## INSOLVENCY PROSPECTS AMONG SMALL AND MEDIUM ENTERPRISES

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### Executive summary and overview
- COVID-19 increased insolvency risks, especially among SMEs, which account for 99 percent of all firms, more than 60 percent of jobs, and more than 50 percent of sales in most economies.
- SMEs with fewer than 50 employees: about two-thirds of jobs in food, accommodation services, and wholesale and retail trade, versus one-third in manufacturing.
- SMEs with fewer than 250 employees: 80 percent of jobs in food, accommodation services, and wholesale and retail trade and 58 percent in manufacturing.
- Announced liquidity support measures in advanced economies were estimated to amount to 11 percent of GDP by October 2020.
- Recommended three-pronged policy approach:
  1. Continued liquidity support for solvent but illiquid firms.
  2. “Quasi” equity injections targeted to solvent-but-illiquid or COVID-caused-insolvent-but-viable firms.
  3. Strengthened insolvency and debt restructuring tools.

### Main projections for SMEs (baseline and cumulative 2020–21)
- Baseline projections (WEO January 2021 Update):
  - Share of SMEs with negative equity projected to rise by about 6 percentage points (relative to a no-COVID scenario) across a large sample of SMEs from Europe and Asia-Pacific.
  - Under a downside scenario with extended lockdowns and persistently weaker demand, the share of insolvent SMEs would rise by 8 percentage points.
  - Projected 6 percentage point rise comparable to exit rates in the five years after the 2008–09 global financial crisis but occurring over a much shorter period.
- Cumulative 2020–21 effects (depending on exit versus survival of illiquid firms at end-2020):
  - Insolvent SMEs could account for up to 9 percent of overall SME debt.
  - Insolvent SMEs could account for up to 11 percent of SME jobs (and nearly 40 percent in accommodation and food services).
  - Corresponds to up to 20 million jobs at risk.
  - Under an adverse scenario, up to 11 percent of SME debt and 13 percent of SME jobs could be at risk.

### Firm-level empirical findings (Orbis sample of about 1.25 million firms)
- Data and scope:
  - 20 countries: Australia, Austria, Belgium, Czech Republic, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, Korea, Norway, Poland, Portugal, Slovenia, Spain, Sweden, and the United Kingdom.
  - SMEs defined as firms with fewer than 250 employees.
  - Baseline year: 2017; projections for 2020 and 2021 incorporate COVID-related shocks.
- Aggregate projected increases by end-2020 (relative to a no-COVID counterfactual):
  - Share of firms with equity gaps increases by more than 5 percentage points.
  - Share of firms with liquidity shortfalls increases by more than 7 percentage points.
  - Share of firms with negative equity increases from about 10 to 15 percent.
  - Share of firms with liquidity gaps increases from 8 to 16 percent.
- Cumulative 2020–21:
  - Share of SMEs at risk of being insolvent in 2020 or 2021: about 16 percent.
  - Share of SMEs at risk of being illiquid in 2020 or 2021: about 18 percent.
- Leverage and interest coverage:
  - Share of firms with a leverage ratio above 1: projected to increase by 4 percentage points in 2021 relative to a no-COVID counterfactual.
  - Share of firms with interest coverage ratio (ICR) below 1: estimated to have risen to more than 35 percent in 2020; estimated to fall back in 2021 but remain about 5 percentage points above pre-COVID levels.

### Sectoral and regional heterogeneity
- Region:
  - Asia-Pacific: estimated increase in share of insolvent firms of 3.5 percentage points.
  - Southern Europe: projected increase of nearly 8 percentage points.
- Sectors:
  - “Accommodation and food services”: projected increase in share of insolvent firms of 25 percentage points.
  - “Arts and entertainment”, “education”, and “other services”: among the hardest hit.
  - “Agriculture”, “water and waste management”, and “mining”: smallest increases in insolvency rates.
- Employment and debt-at-risk (cumulative, assuming illiquid firms exit at end-2020):
  - About 11–16 percent of SME jobs may be at risk overall during 2020–21.
  - “Accommodation and food services”: nearly 40 percent of jobs at risk.
  - Firms estimated insolvent (illiquid) at end-2020 account for more than 9 (12) percent of total SME debt stock — a 2 percentage point increase compared to the no-COVID scenario.
  - Cumulative debt at risk over 2020–21: estimated to account for 9–12 percent of total (initial) SME debt.

### Downside scenario outcomes (illustrative)
- Downside scenario components: a further one-month lockdown, weaker consumer recovery in hard-hit industries, and 1 percentage point lower aggregate demand growth.
- Projected cumulative increases under downside vs baseline (2020–21):
  - Cumulative increase in share of insolvent SMEs: rises from 6 percent under baseline to more than 8 percent under the downside scenario.
  - Cumulative increase in share of illiquid firms: rises from 9 percent under baseline to 14 percent under the downside scenario.
  - SME jobs at risk: would rise to 13 to 21 percent.
  - SME debt at risk: would rise to 11 to 17 percent.
  - These downside outcomes are roughly 40 to 50 percent higher than under the baseline scenario.

### Implications for banks and financial stability
- Mechanism: increased firm defaults raise nonperforming loans and generate bank losses; depressed asset values and overwhelmed insolvency courts may reduce recovery rates and magnify bank losses.
- Bank-impact model and calibration: maps projected SME insolvencies/illiquidity to default probabilities and COVID-driven bank losses, then to changes in systemwide Tier 1 capital ratios; focuses on SME exposure and excludes large borrowers.
- Key projected impacts on Common Equity Tier 1 ratios (CET1Rs):
  - Rising SME insolvencies could reduce average banking systems’ CET1 ratios by less than 1 percentage point under the WEO baseline.
  - The fall in capital could be twice as large in hard-hit countries where SMEs are predominant.
  - In a downside scenario, average banking systems’ Tier 1 ratios could decline by an additional one-third to two-thirds relative to the baseline, depending on region and measure of distress.
  - Adverse scenario average declines estimated between 1.2 and 1.8 percentage points in southern Europe and between 0.5 and 1.1 percentage points in other areas.
- Smaller banks more exposed:
  - SME loans account for about one-tenth of overall bank assets in systematically important banks, explaining modest average reductions.
  - Exposure of smaller banks (bottom quintile by asset size) to SME lending is more than three times larger than that of larger banks (top quintile).
  - One-quarter of small banks could experience a decline in CET1R of more than 3 percentage points.
  - 10 percent could experience a decline of 7 percentage points.
- Modeling caveats:
  - Firm distress is assumed to be instantaneously followed by defaults and write-offs; in practice losses may materialize over time.
  - Insolvency and illiquidity treated as alternative sources of losses and are not additive.
  - Analysis does not directly account for the impact of existing government measures to support firms.

