Look under the hood – an underground bank

Barkema generation

How concerned should policymakers be with UK business bankruptcies at a 60-year high? This phenomenon has been widely covered in the media; With the media attributing the record numbers to a “perfect storm” of energy prices, supply chain disruptions and cost-of-living pressure. Insolvencies are a common measure of economic distress because they have implications for both the financial system and the real economy. For the financial system, insolvency generally means that creditors will suffer losses. Insolvent companies will have to stop trading and lay off workers, which affects the real economy. In this blog post, I take stock of the evolution of corporate bankruptcies over time, including the post-Covid surge to understand what these record numbers mean for the UK economy.

What is insolvency?

Let’s start with the basics – what is insolvency? Insolvency occurs when a company is unable to meet its debt obligations. These liabilities can be bank loans, but they can also include outstanding electricity bills or tax liabilities. The director of the company is obliged to file for bankruptcy as soon as he realizes that his company cannot pay its debts. Hence, most bankruptcies are voluntary and instigated by the company itself. These bankruptcies are called creditor voluntary liquidations (CVLs). In most other cases, the company in question fails to abide by this obligation, and the creditors are forced to go to court and issue what is called a liquidation petition. The judge will then consider the petition and, if deemed valid, issue a winding-up order. After either a CVL or a liquidation order, the liquidator will take control of the company and attempt to liquidate its assets – the proceeds of which will be used to pay off (some) debts. In the remainder of the blog, I will refer to liquidation orders and CVLs as qualifiers. In contrast, bankruptcies will include all insolvency proceedings, even those that do not lead to liquidation (such as departmental).

bankruptcies over time

In the UK, the liquidation rate, which measures the number of liquidations per 10,000 firms, is cyclical and follows a clear downward trend. Chart 1a below shows increases in the liquidation rate (orange line) after the recessions of the early 1990s and 2008. Overlaying this trend with a line depicting the bank rate (blue line) shows that the long-term decline in the liquidation rate coincides with the easing of funding conditions. This is consistent with the probability of company bankruptcy as a function of the economic environment and the cost of its debt. The literature confirms this: Liu (2006) found that interest rates are strongly predictive of the liquidation rate in the UK, both in the short and long term. In contrast, the measure of firm dissolution since the mid-1980s (Chart 1b, green line), which tracks all firm exits (whether or not they are in debt), seems more stable and tracks real economy developments – as measured by GDP growth real total. – Closer. It is important to add that structural changes in the insolvency regime and/or company registry also play an important role in determining insolvency and dissolution trends. For example, Liu found that the Insolvency Act 1986, which introduced the management process as an alternative to liquidation, caused a downward structural shift in liquidations in the United Kingdom.

Graph 1a: Corporate liquidation rate and banking rate over time

Graph 1b: Inverse real GDP growth and rate of dissolution of firms

Sources: Bank of England, Companies House and the Insolvency Service.

Note: Liquidation rate equals the number of liquidations per 10,000 companies. The dissolution rate is equal to the total number of dissolutions divided by the total number of incorporated firms.

Set the record straight

So given that the bank rate was at an all-time low through 2021, how did defaults reach an all-time high? Some of the necessary nuances of this registry is that it only relates to voluntary insolvencies and, more importantly, does not take into account the growth of the company’s registry over time. The filter rate mentioned in the previous paragraph takes this into account and shows that the 2021 numbers are nowhere near the maximum. Moreover, insolvencies are only a fraction of all company exits (4% in 2022), so by themselves they are not a reliable measure of real economy risk.

This does not mean that everything is fine. UK businesses are facing a unique series of shocks with Covid followed by a sharp increase in energy prices. In addition, financial conditions are shrinking faster than they have been in decades, making refinancing more difficult and therefore bankruptcy more likely. Business bankruptcies can lead to defaults and large write-downs, which, in theory, could threaten financial stability if they occur in large numbers or in certain sectors of the economy.

Analysis of bankruptcies at the company level

To better understand the sharp increase in insolvencies and potential financial stability risks, it is helpful to move away from the aggregate numbers and look at insolvencies at the micro level. I do this by scraping individual insolvency notices from the Official Gazette and matching them against company balance sheets obtained through Bureau van Dijk. Having this data matched at the company level allows us to analyze patterns across insolvency types, sectors, age and size ranges.

