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Insolvency and debt overhang following the COVID-19 outbreak

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Insolvency and debt overhang following the COVID-19 outbreak


Insolvency and debt overhang following the COVID-19 outbreak: Assessment of risks and policy responses

Lilas Demmou, Sara Calligaris, Guido Franco, Dennis Dlugosch, Müge Adalet McGowan, Sahra Sakha 22 January 2021

A swift response by policymakers across OECD countries has helped businesses to bridge the short-term liquidity shortfalls due to the economic shock following the COVID-19 outbreak, avoiding immediate and widespread insolvency crises (Demmou et al. 2020, Demmou et al. 2021a). However, many countries have now entered a second wave of the health crisis, magnifying even further the economic shock of an unprecedented scale (Boot et al. 2020, Cochrane 2020). This situation, which forces firms to deplete even further their cash and equity buffers and to raise new financing, is likely to translate into two major risks in the medium and long-term: (1) an enduring wave of corporate insolvencies and (2) a ‘debt overhang’ problem, whereby highly indebted companies may forgo even profitable investment opportunities due to limited access to new credit and pressures to deleverage by cutting costs and downsizing. Using a sample of almost one million European firms, we investigate (Demmou et al. 2021b) the likelihood of these two types of risks, and outline options for policymakers to mitigate them.1 

A large portion of firms are predicted to become distressed and will find it hard to service debt, with negative effects on their investment

Using a simple accounting exercise in the spirit of Carletti et al. (2020), we evaluate quantitatively the impact of the pandemic on firms’ long-term viability. The economic shock is modelled as a change in firms’ operating profits, resulting from the sharp reversal in sales and from firms’ limited ability to fully adjust their operating expenses. After calculating the decline in profits, also taking into consideration governments job support schemes implemented during the first phase of the crisis, the model allows us to predict: (1) the share of distressed firms (i.e. firms whose net equity is predicted to be negative), which are at high risk of being insolvent, and the share of firms not able to cover interest expenses; and (2) the increase in firms’ leverage ratios caused by the crisis. 

To proxy the magnitude of the sectoral drop in sales, the analysis relies on the first-round demand and supply shocks computed at a detailed sectoral level by del Rio-Chanona et al. (2020), which notably account for the large heterogeneity in the ability to telework across sectors. With respect to the duration of the shock, the model presents two alternative scenarios. An ‘upside’ scenario foresees a sharp drop in activity lasting two months (equivalent to the average duration of the confinement period in Q2 2020), followed by progressive but not complete recovery in the remaining part of the year. A ‘downside’ scenario initially overlaps with the ‘upside’ scenario but then models a slower recovery due to more widespread further outbreaks of the virus accompanied by stricter mobility restrictions.

The estimated decline in profits is sizeable – on average between 40% and 50% of normal time profits (depending on the scenario considered). Following this sharp reduction, 7% (9%) of otherwise viable companies are likely to become distressed in the upside (downside) scenario (Figure 1). However, these percentages are heterogeneous across sectors and type of firms. Firms in industries that use intangible assets (such as intellectual property, data, or software) intensively are significantly impacted but better positioned to bridge the crisis, while the hospitality, entertainment, and transport sectors are the most severely hit. In addition, older, more productive and larger companies are relatively better positioned to face the shock compared to their younger, less productive and smaller counterparts.

Figure 1 A substantial portion of otherwise viable firms is predicted to become distressed

Insolvency and debt overhang following the COVID-19 outbreak 1

Note: The figure shows the percentage of distressed firms in the upside (triangles) and downside (bars) scenarios for the whole economy (green bar) and by 1-Digit Nace Rev.2 sectoral classification (blue bars). Firms are defined as distressed if their book value of equity is predicted to be negative one year after the implementation of confinement measures. Notice that the sample is restricted ex-ante to firms having both positive profits and book value of equity in the 2018 reference year.
Source: OECD calculations based on Orbis® data.

The reduction in equity relative to a business-as-usual scenario has immediate consequences for firms’ leverage ratios. The ratio of total liabilities to total assets would increase by 6.7 percentage points in the upside scenario and 8 percentage points in the downside scenario for the median firm in the sample (Figure 2, Panel A). In turn, the increase in the level of indebtedness can push firms towards the so-called ‘debt overhang’ risk. When a firm has a high outstanding debt on which the likelihood of default is significant, the reduced incentives to invest and limited access to new credit generates pressure to deleverage by cutting costs and downsizing, even in companies with profitable investment opportunities, potentially slowing down the recovery from the current crisis. 

To assess formally how the rising tide of debt associated with the COVID-19 outbreak would affect investment and to size the potential magnitude of the effect, we investigate empirically the historical relationship between indebtedness and investment over the 1995-2018 period.2 Results suggest that an increase in the debt to total assets ratio comparable to the one predicted by our accounting model would imply a decline of the ratio of investments to fixed assets by 2 percentage points (2.3 percentage points) in the upside (downside) scenario (Figure 2, Panel B). Finally, in the paper we also show that the decline in profits also impairs firms’ ability to service their debt – between 30% and 36% of firms would not be profitable enough to cover their interest expenses.