### Case for “quasi” equity injections: forms, effects, and constraints
- Rationale: social value of alleviating mass insolvencies exceeds private value due to overwhelmed courts, creditor externalities, reallocation costs, and macro-financial feedbacks.
- Illustrative fiscal size and effects:
  - Equity injections equal to 3 percent of annual pre-COVID revenues for all SMEs (total cost about 3.5 percent of GDP across sample countries) could nearly halve the projected rise in the share of insolvent firms in 2021.
  - Illustration: policy providing each firm with 3 percent of its pre-COVID-19 operational income (overall cost slightly below 3.5 percent of GDP in the average country) delivered as a loan or equity at end-2020:
    - Loan support increases the share of insolvent firms relative to the baseline.
    - Equity injection reduces the share of insolvent firms by almost 2.5 percentage points by end-2021.
- Possible form: “profit participation” loans junior to existing debt—fresh loans or conversion of existing loans—with remuneration partly indexed to firm profits so the government takes an upside claim on recovery.
- Design challenges:
  - Governments typically cannot directly inject equity into smaller non-listed firms.
  - Targeting the right firms (viable post-COVID business models) is difficult.
  - Competitive neutrality, managing many quasi-equity stakes, adjusting support over time, and clear exit plans are required.
  - Not feasible for unincorporated SMEs and problematic where share transfers are restricted.
- Targeting efficiency:
  - Targeted equity injections are far more efficient than blanket injections.
  - For a one-off cost of slightly more than 1/2 percent of GDP, governments could restore positive net equity for nearly 90 percent of SMEs that were solvent without COVID-19 but became insolvent because of it.
  - For the same overall cost, a blanket approach providing equity support to all SMEs would leave less than 20 percent of this group in positive equity territory by end-2021.
  - The fraction of “right” firms saved per dollar spent is more than four times larger under the targeted approach.
- Targeting mechanisms and conditionality:
  - Condition support on investments by private banks and investors to signal viability; provide quasi-equity on generous terms conditional on co-investment.
  - Where governments invest alone, rely on simple viability metrics (pre-COVID solvency and profitability) and start small, reallocating as information improves.
- Productivity and selection:
  - SMEs estimated insolvent at end-2020 have lower total factor productivity than other SMEs in the same country and industry.
  - Firms insolvent only because of COVID-19 are 25 percent more productive than firms that would be insolvent even without COVID-19.
  - Firms facing liquidity problems have higher-than-average productivity, underscoring need for liquidity support for illiquid-but-solvent firms.

### Insolvency and restructuring policy tools
- Core functions of insolvency regimes: restructure viable firms and liquidate nonviable ones to reallocate assets quickly.
- Observations:
  - Insolvency regimes work better for larger firms; fixed costs of ordinary insolvency procedures are a greater burden for smaller firms.
  - Trend toward simplified insolvency regimes for micro and small enterprises (MSEs).
- Recommended toolkit to cope with SME insolvency wave:
  - Dedicated out-of-court restructuring mechanisms (Impact: High — Timing: Short).
  - Hybrid restructuring (Impact: High — Timing: Short).
  - Reorganization and liquidation reforms (Impact: High — Timing: Short/Medium).
  - Simplified insolvency procedures for SMEs (Impact: Medium — Timing: Short/Medium).
  - Increase court capacity (Impact: Medium/High — Timing: Medium/Long).
- Out-of-court restructuring:
  - Effective for financial restructuring of viable SMEs; scalable and reliant on private-sector expertise.
  - Standardized solutions are particularly helpful given the large number and small scale of SMEs (Iceland example).
- Hybrid restructuring:
  - Court intervenes at critical points only; reduces judicial burden and increases efficiency (supported by the EU Restructuring Directive).
- Pre-packaged reorganization plans:
  - Pre-arranged or pre-packaged plans drastically reduce time (example: ordinary US reorganizations averaged 504 days vs pre-packaged 77 days during 2011–18).
- Enhanced reorganization and liquidation:
  - Prioritize judicial resources for SMEs needing both financial and operational restructuring.
  - Improve rules for debtor-in-possession, stay of creditor actions, financing, executory contracts, and cramdown.
  - Consider special financing facilities for distressed enterprises.
- Simplified reorganization procedures for smaller firms:
  - Examples: Japan, Korea, United States, Australia.
  - Reduce costs by eliminating creditor committees, reducing deadlines, and assisting debtors with plan preparation.
- Liquidation policy:
  - Swift liquidation of nonviable firms to free capital; streamline liquidation regimes and use technology for online auctions.
  - For MSEs, aim to provide debt discharge to “honest but unfortunate” entrepreneurs to enable reentry into economic activity.
- Government incentives to tilt toward restructuring:
  - Make debt forgiveness non-taxable.
  - Provide tax credits to creditors that grant haircuts.
  - Apply larger haircuts on government claims relative to private creditor claims on SMEs conditional on restructuring.

### Methodology, limitations, and caveats
- Analysis builds on Gourinchas and others (2020) framework mapping pandemic impacts on aggregate and sectoral demand and supply; firms optimize input usage subject to shocks.
- Projections assume firms can roll over existing maturing liabilities; balance sheets for 2020 and 2021 estimated using Orbis book values.
- Insolvency proxy: negative equity (balance sheet insolvency); distinct from bankruptcy and illiquidity; viability defined as net present value of expected future earnings exceeding liquidation value.
- Limitations:
  - Insolvency measure relies on book values, not market values; estimates may provide an upper bound for solvency risks when market valuations exceed book values.
  - Static, partial-equilibrium framework with fixed prices.
  - Most direct impact of government support not explicitly modeled (some support reflected indirectly via aggregate and sectoral projections).
  - Bank-impact analysis focuses on SME exposures and does not cover large borrowers or differences in accounting practices.