A first look at the data reveals that defaults are partially making up for ground lost during the pandemic. The targeted legislation means Covid-related bankruptcies are temporarily suspended. The suspension of legal trading rules (targeting CVLs) was in effect from March 2020 through June 2021 while the restrictions on liquidation petitions (targeting involuntary defaults) remained in place until March 2022. After those measures were lifted, insolvencies increased rapidly. Chart 2a below clearly shows this: Monthly voluntary defaults (blue line) fell significantly in 2020, but have since surpassed their pre-Covid average, reaching an all-time high. Meanwhile, forced liquidations (yellow line) have been slower to recover but are now exceeding 2019 levels. As of 2022, the fourth quarter, the difference between cumulative bankruptcies in the 11 pre-Covid and 11 post-Covid quarters (“gap”) has almost disappeared. insolvency”).

Graph 2a: Commercial Bankruptcies by Category (Number of Insolvencies)

Graph 2b: Commercial Bankruptcies by Company Size (Number of Bankruptcies)

Sources: Insolvency Service, Gazette and Bureau van Dijk.

Note: Total assets of small companies under £316k, small companies between £316k and £5m, medium companies between £5m and £18m, and large companies over £18m.

Small businesses are driving the recent rise in bankruptcies

Analysis of the post-Covid insolvency rush across company size ranges shows that it is largely driven by micro companies – those with assets under £316k (Chart 2b). In 2022, 81% of insolvencies consisted of microenterprises, compared to 73% in 2019. This rise can be partly attributed to timing. The insolvency process tends to be more protracted for large companies, so it will take longer for the impact of Covid and higher energy prices to be reflected in the stats. But that’s just part of the story. Data from responses to the ONS Business Insights and Terms Survey (BICS) show that smaller companies (less than 50 employees) consider themselves to be at greater risk of insolvency than their larger peers (Chart 3a). In the latest wave (ending in December 2022), small businesses have realized that the risk of bankruptcy is twice as high. This is consistent with the disproportionate impact of higher energy prices on small firms (Chart 3b).

Graph 3a: BICS – Business at moderate/severe risk of bankruptcy (share; by number of employees)

Graph 3b: BICS – Energy Prices as a Principal Concern (share; by number of employees)

Source: ONSBICS.

Note: Different BICS waves will not necessarily have the same questions, hence the difference in x axes between the two charts.

Small business prevalence of insolvency figures is reassuring from a financial stability perspective; The UK banking sector is well capitalized and exposure to these companies is simply not large enough to present significant risk. Moreover, due to the unprecedented financial support provided during the pandemic in the form of loan schemes, some of this debt will be guaranteed by the government. In fact, nearly 60% of all bankruptcies between May 2020 and March 2022 were incurred by companies that also took out a Recovery Recovery Loan. This is also reflected in the data at the company level with smaller companies boasting higher levels of debt before bankruptcy than before Covid (Chart 4). The debt-to-asset ratio for young companies that are insolvent is twice as high in 2022 than it was in 2019.

Chart 4: Indebtedness before insolvency by size (total debt/total assets)

Sources: The Official Gazette and Van Dyck’s Office.

Segmental and age distributions remained unchanged

Financial risks can also arise if insolvencies are concentrated in certain parts of the economy. There is no evidence of this yet: the sectoral distribution of insolvencies, for example, looks very similar to 2019 despite the heterogeneous impact of the pandemic. One explanation for this is that industries that have been hit hard by the pandemic, such as housing and food, are also big beneficiaries of government support schemes. The same is true of the age rating of insolvent companies, which have remained largely unchanged from before the pandemic despite widespread dissolutions among newly incorporated companies.

A series of macroeconomic shocks has pushed UK business bankruptcies to an all-time high. Insolvencies make up only a small percentage of all corporate dissolutions, so they are not an accurate representation of real-economy risk. Furthermore, the majority of companies that go bankrupt are small while the exposures are partially government guaranteed, so I can’t conclude that they also constitute an imminent financial stability issue. However, this could change as macroeconomic challenges continue to pile up, government loan payments come due, financial conditions tighten, and larger and more complex defaults begin to take shape. This is definitely an area worth seeing.

Gili Barkema works in the bank’s financial stability and risk strategy department.

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