Article
Loan guarantees: Costs of default and benefits to small firms

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Abstract

Governments of most countries seek to encourage Small and Medium Sized Enterprise (SME) growth and the job creation that many believe is fostered by such growth. Substantive growth usually requires expansion capital. It is often perceived that compared with larger firms, SMEs face disproportionately less access to the debt capital they need for start-up, growth, and survival. Consequently, governments and trade associations have often intervened in credit markets by taking on the role of guarantor of loans that financial institutions advance to SMEs. For example, the Small Business Administration in the United States provides guarantees of loans made by banks to qualifying small firms. Similar schemes are in effect in, among other countries, Canada, Japan, the U.K., Korea, and Germany. Trade associations take on such roles in France, Spain, and other nations.

Loans that support the expansion of small enterprises may convey significant benefits to the borrowing firms and, through job creation and retention, to the rest of society. However, to the extent that some borrowers are unable to meet the repayment obligations of their debt, guarantors also face material real costs of honoring their guarantee to the lenders. Loan guarantee programs are designed in a variety of ways. Often these programs do not appear to reflect guidance from economic theory or experience. This paper draws on empirical evidence to compare costs with benefits. In addition, it uses the results and economic theory to provide some guidance for the design of loan guarantee programs. Finally, the study shows that loan guarantee programs can be an effective means of supporting start-up, growth, and survival of new and risky enterprises. The work finds that substantial total and incremental job creation may be attributed to the Canadian loan guarantee program.

The paper reviews previous attempts to conduct cost-benefit analyses of loan guarantee programs. It finds wide variation, internationally, in default rates. Published data suggests default rates vary from less than 5% (Germany) to more than 40% (U.K.). The empirical analysis reported here focuses on the Canadian implementation of loan guarantees, the Small Business Loans Act (SBLA). Findings include (1) loan guarantees granted under the terms of the SBLA provide an extremely efficient means of job creation, with very low estimated costs per job; (2) default rates are higher for newer firms, increase with the amount of funds borrowed, and vary widely by sector (borrowers in the retail and accommodation, and food and beverage sectors were significantly more likely to default than borrowers in other sectors); and (3) the widening eligibility to larger firms and to larger loans may not be well advised and is inconsistent with the goals of the program. Moreover, reducing the loan ceiling would arguably discourage fraudulent applications while servicing those SMEs most in need of early-stage capital.

In addition, analysis of the lenders' motives suggests that default rates on the portfolio of guaranteed loans and, therefore, the costs of honoring guarantees, are particularly sensitive to the level of the guarantee. Small reductions in the level of the guarantee (for example, guaranteeing 80% of principal and accrued interest instead of 85%) could lead to substantial reductions in default rates.

Debate persists in economic theory about whether or not government intervention in the credit market is warranted, in spite of the findings that loan guarantees seem to make positive contributions. Further analysis of these issues is advised.

Introduction

For policy makers and entrepreneurship researchers, a far-reaching research finding of the late twentieth century was that a disproportionate amount of job creation is attributable to the growth of SMEs. Consequently, governments of most countries seek to foster SME growth. Many perceive this growth to be obstructed by imperfections in the credit market. The flaws cited are such that smaller firms obtain disproportionately less access to the debt capital needed for start-up, growth, and survival (Llisteri 1997). Governments have, therefore, often intervened in credit markets by using loan guarantee programs.1 Levitsky (1997), however, notes that loan guarantee programs are often designed in an ad-hoc manner and in a variety of ways that do not reflect guidance from economic theory or experience. Therefore, this paper reports on an attempt to draw from empirical evidence and economic theory to guide the design of loan guarantee programs.

The paper opens with a short description of the generic features of loan guarantee programs and describes the agency relationship between the guarantor and delivery agents. The paper then illustrates variations in design and outcomes by describing loan guarantee programs of the United States, Canada, and the UK. This is followed by a more detailed description of the Canadian Small Business Loans Act (SBLA).2 The next section presents empirical findings of the analysis of costs and benefits of the SBLA and identifies empirical relationships between the default rate on guaranteed loans and program parameters. The paper closes with a discussion of the implications of these findings for the design of loan guarantee programs and shows theoretically why the rate of default is highly sensitive to the proportion of loan that is guaranteed.

