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Indecent exposure?


Published: 24 Jun 2022

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Rampant inflation is limiting the ability of central banks to support fiscal policy, and with borrowing costs on the rise, the fear is that many zombie companies kept alive by cheap credit may face a reckoning. In the UK, insolvencies are already at a 60 year high due to the pandemic, covid, and global supply chain disruption. Pressures from the war in Ukraine are also taking their toll as sanctions bite. But how widespread is the problem? And could a perfect storm of causes trigger a wave of insolvencies that could be a systemic risk?

The Covid timebomb

At the outset of the pandemic, corporate indebtedness was already very high. Global corporate debt of nonfinancial companies has reached US$86.29 trillion, and in low and middle income economies is now worth almost 120% of GDP. In the UK, Bank of England statistics show that large companies were carrying debt of £1,200 billion in December 2019, while SMEs carried around £200 billion. While widespread insolvencies were predicted at the outset of the pandemic, this did not materialise because of unprecedented business support from the Government.
‘Businesses have had a lot of help in relation to furloughs and all of the different fundings which has kept them afloat, and therefore they're cash positive,’ says Charles McManus, Group CEO, ClearBank . 
Mahesh Uttamchandani, Practice Manager, Finance, World Bank, agrees. ‘The absence of a rise in insolvencies across the board is the result of unprecedented fiscal and regulatory stimulus, as well as temporary changes to insolvency laws,’ he says. ‘Global value of stimulus since March 2020 is estimated by the International Monetary Fund to be USD $13.8 trillion.’
‘The problem now,’ continues McManus, ‘is that, because of rising interest rates, inflation, less retail spending, looming economic recession, rising energy prices and so on, without more help, insolvencies are going to become a lot more widespread.’ Uttamchandani agrees: ‘The widespread stimulus and forbearance measures may have just caused the postponement, rather than the avoidance, of widespread insolvencies. There remains significant uncertainty about what will happen next.’ 
The insurance multinational Euler Hermes predicts that global insolvencies will rise by 15% in 2022, with sharper rises in Africa, Latin America and parts of Europe while Atradius, a credit insurer, predicts a 33% rise in insolvencies in 2022. The strength of the underlying institutional framework of individual countries, says Uttamchandani, will dictate the level of risk that each nation will face.  
McManus believes that insolvencies becoming a systemic risk is some way off, but no one should feel complacent. ‘Systemic risk means 20-30%,’ he says, ‘and in terms of the market, we're nowhere near that. But all the warning signs are that, over the next few years, if there’s not more help then more businesses definitely will go bust.’

How exposed are banks? 

The link between the quality of a country’s insolvency systems and the availability and cost of credit means that a rise in insolvencies and a rise in the cost of credit tend to go hand in hand. With inflation at 9% and rising, interest rates in the UK are only heading in one direction, along with the lending banks’ cost of borrowing. So what does the future hold?
Some banks, says McManus, are significantly exposed. ‘In order to get through the crisis, small businesses borrowed at cheap rates from a number of banks. The problem now is as their margins and cash flow gets squeezed, they can't pay those bounce back debts back and they can’t invest in their businesses. That means the banks who lent the money are going to get defaults and the government is ultimately going to have to pay the bill for any shortfall. 

Challenging conditions for insurers

Banking is not the only industry to be affected by the insolvency powder keg. Insurers and investors will also have to try to limit their exposure, although Andrew Hodson, risk director at Allianz Trade in UK & Ireland, part of the world’s leading trade credit insurer, remains upbeat. ‘We’re very much open for business in this post-pandemic ‘next normal’ environment,’ he says. ‘Since the UK government exited its various State Support Schemes - including for trade credit insurance - the normalisation of economic activity has brought back our overall risk coverage to pre-pandemic levels, with very positive new business and retention levels this year.’
‘At the same time, we’re acutely aware of the challenging credit conditions that lie ahead for business. Normalisation has stimulated an increase in insolvencies, albeit from an artificially low level. Lingering effects from ‘long Brexit’, post pandemic supply chain and freight disruption, inflation and the cost of living squeeze, the invasion of Ukraine, are all having a negative effect on trade.’
An insurer’s solvency capital requirement takes into account, amongst other things, the credit quality of the debt instruments they hold. High quality sovereign and corporate debt generally attract a lower capital charge.
‘Annuity providers typically apply a matching adjustment in the calculation of their liabilities,’ says Matt Francis, insurance director at KPMG UK. ‘This allows them to derive a discount rate from a portfolio of assets that back those liabilities.  However, the regulatory benefit is diminished when the credit ratings of those assets fall below BBB.
‘According to recent Prudential Regulation Authority data, only 1% of matching adjustment assets are sub-investment grade, while 25% are rated BBB. The UK Government is currently consulting on proposals to revise this to reduce the incentives for insurers to sell assets in a market downturn.’

Private capital watches and waits

If public companies are running large debts, how exposed are privately owned or private equity-owned companies? 
‘Public companies through sheer scale can weather the storm, but the whole private equity market has changed fundamentally in the last few weeks and months,’ says McManus. ‘The valuations of a lot of those private equity backed companies are coming down and that means the private equity firms are not putting up new capital.’

There may be trouble ahead

The upshot of this is that struggling companies are faced with going bust or laying off staff. There are some startling examples of this. Klarna, a hugely successful buy now pay later company, has just announced a raft of redundancies and Coinbase, one of the largest crypto trading companies in the world, recently announced it was cutting its workforce by 17%.
McManus describes the current economic and geopolitical landscape - interest rates and inflation rising, Covid refusing to go away, a volatile situation in Ukraine and Russia squeezing the supply of oil and gas causing energy prices to soar – as ‘a whole cocktail of trouble. Employment is the only bright spot but for how long ?’ 
Consumer credit is a particular area of concern. The role of central banks is to keep raising interest rates to control inflation, but that tips more people into financial hardship – and the last think they will be thinking of is paying for their ‘buy now pay later’ sofa. ‘As far as lending covenants are concerned, you sign those agreements, thinking those events will never happen,’ says McManus. ‘In a credit crisis, they will start to bite.’ 
Uttamchandani also believes that there will be a tightening of credit ‘particularly if banks feel exposed as a result of the underlying economic conditions and a pullback of central bank support. Lending standards generally tightened in the immediate onset of the COVID-19 pandemic, to a degree that was generally comparable to that observed during the Global Financial Crisis. Resisting pressures to lower regulatory standards and soften supervision is critical.’ The UK Government, along with others, have a lot of work to do.