### Conclusion and policy implications
- Even under a solid recovery, about a fifth of SMEs may have negative net equity by end-2021 if they do not exit earlier; other insolvency metrics may deteriorate across the board.
- Deterioration of SME balance sheets may put up to 10 percent of their jobs at risk and 10 percent of their debts at risk.
- Bank balance sheet implications are contained overall but significant for smaller banks and in countries (such as southern Europe) where SMEs are predominant and hard-hit.
- Policy priorities:
  - Continue liquidity support for illiquid-but-solvent SMEs.
  - Consider well-designed quasi-equity injections where fiscal space allows, with strong targeting and conditionality to maximize efficiency.
  - Implement comprehensive insolvency and debt-restructuring tools (out-of-court, hybrid, strengthened reorganization and liquidation, simplified procedures for SMEs).
  - Use fiscal and tax incentives to tilt outcomes toward restructuring where appropriate.

*International Monetary Fund — INSOLVENCY PROSPECTS AMONG SMALL AND MEDIUM ENTERPRISES (sdnea2021002)*

### EXECUTIVE SUMMARY __________________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Introduction and overview
- The COVID-19 pandemic has increased insolvency risks, especially among small and medium enterprises (SMEs), which are vastly overrepresented in hard-hit sectors.
- SMEs account for 99 percent of all firms, more than 60 percent of jobs, and more than 50 percent of sales in most economies.
- For firms with fewer than 50 employees: about two-thirds of jobs in food, accommodation services, and wholesale and retail trade, versus only one-third in manufacturing.
- For firms with fewer than 250 employees: 80 percent of jobs in food, accommodation services, and wholesale and retail trade and 58 percent in manufacturing.
- Announced liquidity support measures in advanced economies (loans, credit guarantees, moratoria, and asset purchases) were estimated to amount to 11 percent of GDP by October 2020.

### Key projected impacts on SMEs
- Under the baseline (WEO January 2021 Update) the share of SMEs with negative equity is projected to rise by about 6 percentage points (relative to a no-COVID scenario) across a large sample of SMEs from Europe and Asia-Pacific.
- In a downside scenario with extended lockdowns and persistently weaker demand, the share of insolvent SMEs would rise by 8 percentage points.
- The projected 6 percentage point rise is roughly comparable in magnitude to the increase in exit rates seen in the five years after the 2008–09 global financial crisis, but would occur over a much shorter period.
- Considering cumulative effects over 2020–21:
  - Insolvent SMEs could account for up to 9 percent of overall SME debt.
  - Insolvent SMEs could account for up to 11 percent of SME jobs (and nearly 40 percent in accommodation and food services).
  - This corresponds to up to 20 million jobs at risk—a number roughly similar in size to the total number of unemployed in the advanced economies considered.
- Under an adverse scenario, up to 11 percent of SME debt and 13 percent of SME jobs could be at risk.

### Implications for banks and financial stability
- Rising SME insolvencies could reduce average banking systems’ common equity Tier 1 (CET1) ratios by less than 1 percentage point under the WEO baseline.
- However:
  - The fall in capital could be twice as large in hard-hit countries where SMEs are predominant.
  - A quarter of small banks could experience a drop of at least 3 percentage points in capital ratios (and 10 percent of small banks could experience a drop of at least 7 percentage points).
- In a downside scenario, average banking systems’ capital Tier 1 ratios could decline by an additional one-third to two-thirds relative to the baseline, depending on the region and the measure of distress.
- The modest average reduction partly reflects the small weight of SME loans in systematically important banks’ balance sheets—about one-tenth of overall bank assets.

### Policy options: liquidity, solvency, and restructuring (three-pronged approach)
- Recommended combined approach:
  1. Continued liquidity support for solvent but illiquid firms.
  2. “Quasi” equity injections targeted to solvent-but-illiquid or COVID-caused-insolvent-but-viable firms.
  3. Strengthened insolvency and debt restructuring tools.

### Quasi-equity injections: forms, rationale, and constraints
- Quasi-equity injections could mitigate SME solvency risks, conditional on adequate fiscal space, accountability, governance, and capacity to reach intended firms.
- Illustrative example: equity injections equal to 3 percent of annual pre-COVID revenues for all SMEs (total cost about 3.5 percent of GDP across sample countries) could nearly halve the projected rise in the share of insolvent firms in 2021.
- Possible implementation form: “profit participation” loans junior to existing debt—via fresh loans or conversion of existing loans—with remuneration partly indexed to firm profits so the government can take an upside claim on recovery.
- Design challenges:
  - Governments typically cannot directly inject equity into smaller non-listed firms.
  - Targeting the right firms (viable post-COVID business models) is difficult.
  - Managing competitive neutrality, a large number of quasi-equity stakes, adjusting support over time, and having clear exit plans.
  - Not feasible for unincorporated SMEs and could be problematic where transfer of shares is restricted.

### Efficiency and targeting of solvency support
- Targeted equity injections are far more efficient than blanket across-the-board injections.
- Illustration of targeting efficiency:
  - For a one-off cost of slightly more than 1/2 percent of GDP, governments could restore positive net equity for nearly 90 percent of SMEs that were solvent without COVID-19 but became insolvent because of it.
  - For the same overall cost, a blanket approach providing equity support to all SMEs would leave less than 20 percent of this group of firms in positive equity territory by end-2021.
  - Thus, the fraction of this group of firms saved per dollar spent is more than four times larger under the targeted approach than under the untargeted one.
- To improve targeting, governments may consider conditioning quasi-equity injections on investments by private banks and investors to signal confidence in firm viability; to incentivize private investors, governments may provide quasi equity on generous terms conditional on other investors injecting equity.

