Financing Scotland's recovery: analysis

Part 2: Financing Business Survival and Resilience

Introduction

Recapitalisation is a term that has gained traction in recent months; used frequently by economists, bankers and policymakers who sometimes appear to mean different things. It is therefore important to be clear about what we mean by it. In my estimation, recapitalisation refers to the package of measures required to help the economy recover from diminished revenues and new exposure to debt. To succeed, any recapitalisation package must therefore achieve two objectives:

• managing debt exposure to prevent it from causing businesses to fail on a mass scale; and
• providing access to new capital to drive recovery, where opportunities exist, through investment in growth, sustainability and innovation.

In Part 2 of this advice I focus on the first of these criteria: aiding business survival and resilience through effective debt management. As we shall see, while most discussions of this recapitalisation tend to focus on injecting capital into the economy, it is just as important for Governments to consider how best to manage the extraction of capital by intelligently managing the timing, intensity and methodology of debt recovery.

The issues explored in Part 2 are mass scale, economy-wide challenges that impact upon businesses of every size and sector. For that reason, they are matters best addressed through the fiscal and regulatory levers available to the UK Government. In some cases I am aware that work is already underway to consider how these challenges should be addressed. The imperative for Scottish Ministers is to influence this work, ensuring that it is sufficiently ambitious and responsive to the needs of the Scottish economy. I have framed my analysis accordingly, proposing a set of positions which, together, can act as a new and credible engagement agenda for Scottish Ministers to press with their UK counterparts.

Engagement Objective 1: Extend Forbearance

A convergence of timelines brings specific risk to the Scottish economy in the first half of 2021. Businesses will face a ‘cliff edge’ at which furlough and other support schemes end just as repayments on loans and deferred taxes begin to fall due. This double pressure will emerge against the backdrop of the economic ‘long-COVID’ phenomenon described earlier.

In many sectors, revenues will take time to recover as supply chains ramp back up, order books refill, household finances recover and consumer behaviour reverts to something resembling normality. The scars of the pandemic will weaken the ability of businesses to drive recovery, with increased debt dampening investment and acting as a drag on job creation and productivity. The uncertainty and additional economic disruption caused by EU exit will compound these challenges.

This will trigger an inflection point, at which we will see a crystallisation of unsustainable debt, defaults and significant levels of business restructuring and failure. This, in turn, will impact upon jobs and household finances. As the evidence presented demonstrates, it is near certain that these consequences will have sectoral and regional dimensions.

We therefore welcome the introduction of the UK Government’s Pay As You Grow scheme which will help companies better manage their Bounce Back Loan repayments, although this facility has not yet been extended to other Government backed loan schemes; rather than extracting capital at precisely the moment businesses need it most to retain jobs and trade their way out of a post-pandemic, post-Brexit crisis. This was a message that came through strongly in all of the engagement that we have had with businesses of multiple sizes and across multiple sectors.

Engagement Objective 2: Extend the Trade Credit Insurance Guarantee beyond 30 June 2021

Trade credit insurance (TCI) plays a critical role in underpinning business-to-business transactions. It provides cover for businesses if customers who owe money for products or services do not pay their debts, or pay them later than agreed payment terms dictate. It gives businesses the confidence to extend credit to new customers and improves access to funding, often at more competitive rates.

The Trade Credit Insurance (TCI) Guarantee Scheme, introduced by the UK Government in June 2020, ensures that TCI products remain available and affordable. While it has attracted less attention than the more high profile loan schemes, businesses are clear that the TCI has been a significant help in supporting them to maintain productive capacity.

Initially this Scheme was due to end in December 2020 but it has now been extended to 30 June 2021. While this is welcome news, trading conditions are unlikely to have returned to normal by this stage and the risk of businesses failing to pay invoices will increase over the full course of 2021. It is likely that TCI products will become scarce and expensive, eroding confidence in business-to-business transactions. This makes a further contribution to the cliff edge scenario in which withdrawal of support and new cash pressures coalesce.

