Taming the Wave of Small and Medium Enterprise Insolvencies

IMF Blog, April 2, 2021

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The pandemic has hit small and medium enterprises particularly hard, partly because they are predominant in some contact-intensive sectors like hotels, restaurants, and entertainment.
Abundant liquidity support through loans, credit guarantees, and moratoria on debt payments have protected many SMEs from the immediate risk of bankruptcy, but liquidity support cannot address solvency problems.
As firms accumulate losses and borrow to keep carrying on, they risk becoming insolvent—saddled with debt well over their ability to repay.

Projected increase in insolvent SMEs from 10 percent to 16 percent in 2021 across 20 mostly advanced economies in Europe and the Asia-Pacific region.
The increase would be on a magnitude similar to the rise in liquidations in the 5 years after the 2008 global financial crisis, but it would take place over a much shorter period of time.
Projected insolvencies put about 20 million jobs at risk (i.e., over 10 percent of workers employed by SMEs), roughly the same as the total number of currently unemployed workers, in the countries covered by the analysis.
Additionally, 18 percent of SMEs may also become illiquid (they may not have enough cash to meet their immediate financial obligations), underscoring the need for continued liquidity support.

Rising SME insolvencies could trigger defaults and cause significant write-offs, depleting banks’ capital.
In hard-hit countries—mostly from Southern Europe—banks’ capital tier 1 ratios could decline by over 2 percentage points.
Smaller banks would be hit even harder:
- A quarter of smaller banks could experience a drop of at least 3 percentage points in their capital ratios.
- 10 percent of smaller banks could face an even larger fall of at least 7 percentage points.

Compared to past crises, there is a clearer case for solvency support by governments because the costs of bankruptcies to society far exceed their costs to individual debtors and creditors.
Risk that overwhelmed courts could fail to restructure viable firms and push them into liquidation, causing undue losses in productive networks, human capital, and jobs.
Practical approach: quasi-equity injections into SMEs in countries with adequate fiscal space, transparency, and accountability.
One approach: extend “profit participation loans” through fresh loans or conversion of existing ones; these loans would be junior to all other existing debt claims and their payoff could be partly indexed to the firm’s profits.
Targeting support to firms insolvent as a result of the pandemic but with viable business models is challenging; governments might consider conditioning support on private investors (like banks) injecting equity to let the market help identify viable firms.
Examples: France, Italy, and Ireland have proposed or enacted policies to incentivize private investors to contribute equity.
Support could be staggered over time, with new tranches deployed only as viability uncertainty dissipates.

Targeted quasi-equity injections would be far more efficient and powerful than providing support to all firms.
Across-the-board (blanket) injections benefit two types of firms that should not receive solvency support:
- Firms that do not need it because they are solvent even amid the crisis.
- Firms that would have been insolvent even without the pandemic and that happen to be less productive.
Illustration: a targeted support program with a budget of roughly half a percent of the overall GDP of the 20 countries analyzed could bring back over 80 percent of the right firms (viable but currently insolvent) to zero net equity (a minimal definition of solvency).
The targeted program’s effectiveness is over four times more than would be achieved under a blanket approach supporting all SMEs without distinction.

Even with public support measures, SME insolvencies are likely to rise, so insolvency proceedings systems need comprehensive tools to cope with added strain.
Recommended tools include:
- Dedicated out-of-court restructuring mechanisms.
- Hybrid restructuring approaches.
- Strengthened insolvency procedures, for instance, simplified reorganization for smaller firms.
Because liquidations may be excessive even under well-functioning insolvency procedures, governments could provide financial incentives to tilt the balance towards restructuring.

Continue targeted liquidity support where needed to address illiquidity (18 percent of SMEs potentially illiquid).
Deploy quasi-equity injections in a targeted manner, conditioned where feasible on private investor participation, and consider profit-participation loan structures.
Strengthen and expand insolvency and debt restructuring mechanisms, including out-of-court and simplified procedures for smaller firms.
Combine continued liquidity support, quasi-equity injections, and enhanced restructuring mechanisms to reduce the risk of widespread SME distress and support a stronger recovery.

IMF Blog post by Federico J. Díez, Romain Duval, Chiara Maggi, Nicola Pierri — April 2, 2021