How the design of bankruptcy procedures impacts macroeconomic and employment outcomes in the post-Covid recovery period: lessons from previous crises
Lead Research Organisation:
London School of Economics and Political Science
Department Name: Financial Markets Group
Abstract
We propose to investigate how the design of bankruptcy procedures impacts macroeconomic outcomes, and whether the design should be different in normal times and during times of economic distress.
The Covid-19 crisis provides motivation for our proposed research. Government assistance has allowed some businesses to cover their operating costs, despite declining revenues. Nonetheless, the debt of these businesses continues to accumulate and as the crisis persists this may force businesses into bankruptcy. In the post-Covid recovery phase, some of these businesses will have permanently low revenues and will need to close. The majority of them, however, will be viable, and a way must be found to bring their debt down from distress levels.
Renegotiating the debt of distressed yet viable businesses is the subject of bankruptcy procedures. Yet, standard procedures are likely to be of little help during the Covid-19 recovery. This is because the procedures are lengthy and available in practice only to the largest firms. The crisis threatens the survival of a large number of small and medium firms as well. If these firms go bankrupt at a wide scale, the crisis will deepen, and there will be large knock-on effects.
For the purposes of the United Kingdom's economic recovery we propose a revised bankruptcy procedure, which includes an automatic write-down on government claims on a firm in exchange for write-downs by the firm's private creditors. We propose to build on previous work done at the London School of Economics and investigate in more depth the interplay between bankruptcy procedures and the macroeconomy. We plan to study this issue both theoretically and empirically.
The Covid-19 crisis provides motivation for our proposed research. Government assistance has allowed some businesses to cover their operating costs, despite declining revenues. Nonetheless, the debt of these businesses continues to accumulate and as the crisis persists this may force businesses into bankruptcy. In the post-Covid recovery phase, some of these businesses will have permanently low revenues and will need to close. The majority of them, however, will be viable, and a way must be found to bring their debt down from distress levels.
Renegotiating the debt of distressed yet viable businesses is the subject of bankruptcy procedures. Yet, standard procedures are likely to be of little help during the Covid-19 recovery. This is because the procedures are lengthy and available in practice only to the largest firms. The crisis threatens the survival of a large number of small and medium firms as well. If these firms go bankrupt at a wide scale, the crisis will deepen, and there will be large knock-on effects.
For the purposes of the United Kingdom's economic recovery we propose a revised bankruptcy procedure, which includes an automatic write-down on government claims on a firm in exchange for write-downs by the firm's private creditors. We propose to build on previous work done at the London School of Economics and investigate in more depth the interplay between bankruptcy procedures and the macroeconomy. We plan to study this issue both theoretically and empirically.
| Description | Economic crises bring an upturn in bankruptcies. Companies suffering losses struggle to survive, and many fail. A wave of bankruptcy filings was expected in the wake of COVID-19 too. Yet during 2020, the number of corporate bankruptcy filings in most advanced economies - members of the OECD - fell by 17% relative to 2019, and by even more relative to previous years. This decline in bankruptcy cases demonstrates the success of the initial COVID-19 response measures. On second glance, however, it brings worries too. Data for 2020 are available on bankruptcy filings in 25 OECD economies. In the US, these fell by 16% relative to last year. The other major economies show the same pattern of decline. In Japan and Germany the falls are 7% and 13%, respectively; in Canada and the UK, bankruptcies fell by around a quarter. The largest decline is in Australia and France (40%), while Poland is the only country that shows no change relative to 2019. The reasons for this decline are twofold. The COVID-19 pandemic has induced governments in many advanced economies to finance job support programmes to assist workers and to temporarily halt bankruptcy procedures - providing lifelines to keep firms alive through the crisis, at a time when premature bankruptcy can worsen the recession. The job support programmes have been updated and expanded in most OECD countries, while the bankruptcy moratoriums are expiring soon in many countries. Australia, for example, returned to normal bankruptcy procedures on 1 January 2021 (Australian Financial Security Authority 2021). For many employers and businesses, the government programmes have worked. Businesses have reacted by keeping