Government and City impasse over loan recapitalisation in 2021

9 September: £35bn of potential bad debt is being quietly fought over between Whitehall and the City once loans start maturing after March 2021, writes Financial Services Faculty commissioning editor Brian Cantwell.

Back in April, the government guaranteed much of the large tranche of taxpayer-funded loans and support to push it through the banking system rather than administer the loans itself.

The fight to push the balance of risk onto the banking system, rather than the taxpayer, is up in the air again as the City and government wrestle over what to do once the first year of the £100bn of government loans passes in March 2021, and businesses must start to repay them.

The government has repeatedly argued that corporate debt is in good shape and therefore it would be better to let banks go through repossessions or the courts to capture unpaid debts. However, banks argue that in order to validate the guarantees it would have to force businesses to default to validate the losses from the government.

Neither side wants mass business failure and unemployment, as both will lose the investment made at the start of the crisis and will suffer from the huge damage to the economy. 

Additionally, the hardest hit are likely to be smaller businesses outside of London - politically difficult for the government’s levelling-up pledge.

Whether or not businesses will be able to survive a potential second wave of coronavirus and earn enough to support loan repayments is likely to be further tested by the ending of the furlough scheme and tax deferrals ending later this year.

The City’s suggestion: more legislation and taxpayer cash

A prominent City working group called TheCItyUK has suggested that the pandemic financial support loans offered to SMEs by the government should be managed by a taxpayer-funded body to allow the minimum of defaults, as smaller businesses are at greater risk of failure and employ millions of people.

It is thought there are around 800,000 SMEs which could fail, which employ around three million people.

The government must provide a suite of financial instruments to help businesses survive after their coronavirus business loans mature in 2021, argued a panel for the Centre for the Study of Financial Innovation in late August.

Miles Celic, Chief Executive of TheCityUK, argued that to put the suite of tools together, more funding from the taxpayer would be required. The consequences of not doing so would see the damage fall hardest on the poorest areas in the UK and harm economic recovery – according to one member of the panel, 90% of workers return to work through SMEs. The government must also accept that recapitalising the loans in 2021 is a problem that requires legislation, said TheCityUK.

Omar Ali, EY UK Financial Services Lead and managing partner at EY, said that without further action the problem would be stark.

There is a huge correlation between businesses that have taken government funding and those that have also deferred tax, with low cashflow, making them extremely vulnerable. SMEs have taken £45bn in government funding guarantees and £30bn in deferred VAT arrangements. 

By March 2021, the unsustainable debt is expected to top £100bn, of which £35bn is government lending and the rest pre-COVID debt. Three-quarters of that debt is held outside London across the UK. 

Action plan

Options for recapitalisation are sobering for those businesses, said Ali. Volumes of UK SME equity investments are staggeringly low at the moment: around £6.5bn per year up to 2018, and in 2019, £8.4bn. Additionally, regional investments thin out away from London.

Ali suggested that scale, need for simplicity, transparency, fairness and conduct are built into possible recapitalisation solutions for SMEs next year, pointing towards an expensive government-led bank.

Because many of the SMEs have very small liquidity and low financial sophistication, simple mechanisms will be required.

The plans suggested, enacted through capital demand from the taxpayer and legislation, are:

1. Business repayment plan – BBL and small CBILS become a tax obligation, administered through HMRC and means-tested, calculated on some mechanism of taxable profits or revenue while minimising the gaming of the system.
2. Business Recovery Capital – subordinated debt or share capital. Not debt for equity swaps, as they do not infer voting rights. SME owners were clear they did not want a loss of control of their business. This would allow growth shares for businesses.

Converting the unsustainable debt burden into the right conditions will promote recovery and allow the private sector to become involved, said Ali, giving a political avenue to stop taxpayer funding.

As for the terms and conditions, the solution would be designed as a toolkit – lenders and borrowers can pick and choose what they would want per each business. It is key that the right triage mechanisms end up in the right schemes.

Government rebuttal

While the COVID crisis looks very different from the global financial crash, politically the government is keen to avoid being associated with the blame game that followed after events in 2008/9. 

The cost of setting up a banking arm to administer the complex solutions required to combat businesses’ debt problems is not guaranteed to be returned, and the government still owns parts of banks from the last crisis, which cost taxpayers somewhere in the region of £850bn, according to National Audit Office (via the Independent).

This time around, public finance debt has gone beyond £2tn for the first time in history. There are also a wave of other demands on the taxpayer, not least the potential head waves in 2021 from Brexit and the increasing probability of no-deal that could damage public finances.

The government believes it has paid enough – now it is time for the banking system to stand up and show it can put customers first and manage forbearance and payment holidays in a regulated and responsible manner.

This political brinkmanship will be tested in October once the furlough scheme ends and businesses start making hard decisions about their finances.