Changing the way firms in distress are dealt with

The current economic crisis in Europe was expected to affect some businesses to the extent that they would have been forced to close down. However, banks and governments often resorted to providing life-saving support to save jobs, or reputation. Many argue that this makes political and social sense, but question whether it really makes economic sense.

What is not acceptable is that businesses which should fail because they are no longer viable, don’t fail- John Cassar White

A recent report by accountancy firm Ernst & Young claims that “zombie companies are holding back the UK economy as while they are still operating, they are taking market share from viable companies that should be growing and boosting the economy”. The report also argues that the financial crisis has created an environment where it is “too difficult to fail” with businesses kept afloat to the detriment of the broader economy. “Banks do not want to be seen to be pulling the financial rug from underneath companies that are facing difficult trading conditions,” the report said.

There are conflicting signals from the business community on the way their banks are reacting to signals of distress. Local property developers, for instance, have complained that as their industry is suffering from clear signs of distress, banks are making the situation worse by being inflexible in providing emergency financing until the business climate improves. They also blame the government for not doing enough to boost demand by reducing property sales taxes.

The IMF paints a very difficult picture of the local banking situation. “Lending (by banks) is highly concentrated in housing and construction, loan quality has deteriorated, and the number of restructured loans increased. Worryingly, provisioning is a mere 19 per cent of non-performing loans, substantially below the euro area average.”

Local regulators seem to rely more on the fact that our banks have passed the stress tests set out by the EU to gauge the ability of a particular bank to withstand a financial shock incident.

Ever since a doctor friend of mine told me that he once had a patient who fully passed a physical stress test only to die of a massive heart attack a few weeks later, I confirmed my scepticism about the reliability of stress tests whether physical or financial. Most of us have an unending ability to underestimate risks that we do not fully understand or acknowledge. We rely on our hunches to reassure ourselves that we are good enough to avoid the mistakes committed by others. Some bankers seem to excel in this dangerous attitude.

The current financial crisis has been extraordinary and it is a good thing that the government and the banks have acted to help viable businesses which were facing temporary liquidity problems to avoid closure. What is not acceptable is that businesses which should fail because they are no longer viable, don’t fail. When this happens the economy loses out.

On the local scene we need to be very aware of a well-known fact that is often repeated to us by international organisations like the IMF, the European Commission and by rating agencies: our economy and banks are too dependent on the property development industry and the few major companies that carry out these developments.

Two major development projects are being restructured as banks are being much more conservative in the financing of major projects. We have more than our fair share of companies that are “too difficult to fail”. What is even more sobering, as rightly pointed out by the IMF, is the reality that the health of some of our banks depends on the destiny of these major development projects and the companies that undertake them.

When banks are faced with non-performing loans made to their clients they should by all means restructure this lending to give their clients a chance to recover. But short-term issues relating to the capital market’s reaction to a bank’s fall in profits should not fog the bankers’ judgment. As the IMF report on the Maltese banking system points out, our banks need to increase their provisions for non-performing loans and not rely too much on the written down values of property held as security. Our property market has possibly become too large for our own economic good.

Distinguishing which businesses deserve to be supported because they are basically sound from those that should be allowed to sink because their economic model is flawed will always be difficult. It will be more so if we have to factor in political considerations.

johncassarwhite@yahoo.com