### Complementary insolvency and restructuring measures
- Solvency support should be complemented by an effective set of insolvency and debt restructuring tools:
  - Dedicated out-of-court restructuring mechanisms.
  - Hybrid restructuring.
  - Strengthened reorganization and liquidation procedures, including simplified reorganization for smaller firms.
- Rationale:
  - In-court and out-of-court restructuring procedures work better for larger firms; SMEs often do not file and are directly liquidated.
  - Out-of-court and hybrid approaches can be especially important where judicial insolvency capacity cannot be quickly expanded.
- Government incentives to tilt toward restructuring may be appropriate to avoid excessive liquidations:
  - Examples include making debt forgiveness non-taxable, providing tax credits to creditors that grant haircuts to debtors, or applying larger haircuts on government claims relative to private creditor claims on SMEs conditional on restructuring.

### Methodology and limitations (overview)
- The analysis builds on the Gourinchas and others (2020) framework mapping pandemic impacts on aggregate and sectoral demand and supply while allowing firms to optimize responses.
- Projections assume firms can rollover existing maturing liabilities and estimate 2020 and 2021 balance sheets for a large sample of SMEs in mostly advanced economies.
- The note uses negative equity as a proxy for insolvency (balance sheet insolvency) and distinguishes insolvency from bankruptcy and illiquidity; viability is defined as net present value of expected future earnings exceeding liquidation value of existing assets.

*International Monetary Fund — EXECUTIVE SUMMARY (sdnea2021002)*

### 8.      The empirical analysis uses firm-level data to quantify solvency and liquidity risks.

### 8.      The empirical analysis uses firm-level data to quantify solvency and liquidity risks.

### Data and sample
- Source: Orbis firm-level data covering 20 countries from Europe and the Asia-Pacific region.
- Country list (as provided): Australia, Austria, Belgium, Czech Republic, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, Korea, Norway, Poland, Portugal, Slovenia, Spain, Sweden, and the United Kingdom.
- SMEs defined as firms with fewer than 250 employees.
- After cleaning and conditioning on non-missing key variables, the resulting data set includes about 1.25 million firms.
- Baseline year for analysis: 2017 (selected as the latest available year with consistently good coverage across the sample).
- Projections incorporate COVID-related shocks to project firms’ balance sheets and solvency and liquidity indicators for 2020 and 2021.

### Definitions and methodology
- Insolvent firms: firms whose total liabilities exceed their total assets (negative equity value).
- Liquidity-risk firms: firms whose cash positions (initial cash stock plus cashflow generated during the year) are insufficient to cover financial obligations, assuming existing maturing debt can be rolled over.
- Equity dynamics: projected using a law of motion where tomorrow’s equity equals today’s equity plus retained earnings.
- Modeling framework: builds on Gourinchas and others (2020). Firms optimize input usage subject to COVID-related supply and demand industry shocks and an aggregate demand shock (calibrated to IMF WEO projections).
  - Firms can reduce variable inputs (labor and intermediate inputs) and may temporarily cease operations if variable profits are negative.
  - Framework yields expressions for cash flow as a function of shocks via revenue and cost impacts.
- Limitations noted:
  - Insolvency measure relies on book values (Orbis), not market values; thus estimates may provide an upper bound for solvency risks when market valuations exceed book values.
  - Static, partial-equilibrium framework with fixed prices.
  - Most direct impact of government support since the pandemic is not explicitly modeled (some support reflected indirectly via aggregate and sectoral projections).

### Main projections and aggregate findings
- Projected increases in financial distress by end-2020 (relative to a no-COVID counterfactual):
  - Share of firms facing equity gaps (negative equity) increases by more than 5 percentage points.
  - Share of firms facing liquidity shortfalls increases by more than 7 percentage points.
  - Share of firms with negative equity increases from about 10 to 15 percent.
  - Share of firms with liquidity gaps increases from 8 to 16 percent.
- Magnitude: projected rise in insolvency rates is roughly comparable to firm exits in the five years after the GFC (including the European sovereign crisis) but occurring over a much shorter period.

### Heterogeneity across regions and industries
- Regional differences:
  - Asia-Pacific: estimated increase in share of insolvent firms of 3.5 percentage points.
  - Southern Europe: projected increase of nearly 8 percentage points.
- Sectoral differences (selected examples):
  - “Accommodation and food services”: projected increase in share of insolvent firms of 25 percentage points.
  - “Arts and entertainment”, “education”, and “other services”: among the hardest hit.
  - “Agriculture”, “water and waste management”, and “mining”: smallest increases in insolvency rates.
- Similar patterns observed for liquidity risks.

### Cumulative 2020–21 risks, leverage, and interest coverage
- Cumulative 2020–21 (depending on exit versus survival of illiquid firms at end-2020):
  - Share of SMEs at risk of being insolvent in 2020 or 2021: about 16 percent.
  - Share of SMEs at risk of being illiquid in 2020 or 2021: about 18 percent.
- Leverage and interest-coverage indicators:
  - Share of firms with a leverage ratio above 1: projected to increase by 4 percentage points in 2021 relative to a no-COVID counterfactual.
  - Share of firms with interest coverage ratio (ICR) below 1: estimated to have risen to more than 35 percent in 2020; estimated to fall back in 2021 but remain about 5 percentage points above pre-COVID levels.

### Employment and debt-at-risk
- SME jobs at risk (cumulative, assuming illiquid firms exit at end-2020):
  - About 11–16 percent of SME jobs may be at risk overall during 2020–21.
  - “Accommodation and food services”: nearly 40 percent of jobs at risk.
  - “Arts and entertainment”, “education”, and “other services”: also high shares of jobs at risk.
  - “Agriculture”, “mining”, “manufacturing”: smaller shares of jobs at risk.
- SME debt at risk:
  - Firms estimated insolvent (illiquid) at end-2020 account for more than 9 (12) percent of total SME debt stock — a 2 percentage point increase compared to the no-COVID scenario.
  - Cumulative debt at risk over 2020–21: estimated to account for 9–12 percent of total (initial) SME debt, depending on whether insolvency or liquidity risks are considered.

### Downside scenario
- Illustrative downside scenario combines: a further one-month lockdown, weaker consumer recovery in hard-hit industries, and 1 percentage point lower aggregate demand growth.
- Projected cumulative increases under downside scenario vs baseline (2020–21):
  - Cumulative increase in share of insolvent SMEs: rises from 6 percent under baseline to more than 8 percent under the downside scenario.
  - Cumulative increase in share of illiquid firms: rises from 9 percent under baseline to 14 percent under the downside scenario.
  - SME jobs at risk: would rise to 13 to 21 percent.
  - SME debt at risk: would rise to 11 to 17 percent.
  - These downside outcomes are roughly 40 to 50 percent higher than under the baseline scenario.

