Restaurant owners, retailers, and the like employ more than 50 percent of the US workforce, yet neither have cash buffers nor access to Federal Reserve support. In the present situation, we do not need to stimulate new business and spending. Instead, policy nowadays should be aimed at stabilizing impaired balance sheets and avoiding business closures via evergreening.
Corporate cash flow is collapsing on an unprecedented scale across wide swaths of the American economy. The service sector and similar sectors that depend on face-to-face transactions are likely to be severely affected by the Covid19 recession.
Yet the current situation is markedly different from a typical recession. While in a typical recession revenues might drop by 10 percent, currently a drop of up to 100 percent is possible. Importantly, the situation facing companies should be viewed as a “pause:” there is nothing to suggest that the service sector is no longer viable, once the Covid-19 recession is behind us.
Large companies can weather the pause through their stock of cash (currently the US non-financial corporate sector holds around $1.5 trillion) and, importantly, they can issue commercial paper, which is bought by the Federal Reserve via its Commercial Paper Funding Facility (CPFF) program.
However, small and medium-sized enterprises (SMEs) such as restaurant owners, retailers, and the like, which employ more than 50 percent of the US workforce, neither have such cash buffers nor access to CPFF. SMEs rely on funding from banks and shadow banks, and such funding is drying up.
The Inverted Economics of COVID-19
The usual policy dos and don’ts are reversed during the Covid-19 crisis. The objective of policy should be to promote the evergreening of loans to carry businesses, esp. small businesses, through their liquidity shortfall. The existing productive structure just needs to be kept alive until the point where the Covid-19 pause lifts. Government programs should use carrots and sticks to provide banks with:
1. positive incentives for banks to evergreen loans, e.g. central bank-provided cheap refinancing for rolling over existing loans.
2. punish banks that do not rollover existing loans, e.g. by strictly enforcing non-performing loan rules. Paradoxically, this is the opposite medicine than economists typically prescribe.
In the typical recession, the Fed lowers interest rates in order to stimulate spending and investment. Evergreening is a problem because it crowds out credit to new firms and spending.
In the present situation, we do not need to stimulate new business and spending. Today’s policy should be aimed at stabilizing impaired balance sheets and avoiding business closures, via evergreening.
Carrot: SME Refinancing Operation (SMERO)
We propose to incentivize the evergreening of existing loans to SMEs by offering lowcost financing from the Federal Reserve against the collateral of these (rolled-over) loans. Evergreen SME loans made by banks will be eligible as collateral for financing at a rate that is x percent less than the discount window rate at the Fed’s discount window at a favorable haircut.
An evergreen SME loan is one that was granted or committed before the start of the Covid-19 pause. Such loans include:
(1) existing callable loans (which could not be extended)
(2) loans that are coming due in the next 3 months
(3) credit line commitments
(4) current floating rate loans which are repaid and refinanced with new debt.
This program is sizeable, as banks currently extend approximately $600 billion of SME loans. The SMERO proposal will significantly ease the debt service costs on eligible SME loans.
Without evergreening, these loans will likely go into default. Given the sheer volume of the defaults, the standard bankruptcy and liquidation process will be inefficient resulting in low recovery values. In contrast, large-scale evergreening will likely lead to higher recoveries for lenders. In short, our SMERO proposal can thus be a win-win for both borrowers and lenders.
Stick: Nonperforming Loan Enforcement & Bankruptcy Delay
In the typical recession, policy is concerned that banks will evergreen loans in order to avoid having loans classified as non-performing and impinging on bank capital.
This private incentive to evergreen crowds out new credit and worsens macroeconomic outcomes. In the Covid-19 recession, however, evergreening is optimal; hence, we propose that regulators announce that they will act more strictly in classifying loans as non-performing. This stick will induce banks to evergreen.
This policy only requires a minor adjustment of Basel bank regulation rules and central bank policy.
Similarly, in a typical recession, a swift bankruptcy procedure is important to promote creative destruction. While we have noted that without intervention into SME credit, there is likely to be a large volume of bankruptcies that will lead to an inefficient process, we suggest that policy should aim to exacerbate this inefficiency.
Creditors should see bankruptcy as a poor outcome and policy should aim to slow down bankruptcy proceedings.
Markus Brunnermeier is the Edwards S. Sanford Professor of Economics and Director of the Bendheim Center for Finance at the University of Princeton. Arvind Krishnamurthy is the John Osterweis Professor of Finance at the Stanford Graduate School of Business and a Research Associate at the Nationa Bureau of Economic Research (NBER).
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