Tolerance Loans as a Crisis Management Tool – Bank Underground

Isabel Roland, Saikyo Shinichi, Philip Schnatatinger

Bank of England Research Agenda (Bear) Set up important areas of new research at the bank for the next few years. This post is an example of the issues considered below Prudential Architecture Theme It focuses on evolving regulatory structures and fresh strategic issues for regulators and supervisors.

Corporate credit market interventions have been prominently featured in policy responses to crisis episodes over the past 20 years. Loan tolerance works prominently between interventions by lenders and/or regulatory authorities. This is a practice that provides temporary relief to struggling borrowers in order to avoid default. To balance, the literature criticizes loan tolerance in the corporate sector as it may contribute to zombification. This is a situation in which bank loans continue to live off-productive businesses and reduce overall factors productivity. Our new results paper Evacuation loans combined with business restructuring plans show that they can provide temporary relief to struggling companies, temporary relief for production and employment protection without contributing to zombification in the corporate sector. Note that our research focuses on the effects of tolerance on the corporate sector. The effect of tolerance on lenders is another question outside the scope of our paper.

Small and Medium Enterprise (SME) Finance Facilitation acts as a semi-experimental environment

With us the studywe focus on the evaluation of a unique large-scale corporate tolerance scheme, namely, Japan’s Small Business Financing Promotion Act. At the same time, the regulator revised supervision guidelines that allow financial institutions to exclude these restructured SMEs from reported non-proven loans, provided that they have developed a business restructuring plan that is expected to be published again within five years. Although no formal penalties were imposed on the bank to reject the application, almost all requests were accepted and reflects informal pressure from the government to ensure that the bank accepts all applications.

Policy Evaluation Framework

Analyze your policy in four steps. First, we develop a search and matching model for the credit market that banks have incentives to ban. Second, we use company-level data from Tokyo Shoko Research (TSR) to estimate the impact of policies on average loan interest rates paid by companies using model-derived variance (DID) specifications. To that end, we use research data from the Research Institute’s Economics, Trade Industry (RIETI) to construct a measure of corporate level exposure to policy. Third, we perform envelope counterfactual exercises based on interest rates using models and estimated annual treatment effects. If no policy is in place, ask yourself what happens to total capital stock, production, and capital productivity. In other words, it removes the annual interest rate subsidies generated by the policy, allowing the company to adjust its capital and labour inputs in response to the resulting changes in capital costs, and calculates the total capital stock, capital productivity, and output produced in this counterfactual economy. Next, compare them with the observed equivalents. Finally, we will look into whether ACT has used the DID framework to contribute to the creation of zombie companies.

Tolerance has generated substantial credit subsidies

Chart 1: Event Study Plot – Treatment Effects on Average Interest Ratess

Note: Chart 1 shows the average loan interest rate from DID estimates, i.e. coefficients for the interaction between the annual dummy variable and treatment exposure, and the coefficients for the 95% confidence interval. For example, a coefficient of approximately -0.4 in 2010 corresponds to a law that reduces the average interest rate for that year by 40%.

Plot the estimated effect of the policy on the average loan interest rate for chart 1. Although there was no significant impact before the law was passed between 2007 and 2008, it can be seen that the law served as an interest rate subsidy since 2010. On average, it reduced interest rates for companies receiving treatment by around 18.5% over 2010-188. The effect is large in the year close to the implementation of the act and disappears over time. The effect switched signatures and tested positive in 2017, reflecting the weakening of tolerant incentives over time. In fact, most tolerance is in the form of temporary payment deferrals (as opposed to forgiveness of debt). Companies that received payment deferred experienced a period of subsidized credits before returning to higher interest rates (which could be higher than before the policy).

Credit subsidies boosted intensive capital stocks at the expense of productivity

Table A: Aggreagte counterfactual

Note: Table A shows the results of deleting the annual treatment effects shown in Chart 1. Percentages indicate annual deviations between counterfactual aggregate output, capital stock, and capital productivity and their observed equivalents. For example, -4.22% of capital stocks in 2010 means that capital stocks would be 4.22% lower in 2010 if no policy was in place.

The counterfactuals in Table A show that cheap credit has boosted gross capital stocks at the expense of gross productivity. The ACT increased total capital stock by 1.4% and increased capital productivity by 0.5% from 2010 to 2018 on average. The scope of the credit real location determines whether the policy leads to profit or loss on the output. We carry out counterfactuals under two scenarios as to what will happen to the capital city that has been released by the removal of the annual grant. First, we assume that capital released from the dealtated companies is not reassigned to other companies. Second, we assume that the released capital is seamlessly rearranged into firms that produce at counterfactual gross capital productivity (i.e., total productivity of unprocessed companies). In the first scenario of a modest credit real location, it is estimated that the law increased its output by 2.5% on average. In contrast, if you are expecting a seamless credit real location, the law is estimated to have dropped by 1.5% on average. As capital redistribution is environmental and so it is falling during a recession, the first scenario is plausible and provides an upper limit estimate of the output gain.

Tolerance did not contribute to the zombification of the corporate sector

Finally, we will look into whether this law contributed to the creation of zombie companies. More specifically, we consider the impact of policy on exits, total factor productivity (TFP), interest defined as interest defined as revenue before interest and tax (EBIT), and the likelihood that a company will be classified as zombies. Zombie companies are typically identified by a set of criteria, in the form of subsidized credits, indicating both financial difficulties and ongoing support from lenders. On the one hand, we found that this policy reduced debt retention pressure (i.e., increased ICRS) and reduced the likelihood of bankruptcy. Meanwhile, the policy has improved corporate-level TFP, and surprisingly reduced the likelihood that companies will be classified as zombies. In other words, the policy achieved the stated goal of supporting the SME sector without contributing to zombification. This suggests that implementing the mandatory business restructuring plan is a prerequisite to avoid loan classifications that contribute to the recovery of poor SMEs as bad.

Policy insights

Our results contribute to the literature by challenging the view that loan tolerance necessarily contributes to the zombification of the corporate sector. Importantly, when combined with business restructuring plans, evacuation is a solvent and can provide temporary debt relief to struggling businesses recovering from temporary shocks. In other words, carefully designed credit market interventions based on tolerance could be used as part of the policy toolkit to address serious stress episodes in the corporate sector, particularly those that involve disruption in the credit market. As long as banks grant toleranty to viable companies, such interventions can allow for late-term limited to overall productivity while limiting the negative impact on late-term productivity.

Isabel Roland works in the Macro Financial Risk Division of Banks, Saikyo Yuko, Faculty of Political Science and Economics, Waseda University, Tokyo, and Philip Schnuttinger I work in the Structural Economics division of the bank.

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