Recommendation 1: The Scottish Government should seek to work with the UK Government to develop a route map that more strategically schedules the repayment of loans and deferred taxes, and Scottish Ministers should consider pressing for a longer extension of the Trade Credit Insurance Guarantee Scheme.

While those who can pay should be encouraged and incentivised to do so, the objective of this route map is to avoid an economy-wide cliff edge, potentially in a way that is sensitive to the acute challenges faced by particular sectors and regions, and which takes account of the need to incentivise innovative companies to invest for growth.

Engagement Objective 3: Secure flexible repayment terms

As part of the Winter Economy Plan, the UK Government announced changes to the repayment terms of both BBLS and CBILS. BBLS can now be repaid over six years, with the option to pause payments for up to six months and to revert to periods of interest only payments. The Chancellor’s February 2021 ‘Pay As You Grow’ announcement introduces further flexibility in allowing firms in receipt of Bounce Back Loans to extend the term period from six to ten years.

Whilst these measures have been welcomed by business, it is arguable that they do not go far enough and that there is scope for more flexible arrangements that can be tailored to the needs of individual businesses, sectors and localities. For example, for the owners of very small businesses there is often little distinction between their personal and business finances – business distress translates to household distress.

For businesses of this kind, especially where they are otherwise viable and provide employment, there is an argument for a student loans style approach, in which repayment is dependent on tests of revenue and affordability.

For larger, more innovative businesses the imperative is to encourage them to drive recovery through investment in growth and job creation. For many, this will require access to additional debt finance and it is important that lenders have the flexibility to consider these matters in the round, e.g. to offer businesses the opportunity to restructure and re-profile coronavirus debt to unlock the capacity to invest.

More generally, it may be helpful to offer banks and other lenders the discretion to use their knowledge of local markets and relationships with customers to craft individualised solutions that would strengthen business resilience and potentially reduce the risk of defaults. Such discretion could be an effective means of diluting and more thinly spreading economic risk, avoiding the economy-wide cliff edge earlier described.

Engagement Objective 4 – We need a framework to fairly manage and recover coronavirus loan debt

However much we seek flexibility and delay, the reality is that repayments will require to begin sometime and, inevitably, there will be businesses who find themselves unable to pay. It bears repeating that the scale of the risk is unprecedented – anywhere between 35% and 60% of borrowers may default on BBLS alone^[25].

Despite the imminence of this risk, there remains uncertainty over the UK Government’s expectations of lenders in relation to recovery processes and how, for example, the guarantees underpinning loan schemes will work in practice. As well as causing confusion for lenders and businesses, this leaves open the possibility of lenders adopting inconsistent approaches to recovery, raising questions of fairness for customers and possible reputational damage to institutions.

This issue matters for other reasons too. As the evidence I have presented makes clear, the profile of the Scottish economy is such that default trends are likely to emerge on a sectoral and geographic basis e.g. tourism businesses in the North. It is therefore important that Governments and banks reflect carefully on how is the recovery procedures deployed in pursuing repayment may impact upon communities and livelihoods. The potential for defaults on an unprecedented scale also presents challenges of a more practical nature and it is unclear whether these have benefitted from sufficient thought.

Due to sheer volume, distress and recovery processes will require to be streamlined and, in the interests of fairness, it is important that businesses have the opportunity to seek the appropriate advice e.g. from turnaround specialists whose expertise can help restore viability and from insolvency practitioners who can help salvage jobs and value from distressed businesses.

It is presently unclear how such expertise could be made available at the scale necessary – making reducing the risk of default all the more important.

Recommendation 2: The Scottish Government should consider pressing UK Ministers on the creation of a comprehensive, nationally agreed framework for the management of debt incurred as a result of the pandemic. Such a framework should:

• Provide a flexible repayment model allowing for lender discretion that is sensitive to business size, communities and sectoral impact.
• Provide the opportunity to refinance or restructure coronavirus debt in circumstances where it encourages access to growth capital.
• Consider a student loan style model for small businesses, with payments contingent on income and deducted through the tax system.
• Ensure that recovery processes are clear, fair and universally applied.
• Outline streamlined and sympathetic insolvency procedures that offer a ‘soft landing’ for distressed businesses, including tackling the issue of mass access to turnaround and insolvency expertise.

