the institute for employment studies

The Role of Loan Guarantees in Alleviating Credit RationingMarc Cowling

Outline

Capital market imperfections exist & limit availability of capital to smaller firms?

Loan guarantee schemesTests of credit rationingMy data and estimationMy resultsSummaryConclusions

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)

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

Credit rationing exists when…

Bank margins are stickyCommitment lending increases

when treasury rates riseMore loans are collateralised

when treasury rates riseRiskier loans do not attract higher marginsNew firms do not attract higher marginsFixed rate borrowing decreases

when treasury rates rise

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

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

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.

My results

Stickiness testsmargins are sticky (real and nominal)commitment loans equally stickyno negative marginsfixed rate loans stickierdefaulting loans less stickysecured loans stickier

Proportions testscommitment loans decrease with treasury

ratessecured loans decrease with treasury

ratesfixed rate loans decrease with treasury

rates

Margins and real interest rates

2.8

3

3.2

3.4

3.6

3.8

4

93 94 95 96 97 Year

margin rbase

Real Rates

Margins and nominal interest rates

3

4

5

6

7

93 94 95 96 97 Year

margin base

Nominal Rates

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.

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.

… thank you

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