### Implications for financial stability and banks
- Mechanism: increased firm defaults (due to negative equity or liquidity shortages) could raise nonperforming loans and generate bank losses; depressed asset values and overwhelmed insolvency courts may reduce recovery rates and magnify bank losses.
- Illustrative bank-impact model:
  - Inputs: bank debt of firms in Orbis projected to become insolvent or illiquid in 2020 and 2021 to estimate default probabilities on SME loan portfolios.
  - Output: COVID-driven bank losses on loans (relative to a no-COVID scenario) and projected changes in systemwide bank Tier 1 capital ratios after deducting losses from pre-COVID capital.
  - Coverage limitations: focuses only on SMEs (excludes large borrowers); relies on cross-country and bank-level data including EBA Transparency Exercise, ECB Consolidated Banking database, and Fitch Connect; concentrates on loan write-offs and increases in risk weights and does not consider differences in accounting practices.
- Projected impacts on Common Equity Tier 1 ratios (CET1Rs):
  - Average declines in CET1Rs are below 1 percentage point of risk-weighted assets in the baseline, regardless of using insolvency or illiquidity as the source of losses—except for southern Europe where capital ratios drop more substantially (text truncated here).

*Source: Orbis; and IMF Staff calculations.*

### 0.9 and 1.1 percentage points.

### INSOLVENCY PROSPECTS AMONG SMALL AND MEDIUM ENTERPRISES

### Impact on Bank Capital from SME Losses
- Average hit to banks’ CET1Rs is relatively small in absolute terms because the ratio of SME loans to banks’ assets is, on average, lower than 10 percent.
- The drop in capital ratios could be an additional one-third to two-thirds larger in the adverse scenario, relative to the baseline.
- In the adverse scenario, the average decline is estimated to be between 1.2 and 1.8 percentage points in southern Europe and between 0.5 and 1.1 percentage points in the other areas.
- Some banks—primarily in southern Europe—are expected to be affected 10 times more than in others; the decline in CET1R could be more than 2 percentage points in the most exposed countries.
- Among the smallest banks (bottom quintile by asset size):
  - Exposure of smaller banks to SME lending is more than three times larger than that of larger banks (top quintile).
  - One-quarter is estimated to experience a decline in CET1R of more than 3 percentage points.
  - 10 percent could experience a decline of 7 percentage points.
- Analysis uses country-level estimates calibrated to historical SME loan portfolio default data and additional bank-level analysis for a subset of European countries (European Banking Authority data).

### Modeling Assumptions and Caveats
- Firm distress is assumed to be instantaneously followed by defaults and write-offs; losses may in practice take time to materialize and be recognized.
- SMEs’ insolvency or illiquidity are treated as two alternative sources of losses and are not intended to be added up.
- Forward-looking country-level estimates are calibrated by (1) quantifying the relationship between estimated probabilities using data on debt at risk held by insolvent or illiquid firms and observed loan defaults before the pandemic, and (2) assuming such relationship also holds during the pandemic.
- The analysis does not directly account for the impact of existing government measures to support firms.

### Case for Quasi-Equity Injections into SMEs
- The social value of alleviating mass insolvencies exceeds private value for at least four reasons:
  - Overwhelmed courts could fail to deliver timely restructuring of viable firms, pushing them into liquidation.
  - Creditors do not internalize network and macroeconomic effects of individual bankruptcies; reallocation costs (sunk capital, job-match surplus, network effects) can be large relative to gains, especially if the shock is temporary.
  - Heightened uncertainty about post-COVID-19 winners and losers makes identifying viable firms unusually challenging.
  - Macro-financial feedback mechanisms may amplify economywide costs (weaker aggregate demand, weaker bank balance sheets, systemic financial risk).
- Forms of solvency support and design considerations:
  - Government quasi-equity (e.g., “profit participation loan” junior to existing debt, remuneration partly indexed to profits).
  - “Equity-like” injections via grants combined with higher future corporate taxation (less tested; legal and administrative issues).
  - Design challenges: targeting under pervasive uncertainty, ensuring competitive neutrality, managing many quasi-equity stakes, monitoring recipients, adjusting support over time, and clear divestment/exit plans.
- Targeting difficulty stems from:
  1) uncertainty about firms’ post-COVID net present value of earnings;
  2) information asymmetry between firms and government;
  3) limited government capacity to analyze and channel support to many firms.
- For SMEs, lack of comprehensive and timely financial information magnifies targeting challenges and underscores the importance of enhancing SME reporting standards.

### Targeting Mechanisms and Conditionality
- Governments may condition support on private bank/investor participation to extract viability information; may provide quasi-equity on generous terms conditional on co-investment.
- Where governments invest alone, they may rely on simple viability metrics (pre-COVID solvency and profitability) and start small, reallocating support over time as information improves.

### Loans versus Equity: Illustrative Simulations
- Illustration: policy providing each firm with 3 percent of its pre-COVID-19 operational income (overall cost slightly below 3.5 percent of GDP in the average country), delivered as either a loan or an equity injection at end-2020.
  - Loan support increases the share of insolvent firms relative to the baseline.
  - Equity injection reduces the share of insolvent firms by almost 2.5 percentage points by end-2021.
- Rationale: loans strengthen cash but increase liabilities and future interest payments; equity injections immediately strengthen both cash and equity positions.

### Efficiency of Blanket versus Targeted Equity Support
- Blanket equity injections are inefficient because they benefit many firms that do not need support or would fail regardless of COVID-19.
- Across the sample, the cost of covering the 2020 equity gaps of the “right” firms (those insolvent with COVID-19 but solvent without it) is estimated at a bit more than 0.5 percent of the total revenue of all SMEs.
- A blanket policy giving each firm 0.5 percent of revenue would end up spending slightly more than 3 percent of its overall budget on the “right” set of firms, with the rest spent on firms that are solvent or would be insolvent even without COVID-19.
- Illustration of targeted budget allocation:
  - Allocating a budget of 0.5 percent of total SME revenue only to the “right” firms in proportion to their 2020 equity shortfalls would almost fully address those shortfalls; nearly 90 percent of these firms would still show positive net equity at end-2021.
  - The same overall budget under a blanket approach distributed to all SMEs would save slightly less than 20 percent of the “right” firms.
  - The fraction of “right” firms saved per dollar is more than four times larger under the targeted approach versus the blanket approach.

