With global economic growth almost grinding to a standstill at the end of 2020, there is a global supply chains risk of widespread insolvency domino effect. This Covid-19-triggered event would impact virtually all sectors, geographies and business models.
Covid-sensitive sectors such as hospitality, non-food retail and transportation (especially air transport and automotive), are expected to bear the brunt of customer insolvencies. This could lead to global insolvencies increasing by +25% y/y in 2021, according to our latest Covid-19 report “Vaccine Economics”. But what exactly is the domino effect and why is it such a threat in terms of corporate insolvency risk?
In essence, the insolvency domino effect is a chain reaction which starts when an insolvent company is unable to meet its obligations to its trading partners. In its simplest form, this is when a company is unable to settle payments with customers and suppliers, leaving them with unpaid invoices.
Triggering an insolvency chain reaction
Maxime Lemerle, Head of Sector and Insolvency Research at Euler Hermes, explains that such insolvencies undermine wider supply chain liquidity making the domino effect more likely. He says: “This inability to meet obligations can trigger a knock-on effect through trading networks, along the linkages between companies, sectors and countries, ultimately leading to other payment defaults and insolvencies.”So, with the resurgence of Covid-19 infections and imposition of fresh lockdowns, why haven’t we already seen the corporate insolvency domino effect in action? The simple answer, according to Marine Bochot, Head of Group Credit Underwriting at Euler Hermes, is that “unlike any previous crisis, the massive amount of state aid pumped into the markets by developed and emerging economies prevents liquidity crisis of businesses.”
Instead of witnessing a wave of insolvencies, state intervention has absorbed the Covid-19 shock, enabling many companies to avoid insolvency – at least for the time being.
Maxime says: “It is clear that the massive state assistance from governments has ‘frozen’ the situation of many companies and led to an unprecedented and artificial fall in business insolvencies worldwide during 2020. The phasing out of state supports still depends on pandemic uncertainty. Yet, albeit gradually and orderly, it will trigger a return to a normalised number of insolvencies with two kinds of insolvencies: those of companies that were no longer viable before the crisis but were kept afloat by emergency measures, and those of companies weakened by the crisis, due to over-indebtedness or under-capitalisation.”
Under normal conditions, a wide range of factors influence the severity, penetration and level of supply chain risk achieved by the insolvency domino effect. For example, while there is market liquidity and access to credit, the impact can be less pronounced.
It also depends on the extent to which companies and sectors rely heavily on any given organisation before it goes bust. If reliance on a business is high – the famous sales or supply concentration factor – then the insolvency risk will be high too and the effect can be dramatic.
Surprise is another key factor. If you are able to predict that a player will encounter difficulties you can mitigate or even prevent losses before they happen. On the other hand, if events take place at speed or on a very large scale with long supply chain or long payment terms across the chain, the corporate insolvency domino effect is potentially heightened.
The insolvency crisis surrounding UK construction company Carillion may not have been pandemic related, but it’s still a textbook example of the domino effect in action.
When Carillion went bust in January 2018, leaving liabilities of almost £7 billion, it was described by the UK’s Official Receiver as the country’s ‘largest ever trading liquidation’.
The corporate insolvency triggered a powerful domino effect through Carillion’s trading network of 30,000 subcontractors and suppliers, with many pushed into insolvency.
Just months later, in October 2018, a report from accountant Moore Stephens said there was a 20% spike in the number of UK building sector firms becoming insolvent following Carillion’s liquidation.
While state intervention delayed any such Covid-19-triggered insolvency domino effect during 2020, we still saw isolated examples of large-scale insolvencies caused by lockdown.
These examples include Avianca, one of Latin America’s biggest airlines, which filed for insolvency in May 2020. While the Colombian airline’s suppliers were left with unpaid invoices, the insolvency also had a devastating transversal impact on footfall at travel hubs causing retailers and service providers to go bust.
Another example is CBL Properties, a large US mall owner, which filed for Chapter 11 bankruptcy protection in November 2020. It took this step to clear $1.5 billion from its balance sheet following the insolvency of a string of key mall tenants.
The non-food retail sector in general, which had already lost momentum in the last decade, has been further severely weakened by the pandemic, with the fashion and apparel segment hit particularly hard.
Large-scale retailers pushed into insolvency during lockdown include the Arcadia Group, which owned a large portfolio of British clothing stores including Topshop/Topman, Burton, Dorothy Perkins and Evans. Arcadia Group’s demise led UK department stores Debenhams as well as Edinburgh Wollen Mill to move from administration to liquidation. These insolvencies undoubtedly caused fractures within their respective supply chains.
It is important to remind that the insolvency freeze and moratorium legislation voted during the first quarter of 2020 in several countries such as Germany, France, the UK, Japan, India, Singapore or Australia have made it significantly easier for struggling businesses – so-called zombie companies – to continue trading even though they may be technically insolvent. Even if those assistance mechanisms are justified in the very short-term, the longer the natural process of bankruptcies is prevented, the higher the distortions of the competition and the higher the damages for the economy over the medium-term.
Thanks to unprecedented liquidity in the global markets, businesses now find themselves in a unique position. Indeed, C-suites have a golden opportunity to anticipate and reduce their supply chain risk prior to the withdrawal of state support, which still depends on pandemic uncertainty.
Achieving the required level of insight in-house may not be possible for many companies. But with solutions such as trade credit insurance in place, businesses can be confident they are protected against customer and supplier insolvency risk beyond their control.
Trade credit insurance compensates your company in the event of late or unpaid invoices, but more importantly, it helps you avoid bad debt in the first place. Trade credit insurers such as Euler Hermes invest significant time and resources in carefully mapping the global trade credit landscape, grading businesses’ risk levels and advising their clients on the safest way to do business.
The other benefits of trade credit insurance can include:
- · Improved customer relationships, thanks to financial guarantees and increased confidence
- · More competitive trading conditions, thanks to more secured payments
- · Effective and efficient worldwide debt collection and therefore a good night's sleep knowing that your risks are insured and your payments guaranteed.
- · Improved payment behaviour, because customers pay an average of five days faster if they know you have credit insurance, which improves your liquidity.
Marine Bochot says: “In the current economic climate, a well-run trade credit insurer does whatever it takes to understand the levels of risk in their client’s supply chains. It’s often said that ‘know your customer’ is an essential business mantra, and this remains true in 2021. The more granular your insight into your customer’s ability to trade and pay, the better you can anticipate a potential domino effect.”
In the second article from our three-part of Covid-19 insolvency domino effect series, we examine how to identify corporate insolvency risk, while our final article provides actionable insights on how to protect your supply chain so it remains resilient against the insolvency domino effect. This includes pivoting towards digitally transformed trading partners, ensuring supply contracts provide insolvency protection and fully diversifying both your customers and supplier baskets.CTA: You might be interested in… + link to the other articles (with specific tag)OR Interested in protecting your business against insolvency risk? Contact our local teams.