Figure 2 Leverage ratios are predicted to increase, potentially acting as a drag on investment

Insolvency and debt overhang following the COVID-19 outbreak 2

Note: Panel A shows the percentage points increase in the liabilities to total assets ratio for the median firm of the leverage distribution following the COVID-19 outbreak in the upside (blue bars) and downside (red bars) scenarios. Panel B shows the predicted decrease in the investment to fixed assets ratios under the hypothetical increase in the debt over total asset ratios shown in Panel A for the median firm.
Source: OECD calculations based on Orbis® data.

Policies to support the corporate sector ability to weather the crisis and recover fast

The empirical analysis emphasises that distress and debt overhang of non-financial corporations could threaten the recovery by compromising firms’ ability to invest, suggesting that governments should carefully design support packages in order to limit the increase in corporate indebtedness. Another challenge with respect to policy design relates to the targeting of the support – policymakers need to find the right balance between the risk of supporting potentially non-viable firms against the risk of forcing viable and productive firms into premature liquidation (Laeven et al. 2020). In the current situation, the balance of risks should be tilted in favour of the former. The risk of pushing out of the market many viable firms is indeed particularly high in time of crisis, where uncertainty on the new normal is large and courts are congested. Considering those difficulties to distinguish ex-ante viable from non-viable firms, governments may adopt the following cascading approach, regularly reassessing and adapting support as the economic situation evolves:

  • Support measures should first aim at ‘flattening the curve of insolvencies’ by ensuring that distressed firms have access to additional resources and taking into account a number of considerations when designing policies: 
    • To mitigate debt overhang concerns, measures should increasingly include complementary non-debt financing instruments. Firms could be recapitalised through equity financing instruments, including: (1) equity and quasi-equity injections (e.g., preferred stocks, convertible loans), (2) phasing in an allowance for corporate equity,and (3) debt-equity swaps to provide firms with the required liquidity, without increasing their leverage. Quasi-equity instruments (e.g. hybrids that combine debt and equity-type features) may have to be favoured over common equity because they provide a senior claim to dividends and assets in case of liquidation, and allow companies to raise funds without diluting control.
    • Equity instruments require monitoring and it is difficult for the government to manage a large number of small equity claims. Hence, policymakers could use indirect measures to assist smaller firms. For instance, repayment could be linked to businesses’ returns – firms that recover most robustly would pay back more, in the form of future taxes, while those that struggle longer would pay back less. These instruments would allow the repayment to be state-contingent, mimicking equity injections. 
  • If this strategy proves insufficient, policymakers could encourage timely debt restructuring to allow distressed firms to continue operating smoothly. This would help to coordinate creditors’ claims in a manner that is consistent with preserving the viability of the firm and its capacity to invest going forward. Relevant measures include establishing legal conditions favouring new financing for distressed firms (for example, granting priority over unsecured existing creditors), reforms to insolvency regimes including promoting pre-insolvency frameworks and specific procedures to facilitate the restructuring of SMEs.
  • These two steps aim to reduce the number of viable firms that would otherwise be liquidated. To deal with firms that would still be non-viable despite public support and debt restructuring, governments could improve the efficiency of liquidation procedures to unlock potentially productive resources. Providing the institutional conditions for a fresh start by removing barriers that might push debtors to delay liquidation, in particular by reforming the personal insolvency regime, remains a key challenge in several countries.


Boot A, E Carletti, R Haselmann, H Kotz, J P Krahnen, L Pelizzon, S Schaefer and M Subrahmanyam (2020), “The coronavirus and financial stability”, VoxEU.org, 24 March.

Carletti, E, T Oliviero, M Pagano, L Pelizzon and M G Subrahmanyam, (2020), “The COVID-19 shock and equity shortfall: Firm-level evidence from Italy”, COVID Economics 25.

Cochrane, J H (2020), “Coronavirus monetary policy”, in R Baldwin and B Weder di Mauro (eds), Economics in the Time of COVID-19, CEPR Press.

del Rio-Chanona, R M, P Mealy, A Pichler, F Lafond and J D Farmer, (2020), “Supply and demand shocks in the COVID-19 pandemic: An industry and occupation perspective”, COVID Economics 6.

Demmou, L, S Calligaris, G Franco and D Dlugosch (2020), “Corporate sector vulnerabilities during the COVID-19 outbreak: Assessment and policy responses”, VoxEU.org, 23 May.

Demmou, L, S Calligaris, G Franco and D Dlugosch (2021a), “Liquidity shortfalls during the Covid-19 outbreak: assessment and policy responses”, OECD Economics Department Working Papers, No. 1647.

Demmou, L, S Calligaris, G Franco, D Dlugosch, M Adalet McGowan and S Sakha (2021b), “Insolvency and debt overhang following the COVID-19 outbreak: assessment of risks and policy responses”, OECD Economics Department Working Paper No. 1651.

Laeven, L, G Schepens and I Schnabel (2020), “Zombification in Europe in times of pandemic”, VoxEU.org, 11 October.


1 We use the Orbis dataset (provided by the Bureau Van Dijk) for 14 European countries: Belgium, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Poland, Portugal, Romania, Spain, Sweden and the UK. We assume that the last available data for each firm (end of 2018) represent its financial situation in normal times with respect to its revenues, operating expenses, tax payments and the book value of equity.

2 In the paper we also examine the specific features characterising the relation during sharp downturns by estimating a cross-sectional model comparing the pre and post Great Financial Crisis (GFC) period. Results shows that the effect of a change in debt on investment is heterogeneous across firms. Firms that entered the GFC with a higher financial leverage ratio experienced a sharper decline in investment. Further details can be found in Demmou et al.

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