Ailing banks increase leverage of ailing firms

Euro area countries such as Greece and Spain continue to struggle not only with their banks, but also with highly indebted domestic firms. Michael Koetter from the Halle Institute for Economic Research (IWH) and co-authors show the failure to resolve banks’ financial difficulties also prevents debt reduction of over-leveraged firms – and sometimes even contributes to increasing leverage of the weakest firms.

Authors Michael Koetter

Since the financial and debt crises, European banks are confronted with the task to reduce bad loans. Struggling banks are particularly prevalent in Greece, Portugal, and Spain. The study finds that permitting the problems of banks to drag on without a swift and stern resolution also prevents restructuring efforts in the corporate sector. That approach implies also that many non-viable firms (“zombie firms”) fail to reduce their debt.

Looking at more than 400,000 small and medium-sized enterprises in Greece, Ireland, Portugal, Spain, Slovenia as well as Germany and France between 2010 and 2014, the study shows that the debt of healthy companies remains largely unaffected by the stress felt by banks. On average, these companies were even able to reduce their debt. Zombie firms, on the other hand, are affected by ailing banks in their countries. “These firms are already highly leveraged in any case. The banks’ financial trouble has now led to their debts increasing even further. To the order of one percentage point per year,” says Michael Koetter, who is Head of the Financial Markets Department at the Halle Institute for Economic Research (IWH).

These results were only significant for firms in Greece, Ireland, Portugal and Slovenia whereas stressed banks in Germany and France exhibit no significant effect on the debt of zombie firms. These results thus reflect the geographical distribution of ailing banks and zombie firms, of which most but not all reside in the economies of Greece, Ireland, Portugal and Slovenia.

“Whether and how quickly corporate borrowers reduce debt levels therefore also depends on the interaction between corporate and financial sector health,” explains Koetter. “Our findings indicate that the interaction between weak banks and weak non-financial corporations is a possible source of distortion in the deleveraging efforts of the euro area economies such as Greece and Spain. A sustainable economic recovery therefore needs both the reduction of the debt of banks as well as that of firms.” The results of the study corroborate efforts by policy makers to create incentives for banks to advance the swift workout of bad assets, which will also facilitate a more rapid debt reduction in the corporate sector.

The data set for the study is representative of the corporate sector as well as the size of companies and covers between 25% and 65% of employees in the countries under study.

Storz, M.; Koetter, Michael; Setzer, R.; Westphal, A.: Do We Want These Two to Tango? On Zombie Firms and Stressed Banks in Europe, in: IWH Discussion Papers, 13/2017. Halle (Saale) 2017.

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