### Productivity and Selection Effects of Targeted Support
- SMEs estimated to be insolvent at end-2020 have lower total factor productivity than other SMEs in the same country and industry, consistent with historical patterns where exiting firms are less productive.
- Heterogeneity within insolvent firms:
  - Firms that became insolvent only because of COVID-19 are 25 percent more productive than those that would be insolvent even without COVID-19.
  - Firms facing liquidity problems have higher-than-average productivity, underscoring the need for continued liquidity support for illiquid-but-solvent firms.
- Targeting “right” firms can be productivity-enhancing and reduce risks of low-productivity zombie firms lingering.

### Strengthening SME Insolvency and Restructuring Procedures
- Policymakers should prepare for an SME insolvency wave and deploy insolvency and restructuring procedures that preserve viable SMEs and swiftly liquidate unviable ones.
- Needed tools include:
  - Dedicated out-of-court restructuring mechanisms.
  - Hybrid restructuring arrangements.
  - Strengthened reorganization and liquidation procedures, including simplified reorganization procedures for smaller firms.

*Sources: European Banking Authority; European Central Bank; Orbis; and IMF staff calculations.*

### 31.      Insolvency and debt restructuring frameworks perform two crucial functions in

### 31.      Insolvency and debt restructuring frameworks perform two crucial functions in

### Insolvency regimes and firm size
- Insolvency and debt restructuring frameworks perform two crucial functions in addressing firm distress—restructuring viable firms and liquidating nonviable ones so their assets can be redeployed quickly to more productive uses (IMF 1999).
- Efficient and predictable insolvency regimes can improve the allocation of capital and labor in the economy, thereby increasing productivity and output. This is most important in the wake of major economic shocks such as the GFC or COVID-19 (Aiyar and others 2019).
- Restructuring of viable firms can be conducted out of court or in court, by way of reorganization proceedings. Liquidation of nonviable enterprises generally requires judicial proceedings.
- Insolvency regimes apply to firms irrespective of their size, but they work better for larger firms than for smaller ones. The distinction between large firms and SMEs is purely economic and has no legal significance.
- Insolvency regimes that follow the international standard23 tend to work better for large and medium enterprises than for micro and small enterprises (MSEs), due to the complexity and cost of ordinary insolvency procedures (World Bank 2018)—fixed costs in dealing with insolvency are a greater burden for smaller firms. This explains the trend toward developing simplified insolvency regimes for MSEs (UNCITRAL 2020).
- Out-of-court debt restructuring complements the insolvency regime, but is less effective for smaller firms. Out-of-court or “informal” restructuring frameworks are designed for complex multicreditor workout situations, with assistance of multiple financial, business, and legal experts.
- The dividing line between simplified and complex mechanisms differs between insolvency regimes and out-of-court restructuring: medium-sized enterprises fall under ordinary insolvency regimes, but they require simplified out-of-court debt restructuring, because multicreditor workouts are designed for large enterprises.

- Table of applicability (as presented in source):
  - Insolvency Regime: Large Firms √, Medium Firms √, Micro and Small Firms √
  - Simplified Insolvency Regime: Large Firms √, Medium Firms (blank), Micro and Small Firms √
  - Out-of-Court Debt Restructuring: Large Firms √, Medium Firms (blank), Micro and Small Firms (blank)
  - Simplified Out-of-Court Debt Restructuring: Large Firms (blank), Medium Firms √, Micro and Small Firms √

- The quality of insolvency regimes and out-of-court debt restructuring practices varies widely across countries. Sound insolvency regimes must include options for firm reorganization and liquidation and enable viable firms to be restructured and nonviable firms to be liquidated.
- Reorganization of SMEs is less frequent, because they have smaller going concern value compared to the—partly fixed—costs of reorganizing them.
- Out-of-court debt restructuring is frequent in high-quality systems, due to the quality of advisors and the predictability of court outcomes. Paradoxically, in weak insolvency systems, out-of-court restructuring is also used, mainly because it is the only alternative to long and unreliable judicial procedures.

*23 The international standard is composed of the World Bank Principles for Effective Insolvency and Creditor Rights Regimes and the recommendations of the United Nations Commission on International Trade Law Legislative Guide on Insolvency Law.*

### B. The COVID-19 Challenge
- COVID-19 will put insolvency and debt restructuring systems under severe pressure.
- The pandemic not only increased insolvency risks, it also stopped the normal functioning of the debt resolution system, as insolvency procedures and debt enforcement activities were temporarily stopped in numerous countries.
- Among G20 countries France, Germany, India, Italy, Spain, and Turkey have introduced debt repayment or debt enforcement moratoria, and/or restricted access to the insolvency system for a long period.
- At this stage of the crisis, general moratoria should be lifted to avoid lasting damage to credit discipline. If necessary, limited measures for affected sectors could be envisaged, alongside support programs.
- A sudden increase in insolvency cases could result in the congestion of the courts, creating risks of mass liquidation of viable firms.
- The extent of insolvency waves will depend on:
  - the persistence and severity of the crisis,
  - the magnitude and effectiveness of mitigating measures,
  - the extent to which economic actors consider insolvency procedures as an effective means of resolving debt problems,
  - the trust in the court system to process insolvency cases,
  - the availability of alternatives to formal insolvency.
- Projections and past-crisis experience (United States during the GFC and Spain during the GFC and the euro area crisis) point to sizeable risks of a sudden increase in insolvency cases, which could result in the congestion of courts, reducing opportunities to effectively reorganize firms—particularly for smaller ones, whose going concern values tend to be smaller too—and making it more likely that firms with viable business models be liquidated instead (Iverson 2018).
- Note on error types: court congestion could exacerbate so-called type-I errors—when a viable enterprise is liquidated—vis-à-vis type II errors—when a nonviable enterprise is restructured (White 2016).

