Simulating Business Failures through the Liquidity and Solvency Channels: A Framework with Applications to COVID-19

We develop a microsimulation model that can identify Small and Medium Enterprises (SMEs) as financially distressed due to their inability to meet short term losses with cash (liquidity distress) or to meet their debt repayments (solvency distress). We estimate that – on these metrics – around one-in-six Irish SMEs may have been financially distressed at the end of 2020, or 14 per cent when weighted by debt balances. The model can be used for policy assessment: we calibrate the model to fiscal support implemented in Ireland during the first three quarters of 2020 and estimate that it reduced the share of distressed SME debt by two-fifths. On targeting, we show that a hypothetical scheme selecting firms with the smallest losses first could reduce distress rates from 19 to 7 per cent – albeit we do not suggest this is the welfare-optimising approach. On policy design, we show that debt-based support schemes reduce distress rates by less than grants, and this is driven by the greater role played by solvency over liquidity concerns in a debt-based support regime.