SME financing with new credit guarantee contracts over the business cycle

Two new credit guarantee contracts, called option-for-guarantee swaps (OGSs) and equity-for-guarantee swaps (EGSs), have become the important financial innovations/instruments over the past decade in China’s credit guarantee market and provide small and medium-sized enterprises (SMEs) with stable finance. In this paper we introduce a competitive credit guarantee market along with these two new financial contracts in a classical contingent claims model to analyze SME financing and investment and the incentives that these instruments create for entrepreneurs over the business cycle. We compare the main effects produced by OGSs and EGSs. The model based on our calibration of parameters predicts that financing through an EGS entails a higher market leverage ratio and a higher production capacity and, thus, a higher ex ante firm value than an otherwise identical firm financed with an OGS. We also show that, overall, EGS financing is effective at reducing the asset substitution incentive, while OGSs reduce the debt overhang problem. These findings offer a possible explanation for why these two new credit guarantee contracts are adopted by entrepreneurs in China’s credit guarantee market, and the optimal choice between OGSs and EGSs depends on priorities (attenuate the asset substitution incentive, reduce the debt overhang problem, or enhance value).