On March 2014 the European Commission published its “Commission Recommendations of 12.3.2014 on a new approach to business failure and insolvency”. The main thrust of the recommendations is to shift the emphasis of insolvency proceedings away from liquidation to pre-insolvency restructuring, in order to allow viable firms to be turned around and return to going concern status. Subsequently, in the action plan for its proposed Capital Markets Union, the EC highlighted that adopting minimum insolvency standards across Europe would help to reduce barriers to cross-border investment and enable faster restructuring by firms.
National European insolvency laws vary in many respects. The divergences include, among others, the criteria to open an insolvency proceeding, ranking of creditors, valuation procedures and the role and level of participation of creditors in an insolvency proceeding.
The Commission is expected to propose a legislative initiative on business insolvency by the end of 2016 addressing the negative effects of divergent, and in some instances inadequate, insolvency regimes have on European capital markets and the economy in general. Our study contributes to the evidence supporting the relevance of this initiative on capital markets and borrowing costs, more specifically on corporate bond spreads (AFME, Frontier Economics and Weil, Gotshal & Manges 2016).
The economic case for insolvency reform
A body of research points to the positive effect of well-functioning insolvency regimes on financial markets and economic performance.
The benefits of adequate insolvency frameworks range from improving the size and deepness of capital markets, improving access to finance, enhancing entrepreneurship and company formation, and contributing to faster and more efficient deleveraging and adjustment of non-performing loans.
Insolvency frameworks and non-performing loans
Sound insolvency regimes provide the opportunity for viable companies in distress to restructure quickly, while inadequate costly frameworks could precipitate liquidation or make companies accumulate excessive levels of debt which could evolve into non-performing loans (NPLs).
This is particularly relevant in the current context of high non-performing loans in some European countries (Ayiar et al. 2015). The ECB’s 2014 comprehensive assessment identified €879 billion in non-performing exposures in the banking system, which absorb high levels of bank capital, reduce the efficiency of capital allocation, and represent a challenge to the banking system’s stability.
The IMF (2015) found that countries with better insolvency frameworks deleveraged faster during the post-crisis period. Also, countries with sound insolvency frameworks were able to adjust their non-performing loan ratios more rapidly than countries with weaker regimes (see Figure 1 and EC 2015).
Figure 1. Quality of insolvency regimes in 2015 (distance to frontier) and change in NPLs in Europe, Japan, and the US
Source: World Bank and Doing Business 2015
Access to finance, entrepreneurship, and cross-border investment
Inadequate insolvency regimes create uncertainty for creditors, generating greater difficulties for companies seeking to access credit. Davydenko and Franks (2008) find that unfriendly bankruptcy codes lead to higher collateral requirements. Also, a recent study by the ECB (2015) found that sound and efficient investor protection rules increase the likelihood of companies gaining access to credit.
Likewise, adequate insolvency regimes encourage entrepreneurship estimated as the likelihood of self-employment (EC 2015) and rate of new firm entry (Leea et al. 2011).
On the other hand, due to the existing divergence in national European insolvency regimes, creditors, administrators, and stakeholders can expect to receive different rights, obligations, protections, and outcomes depending on the European jurisdiction in which the insolvency proceeding is conducted. This creates uncertainty for cross-border investment, making it harder for investors to assess credit risk and reducing the benefits of PanEuropean economic integration.
Sound insolvency frameworks reduce borrowing costs
In our report we have focused on the effect of insolvency regimes on corporate bond spreads. We use a bond pricing model to estimate the impact of insolvency regimes on the risk premium. This result is then used to estimate the potential long-term impact on EU GDP and employment.
In principle, creditors should set higher risk premia for bonds issued by companies whose assets are located in unfriendly insolvency regimes (i.e., regimes with high restructuring costs and uncertain likelihood of recovering one’s investment or loan should a company become insolvent).
