the institute for employment studies The Role of Loan Guarantees in Alleviating Credit Rationing Marc Cowling

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

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 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

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 ,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 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

Proportions tests commitment loans decrease with treasury rates secured loans decrease with treasury rates fixed rate loans decrease with treasury rates

Margins and real interest rates

Margins and nominal interest 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.

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