Small firms and the COVID-19 insolvency gap

COVID-19 and its unprecedented economic impacts have ground economies worldwide to a halt. As a result of the early lockdown measures to contain the spread of the virus, many companies faced reduced business activity and declining sales, which had an immediate impact on their liquidity positions. Indeed, both the negative demand shock paired with a negative supply shock in most industries have put numerous companies under severe pressure to keep their operations afloat. Previous crises have taught that small entrepreneurial firms are particularly prone to considerable liquidity constraints in deep recessions. For example, literature on the financial crisis of 2007–2009 shows that especially small and entrepreneurial enterprises were exposed to a severe liquidity crunch due to the collapse of the interbank market and its negative impact on corporate lending (e.g. Cowling et al., 2012; Iyer et al.2014; Lee et al., 2015; McGuinness & Hogan 2016). In the COVID-19 crisis, the early effects of the combined negative supply and demand shock are also characterized by a deep liquidity shock in the real economy. The decline of trading activities and lack of business revenues made many firms dependent on their cash reserves in order to meet their unchanged fixed cost obligations. As smaller and entrepreneurial companies are characterized by strong dependence on internally generated funds to capitalize their business and provide the liquidity needed to finance day-to-day operations, both their cash reserves and collaterals for external financing are generally limited (Cowling et al., 2020). In times of financial distress as in the current COVID-19 crisis, this makes small ventures particularly vulnerable to financial insolvency (Fairlie, 2020; Bartik et al., 2020). Recent research suggests that severely affected small entrepreneurial ventures even seek for alternative financing methods such as bootstrap financing to keep their businesses alive (Block et al., 2021). Trapped in a situation of thin capital reserves and lack of collaterals for drawing new credit lines, small firms face therefore a particularly high risk of business failure without the relief through policy intervention.

Aware of the far-reaching consequences of a wave of corporate insolvencies, governments in almost all countries have initiated a series of emergency measures to strengthen liquidity positions of their national companies, some of which exclusively focusing on easing the burden of Small and Medium-sized Enterprises (SMEs) (OECD, 2020a). In the European Union (EU), for instance, member states’ liquidity support in form of public loan guarantees and tax deferrals for distressed sectors has increased by an estimated 6 percentage points (pp) of EU GDP compared to pre-crisis levels (Council of the European Union, 2020). In most countries, policy measures have gone beyond deferrals and loan guarantees, including instruments such as wage subsidies and adjustments in bankruptcy regimes. While there is no doubt that a strong policy response was necessary to keep the struggling economy afloat, the need to respond quickly and the sheer volume of firms seeking assistance left little time for policymakers to assess the viability of firms that received early government support. Thus, many of the early policy measures were not only unprecedented in scale but also largely granted indiscriminately with the primary focus to avoid corporate bankruptcies.¹ Even though some programs’ eligibility criteria are formally linked to pandemic-induced financial distress only, information asymmetries make drawing a line often difficult in reality. We argue that these circumstances have favored a substantial backlog of corporate insolvencies as policy measures have also kept otherwise insolvent firms in the market. This phenomenon is referred to as insolvency gap in the remaining of the paper.

The central purpose of this study is to analyze whether the early policy response has indeed induced such an insolvency gap and, if so, by which firms the gap is mainly driven. We do so by incorporating the Schumpeterian cleansing effect usually observed in economic crises into our analysis. In Schumpeterian economics, crises are typically seen as cleansing mechanism forcing unviable firms out of the market thereby efficiently reallocating resources to more productive companies. Our hypothesis is that this cleansing mechanism is strongly compromised by the undifferentiated policy response which favors the survival of otherwise unviable firms. Since in times of crises small firms tend to be particularly prone to liquidity shortages, we believe that the risk of unviable ‘survivors’ is especially high among smaller enterprises. The strong policy focus on SMEs in many countries (OECD, 2020a) reinforces this hypothesis. Finally, it is likely that the prolonged expansion prior to COVID-19 along with the low interest rate environment have already accumulated a substantial number of financially weak companies before the pandemic (Barrero et al., 2020). Normally, the COVID-19 crisis would have been a ‘natural’ mechanism to force such ailing firms out of the market. Given the interplay between prolonged expansion and sudden economic decline paired with a strong policy response, our hypothesis is that the insolvency gap is strongly driven by small firms with weak financial conditions prior to the crisis.

