policy Letter builds on earlier letters by the same authors on the Coronavirus crisis and its implications for financial stability.1 In our earlier work, we have argued that massive financial support during the Corona crisis is warranted in order to bridge the almost universal cash flow shortfalls at the firm level, and across the European Monetary Union (EMU) member states, caused by the series of shutdowns.

The provision of bridge financing is also necessary from a systemic risk perspective. Significant cash flow shortfalls, highly correlated across firms and countries in a deeply integrated economic zone, could quickly translate into solvency problems for firms and subsequently for banks, ultimately undermining the financial positions of the EMU member states. Current rescue programs have important side effects, as they are largely debt based, suggesting a rapid rise in debt levels at the firm level, not coordinated at a European level, and differ greatly in volume across EU member states.

Based on the above analysis, we propose a European Pandemic Equity Fund (EPEF). The EPEF will undertake equity-like investments, particularly in small and medium sized enterprises (SMEs), which generally tend to oppose the outright dilution of existing control rights, which occurs if common equity is issued. Since such firms are the backbone of Europe’s economy, their concerns are of paramount importance.

Our proposed scheme is simple: it basically trades an initial cash flow injection by the EPEF into the firm against a proportionate participation in future gross earnings (“value added”) or net earnings (“profits”). The former can be implemented by conditioning on the firm’s value added tax (VAT) remittances, while the latter relies on a tax surcharge, conditional on corporate tax payments. Moreover, the firm can terminate its annual payment of surcharges to the fund by paying, after a number of years, a fixed amount to the EPEF, as the exercise price of an option to terminate the assistance program.

The open questions posed by this proposed scheme and tackled in this Policy Letter, are the following:
 What are the general conditions (“criteria”) that the EPEF needs to fulfill in order to be financially viable, effective and, at the same time, politically acceptable?
 What are specific requirements relating to the implementation and structuring of the cash (equity-like) investments in the firms, e.g., general eligibility criteria, and contract features?
 What are suitable funding/sourcing options for the EPEF?

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