All loan guarantee programs involve at least three parties: borrower, lender, and guarantor. The motives of the three participants differ. The borrower is often an SME seeking debt capital. Typically, the borrower approaches a lender for a business loan. The lender is most often a private financial institution seeking to profit from the loan transaction. Faced with information asymmetry, lenders look for signs of creditworthiness from borrowers. For new or small businesses the high costs of evaluation may prompt the lender to refuse the loan application. Alternatively, the parties may resort to a third-party guarantee of the loan. The guarantor, usually a government or a trade association, seeks to facilitate access to debt capital by providing lenders with the comfort of a guarantee for some material portion of the debt. This generic arrangement implies an agency relationship between the guarantor and the lender.

The lender acts as a delivery agent for the guarantor; however, lender and the guarantor have different objectives. The guarantor must align its objective (facilitating credit) with the lenders' profit-maximization motives. Typically, guarantors can manage the following parameters.

  • 1.

    The degree of discretion in credit decisions. In some jurisdictions (e.g., Canada), the lender decides which borrowers receive guaranteed loans. In others (e.g., the UK), the guarantor reviews—at least notionally—each application.

  • 2.

    The level of the guarantee. This also varies by jurisdiction and within jurisdictions. For example, when the U.S. SBA introduced its “Preferred Lender” program in 1982, the guarantee was for 75% of the debt compared with the 90% in effect for the (then) usual SBA-guaranteed loans.

  • 3.

    Fees. Typically, guarantors set fees in an attempt to recover costs of honoring defaults or to preserve the integrity of the pool of capital that, in some implementations, often lies behind the guarantees. 4. Eligibility criteria. In most implementations, guarantees may not be permitted for certain purposes of borrowing. In Canada, for example, guarantees are not available for loans used to support working capital.

To illustrate variations on these themes, it is instructive to review selected international implementations of loan guarantee arrangements.

The Small Business Loans Act (SBLA) has provided for federally-guaranteed term loans through approved lenders since its inception in 1961. Borrowers negotiate for a loan from an approved lending institution to obtain an SBLA-guaranteed loan. Lenders have full discretion regarding the loan decision and the invocation of the guarantee within the terms of eligibility. Unlike loan guarantee schemes in the United States and the UK, the role of the Canadian government is passive. The Industry Ministry is responsible primarily for maintaining registration of the loans and, in the event of default, it honors the guarantee.

The SBLA program provides exclusively for guarantees of term loans where the proceeds are used to finance land, premises, equipment, and certain other items. Proceeds may not be used to finance working capital, share acquisition, refinancing, and intangibles (including franchise and operating permits). In April 1993 the Canadian federal government amended the Act in a variety of ways.3 These changes included:

  • temporarily increasing the level of the guarantee from 85% to 90%;4

  • widening eligibility to firms with annual revenues of up to $5 million (the previous limit was set at $2 million) and to firms in sectors such as finance, insurance, mining, and the professions;

  • increasing the maximum loan size from $100,000 to $250,000;

  • providing for a higher interest rate spread of up to 1.75% over prime.

  • As a partial result of these changes, lending volume under the terms of the Act increased from an annual dollar volume of approximately $500 million in 1993 to $3.5 billion during 1994. By 1997, cumulative lending was in excess of $10 billion, and the terms of the program were again reviewed.

At its founding, a premise for the Small Business Administration (SBA) was that banks were too risk averse to lend to small firms, yet there were plenty of “good” small businesses worthy of credit. Hence, the SBA was created in 1953 to make direct loans, loans in partnership with banks, and to provide loan guarantees. At its inception, it was intended that the SBA would not compete with bank lenders. The SBA, therefore, moved away from direct lending towards loan guarantees. Such guarantees were intended for borrowers who, because of their small size, did not meet bank credit standards. From 16,800 loans valued at about $2.8b in 1986 (Rhyne 1988), 45,288 guaranteed loans were made in 1997, valued at about $9.46b.

