Financial guarantees: potential debt straight-jacket in the making?

23 July 2020: There is growing concern that additional debt taken on by businesses during the lockdown period could dampen the economic recovery as companies service their debt rather than invest to expand. Henning Diederichs​ from ICAEW’s Public Sector team reports.

Mandatory lockdowns of ‘non-essential’ businesses and the effects of the pandemic on both supply and demand have been mitigated by a wide range of measures to help economies through these unprecedented times. Many governments around the world have used financial loan guarantees as part of their response to the COVID-19 pandemic.

Ensuring businesses have adequate access to finance, often on favourable terms, has been a key part of the response by policymakers, including loan guarantees to support banks in lending to business.

Many businesses, small and large, have subsequently increased their debt by taking out COVID-related loans to survive the pandemic. But while many of these loans were issued at favourable rates with deferred interest payments, these loans not only sit on top of existing loans, they are being used to replace lost sales and to cover costs.

There is growing concern that this additional debt could seriously dampen the economic recovery as companies face having to service their debt rather than invest in their businesses to expand.

In the UK, for example, the government has provided guarantees to banks to lend in excess of £45bn to more than one million businesses, many of them very small. Neither the government nor the banks will wish to see thousands of businesses close down after being pursued for failing to pay back the loans. The government does not want the political fallout and the banks are still repairing their reputation following the 2008/09 financial crisis.

Richard Hughes, the new head of the Office for Budget Responsibility (OBR), in his previous role with UK-based think tank the Resolution Foundation, has suggested linking loan repayments to business earnings and that anything remaining due after a specific time period is cancelled. This would ensure companies are paying back the loans only if they recover themselves. If the loan repayments are linked to future earnings this may suggest a modification to the loan and have an impact on the accounting.

Guidance on some of the key accounting issues surrounding financial guarantees can be found here.