Weak revenues and low profit margins continue to weigh on corporate profits, gradually raising the pressure on corporate solvency. That is one of the conclusion from the latest third issue of the Financial Stability Review (FSR) prepared by the European Central Bank (ECB) in the context of the coronavirus COVID-19 pandemic. ECB is optimistic that financial and economic conditions will bounce back. As the bank is saying, there is, however, a reality that the pandemic will leave a legacy of higher debt and weaker balance sheets, which – if unaddressed – could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery.
Similar to previous recessions, gross corporate profits declined more than gross value added in 2020, as squeezed profit margins added to the fall in corporate revenues (see Chart 1.10, left panel). Although both profits and revenues were more resilient in the second wave than during the initial phase of the pandemic, their continued decline added to the total shortfall compared with 2019 levels. In total, corporate profits in 2020 were 8.1% below gross profits in 2019. Consequently, retained earnings (measured by gross savings) dropped substantially, unlike in the global financial crisis when they recovered during the first year of the recession. This sharp and persistent drop in corporate savings limits the scope for new investment going forward, although firms may use available cash buffers to support capital accumulation.
Chart 1.10: Falling profits weigh on liquidity and leverage ratios at the most vulnerable firms
Aggregate liquidity and capital buffers conceal a divergence across corporates, as risks rise for cash-strapped and overindebted firms. On aggregate, the considerable increase in gross debt has so far largely been offset by a similar rise in corporate holdings of liquid assets. Granular data for listed firms confirm that corporates took on more debt to build up precautionary liquidity buffers as the correlation between changes in gross debt and changes in cash buffers across firms increased (see Chart 1.10, middle panel). However, this effect is particularly prominent for large listed corporates whereas SMEs, which were more heavily affected by the pandemic and are less likely to have access to market-based funding, face more severe liquidity challenges. The concentration of liquidity risk among the most vulnerable corporates implies that a sudden tightening of financing conditions or a protracted economic recovery could have more severe consequences for financial stability than the aggregate picture suggests. In addition, liquidity problems increasingly morph into solvency issues – while the first wave of the pandemic was characterised by bond issuance and bank borrowing to meet liquidity needs, firms have recently issued more equity (see Chart 1.10, right panel). Among listed firms, however, equity issuance has been concentrated in a few firms, especially in the technology sector, which tend to have benefited from the pandemic.
The concentration of liquidity risk among the most vulnerable corporates implies that a sudden tightening of financing conditions or a protracted economic recovery could have more severe consequences for financial stability than the aggregate picture suggests.
More recently, corporate credit growth has slowed, reflecting both corporates deferring investment and banks tightening lending conditions. In the second half of 2020, demand for bank loans slowed abruptly as bank lending conditions tightened and the need to bridge working capital needs subsided (see Chart 1.11, left panel), especially in the worst affected sector, services. Besides the drop in demand for liquidity and the more cautious risk perceptions of banks, the slowdown in bank lending to corporates also reflects the reduced willingness of firms to invest in fixed capital while uncertainty remains about the timing and pace of the economic recovery. However, the subdued investment activity could also indicate a more structural pessimism about the viability of certain business models or the limited scope for new investments amid elevated debt levels. That in turn would have a more lasting impact on the economic recovery and corporate balance sheets. Moreover, building up liquidity buffers in the early stages of the pandemic has shielded some firms from revenue shortfalls and reduced the subsequent need for additional external financing.
However, the subdued investment activity could also indicate a more structural pessimism about the viability of certain business models or the limited scope for new investments amid elevated debt levels. That in turn would have a more lasting impact on the economic recovery and corporate balance sheets.
Government-guaranteed loans may have become less effective in supporting corporate financing conditions. Following the large take-up of guaranteed loans in the second quarter of 2020, the demand for such loans has dropped sharply in tandem with the slowdown in new bank loans to corporates in the second half of 2020 (see Chart 1.11, middle panel). Looking ahead, the take-up of government-guaranteed loans is likely to fall further, as guarantees appear to have become less effective in supporting corporate financing conditions. Throughout 2020, credit standards eased considerably for guaranteed loans while tightening for non-guaranteed loans (see Chart 1.11, right panel). However, this gap in credit standards between guaranteed and non-guaranteed loans is projected to narrow in the first half of 2021. Also, overindebted corporates may be unwilling to take on additional debt, given the uncertain outlook.