Historically, a borrower seeking a loan could apply to the SBA for a guarantee through the lender. To be eligible, the lender must have certified that the business would not have qualified for credit without the guarantee—but that the likelihood of repayment is sound! Originally, SBA staff reviewed each application. If approved, a guarantee of up to 90% of loans up to $155,000 could be advanced. Loans were secured to the extent that tangible assets were available and the Chief Executive's personal guarantee was required. Under the terms of the guarantee, if the borrower was at least 60 days in arrears the lender could demand that the SBA purchase the outstanding principal and interest and become responsible for collection.

The SBA has moved away from approval of all loan applications to place more responsibility on the lenders during the last decade. Approximately two-thirds of U.S. banks act as lenders under the SBA program. Yet, there is considerable variation in the extent to which various lenders actually participate. The SBA has come under considerable praise but has also been subject to intense criticism. Among the major causes of concern were the high costs of program administration and costs of honoring loans in default. During the 1980s, the operating budget of the SBA was of the order to $70 million per year (Rhyne 1988), and estimates of long-run default rates ranged from 16.4% (SBA, 1983, as reported by Mandel 1992) to 23.5% (Rhyne 1988). More recently, the SBA has concentrated lending with the more efficient and responsible lenders and also encouraged other lenders to emulate their examples. These efforts, according to the SBA (1998), have resulted in increased productivity and efficiency and a reduced rate of defaults.

As part of the continuous effort to reduce the default rate on loans, the Office of Inspector General (1996) sought to identify the best credit initiation, analysis, and monitoring techniques of a cross-section of successful lenders. The work identified some practices as effective in controlling credit risk. Successful lenders:

  • foster a long-term and comprehensive relationship with their borrowers that extends beyond the scope of an SBA loan

  • rely more on evaluating an individual borrower's situation than on automated screening methods such as credit scoring

  • generally avoid the use of external loan packagers

  • require the borrower to demonstrate relevant experience in the type of business to which credit is to be extended

  • require the borrower to pledge both personal and business assets as collateral, despite the availability of the SBA guarantee

  • centralize final lending decisions to ensure consistency and control

  • emphasize quality loan origination over monitoring

  • assign risk ratings to new loans and periodically reassess them throughout the life of the loans

  • proactively watch for warning signs of future loan repayment problems

  • identify past due loans early and initiate vigorous collection efforts

  • emphasize working out a problem loan to avoid liquidation.

The report concluded that the above practices, although not comprehensive, could be a useful guide to lenders who need to develop procedures for the management of their SBA loan portfolio or wish to improve controls over credit systems. The SBA could also encourage or require these practices of lenders who need to improve their management of SBA-guaranteed loans.

The loan guarantee scheme (LGS) was introduced in 1981 following the recommendations of the Wilson Committee (1979) that “competition between banks … was insufficiently effective to ensure that viable small businesses always had the necessary access to sufficient funds on reasonable terms.” The scheme is a joint venture between the Department of Trade and Industry (DTI) and lenders such that guarantees are restricted to firms that have tried and failed to obtain a loan. Lenders must satisfy themselves that they would have offered conventional loans but for the lack of collateral or track record and that all available personal assets have been used for conventional loans. On acceptance, the DTI provides the lender with a guarantee for 85% of the total loan. In return for government backing, the borrower must pay the DTI an annual premium.5 In addition, the lender may require a pledge of real assets as security and will usually take a fixed or floating charge on such assets.

As noted by Pieda (1992)(Appendix 5), the default rates of LGS loans is of the order of 40% for loans granted between June 1981 through March 1984. For loans granted from October 1988 through September 1989, 30% had defaulted within the first two years. Moreover, the majority of defaults occur within the first two years, indicating potential flaws in the credit decision-making procedure. Defaults were also more common among those firms that used the guarantee to finance working capital, a result to be expected: The use of long-term obligations to finance short-term assets contravenes long-standing financial wisdom.

Figure 1 illustrates historical cumulative default rates for the Canadian, U.S., and UK programs' seven-year maturity loans. This chart is revealing in that the high default rates during the initial years of the UK, and to a lesser extent the United States, approaches imply that loans have often been advanced to non-viable businesses, in contravention of the explicit objectives of the two programs. Three differences in program design may be pertinent to this finding.

