Are loan guarantees the right tool for small businesses?

Thomas Mosk: Policymakers should critically examine corporate credit risk-taking to avoid unintended side effects

Widespread "lockdowns" as a result of the global corona pandemic have had a significant impact on the economy, particularly on small and medium-sized enterprises (SMEs). Smes are particularly vulnerable to crises because of their "basic ailments," i.E., their dependence on bank financing and the financial constraints that come with it. Accordingly, there have been numerous calls from academia, policymakers, and stakeholders for support for SMEs in the current corona crisis. A widespread policy response has been to introduce or modify existing government loan guarantee programs. Almost all countries (see table) put loan underwriting at the center of their strategy to alleviate SMEs' financing problems.

Although guarantee schemes seem to be an efficient choice due to the direct applicability of an already existing institutional framework in most countries, it is not obvious whether government guarantee schemes are the right means to help SMEs in distress.

The role of loan guarantee programs in the Corona crisis

The current economic crisis is remarkable in its nature because it consists of at least two types of economic shocks: an output shock due to disrupted global supply chains and an unprecedented demand shock resulting from the lockdown. The demand shock has led to a sudden drying up of cash flow and liquidity shortages for most small businesses. The respective governments supported SMEs directly with direct subsidies and short-term wage compensation payments – such as the Kurzarbeitergeld in Germany – but also by significantly expanding government risk-taking of business loans. The table below provides an overview of the specific COVID-19 guarantee programs in eight countries.

Common proposed changes include an expansion of the maximum guarantee, broader guarantee coverage, expanded eligibility, and better terms and provisions. For example, Germany increased the maximum guarantee to 2.5 million euros per company and the maximum guarantee coverage for working capital to 80 percent. Although some empirical evidence shows that guarantee programs improve access to finance and help start-up firms grow faster (Lelarge, et al., 2010; Ioannidou, et al., 2018), little is known so far about unintended effects of guarantee programs. Therefore, policymakers need to weigh the pros and cons of guarantee programs before using this tool.

Overview of COVID 19 guarantee programs in eight countries

Landcovid guarantee programProposed changesUnited KingdomUSAGermanyFranceSpainItalyNetherlandsPortugal

Coronavirus Business Interruption Loan Scheme, Bounce Back Loan Scheme Expansion of maximum guarantee, higher guarantee coverage, broader subsidies, better terms and conditions
Express Bridge Loan Scheme, Economic Injury Disaster Loan, Paycheck Protection Program More comprehensive eligibility, better terms and conditions
Coronavirus financing solution, corona aid Higher guarantee coverage, broader eligibility
Garantie bancaire du renforcement de la tresorerie Coronavirus Higher guarantee coverage, broader eligibility, better terms and conditions
LIneas COVID-19 Extension of the maximum credits, higher guarantee coverage
Guarantee Fund for SMEs, and various regional schemes Higher guarantee leverage, better terms and conditions
Guarantee scheme (BMKB) Higher guarantee coverage, broader eligibility, better terms and conditions, more participating financial institutions
Linha EspecIfica Encerrada COVID-19 Expand maximum credits, provide higher guarantee coverage, and offer better terms and conditions

Benefits of guarantee programs and possible unintended side effects

The main advantage of guarantee programs in the current crisis is that they can be based on existing institutions. Almost every country can use structures of existing programs to directly implement COVID-specific changes. Since most companies initially faced short-term liquidity constraints, any policy addressing these issues should aim for a short implementation period. Another benefit of guarantee programs is the familiarity of bank employees and entrepreneurs with the programs. Despite these benefits, guarantee programs could lead to several unintended outcomes or conflicts with other financial regulation policies.

Not only could guarantee schemes distort competition across borders, but the mismatch with the financing needs of SMEs could also lead to over-indebtedness of firms and disincentives to credit institutions. Policy makers should therefore critically review the guarantee schemes chosen. The following list provides an overview of these unintended side effects and policy recommendations to address them:

  • Poorly tailored to the financing needs of SMEs in the Corona crisis
    Most guarantee schemes are designed to encourage small businesses to invest in fixed assets, rather than providing guarantees to meet short-term liquidity needs. It some programs explicitly specify the purposes for which these loans can be used or link guarantees to term loans rather than lines of credit, while businesses often use lines of credit to finance their short-term liquidity needs. A guarantee program should therefore be designed differently to deal with a sudden demand shock than a program designed to deal with a bank-induced credit crunch. For example, the guarantee program should allow companies to use the guarantee to secure new lines of credit, rather than limiting the assumption of liability to investments in fixed assets.
  • Over-indebtedness
    Guarantees are always associated with debt, which ultimately increases corporate leverage ratios. High leverage increases the likelihood of (strategic) default due to high interest expenses and installment payments. In addition, high leverage ratios could create problems with debt overhang in the long run, which reduces the incentives for entrepreneurs to make investments. To prevent these problems, governments should consider complementing guarantee programs with equity-like instruments (see z.B. The proposal by Boot, et al., 2020).
  • Guarantee programs may provide disincentives to banks
    Guarantee programs could lead to an effective transfer of credit risk from the bank to the liable party of the loan guarantees. This risk transfer could reduce banks' incentives to review companies because they carry less risk. Guarantee programs should therefore include clear and verifiable screening guidelines for banks, which the competent authority, the guarantee agency, could review before making a disbursement. Moreover, in the event of a default, banks may prefer to liquidate government-guaranteed loans rather than renegotiate terms with the company in question to allow for reorganization. The liquidation costs of guarantees are low compared to the liquidation of commercial real estate or corporate assets. Because liquidation of guaranteed loans is quick and cheap, banks may prefer liquidation to debt restructuring. Companies that receive a guarantee loan today can still be liquidated later on. It is therefore important that guarantee programs do not pay off too quickly.
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