Smaller firms benefited most from government guarantees but are particularly affected by a recent tightening of bank lending conditions. SMEs have been more likely to resort to government-guaranteed loans than larger firms, given their reliance on bank lending and the disproportionate impact of the pandemic on smaller enterprises. They have also been more likely to benefit from the benign effect of guarantees on credit standards, as they faced a sharper tightening of credit conditions for non-guaranteed loans (see Chart 1.11, right panel). The projected tightening of credit standards on guaranteed loans therefore disproportionately affects SMEs.
Chart 1.11: Corporate loan demand has faded as external financing needs moderated, credit conditions tightened and guarantees became less attractive for SMEs
An abrupt increase in bankruptcies could challenge insolvency frameworks and impede the efficient reallocation of resources. Despite the unprecedented fall in corporate revenues and profits, bankruptcies in the euro area decreased by approximately 20% in 2020 relative to 2019 levels as public authorities provided policy support and in some cases suspended mandatory insolvency filings. Dealing with such a backlog of delayed bankruptcies would prove a challenge for judicial systems even in normal times. Although corporate solvency is likely to be more resilient than historical comparisons suggest, given the relatively swift recovery and the sizeable policy support, the number of insolvencies-in-waiting could still be higher than the current expected default frequency suggests (see Chart 1.12, left panel). Once support measures end, bankruptcy courts could therefore see an abrupt increase in insolvency filings, which could lead to the legal system becoming congested and insolvent firms taking longer to be resolved. That in turn could result in an inefficient and delayed reallocation of resources to more viable businesses, with adverse macroeconomic consequences in the medium term. Public authorities should therefore ensure that insolvency frameworks are sufficiently resourced to deal with a higher number of corporate insolvencies (see Chart 1.12, right panel).
Chart 1.12: Backlog of insolvencies could lead to challenges in countries with inefficient insolvency frameworks
Given the uncertain outlook for the viability of business models, targeting policy support towards viable firms remains challenging. Ideally, the broad-based liquidity support measures that shaped the early phase of the pandemic would be superseded by more targeted measures that help viable firms remain solvent. However, assessing corporate viability remains challenging in the light of the uncertain economic outlook and the post-pandemic prospects of different business models. While broad-based measures may lead to some misallocation of resources to non-viable firms, the alternative of withdrawing support to viable firms too early may have even more adverse consequences.
NOTES & SOURCES
Chart 1.10: Falling profits weigh on liquidity and leverage ratios at the most vulnerable firms
Sources: ECB and Eurostat (quarterly sectoral accounts, securities issues statistics); middle panel: Refinitiv and ECB calculations.
Notes: Middle panel: data do not include unlisted firms and are therefore likely to be biased towards larger corporates. Right panel: both time series are z-scores based on the respective sample from January 2012 to January 2021. Note that net equity issuance refers to listed non-financial corporates whereas net loan flows covers all non-financial corporates.
Chart 1.11: Corporate loan demand has faded as external financing needs moderated, credit conditions tightened and guarantees became less attractive for SMEs
Sources: ECB bank lending survey and national sources.
Notes: Right panel: the net percentage refers to the difference between the sum of the percentages for “tightened considerably” and “tightened somewhat” and the sum of the percentages for “eased somewhat” and “eased considerably”. Data for H1 2021 reflect expectations indicated by banks in the latest round of the bank lending survey.
Chart 1.12: Backlog of insolvencies could lead to challenges in countries with inefficient insolvency frameworks
Sources: Moody’s Analytics and Eurostat; right panel: EBA and Allianz Euler Hermes (see notes to Chart 4 in the Overview for details).
Notes: Left panel: the yellow dotted circle shows the counterfactual expected default frequency (EDF) based on the historical relation between GDP growth and EDFs for the second quarter of 2020. Right panel: expected insolvencies are relative to 2019 levels, based on projections provided by Euler Hermes in December 2020. The net present value (NPV) loss associated with insolvencies encompasses the direct administrative costs and the time until the insolvency is resolved. It does not contain the additional NPV loss if the underlying loan is sold to an investor.
source: European Central Bank