employees on board or hiring new ones when restrictions on business operations became less onerous. In turn, the support keeps businesses open, in the hope that the economy turns around. This availability of plentiful financial support to businesses cannot continue for long. A large number of firms will need debt restructuring once government support programmes run out and the courts open up. Extensive reorganisation or liquidation procedures, which may work in normal times, will prove insufficient to service a large wave of insolvencies. Changes to existing regimes should be done now, before the wave on bankruptcies comes. In March 2019 - a year before COVID started closing down businesses - the European Parliament adopted a new directive on preventive restructuring, aiming to increase the efficiency of insolvency proceedings. The Reform Directive specifies that a new procedure must be in place in all EU member countries by 2022. The UK has done just that and thus provides an example for other governments to follow. |
| Exploitation Route | The amendments to the UK insolvency law, adopted in June 2020, add three features investigated with this award. First, these amendments introduce a two-month moratorium, during which the company benefits from a payment holiday from the majority of its debts. Second, the amendments allow the debtor to propose a rescue plan that can be forced onto every creditor if the majority of creditors agree. Third, suppliers are prevented from stopping deliveries once they find out that the debtor has trouble paying creditors, as long as the firm pays for its supplies on time - even ahead of bank creditors. Research on bankruptcy procedures around the world shows that the type of changes the UK has enacted increase the likelihood firms will survive, as they continue operating during their restructuring. Some economists are concerned that keeping insolvent firms alive will drain resources from the healthy parts of the economy. These fears are fundamentally misguided. Policies to force businesses to shut down permanently risk slowing down the COVID recovery. As businesses shut down, they break a supply chain that affects other businesses, including in healthier sectors. Such breakage should be avoided as much as possible. |
| Sectors | Financial Services, and Management Consultancy,Government, Democracy and Justice,Manufacturing, including Industrial Biotechology |
| URL | https://voxeu.org/article/covid-rages-bankruptcy-cases-fall |
| Description | The findings of this work have been used to identify the features of recent UK bankruptcy legislation that has assisted economic recovery during COVID. The findings are also starting to be used by governments in other European countries, for example Austria. The European Central Bank and the Bank of England have used the analyses in their 2021 financial market stability assessments. Furthermore, the findings were used in the 2022 revisions of the UK bankruptcy law in the part on priorities for different groups of creditors. |
| First Year Of Impact | 2022 |
| Sector | Government, Democracy and Justice |
| Impact Types | Economic |
| Description | The research has influenced the decision-making at the Bank of England and the European Central Bank on the redesign of insolvency procedures as these relate to small businesses. |
| Geographic Reach | National |
| Policy Influence Type | Contribution to a national consultation/review |
| Impact | The main findings of the research show that the extension of the insolvency moratorium for the duration of the pandemic has had a highly beneficial effect on the survival of small UK firms. Detailed proposals of what additional features can be helpful to small businesses have been put forward to serve in future legislative changes in 2022. |
| Description | Bank of England research department has joined our project. |
| Organisation | Bank of England |
| Country | United Kingdom |
| Sector | Private |
| PI Contribution | Our research has been presented at the Bank of England annual conference and has served as the basis for a current research cooperation between LSE and BoE. This cooperation has resulted in the use of more extensive data available only to Bank of England researchers, which extends our own data sources. |
| Collaborator Contribution | Bank of England researchers have used our analysis to develop first their own research; and more recently to develop joint research with our team. The first portion of this work was presented in December; the second portion is coming out in April 2022. |
| Impact | December 2021 conference event. |
| Start Year | 2021 |
| Description | Presentation at the Bank of England |
| Form Of Engagement Activity | Participation in an activity, workshop or similar |
| Part Of Official Scheme? | No |
| Geographic Reach | National |
| Primary Audience | Professional Practitioners |
| Results and Impact | The one-day conference was organized by the Bank of England for the purposes of exchanging the latest research on how the UK can improve its insolvency legislation to cater to small companies. |
| Year(s) Of Engagement Activity | 2021 |