Emily Clayton and Martina Fazio
Debt creates threads between the financial system and the real economy. These threads transmit shocks across a web of connections, meaning that financial shocks may pose risks to households and businesses, and real-economy shocks may jeopardise financial stability. These threads can also become entangled into knots – sources of inefficiency. Macroprudential regulators in the UK have already intervened partially to disentangle the inefficiency from consumption cuts by over-indebted households. In the next decade, policymakers could consider whether a similar intervention is needed to limit corporate debt. In this post, we map the threads that corporate debt creates, identifying areas where entanglement may have created inefficiencies, and considering the potential case for borrower-based tools to unravel them.
Tracing the web
Imagine a company – Spider Holdings – which has borrowed to finance a long-term investment. It now needs to rollover the loan as it matures. But a shock has hit the financial system, so it is unable to obtain finance at the original rate. Given the new rate, Spider Holdings can only afford to borrow less than it needs to repay.
What does Spider Holdings do? One option is to use retained earnings to repay a portion of the maturing loan. But as a result of this, its investment plan needs to be downsized, prompting it also to reduce its employment.
But what if Spider Holdings does not have sufficient retained earnings? Then it defaults on its loan and enters insolvency. Arachnid Financials, its main lender, sells the commercial property it took as collateral on the original loan, but at a discount given it wants to divest quickly, and so takes a loss. Other businesses that had trade credit and supply contracts with Spider Holdings also face losses.
Now imagine it is not just Spider Holdings that faces this chain of events, but thousands of companies concurrently. Figure 1 maps these dynamics. The threads of debt make all companies vulnerable to the same tightening of credit conditions (C.1). When they each cut investment and employment, falls in demand for investment and consumer goods negatively impact operating conditions for businesses across the economy, and the economy’s future supply capacity (A.1, A.2, A.3). If companies do not have sufficient retained earnings, many businesses fail simultaneously, prompting concurrent attempts to sell-off collateral, resulting in large discounts, amplifying losses (B.1, B.2). And with lower collateral values (C.2), and tighter credit risk appetite from lenders (C.1), companies can no longer borrow enough to repay their maturing debt. The cycle continues.
Figure 1: Mapping the web of interconnections from debt, and potential knots of inefficiency
When choosing to borrow and lend, neither Spider Holdings nor Arachnid Financials account for the consequences of this debt for the wider system. These potential externalities – visualised as knots in the web – imply that the efficient level of debt is lower than the privately optimal level chosen by companies and lenders. In such cases, macroprudential interventions, similar to mortgage market tools, could help reduce debt towards its social optimum. So what is the evidence for potential knots in the web of corporate debt?
Knot A: Excessive corporate debt leads to inefficient cuts in investment and employment
More-indebted businesses have less flexibility to absorb shocks, as they must use a greater share of earnings to meet debt repayments. Consequently, such companies are more likely to cut investment and employment when faced with a shock. These cuts to investment and employment can reduce aggregate demand directly, and also indirectly via spillovers to households or to other businesses.
And the effects of these cuts may be persistent. Employment turnover and capital scrapping may result in economic scarring. Missed investment, especially in research and development, reduces opportunities for productivity growth, dragging on GDP. In addition, even outside of shocks, excessive levels of debt may cause sub-optimally low levels of investment.
But policymakers need evidence of aggregate effects to motivate interventions to unravel a knot. For one, business investment decisions are not particularly responsive to interest rate changes, especially for large companies and during recessions. This means it is unlikely that other firms will step in to replace cut investment or employment fully. In addition, as with household consumption, when interest rates cannot fall much below zero, monetary policy may not be sufficient to counteract the effect of shocks. Constrained monetary policy provides a motivation for mortgage market tools – could it also motivate corporate debt tools?
To us, this evidence indicates that macroprudential policymakers may benefit from further research on the potential for aggregate effects from this knot.
Knot B: Excessive corporate debt leads to inefficient contagion and scarring, via higher company failures
More-indebted businesses are more likely to fail, as they have less ability to absorb shocks given their debt repayment obligations. Not all businesses’ failures are inefficient. But they can represent a knot if they result in contagion, firesales or a less efficient redeployment of capital and labour. In addition, the larger the share of companies with a high probability of failure, the weaker the effect of monetary policy, which could increase output volatility.
Conversely, a larger number of businesses on the verge of failure at the same time, combined with insufficient lender capitalisation, may increase incentives for creditors to forbear inefficiently, or even to continue to lend to unsustainable zombie companies. This can result in an over-accumulation of debt, a misallocation of labour and capital, and a drag on aggregate productivity.
But the key root of these inefficiencies is not excessive debt. And so policymakers should prioritise options to disentangle the knot fully, rather than simply shrinking it by reducing debt. For example, corporate debt build-ups in countries with more efficient restructuring practices do not lead to the same persistent negative effects on aggregate demand after shocks. And reforms since the global financial crisis (GFC) have increased the loss-absorbing capacity of the financial system, especially for the major UK banks, which should weaken the incentives for creditors to forbear inefficiently. Further improvements in the insolvency regime and creditor resilience may disentangle this knot fully, without the need for corporate debt restrictions.
Knot C: Excessive corporate debt makes the economy more sensitive to credit supply dynamics
Excessive debt levels likely also increase the sensitivity of companies to fluctuations in credit supply. During the GFC, drastic reductions in credit supply drove forced deleveraging, inducing cash-poor firms to cut employment and investment, as described in Knot A. These effects are exacerbated when companies rely heavily on short-term debt, as this increases their exposure to credit supply fluctuations. They are also likely to be a bigger concern for SMEs, which typically have less diversified funding sources.
Collateralised lending also amplifies credit supply volatility. This represents a large fraction of companies’ borrowing, especially among SMEs. Collateral helps overcome market failures in the presence of information asymmetries, and aids lender resilience by improving the recovery of funds in default. But it can also lead to a knotty feedback loop. Tighter credit conditions can result in the need to liquidate assets and, in the limit, in inefficient defaults, as described in Knot B. This can push down on the value of collateral and further restrict credit access, amplifying downturns. Excessive lending on commercial real estate may strengthen this dynamic. If loose credit conditions drive unsustainably high valuations before a shock hits, this can lead to sharper credit contractions in the downturn.
In turn, these inefficiencies in credit supply may result in resource misallocation across firms or sectors, leading to lower aggregate productivity and a slower macroeconomic recovery from shocks. More broadly, if misallocation skews credit towards financing demand or to purchasing existing assets rather than towards productivity-boosting activities, this can also increase risks to financial stability.
In this case too, we think that the root cause of these knots lies more in weakness in lender resilience than in excessive corporate debt levels. As already mentioned, reforms since the GFC have mitigated some risks from credit supply volatility. Yet it is likely impossible for policy to completely stabilise credit supply. Therefore, unlike in Knot B, there may be benefits from reducing the number of threads in Knot C through restrictions on debt, though further investigation is needed.
Wrapping up
Policymakers still do not have a complete understanding of the web created by corporate debt, or the presence and size of knots within it, especially where these have already been partially unravelled by existing macroprudential reforms. Further unravelling may not be possible, but cutting debt threads comes with costs. Debt allows companies to smooth away short-term shocks and invest over the longer term, as well as providing a mechanism to allocate economy-wide resources to the most beneficial projects. With UK corporate debt close to historic highs and debt-servicing pressures mounting, the benefits of removing these knots, the costs from any restrictions on debt, and the alternatives for additional unravelling, would be useful areas for further consideration.
Emily Clayton works in the Bank’s Strategy and Projects Division and Martina Fazio works in the Bank’s Macro-Financial Risks Division.
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