- Figure 14 (as described): Examples of Insolvency Waves in Past Crises (Number of cases) — United States and Spain (right scale). (Source: Euler/Hermes.)

### C. Policy Options to Cope with the Wave of SME Insolvencies
- The wave of SME insolvencies could be tackled with a comprehensive set of insolvency and debt restructuring tools. These include:
  - dedicated out-of-court restructuring mechanisms,
  - hybrid restructuring,
  - strengthened reorganization and liquidation procedures—including simplified reorganization procedures for smaller firms (Table 2; Liu, Garrido, and DeLong 2020).
- Among distressed but viable SMEs:
  - those that need financial restructuring should be primarily restructured out of court or by hybrid restructuring,
  - those that require both financial and operational restructuring will need a judicial reorganization.
- Legal reforms require observance of legislative procedures, although they may take less time if they introduce surgical changes.
- The scope for increasing the capacity of bankruptcy courts is more limited in the short term since selecting, appointing, and training judges necessarily takes time.
- Other measures that increase the capacity of the courts, such as improving case management systems or appointing additional support staff, may be taken within a shorter timeframe, but their impact may be more limited.

- Table 2. Potential Measures to Address a Wave of Insolvencies (as presented in source):
  - Out-of-court restructuring for SMEs — Impact: High — Timing: Short
  - Hybrid restructuring — Impact: High — Timing: Short
  - Reorganization and liquidation reforms — Impact: High — Timing: Short/Medium
  - Simplified insolvency procedures for SMEs — Impact: Medium — Timing: Short/Medium
  - Increase court capacity — Impact: Medium/High — Timing: Medium/Long

- The triage of SMEs will be difficult, calling for some government financial support to alleviate excess liquidations.
  - Triage is needed to distinguish between viable and nonviable firms, which is based on a comparison between the liquidation value of the firm’s assets and its going concern value, based on future earnings.
  - Government financial support to restructuring could help alleviate excess liquidations of viable firms, where banks and other investors may otherwise provide insufficient support given existing uncertainty and adverse externalities from mass liquidations.
  - The case for government support to restructuring may be particularly strong where little-or-no government solvency support was provided to mitigate SME distress in the first place.

- Out-of-court restructuring mechanisms
  - Out-of-court restructuring mechanisms are most effective at financial restructuring of viable SMEs.
  - Financial restructuring refers to the reduction of the debt burden or other changes in the capital structure, without significantly altering the business operations. It may involve rescheduling or writing down existing debt, or converting part of the debt into capital.
  - An advantage of out-of-court frameworks is that they can be easily scaled up or down, since they rely on expertise available in the private sector, rather than on creating permanent judicial positions.
  - Past cases include Iceland (effective framework after the 2009 crisis) and Asian countries (Indonesia, Korea, Malaysia, and Thailand) after the Asian financial crisis, with more modest results.25

- Standardized solutions are particularly helpful.
  - SME restructuring schemes are a simplified version of the out-of-court mechanisms designed for large enterprises and rely on the cooperation of banks.
  - Agreements with banks and the state can set the parameters for restructuring, and conflicts can be resolved by swift alternative dispute resolution mechanisms.
  - Because the high number and smaller scale of SMEs do not justify investing substantial resources in detailed viability studies and restructuring plans, an effective approach, as seen in Iceland, consists of providing standardized solutions for restructuring cases. SMEs are classified according to their restructuring needs, and a series of solutions are offered to them by the financial sector; these solutions are transparent and offered to all SMEs that comply with the requirements.

- Box 1. Standardized SME Debt Restructuring in Iceland — Key measures and outcomes:
  - Only companies that could evidence future positive cash flow and had accounts for the previous two to three years were considered.
  - Management should continue operating the business.
  - In case the debtor had loans with several banks, one of the banks would act as coordinator.
  - The debt could be written down to the discounted value of the cash flows generated by the business, or to the liquidation value of the enterprise, including any additional collateral.
  - Loans could also be “deferred” by generating low interest during the first three years of the arrangement.
  - Disagreements about the valuation of the going concern or the assets would be resolved by a third-party valuation.
  - Disputes between creditors would be subject to arbitration.
  - Tax claims could be reduced in the same proportion as the creditors’ write-down. The payment of remaining tax claims could be postponed. The rules for taxation for debt forgiveness were also amended to provide more relief to debtors.
  - The approach simplified the restructuring of the SME sector: it avoided the collapse of the courts, reduced the number of liquidations, and provided creditors with higher returns.

25 For an evaluation of the effects of these schemes, see Annex in Bergthaler and others (2015). For a discussion of current policy challenges and options to deal with rising corporate sector risks in Asia, see Bauer and others (2021).

- Public support could incentivize SME restructuring over liquidation.
  - Governments could provide incentives for SME debt restructuring, for example, through loss carry over rules (or by making debt forgiveness non-taxable)26 or by granting tax credits to creditors that grant haircuts to debtors.
  - Governments could also facilitate restructuring by taking a higher haircut on their claims than private creditors on theirs (Blanchard, Philippon, and Pisani-Ferry 2020). Because such a higher haircut would be conditional on restructuring rather than liquidating the firm, it would act as a “premium for continuation.”
  - This approach would be most effective where governments have already provided sizeable financing to SMEs by way of direct loans or guarantees.
  - In countries without such programs, the state tends to have other claims, such as taxes and social security contributions, on which the haircut could possibly be applied. A complicating factor is that taxes and social security contributions may have priorities in the ranking of claims, and in any event have separate regimes and status from government loans. It is easier for the government to provide a haircut for claims that have unsecured status.