First, the UK approach involves the guarantor in the loan approval step, at least in name. This is time consuming, costly, and at variance with the idea that commercial lenders are best equipped to make credit decisions. In Canada, the decision is left exclusively to the lender, relying to a greater extent on the expertise that the banking sector can contribute. Second, the level of guarantee may have a dramatic impact on default rates. For the period during which the default rates in the United States were measured, the level of the guarantee had been set at 90%. Third, the level of fees can arguably affect the quality of borrower drawn to the program. If the fees are too high, good quality borrowers will not use the program, and the cycle of market deterioration described by Akerlof (1970) and Stiglitz and Weiss (1981) can result.

Higher default rates are not, in themselves, negative indications. What is important is the degree to which social welfare benefits exceed the subsidy implicit in the costs of the program. In the United States, Rhyne (1988) estimated this subsidy at 11 to 13%. However, as Vogel and Adams (1997) observe, no rigorous assessment of social welfare benefits has been conducted in either the United States, the UK, or Canada. Hence, any statements must be qualified. However, it is clear that the hurdles to positive assessments are greater in the UK and in the United States than in Canada.

Other countries have schemes designed to facilitate SME financing through loan guarantees. In the Netherlands and Germany, governments fund guarantees for business loans. Organizations external to government, including trade associations, provide loan guarantees in Belgium, Luxembourg, Ireland, France, Portugal, Spain, and Greece. In Asian countries such as Japan, Korea, Taiwan, and Malaysia, a variety of institutional arrangements provide for loan guarantees. The operating policies and details of programs differ considerably across jurisdictions, yet little theory-based or empirical research exists to guide program design.

Vogel and Adams (1997) present a critical review and analysis of the rationales advanced in support of loan guarantee programs. They note that:

  • 1.

    the design of loan guarantee programs does not logically reflect assumptions about credit market imperfections;

  • 2.

    all loan guarantee programs involve subsidies;

  • 3.

    most evaluations report only a portion of the costs of the program; and,

  • 4.

    research cannot measure accurately “additionality.”

Vogel and Adams point out that credit market imperfections do not provide a valid rationale for loan guarantee programs, yet they identify two circumstances under which small firms may face disproportionate difficulty obtaining debt capital, situations that loan guarantees may address.

The first condition arises when the cost of lending to SMEs is too high to be economical for financial institutions. This high cost stems from two sources: the risk premium that lenders could expect and fixed costs of evaluation and monitoring. These are not imperfections in the market. These conditions are part of the normal way in which such markets operate. Nonetheless, SMEs face disproportionate difficulty with access to debt capital.

The second situation arises when lenders place importance on the availability of collateral. Loans may be denied if small firms do not have sufficient collateral available in terms of the quality and quantity required. Again, this is not an imperfection in the credit market; rather, this condition is an aspect of the normal operation of credit markets. Experience suggests this situation—where lenders require collateral that SMEs do not have—is one common to young firms.

Section snippets

Evaluation of the sbla program

Rhyne (1988) and Vogel and Adams (1997) concluded that most evaluations of loan guarantees have not been comprehensive, either as to costs or benefits. Moreover, attribution of default losses to program design is problematic because losses tend to occur years after the loans are made, and estimates seem to vary widely (see, for example, Mandel 1992). Few attempts have been undertaken to measure incremental compliance costs. More problematic still is that it is difficult to determine the extent

Summary and discussion

This study reported several major findings. First, it was found that loan guarantees granted under the terms of the Canadian Small Business Loans Act provide an extremely efficient means of job creation, with an average guarantee cost of approximately $2,000 per job. Most of the cost stems from honoring lenders' claims in respect of defaults.

Two measures of default rates were employed. The first was the long-term default rates on guaranteed loans. Unfortunately, such rates remain unknown until

Acknowledgements

The authors acknowledge with appreciation the cooperation of Industry Canada, the Social Sciences and Humanities Research Council, the Entrepreneurship Research Alliance of the University of British Columbia, and the Small Business Loans Administration of the government of Canada for support in the conduct of this research. The helpful comments of two reviewers and the editor of this journal are gratefully acknowledged.

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