Not all firms benefit the same from credit guarantees

Government guarantee programs

Governments resort to credit guarantee schemes to support private credit in difficult times. Under these schemes, governments guarantee a certain amount of credit by committing to compensate banks in the event of borrower default.

During the recent Covid pandemic, these were some of the largest policy programs implemented in Europe. As early as April 2020, for instance, Germany, France and Italy had jointly committed about €1.9 billion to guarantee private credit. Spain also implemented a large-scale credit guarantee program, which – as Figure 1 shows – backed approximately 40% of all credit granted between March 2020 and February 2021.

chart — Figure 1. Credit to Non-Financial Companies in Spain 2019-2021

Note: The amount allocated through the credit guarantee program appears in blue. The bulk is concentrated between March and July of 2020, coinciding with the hardest period of the Covid pandemic.

A key feature of guarantee programs is that they rely heavily on private banks to allocate the public guarantees among borrowers. In most scenarios, governments commit to a volume of guarantees, but it is banks who decide which borrowers/loans are guaranteed, by how much and at which terms (given some constraints imposed by the government). Thus, it is crucial to understand bank incentives in order to assess the effects of guarantee schemes.

In Barcelona School of Economics Working Paper 1389, “Banks vs. Firms: Who Benefits from Credit Guarantees?” (also forthcoming in the Bank of Spain Working Papers Series), Alberto Martin, Sergio Mayordomo, and Victoria Vanasco study these incentives and contrast their findings with Spanish data.¹

Read BSE Working Paper 1389 on bse.eu

A model with heterogeneous borrowers

The authors build a model to formalize the relationship between banks and the entrepreneurs (or firms) that need to borrow from them. Entrepreneurs need funds to roll-over pre-existing debt and to carry out their investment projects. The primary friction is that the project’s success depends on the entrepreneur’s effort, which is not contractible. This gives rise to a debt overhang problem: namely, indebted entrepreneurs exert a sub-optimally low level of effort because they understand that part of the benefits of this effort will be appropriated by the creditor banks.

The paper shows that entrepreneurs can be classified into three types according to their productivity:

Solvent borrowers: these are the most productive borrowers, who can borrow enough to roll-over pre-existing debts and to finance their projects.
Insolvent borrowers: these have the lowest productivity and are liquidated.
Captive borrowers: these borrowers have intermediate productivity because they can only obtain credit from their pre-existing bank, which is willing to grant them loans at a subsidized interest rate. Banks do this in the understanding that, by helping these entrepreneurs continue, they increase the likelihood of being repaid their pre-existing debts.

Captive borrowers are more prone to be hurt by how banks allocate guarantees

In this context, guarantees may intuitively seem like a useful policy measure to deal with the debt overhang problem. However, since banks are in charge of allocating guaranteed credit, it all depends on how they do so.

The authors show that banks have distorted incentives in the allocation of guarantees. In particular, banks benefit from granting guaranteed credit to risky borrowers, since this maximizes the expected payments from the government. Moreover, banks benefit from granting guarantees to captive borrowers. Since these borrowers can only continue operating if their creditor bank grants them a subsidized interest rate, they are in a weak bargaining position vis-à-vis their bank. Thus, the bank is able to fully appropriate the benefits of the guarantees granted to these borrowers, who may even see their interest rates rise as they receive guarantees.

These distortions imply that guarantees are not optimally allocated by banks, and that guarantees granted to captive borrowers actually reduce entrepreneurial effort and efficiency. From a social perspective, it would be better to tilt guaranteed credit towards safer and more productive entrepreneurs, and to fully pass on the benefits of guarantees to entrepreneurs in the form of lower interest rates.

The Spanish credit guarantee program as a case study

Although the model applies to credit guarantees in general, Covid provides an unrivalled opportunity to test its predictions. The authors focus on the credit guarantee program put forward by the Spanish government through the Official Credit Institute as a response to the Covid pandemic. To this purpose, they merge loan-level data from the Bank of Spain’s Central Credit Registry with balance sheet data of non-financial firms coming from the Central Balance Sheet Data Office Survey.

The loans under this program covered up to 80% of potential losses of bank finance extended to non-financial firms depending on certain characteristics. All loans granted to firms located in Spain at the time of the policy were eligible, excepting firms subject to bankruptcy proceedings and those deemed to be in distress. Banks were allocated a share of these guarantees according to their market share and they decided in turn how to allocate these among their borrowers.

The evidence matches the model’s predictions

The authors find evidence supporting the model’s predictions. For instance, guaranteed loans were more likely to be allocated to borrowers with a higher default probability, those in sectors more affected by the pandemic, or those with higher liquidity needs.

Also, all else equal, banks were more likely to allocate guaranteed credit to their captive firms (borrowers with a higher default risk before the pandemic and with which they had a pre-existing lending relationship).

Finally, the authors analyze the conditions under which banks granted guaranteed credit. The main finding is that, in line with the theory, captive firms received no discount on their guaranteed loans. In other words, they paid the same interest rate as they did on non-guaranteed loans. This is in contrast to non-captive firms, which received a significant discount on their guaranteed credit.