Our contribution to the fast growing literature on the economic effects of the COVID-19 crisis is manifold. First, we examine the heterogeneity with respect to firm size in policy makers’ response to the risk of large-scale business failures. Second, we translate Schumpeter’s theory of the cleansing effect in economic crises into an empirical assessment by estimating the size of a policy-induced insolvency gap using firm-specific credit rating data combined with information on insolvency filings. Controlling for updates in a firm’s credit rating, we estimate the insolvency gap induced by the COVID-19-related policy measures using a potential outcome setting. Based on pre-crisis observations of no policy intervention comparable firms with closely matching changes in their credit rating are used as control group for the estimation of counterfactual insolvency rates. Finally, we discuss the consequences for entrepreneurship if efficient resource reallocation and business liquidation are compromised.

The remainder of the paper proceeds as follows. Section 2 gives an overview of the relevant literature. In Section 3, we discuss the different COVID-19 support instruments for firms in Germany and emphasize their different orientations depending on firm size. Section 4 introduces the data sources and variables used to estimate the insolvency gap. Moreover, the framework for the matching of counterfactual survival states is introduced. Section 5 empirically examines the adverse impacts of the pandemic and its heterogeneity across firms of different size and sector affiliation. Moreover, it presents the empirical results of the insolvency gap estimation. Ultimately, Section 6 discusses the implications of our results and concludes.

The fast growing literature on business failures in response to the adverse economic impacts of COVID-19 stresses that the early assistance packages may bare high economic costs if they keep unviable firms alive (Kalemli-Ozcan et al., 2020; Barrero et al., 2020; Cowling et al., 2020; Juergensen et al., 2020; OECD, 2020b; Didier et al., 2021). Kalemli-Ozcan et al. (2020), for example, find for a number of European countries that without appropriate targeting of policy instruments, the fiscal costs of intervention and the number of ‘ghost’ firms kept alive are substantially higher compared to a scenario in which policies target only ‘viable’ firms. Besides the direct fiscal costs associated with indiscriminate policy interventions, there is yet another source of economic costs associated with keeping unviable firms alive. In Schumpeterian economics, this may also impede the cleansing effect of creative destruction (see, for example, Legrand 2017 and in the COVID-19 context Barrero et al., 2020; Guerini et al., 2020). This effect describes a process in which resources are reallocated from less efficient and less creative firms to more efficient ones enhancing overall economic productivity and innovation (Schumpeter, 1942). Typically, this process of efficient resource reallocation is particularly strong in times of economic crisis, allowing viable and innovative firms to gain market share as unprofitable firms exit the market (Caballero and Hammour, 1994; Archibugi et al., 2013; Carreira & Teixeira, 2016). As such, without the intervention of fiscal policy, business failures of unviable firms are expected to be substantial in economic recessions and, given the strong vulnerability of small and entrepreneurial firms, the effect is expected to be particularly pronounced among smaller businesses. In the current crisis, however, there is growing public concern that this process of creative destruction and ‘cleanse out’ of unviable firms is seriously hampered by an increasing policy-induced ‘zombification’ of the economy (see, e.g., The Economist 2020a; The Washington Post 2020). Analyzing only the short-term effects of policy aid on firm survival, we do not want to go as far as speaking of a zombification which typically refers to situations in which credit misallocation by banks sustains the survival of de facto insolvent firms over a longer period of time. Still, we hypothesize that the early policy measures with strong focus on SME relief induced an insolvency gap, defined as backlog of corporate insolvencies which are usually to be expected in a crisis like this.

If efficient resource reallocation and business liquidation are compromised through policy interventions, this has immediate consequences on entrepreneurship. Focusing on Germany, a country where liquidity support for SMEs has not only been particularly strong by international standards (Anderson & et al., 2020; OECD, 2020a) but also been accompanied by a temporary suspension of the obligation to file for insolvency (Federal Ministry of Justice and Consumer Protection, 2020), we identify the insolvency law as an important institutional determinant for entrepreneurship dynamics. Past literature has shown that (changes in) the institutional environment have an important influence on entrepreneurial outcomes (Baumol, 1990; Acs et al., 2008; Peng et al., 2010; Levie et al., 2014; Chowdhury et al., 2015; Arcuri & Levratto, 2020) determining both entrepreneurial exit but also firm entry (Melcarne & Ramello, 2020). Empirical results suggest that entrepreneur-friendly insolvency laws, characterized primarily by speed and efficiency in liquidation and reorganization processes, have a positive impact on new firm entry (Chemin, 2009; Lee et al., 2011). Moreover, research shows that the design of bankruptcy laws can favor high-growth entrepreneurship (Estrin et al., 2017; Eberhart et al., 2017). In fact, entrepreneurs seem to incorporate the efficiency of insolvency legislation into their founding decision as regions with faster liquidation proceedings appear to be associated with higher levels of business formations and firm growth (García-Posada & Mora-Sanguinetti, 2015; Melcarne & Ramello, 2020). However, entrepreneur-friendly insolvency laws can also have adverse impacts on start-ups and SMEs as refinancing costs may increase and access to credits is tightened by banks accordingly (Djankov et al., 2007; Berger et al., 2011; Rodano et al., 2016). On the exit side, literature points out that changes in the design of insolvency legislation strongly determine which type of firms predominantly initiate insolvency proceedings. In the late 1990s, for instance, various European countries have introduced formal restructuring procedures to allow reorganization of distressed firms (Brouwer, 2006). It appears, however, that the introduction of formal restructuring has barely been used by small firms as the costs of reorganization proceedings are often too high for smaller, financially constrained companies (Cook et al., 2001; Dewaelheyns & Van Hulle, 2008). Thus, for small entrepreneurial firms, insolvency declarations often offer no realistic path towards reorganization but are more likely to end in liquidation. Since the prospects of reorganization are low, insolvent small business owners have an additional incentive not to file for bankruptcy, which is why we argue that the temporary filing suspension is disproportionately used by smaller firms.