26 Under general tax rules, debt forgiveness generates an equivalent amount of taxable income for the debtor.

- Hybrid restructuring
  - Hybrid restructuring can contribute to the restructuring of a large number of SMEs. It seeks to improve on the functioning of out-of-court restructuring but without incorporating all the elements of judicial intervention of a formal insolvency procedure.
  - Under a hybrid restructuring procedure, the court intervenes only at critical points—typically, at the start, to prevent creditors from taking action against the debtor, and at the end, to confirm the agreement negotiated between the debtor and the creditors—but during the rest of the time the process advances without judicial intervention.
  - This approach is supported by the EU in its 2019 European Restructuring Directive following the experiences of France, Italy, and Spain during the euro area crisis, and the United Kingdom in its recent insolvency reform as part of the 2020 Corporate Insolvency and Governance Act.
  - The reduction in judicial intervention saves scarce judicial resources and increases efficiency. Other examples exist in common law countries (Australia, Canada, South Africa), which could be improved through targeted legal reforms.

- Pre-packaged reorganization plans
  - A simple and highly effective hybrid restructuring technique is the “pre-packaged reorganization” plan. After an informal negotiation and agreement between creditors and the debtor is concluded, a reorganization procedure is opened just to confirm the “pre-packaged” reorganization plan.27
  - There is ample experience with the use of pre-arranged and pre-packaged plans in the United States, as well as in other countries such as Argentina and Japan.
  - This option requires only minor legal changes and results in huge time reductions and minimal use of the resources of the courts.
  - Example timing: ordinary reorganization procedures during 2011–18 in the United States lasted 504 days, while pre-packaged reorganizations lasted only 77 days, on average. (The Deal Pipeline and FTI Consulting)

27 Pre-arranged plans are those that have been negotiated with major creditors before the start of the case. Pre-packaged plans go one step further; they already have the support of the necessary majority of creditors, not just major ones. In both cases, the fact that the plan has already been designed shortens the process.

- Enhanced reorganization and liquidation procedures
  - Firms that need both financial and operational restructuring will require judicial reorganization. The use of judicial resources should be prioritized for SMEs that require swift judicial actions to preserve their viability.
  - Countries should assess and improve reorganization procedure features most relevant during this crisis, namely debtor-in-possession, adequate rules for stay of creditor actions, financing and executory contracts, and provisions for cramdown in the approval of reorganization plans.
  - EU countries can incorporate the EU Restructuring Directive to improve their reorganization procedures.
  - Countries should pay special attention to rules that allow enterprises to receive new financing during the procedure. Governments may need to provide financial support by establishing a special financing facility for distressed enterprises.

- Simplified reorganization procedures for smaller firms
  - Countries may consider introducing simplified reorganization procedures for smaller firms. Some countries (Japan, Korea, United States) have introduced simplified versions that reduce cost and complexity; Australia recently joined this trend.
  - These procedures simplify and reduce costs by eliminating creditor committees, reducing deadlines, and assisting the debtor in the preparation of a reorganization plan.
  - Reforms can be made by amending ordinary procedures or designing a new procedure—amendments take less time; new procedures may be more effective in the longer term.

- Liquidation of nonviable firms
  - Firms without viable business models should be liquidated swiftly so capital can be freed up and reallocated quickly.
  - In some countries, judicial liquidation can be long and costly; this may lead firms without significant assets to simply close their doors and secured creditors to use debt enforcement to seize collateral.
  - Countries can introduce reforms to streamline liquidation regimes, including using new technology for online auctions of assets (recent examples include Italy, Greece, and Ukraine). Such reforms require legal amendments, new technology, and training of judicial and private actors.
  - Other reforms can facilitate the acquisition of assets by creditors in exchange for their claims.
  - For MSEs, which often have no significant assets, the most important goal of the insolvency process should be to provide a debt discharge to “honest but unfortunate” entrepreneurs so that they can start other economic ventures.

*International Monetary Fund*

### CONCLUSION

### CONCLUSION

### SME solvency risks and macrofinancial implications
- Increasing SME solvency risks raise important concerns regarding economic growth, jobs, and the financial strength of creditors.
- Even under a solid economic recovery, about a fifth of SMEs may have negative net equity by the end of 2021—if they do not exit earlier—and other insolvency metrics may deteriorate across the board.
- The deterioration of SME balance sheets may put up to 10 percent of their jobs at risk of being shed and 10 percent of their debts at risk of not being repaid.
- While contained overall, the implications for bank balance sheets are significant—notably for smaller banks, and in countries (such as southern Europe) where SMEs are predominant and have been particularly hard-hit by the COVID-19 crisis.

### Role and design of “quasi” equity injections
- Well-designed “quasi” equity injections could bolster the solvency of SMEs.
- Liquidity shortfalls remain a risk and should be addressed, but access to new credit alone will not resolve deeper, slowly-building insolvency and debt-overhang problems.
- There may be a stronger rationale for “quasi” equity injections during this crisis in countries with fiscal space.
- The note highlights the power of such equity injections in bolstering SME solvency, and the large efficiency gains from targeting them to the “right” firms—those viable firms facing insolvency, but with clear post-COVID-19 recovery prospects.
- In practice, equity injections into SMEs could take several forms, including (junior) “profit participation” loans—either through fresh loans or conversion of existing ones.
- To maximize chances of targeting the “right” firms, governments may:
  - condition such “quasi” equity injections on injections by banks and other investors;
  - invest on generous (subsidized) terms to incentivize private investors.

### Need for comprehensive insolvency and debt-restructuring tools
- Even with continued liquidity support and equity injections, a wave of SME insolvencies is likely unavoidable; therefore, a comprehensive set of SME insolvency and debt restructuring tools is needed, alongside government subsidies.
- Useful mechanisms include:
  - out-of-court restructuring mechanisms;
  - hybrid restructuring;
  - strengthened reorganization and liquidation procedures, including simplified reorganization procedures for smaller firms.
- Given risks that a priori viable firms could still face liquidation even under well-functioning procedures, government incentives could be considered to tilt the balance toward restructuring, for example:
  - making debt forgiveness non-taxable;
  - providing tax credits to creditors that grant haircuts to debtors;
  - applying larger haircuts on government claims (relative to private creditor claims) on SMEs conditional on restructuring.
- Although most relevant for SMEs, these policy options to dampen the rise in insolvencies and facilitate restructuring could also be helpful for larger firms.

*International Monetary Fund — INSOLVENCY PROSPECTS AMONG SMALL AND MEDIUM ENTERPRISES (CONCLUSION)*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2021/english/sdnea2021002.pdf_