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[...]The coronavirus crisis arrives against a backdrop of private sector indebtedness. Corporate and household balance sheets in Europe are extended - neither firms nor households deleveraged substantially since the Global Crisis and the European sovereign debt crisis. On the contrary, low monetary policy rates and low credit spreads lured them into complacency about debt levels. Corporate leverage is at an all-time high (IIF 2020, Graham et al. 2015). A large fraction of corporate debt is now rated BBB, the lowest investment grade rating, while corporate debt rated below investment grade is at an all-time high. For example, almost half of all US corporate bonds maturing in the next five years are below investment grade.
Current policies will inevitably leave parts of the corporate sector with even larger debt burdens. These will delay a recovery - distressed firms tend to implement labour reductions, sell assets, reduce investments and employment, and shrink their business, and they become reluctant to raise new capital. Additionally, banks and other lenders stuck with underperforming loans may restrain lending (Becker and Ivashina 2014) and misdirect it to ‘zombie firms’ (Caballero et al. 2008). If one firm is affected, its customers, suppliers and employees are affected in turn. All of this can turn a temporary economic shock into a long-term balance-sheet driven dislocation. One policy lesson of the big financial crises in the developed world, starting with Japan in the early 1990s, is that the effects of simmering corporate debt overhang are multiple and nefarious (Koo 2003).
To manage the looming corporate debt strains and keeping the likely precarious situation of sovereign finances in mind, we see three broad policy areas that require addressing.
First, public credit packages such as loan guarantee programmes should be designed with the looming debt overhang problem and the future need for debt restructuring in mind. Conflicts of interest become important when companies have multiple creditors (Gertner and Scharfstein 1991, Hege and Mella-Barral 2019), and bailouts create new creditors, making restructuring more complicated, as the bank bailouts after the Global Crisis demonstrated. Programmes must also ensure that bailout funds are used as intended to ensure business continuity, and not to benefit existing debt holders or shareholders. Policy should also have an eye to future crises. One important difference between the coronavirus crisis response and bank bailouts after the Global Crisis is the extent of moral hazard. This time, bank risk-taking did not trigger the crisis and this means moral hazard concerns are weaker. They are not absent, however, since banks may infer from current policy choices what taxpayer support will be available in other types of crises. Therefore, bailouts should be designed to avoid benefitting existing creditors and shareholders, when possible. Given all these concerns, bailouts should contain provisions that limit the scope to which investors benefit from support. We recommend banning dividend payments and most debt reductions for all recipients of support. We also recommend that any taxpayer-funded credits be senior in the event of future restructurings. It may also make sense to attach options to the bailout funds in the form of stock warrants or convertibles that can ensure that the public benefits from future gains in corporate valuations made possible by public money, especially for publicly listed companies.
Second, European systems for handling insolvency in court are not good at protecting viable businesses with unsustainable capital structures. Businesses are too often liquidated, generating poor returns for bankruptcy claims, and processes can be slow. These inefficient in-court proceedings hold back credit market development even in good times (Becker and Josephson 2016). In a recession or crisis, it slows down returning productive assets to the economy and may destroy valuable businesses (Gilson 2012). Any reforms that can simplify and speed up in-court processes should be considered. Such reforms would need to be exceptionally quick to impact short-run developments, but they can help support a vigorous recovery. Current EU initiatives for better resolution of corporate insolvency should be accelerated.6
Third, given the inefficiencies of court-supervised bankruptcy procedures, government agencies must be prepared to be a leader in debt restructuring for the companies that receive bailouts. They should prioritize out-of-court renegotiations whenever possible. They have proven to be a successful tool after the Global Crisis (Bernstein et al. 2019, Hotchkiss et al. 2014). This can include temporary nationalisations where needed, with tough conditions for existing shareholders to avoid distortions. Public agencies such as public development banks in charge of loan guarantees may not be the best placed to oversee debt restructuring – with their own balance sheets exposed, they may be inclined to ‘extend-and-pretend’ distortions in their actions (Sapienza 2004, Bertay et al. 2015). So, it is worth thinking about an independent organisation of government leadership in debt restructuring.