The Banking Barometer should be used to monitor the performance in Scotland of such a framework over time.

Engagement Objective 5: Ensure that successor loan schemes are ambitious, flexible and responsive to the needs of the Scottish economy.

The UK Government and lenders will require to adapt to a new economic reality, requiring flexibility and new models for considering the question of viability and the risk of new debt in circumstances where many SMEs are already heavily leveraged. A key element of the solution is to ensure that well-designed successor schemes are in place to bridge the gap between the end of CBILS and BBLS and the return of normal market conditions. The Chancellor’s Winter Economy Plan acknowledged as much with its commitment to a reformed Enterprise Finance Guarantee Scheme^[26]. In the following recommendation I highlight some of the key features that may be desirable in such a scheme if it is to act as an effective support for Scottish businesses.

Recommendation 3: The Scottish Government should seek to influence the discussions between HM Treasury and UK Finance over the design of successor loan schemes, ensuring their terms and structure meet the needs of Scottish businesses.

Particular features that Ministers may wish to press for include:

• Responding to the needs of Scotland, where many small businesses will require cheap access to relatively small loans.
• The ability to fairly refinance and restructure coronavirus loans, alongside accessing new capital for growth.
• Replicating the extended repayment terms already introduced for BBLS and CBILS.
• Portability, allowing businesses to refinance and move between lenders as part of their personal recovery plans. This would facilitate competition between lenders, to some extent easing market distortion.
• A flexible approach to underlying scheme rules e.g. a new, post-pandemic model of assessing viability that allows lender risk committees to act with discretion and to more fully consider the circumstances of individual businesses and their markets.
• As far as possible maintaining the significant process improvements seen through the operation of CBILS and BBLS both of which were simple, fast and digital.

• Broadly maintaining the progressive approach taken under CBILS and BBLS to Government-backed guarantees and minimising the need for personal guarantees.
• Ensuring that lender accreditation is extended widely, including to alternative non-bank lenders; fostering competition and ensuring there is adequate coverage in Scotland. This should include the Scottish Government’s own commercial loan schemes.

Engagement Objective 6: Ensure SMEs can seek meaningful redress for unfair treatment

It is important to learn lessons from the 2008 financial crisis when banks received a substantial volume of complaints from SMEs about their handling of broadly similar issues. The industry has changed significantly since that period but it remains important that businesses have access to meaningful redress without resorting to unaffordable legal action. Ministers will wish to note that the banks have collaborated with SMEs to create a new, UK-wide Business Banking Resolution Service (BBRS) which will handle complaints and dispute resolution for smaller SMEs.

It may be useful for Scottish Government officials to engage with the leadership of BBRS to ensure that sufficient coverage is being extended in Scotland.

Supply Chain Pressures

The impact of financial distress often cannot be isolated to an individual business. Distress often carries a contagion effect, where financial pressures and disruption spread quickly through supply chains. For example, if a large firm at the top of a supply chain is unable to access sufficient TCI coverage, this will likely reduce its credit limits. It will then be forced to use cash to pay invoices and will be more careful in its dealings with suppliers: issuing stricter payment terms, calling in invoices from creditors and potentially placing fewer orders. This, in turn, impacts on the credit ratings and behaviours of businesses right through the supply chain, damaging liquidity and weakening the resilience of the entire chain. In some cases, this alone will be sufficient to trigger business failures. The CBI reports that there is already evidence of pressure building in supply chains and EU exit will see that pressure intensify.

Recommendation 4: Banks, business organisations and enterprise agencies should collaborate to identify distressed businesses that play an important role in key supply chains. Once identified, and where appropriate, the Scottish Government should collaborate with the relevant bank and enterprise agency to deliver the strategic and financial support necessary to protect the supply chain.