Besides Germany, further countries such as France, Spain, Luxembourg, Poland, Portugal, Russia and the Czech Republic have temporarily released corporate directors and entrepreneurs from their insolvency filing obligation in response to the pandemic. Other countries such as the USA temporarily raised the debt threshold for small businesses eligible to participate in reorganization proceedings (Gurrea-Martínez, 2020). Using insolvency data on French firms, Cros et al. (2021) find that insolvency rates have substantially fallen below pre-crisis rates. However, they argue that the selection process to file for insolvency has not been distorted during the pandemic because firm characteristics that determine failure and survival have remained unchanged compared to pre-crisis times. For the US economy, Wang et al. (2020) find a sharp decline in insolvency filings among small firms, while bankruptcy proceedings among large firms remain at normal levels. Despite the eased access to reorganization for smaller firms, they suggest that small businesses see insolvency proceedings only as a last resort because successful reorganization is unlikely and often too costly. In general, official figures show that corporate insolvency numbers after the outbreak of the crisis have strongly decreased compared to 2019 levels especially in countries which implemented changes in their insolvency frameworks (see Fig. 7 in the Appendix). This underpins the idea that the large-scale governmental support programs have, indeed, led to substantial distortions in business dynamics. Clearly, the suspension has allowed entrepreneurs with viable business models to stay in the market and use public liquidity subsidies to avert insolvency. But at the same time, if unprofitable firms do not exit the market because they are not required to do so, the efficient reallocation of resources is impeded. Access to skilled human capital, physical resources such as office space, and bank loans is limited for newly entering firms when unviable firms congest the market. This may prevent future entrepreneurs from starting up, but can also discourage existing entrepreneurs from initiating new, more promising ventures. Hence, we assume that an insolvency gap along with a further prolongation of aid measures in the ongoing crises is likely to result in a decrease in entrepreneurial activity in the longer term.

Official figures show that in Germany, the fiscal policy response to prevent corporate insolvencies due to crisis-related liquidity bottlenecks is particularly pronounced by international comparison. According to a comparative study of the economic think tank Bruegel, nearly 40% of Germany’s 2019 GDP was spent on COVID-19 measures to strengthen companies’ liquidity positions (Anderson et al., 2020). Compared with a number of selected OECD countries, this is the second strongest response in terms of a country’s overall economic performance (see Fig. 6 in the Appendix). In fact, the German Federal Government itself describes the response as the ‘largest assistance package in the history of the Federal Republic of Germany’ (Federal Ministry of Finance 2020d, 3).

From a small business economics view, it is interesting to see that a number of intervention measures adopted by the German Federal Government have been specifically designed to target SMEs (OECD, 2020a). In the following, we describe the policy instruments to counter the economic impacts of the COVID-19 crisis in more detail, focusing on how the instruments differ with respect to firm size (for a quick overview of the measures and possible effects on corporate insolvencies the reader is referred to Table 10 in the Appendix).