Using a panel of corporate bonds issued by EU members states and two OECD countries, we modelled bond spreads (bond yields against risk-free rates) as a function of liquidity, time to maturity, credit ratings, market beta, institutional variables, and quality of insolvency regimes. We proxied quality of insolvency regimes as the annual recovery rate as reported by the World Bank.1
Figure 2. Recovery rate in Europe (%)
Source: Doing Business (2015)
Our results indicate that improving the insolvency recovery rate by 10 percentage points (pp) reduces corporate bond spreads by 18 to 37 basis points (bps). That is, creditors are willing to reduce risk premia by between 18-37 basis points if they expect to reduce their loss given default by 10 percentage points if a company declares insolvent.
In our results, we have also established an indirect impact via credit ratings as we found evidence that credit ratings agencies adjust individual bond ratings in light of a jurisdiction’s recovery rating.
As a second step, we derived the impact of insolvency reform on macroeconomic performance based on existing evidence of the relationship between bond spreads, GDP, and employment in Europe. Our estimations are based on the results of Bleaney et al. (2013), who find that a percentage point reduction in bond spread is associated with a 1.57 percentage point increase in long-term GDP and a 1.06 percentage point increase in long-term employment.
Applied across the EU, assuming that reform would improve recovery rates to the level of the top 6 EU economies (to 85% from the current weighted average of 77%) lower corporate bond spreads could add between 0.3% to 0.55% to EU GDP over the long-term and an employment increase of between 600,000 to 1.2 million.
The biggest gains in absolute terms accrue in large economies such as Italy and Spain. However, smaller member states such as Bulgaria, Croatia, and Greece stand to gain the most in relative terms, adding as much as 2% to long-term GDP if they can bring their recovery rates to 85%.
Figure 3. Relative impact of reform by country: potential employment and GDP impact
Source: Frontier analysis of Datastream, World Bank, S&P and Moody’s data
These results are first estimates of the benefits of sound insolvency regimes on borrowing costs. These are in addition to the wider economic benefits described earlier on non-performing loans adjustment, entrepreneurship, company restructuring, access to finance, and economic integration.
A Chapter-11 framework for Europe
AFME has put forward a number of concrete proposals for targeted harmonisation of insolvency laws through minimum European insolvency standards.
- First, we recommend that all member states should have a Chapter 11-type stay of proceedings to enable quick and effective restructuring.
- Second, we advocate special protection for new financing to provide working capital to a distressed company.
- Third, we propose stronger creditor rights.
- Fourth, we suggest that national insolvency agencies should regularly report on their results in order to better inform investors, policymakers, analysts, and stakeholders.
In addition, AFME proposes consistent and effective valuation procedures and experienced and dedicated judicial and professional frameworks across Europe.
We hope these recommendations and the economic evidence provided support a meaningful discussion on creating a viable European framework for minimum insolvency standards as part of the Commission’s initiative.
References
AFME, Frontier Economics and Weil, Gotshal & Manges (2016), Potential economic gains from reforming insolvency law in Europe.
Aiyar, S, A Ilyina, and A Jobst (2015), “How to tackle Europe’s non-performing loan problem”, VoxEU.org, 5 November.
Bleaney, M, P Mizen, and V Veleanu (2015), “Bond spreads and economic activity in eight European economies”, Economic Journal.
Davydenko, S and J Franks (2008), “Do Bankruptcy Codes Matter? A Study of Defaults in France, Germany, and the U.K.”, Journal of Finance 63 (2): 565–608.
European Commission (2015), “The Economic impact of Rescue and Recovery Frameworks in the EU”, Discussion Paper 004, September 2015.
Ferrando, A, D Maresch and A Moro (2015) “Creditor protection, judicial enforcement and credit access,” ECB Working Paper Series, No. 1829. July 2015.
IMF (2015), Global Financial Stability Report, April.
Leea, S, Y Yamakawab, M W Penga and J B Barneyc (2011), “How do bankruptcy laws affect entrepreneurship development around the world?”, Journal of Business Venturing 26(5).
Endnotes
[1] Other metrics for insolvency frameworks were utilised for robustness checks
