Rising interest rates around the world present Cash Managers with the question of the quality of the Debtor Book i.e. of Accounts Receivable with whatever credit period and whether based on just an invoice (Open Account) or an instrument conferring stronger legal rights (accepted Bill of Exchange, an LCR in France, a RIBA in Italy).
There is a problem in the global economy and it is going to be exposed by rising interest rates.
It is known that commercial banks, particularly in Europe, still have what is known as an inventory of Non-Performing Loans, or "NPLs". The nomenclature suggests that this is some kind of asset class that banks elect to invest in, rather than what they are: loans that have gone bad.
Italian banks, as an example, recognise three categories within NPLs:
- Non-performing and Past Due
- Unlikely to Pay
- Bad Exposures
The loans travel down this ladder as the chance of recovery dwindles, and banks' Provision for Bad Debts should rise in the exact inverse proportion.
What is less known is the qualification for a loan to become classified as an NPL in the first place, and what that means for Debtors still classed as solvent.
"Non-performing and Past Due" means broadly that 90 days have passed since a borrower failed to perform against a given trigger – which may not have been the making of a debt service payment.
For example, if it is a loan on overdraft at a German bank, the trigger event is when a customer has been in overdraft for 30 days in succession without ever coming into credit, if there is no "credit contract" and if the amount is over €1,000.
The trigger is flipped at that point and the further day-count of 90 days begins.
If, after those further 90 days, the account has not once come into credit, the bank must claim insolvency and the overdraft must then be recorded as "Non-performing and past due".
The trigger can be delayed or the clock set back to zero if it can be arranged that the account comes into credit even for one day, likewise if a credit contract is put in place when none was there before.
The concern is that loans are being artificially held from dropping into the category "Non-performing and Past due" by techniques known as "Forbearance". The typical one is the capitalisation of interest, adding it to the principal instead of asking the borrower to pay it. The justification for this is usually found in collateral that is assessed as exceeding the value of the loan, albeit that the collateral may not be attachable, and/or that there is no third-party valuation of it.
Capitalisation of interest may not even be necessary when the European Central Bank base rate for calculation of interest is -0.40% per annum. A credit contract stating cost-of-funds as this base rate and adding a 0.40% margin enables the loan to be recorded as "current" even if the borrower cannot manage to bring about any debt service from their own resources. They do not need to: the all-in loan rate is 0%.
Thanks to such techniques the loan balance never gets recorded as "Non-performing and past due", even if it is suspected or actually palpably obvious that the borrower cannot repay the principal, and/or that any security for the overdraft is either not attachable, or is worth far less than the overdraft, or represents the same credit risk as the borrower itself.
This will all be opaque to Cash Managers because the Debtor will appear solvent, will not be recorded in any official register as having defaulted or sought protection from creditors, or even be reported in newspapers as in difficulties.
These are Debtors, though, with very low Interest Cover who cannot sustain a rise in interest rates, and they are known as "zombie companies".
It has become a major concern that the combination of very low interest rates and the accounting/forbearance techniques practiced by banks has created a class of loan that is recorded as "Performing" but will only remain so if interest rates remain at low levels, when in fact they are starting to rise.
These "zombie companies" cannot afford debt service and would have gone bankrupt in times of normal interest rates, whereas they have survived and distorted the economy.
The website Zero Hedge has reported that, as of July 2017, 9% of Stoxx 600 companies were zombies. They predicted that as interest rates rise and as the monetary support from the ECB and other central banks tails off, the "zombie companies" will default and be unable to pay their debts – debts to banks and debts to trade creditors.
So now is the time for Cash Managers to check the quality of their Debtor Book, identify their exposure to "zombie companies", and take steps to mitigate it.