BankingCorporate to Bank RelationshipsHow exposed are banks if corporate debt starts to crumble?

How exposed are banks if corporate debt starts to crumble?

In the face of mounting concern over global levels of corporate debt, Richard Crecel, Executive Director at Global Credit Data, argues that banks, at least, are well positioned to manage corporate defaults.

At the beginning of April, the International Monetary Fund (IMF) warned that high levels of corporate debt across nearly three quarters of the global economy are threatening financial stability and amplifying any potential economic downturn. It is not a lone voice. In February, the Organisation of Economic Co-operation and Development (OECD) announced that companies around the world find themselves needing to refinance or repay as much as US$4 trillion over the next three years.

It’s a situation that raises an important question. What happens if corporates start defaulting on the high levels of debt they’ve incurred? And how well placed are banks to manage the impact? Global Credit Data’s latest report on loss given default (LGD) for large corporate borrowers (those with a consolidated turnover of more than €50 million) sheds some light on this.

The results show that banks recover, on average, 76% of debts owed by large corporate borrowers after default. In most cases, banks will recover nearly all of the outstanding amount on a defaulted loan. When this isn’t the case, however, they recover almost nothing. Partial repayment is possible but is markedly less common than the two extremes.

These are not one-off figures either. Confirming the results of the previous year – and based on a reference data set reaching back 14 years – the report incorporates data from 10,373 defaulted borrowers, 18,465 facilities and 58 lenders from right across the globe. What’s more, all the data involved has been cleaned, submitted and periodically checked and improved by each lender to ensure reliability.

These are, therefore, reassuring results (though the global outlook for corporate debt remains worrying), indicating that banks are well positioned to absorb corporate defaults without incurring damaging losses. For comparison, the Basel Committee on Banking Supervision (BCBS) requires a recovery rate of just 55% under the Foundation IRB approach.

Why are recovery rates so high?

What is it that ensures banks are able to consistently recover this level of defaulted debt? The survey shows that collateral and seniority remain important tools in this respect – maximising recovery and minimising LGD. Banks commonly require corporate clients to front collateral, such as real estate, inventory or receivables, which the bank can claim and sell in the case of a default. And the data confirms, for the second year in a row, that secured LGDs are lower than unsecured (22% vs. 27% on obligor level).

Banks also use seniority of debt – that is, priority rights to repayment in cases where the corporate defaults on its debt to several parties and only has the assets to repay certain parties. Again, the LGD report shows this to play an important role – with senior unsecured debt posting an average LGD of 24%, compared to 36% when subordinated.

How long does it take to recover defaulted debt?

The report also shows that the time banks take to recover defaulted debt is quicker than might be expected. While time to resolution is two years on average, the average time to recovery (TTRec) – the average period between default and cash flow payment weighted by the amount of the payment – is only 1.2 years. TTRec is a more objective measure of the time in default, being dependent only on the time to cash flow, rather than being influenced by choices made by the bank involved. Because of this, it represents a useful tool for understanding the effect of discount rates on LGD. Interestingly, outcomes for TTRec are remarkably similar across differing collateral and seniority states.

Vulnerabilities in both the world’s financial sectors and households are much higher today than they were at the time of the last financial crisis, and fears remain widespread that bankruptcies and defaults could amplify any economic downturn.

These are real and valid concerns. Yet the latest figures on LGD provide a degree of reassurance. Recovery rates are high and unlikely to drop significantly – even during the financial crisis of 2008 to 2009 they only decreased to an average of 69%, according to Global Credit Data’s historical records. In general, then, banks have adequate recovery strategies in place to deal with any defaults that arise.

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