Do Loan Guarantees Alleviate Credit Rationing and Improve Economic Welfare?

Yu-Lin Wang, Chien-Hui Lee and Po-Sheng Ko
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Yu-Lin Wang: Department of Economics, National Chung Cheng University, Chiayi 621301, Taiwan
Chien-Hui Lee: Department of International Business, National Kaohsiung University of Science and Technology, Kaohsiung 80778, Taiwan
Po-Sheng Ko: Department of Public Finance and Taxation, National Kaohsiung University of Science and Technology, Kaohsiung 80778, Taiwan

Sustainability, 2020, vol. 12, issue 9, 1-16

Abstract: By designing credit contracts with inversely related interest rates and collateral, banks can overcome the problems of adverse selection and moral hazard when there is an informational asymmetry in competitive credit markets. One salient result points out that, if borrowers’ insufficient endowments of wealth cause a binding collateral constraint, a credit rationing equilibrium arises because of collateral’s inability to achieve perfect sorting. The purpose of this paper is to examine the consequences of government loan guarantees on equilibrium credit contracts and economic welfare. More specifically, the effects of loan guarantees on interest rates, collateral, and credit rationing were studied. Our results suggest that government loan guarantees should target high-risk entrepreneurs. Loan guarantees targeting high-risk entrepreneurs reduce a pledge of collateral in credit contracts, drop social cost, and increase economic welfare. Under the circumstances that borrowers’ insufficient wealth causes a binding collateral constraint, loan guarantees targeting high-risk entrepreneurs alleviate the problem of credit rationing and improve economic welfare.

Keywords: loan guarantees; collateral; credit rationing; economic welfare (search for similar items in EconPapers)
JEL-codes: O13 Q Q0 Q2 Q3 Q5 Q56 (search for similar items in EconPapers)
Date: 2020
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