The Role of Loan Guarantees in Alleviating Credit Rationing

1. The Role of Loan Guarantees in Alleviating Credit Rationing Marc Cowling

2. Outline • Capital market imperfections exist & limit availability of capital to smaller firms? • Loan guarantee schemes • Tests of credit rationing • My data and estimation • My results • Summary • Conclusions

3. Small firms and credit markets • Small firms create jobs, innovate, introduce competition etc • Do the rich make better entrepreneurs? • Loan requests often turned down, so why doesn’t price simply adjust upwards? • Adverse selection • Moral hazard • Asymmetric information (sorting by collateral)

4. Loan guarantee schemes • Government response to ‘perceived’ credit rationing of smaller firms with ‘viable lending propositions’ • Government provides a guarantee on behalf of firm against a bank loan • In return gets a ‘premium’ (interest margin) • Contract parameters typically specify maximum loan amount, duration, age of eligible firms, size limit, sectors etc

5. Credit rationing exists when… • Bank margins are sticky • Commitment lending increases when treasury rates rise • More loans are collateralised when treasury rates rise • Riskier loans do not attract higher margins • New firms do not attract higher margins • Fixed rate borrowing decreases when treasury rates rise

6. Tests of credit rationing • Are loan rates sticky? • Further ‘stickiness’ tests examine loan contract variables and a measure of macroeconomic circumstance • Key variables of (contractual) interest include commitment loans, collateralised loans and floating rate loans • PROPORTIONS tests: probability that a loan is (a) under commitment (b) collateralised and (c) floating rate

7. My data • Complete records of all loans issued under UK SFLGS between 1993 and 1998 • 27,331 loans • 35 banks (80% through big-4 banks) • Average margin 3.25% (spread 0.25 – 9.75) • 43% loans under commitment, 63% floating rate, 30% collateralised, 43% new firms, and 20% ended in default

8. Estimation • Stickiness tests – bank margin is regressed against real and nominal interest rates, loan contract terms, macroeconomic variables and bank dummies, firm characteristics and ex post default. • Proportions tests – three binary dependent variables (commitment loan, collateralised loan, and fixed rate loan). RHS variables same but interaction terms omitted.

9. My results Stickiness tests • margins are sticky (real and nominal) • commitment loans equally sticky • no negative margins • fixed rate loans stickier • defaulting loans less sticky • secured loans stickier

10. Proportions tests • commitment loans decrease with treasury rates • secured loans decrease with treasury rates • fixed rate loans decrease with treasury rates

11. Margins and real interest rates

12. Margins and nominal interest rates

13. Summary • Empirically examined prevalence of information-based, equilibrium credit rationing amongst small businesses in the UK. • In support of credit rationing we have sticky margins, lack of non-negative margins, and our collateral results. • Against credit rationing we have equality of stickiness between commitment and non-commitment loans,and the fact that new loan defaulters are offered higher margins to reflect their riskier status.

14. Conclusion • On balance, credit rationing is not an explanation consistent with the loan market for most small businesses in the UK. • However, there is a pool of small firms (and potential entrepreneurs) who, due to information problems, will always find it difficult to raise loans when macroeconomic conditions are worsening, even when collateral is available.

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