Finance: Research, Policy and Anecdotes

Credit guarantees for (small) businesses have been one popular policy tool in government’s fight against the COVID-recession. At a time when revenues fall away, but many businesses still have to cover at least part of their costs, cash can run out quickly. Further, the changed economic environment and high degree of uncertainty increases the riskiness of these borrowers in the eyes of the banks, which might result in reductions of credit lines or non-renewal of loans at a time when external funding is most needed; where funding is not cut, higher risk could be reflected in higher interest rates or demands for additional collateral. Credit guarantees are supposed to counter these effects and help small businesses through these hard times, in line with the idea that the economy is to go into the freezer for some weeks or months but should roar back to life quickly once it is possible. Maintaining the productive capacity is key in this context.  

Before discussing their effects, it is important to note that credit guarantees have been used for a long time by governments in the developed and developing world alike. Though their purpose has been traditionally a different one – trying to expand access to external finance among small businesses without sufficient access to bank finance. With this purposes, policy makers typically face the trade-off between additionality and sustainability, i.e., reaching firms that previously did not have access to external funding while at the same time minimising losses that arise from banks calling in guarantees. The track record is a mixed one, with problems ranging from limited take-up over administrative barriers to lack of limited additionality and unsustainable losses. However, there have also been quite some successful cases, as a growing literature has shown.

Back to credit guarantee as crisis management tool.  The issue here is not additionality or sustainability, but survival. Guarantees are targeted at existing borrowers with the objective of guaranteeing their survival during the Great Lockdown and incentivising banks to extend as much financing as necessary. The challenge is one of speed – how to get cash as quickly as possible to firms affected by COVID-19.  However, there are clearly still design issues and trade-offs to be considered. Underlying these trade-offs is the deeper issue whether liquidity support is really the ideal way to address what increasingly seems more like a solvency problem.

First, what should be the coverage? 100% (as in Switzerland) or rather 80% (as in the UK)? On the one hand, incentive theory tells us that banks should maintain skin in the game so that they keep monitoring borrowers. On the other hand, anything less than 100% loss coverage might make banks reluctant to lend in these uncertain times and might make them also slower in their lending decisions. The recent decision of the UK government to shift towards 100% guarantees clearly shows these problems.

Second, for how long will such guarantees last? As with containment policies, there is the question of an exit strategy. As our economies will slowly emerge from the Great Lockdown, it will become very clear that there are winners and losers (at least in relative terms). Capital reallocation to winning sectors will be important as will be to NOT keep zombie firms alive. Borrowing firms might not be able to repay loans quickly and might need additional funding during the recovery phase. There will be thus pressure to extend the guarantee scheme further. Converting many of these guaranteed loans into grants ex-post might be one way to address this challenge, which would be the ultimate recognition that the Great Lockdown implies solvency and not liquidity problems. There will be losses from these guarantee schemes, with government bearing all or large parts of them (which will bring some governments in the euro area into potential trouble).

While the ultimate reckoning can be delayed, it cannot be avoided. If we want to avoid the banking system turning into a utility channelling government funds to the private sector, it has to eventually recover its function as screener and monitor, deciding on credit allocation across sectors and firms according to expected risk-adjusted returns. There will be a clear trade-off between a quick recovery, with government continuing to be the ultimate guarantor and with an increasing contingent debt burden vs. a slower recovery with more pain but possibly returning eventually to a more sustainable growth part. Corporate restructuring programmes for small businesses, as used previously in emerging market crises, might be one valid policy option.  Challenges that still seem far away but it is important to start thinking about them now.

Overview