Corporate bankruptcies are expected to rise as credit support measures are wound back, some sectors downsize, and firms run out of liquidity buffers.
The BIS (Bank for International Settlements) has released its latest Quarterly Review, in which it highlights a further strengthening of risky assets from December 2020 to February 2021.
“This buoyancy was set against a backdrop of continued strong monetary accommodation, growing expectations of fiscal stimulus, and cautious but fluctuating optimism about recovering from the pandemic,” the BIS said.
“Elevated risk appetite was reflected in continued strong corporate debt issuance, especially by lower-rated firms.”
According to the BIS, the all-time highs reached by many stock indices in February “[revived] memories of the late 1990s tech boom as retail investors flexed their increasing influence on market dynamics.”
The BIS notes that stock returns are more sensitive to monetary policy news in periods of low interest rates and high P/E ratios, and that retail investors are also increasingly exerting their influence on equity markets, where “substantial and erratic activity” can amplify price volatility.
Broadly positive sentiment towards emerging market assets was observed, particularly in East Asia, amid a search for yield that supported portfolio flows into these economies, the BIS says.
The BIS also examines banks’ loan loss provisioning during the Covid crisis, saying the initial shock triggered “significant upward revisions” to banks’ forward-looking assessment of credit losses. For a sample of 70 large, internationally active banks reporting under ECL accounting, provisions totalled USD 161 billion in the first half of 2020, compared with USD 50 billion in the second half of 2019.
However, as the economic outlook improved in H2 2020, banks reduced their quarterly provisions, with some even taking negative provisions. In Q3, the total provisions of the banks in the sample declined to USD 29.5 billion, approaching pre-Covid levels.
By year-end, the 57 banks that had published fourth quarter financial data took an aggregate of USD 20 billion in provisions, with six banks announcing a reduction in loan loss reserves, though the reductions remained “substantially smaller” than the amount of loan loss reserves added during the previous three quarters.
The BIS Quarterly Review features an analysis of withdrawals from money market funds in March 2020, which found that large investors paid little attention to the liquidity conditions of individual funds, and portfolio managers responded to the surge in redemptions by hoarding liquid assets.
An additional report has found that the dollar liabilities of non-US banks grew in 2020, despite market stress and a decline in funding from US and offshore money market funds. Non-US banks are said to have witnessed a shift in US dollar funding sources to other non-bank financial institutions.
Meanwhile an examination has found that the arbitrage mechanism behind bond ETFs can help to absorb market shocks. While this mechanism is weaker than for equity ETFs because of the illiquid nature of bond trading, it results in differences between baskets and holdings that can serve as a “stabilising force during runs and prevent fire sales”.
A separate analysis explores how much stress the pandemic could put on corporate credit in G7 countries, Australia and China, suggesting that credit loss rates could be lower than during the 2007–09 GFC, because the sectors most affected by the pandemic account for a smaller share of total corporate borrowing.
Yet, the analysis projects that bankruptcies stemming from Covid-19 could result in credit losses up to USD 1 trillion, beyond what would have been expected in the absence of the pandemic.
While corporate bankruptcies remain “fairly low” in most countries, despite the sharp decline in economic activity, they are “expected to rise as measures to support credit are wound back, new consumption habits and business practices accelerate the downsizing of specific sectors, and some firms run out of liquidity buffers”.
“The looming increase in corporate bankruptcies will generate credit losses that will need to be absorbed, either by the financial system or by taxpayers.”
In China, economic activity is projected to be just 1 percent below its pre-pandemic trend by early 2022, while Australia is projected to experience the fastest recovery among advanced economies due to low Covid-19 infection rates.
China is among the countries with the highest levels of corporate credit, equivalent to more than 100 percent of GDP. However, the increase in credit losses is most contained in the country, projected to amount to just 0.7 percent of annual GDP (compared to 5.1 percent in the UK).