The ongoing COVID-19 crisis has placed a special role on policy in order to soften the adverse economic impacts faced by many firms. There is little doubt that, in the short term, liquidity subsidies and loan guarantees have been necessary to save companies under severe liquidity pressure from insolvency. In Germany, a country where fiscal policy played a crucial role in mitigating the crisis’ impact, liquidity subsidies were accompanied by a temporary suspension of the insolvency regime. While both measures are different in design, they target the same objective: preventing an unprecedented wave of corporate insolvencies. Studying Germany’s policy response, it becomes also apparent that a number of aid schemes were either explicitly designed to save smaller companies or at least implicitly favored the survival of particularly small entrepreneurial firms. This policy environment is the basis for our hypothesis that a substantial backlog of insolvencies has accumulated particularly among SMEs as a result of the COVID-19 policy response. If, however, support schemes postpone or even prevent the exit of financially weak SMEs, there is the danger of negative long-term effects on the entire economy. In fact, in the ongoing crisis it is likely that early liquidity issues increasingly translate into an erosion of firms’ equity. Suspending bankruptcy proceedings of such over-indebted firms over a longer period of time not only is ‘to deny reality’ (The Economist 2020a, 3) but also hampers the efficient reallocation of resources. In this vein, economic crises also serve as cleansing mechanism to release resources from inefficient and non-innovative firms which typically find more productive use elsewhere. The early policy response of the German government not only has been targeted disproportionately at smaller firms but also did so with little screening mechanisms in place (see, for example, Federal Ministry for Economic Affairs and Energy 2020) rescuing companies from insolvency in a fairly indiscriminate manner.

Making use of both survey data and a unique and large dataset of firm-specific credit rating data along with information on firm insolvency filings, we investigate whether the German policy response has indeed caused distortions in the natural cleansing mechanism typically encountered in liquidity crises. While the policy response to the economic impact of COVID-19 in Germany suggests notable differences in firm size, our survey results reveal strong heterogeneity across economic sectors in their exposure to the adverse effects in the current crisis. With these findings, we estimate the extent of an insolvency gap, defined as the deviation of observed insolvency rates during the COVID-19 pandemic and expected insolvency rates based on a counterfactual pre-crisis setting with no policy intervention, for 52 distinct sector-size strata. In line with our hypothesis, our results show that the insolvency gap is particularly significant in the group of micro-enterprises (at most 10 employees) and that the gap gradually vanishes with increasing firm size. Furthermore, we distinguish between financially strong and financially weak firms in our analysis with the latter being defined as companies with below median credit rating prior to the crisis. Thus, we refer to financially weak firms as companies being relatively more vulnerable to default in the current crisis based on their pre-crisis financial standing. Our findings suggest that the backlog of insolvencies is mainly driven by firms with a relatively poor credit rating prior to the crisis. This indicates that particularly financially weak, small firms may take advantage of the less stringent screening processes associated with many of the COVID-19-related policy instruments or absorb the liquidity injections as windfall gains, especially during the first months of the crisis when eligibility criteria were low.

From a welfare perspective, this comes at the burden of high fiscal costs that are associated with granting financial aid to unviable firms. Favoring the survival of financially weak firms as our findings indicate, however, also imposes indirect costs in the longer term as such firms tie up resources whose efficient redistribution would have facilitated entrepreneurship. Past experience shows that keeping distressed firms alive may severely obstruct business dynamism and structural change. Literature on Japan (Caballero et al., 2008), but also on other OECD economies (Adalet McGowan et al., 2018), suggests that granting life-sustaining credit to near-insolvent firms has not only lowered aggregate productivity but also deterred market entry of new entrepreneurs. Although in these cases the survival of insolvent firms is mostly attributed to questionable bank lending practices and not to a crisis-related policy response, some lessons can still be learned from these experiences: keeping unviable firms alive causes severe market congestion which creates barriers to market entry and limits the growth of young companies. The persistence of crisis-induced SME support along with a further prolongation of the (at least partial) moratorium of Germany’s insolvency regime increasingly favors such a market congestion with the risk of creating barriers to entrepreneurship. It is likely that once the policy instruments will cease, i.e. liquidity support will terminate and the German insolvency regime returns back to the filing obligation, a number of small business insolvencies will follow. Without an ‘evergreening’ of policy support it is, however, doubtful if they can be prevented at all. In the ongoing crisis, it will therefore become increasingly important to think about policy measures that remove entry barriers for young and innovative businesses and create growth opportunities for firms which respond innovatively to the pandemic instead of prolonging the survival of near-insolvent firms. For example, policy makers are well advised to consider law reforms that lower the barriers to corporate restructuring for viable smaller firms while streamlining and encouraging liquidation procedures for unviable companies. Past experience suggests that this would stimulate the reallocation of capital to more productive entrepreneurial endeavors (Adalet McGowan et al., 2018).

Understanding the effects of the interplay between liquidity support on the one hand and temporary adjustments to insolvency regimes on the other hand will be an important lesson from the COVID-19 crisis. Does the interplay of these two instruments impair entrepreneurship and economic recovery as it primarily discourages struggling firms from exiting the market or does it, if well dosed, even serve as a useful policy mix in liquidity crises? Our results which only look at the early policy effects in the pandemic suggest the former. It is left to future research to investigate the long-term5 effects on productivity, innovation and entrepreneurship induced by the policy responses to COVID-19.