Is the Surge in Inflation Steering Interest Rates Towards a Path that Could Lead the UK into a Deluge of Loan Defaults and Insolvencies?

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James Dowdall

Since the 2007-2008 financial crisis, symbolised by the collapse of Lehman Brothers and overseen by the self-styled "Masters of the Universe," a surplus of zombie companies continue to linger across various sectors, acting as a drag on economic vitality. These enterprises divert resources that could otherwise be allocated to more productive ventures and are perceived as despondent and wayward by their creditors and lenders.

Financial institutions, constrained by the ethical framework of 'Treating Customers Fairly' and the fear of negative media coverage, found themselves unable to take assertive measures to remove struggling companies from their portfolios. Post the financial crisis, many lenders adopted a more patient and less intrusive approach, steering clear of actions that might attract public backlash, fuelled by the well-publicised grievances against the restructuring division of RBS, the Global Restructuring Group (GRG).

Nevertheless, it seems market dynamics are poised to exert their influence and prompt a shift in the prevailing situation. Higher borrowing, energy, supplier, and staff costs are squeezing companies cash flows pushing them closer to the brink of failure, and lenders are curtailing further lending, making a surge in insolvencies inevitable.

After receiving a wave of pandemic-related support, such as state-backed loans, interest-only periods, and lenient amend-and-extend deals on facilities, businesses continue to express concern about the ongoing impact of higher interest rates.

In 2022, inflation spiked globally, including in the UK, driven by robust consumer demand post-Covid-19 lockdowns, energy price shocks, and escalating food prices. The Bank of England responded with an exceptional increase in interest rates, elevating them from 0.1% at the end of 2021 to 5.25% in August 2023, marking a 16-year high. This has substantially raised the cost of borrowing for UK businesses, many of which were already grappling with significant post-pandemic leverage.

According to the OECD in December 2023, bankruptcy rates in several countries exceeded those witnessed during the financial crisis. In the same month, insolvencies in England and Wales reached their highest levels since 2009. A report in January 2024 from insolvency specialists Begbies Traynor suggested that over 47,000 businesses in the UK are on the verge of collapse.

It is important to note that more companies tend to face insolvency as they emerge from a recession due to a lack of available cash to meet increased demand during the recovery. Considering the UK has only just officially entered a recession, the road ahead appears precarious and potentially painful.

The repercussions will not be limited to zombie companies; even healthy, capital-hungry startups, early-stage businesses, and small & medium sized enterprises (SME) will be weighed down by higher energy and borrowing costs, compounded by additional Covid-19 indebtedness taken on to weather the pandemic shutdowns. The typically buoyant venture capital space, often a key source of funding for fast-growing tech businesses, has become more conservative, delaying investments, and urging portfolio companies to achieve breakeven sooner while pulling back from cash-burning strategies to grow market share.

One of the primary recipients of this economic storm will be lenders, with their capital at risk in the form of loans, likely to be impacted by resulting defaults. Following the financial crisis, alternative capital providers emerged to lend to SMEs and mid-market companies as traditional banks retreated from riskier lending. Private credit or debt funds, along with challenger banks, are expected to face higher impairments as borrowers struggle to make repayments in a higher interest rate environment.

While the balance sheets of these newer players have yet to experience a significant economic downturn, they have benefited from government guarantees, such as those under the Coronavirus Business Interruption Loan Scheme (CBILS). However, it remains uncertain how many of the issued loans will be deemed 'non-compliant’ due to strict lending criteria not being met, resulting in the implicit guarantee not being honoured.

One argument suggests that private credit funds and challenger banks can effectively spread risk throughout the system with private investors bearing the brunt and reducing the risk of contagion across the financial system. This contrasts with the 2008 scenario when the UK government had to bail out RBS with a £37 billion investment, resulting in an 84% ownership stake. Sixteen years later, the government still holds 48%, having sold shares at an average of 253p per share between 2015-2022, compared to the 500p paid in 2008, resulting in a substantial loss for the public purse.

The ripple effects of losses incurred by lenders will indirectly affect borrowers and the broader SMEs and mid-market firms in the UK. Lenders, adopting a more cautious stance, are likely to pass on higher wholesale costs to companies, constraining lending, and liquidity. This could leave this segment in the UK underserviced from a liquidity perspective, exacerbating challenges for the overall economy.

As we progress into 2024 and beyond, economic trends and realities will likely deviate, requiring a more nuanced approach. Some traditional thinking may no longer align with current circumstances, making predictions more challenging. Every recession is unique, and the current one will be no exception.