Small business loan guarantees as insurance against aggregate risks

This paper assesses whether insurance against aggregate risk (such as the current economic downturn) could be an important rationale for popular government operated loan guarantee programs for small and medium enterprises (SMEs). We demonstrate in a model that firms could be credit-constrained due to aggregate uncertainty because financial institutions face high borrowing costs during economic downturns. Since it enjoys relatively lower borrowing costs during recession, the federal government could offer insurance in the form of loan guarantees to ease borrowing constraints for small businesses. Furthermore, we show that a guarantee program with a fixed fee is associated with adverse selection, and leads to the “over-lending” problem. We also show that under certain conditions, a program with a net present value of zero could be socially beneficial. Then, the high cost of obtaining guarantees and thorough qualification requirements can be viewed as tools to mitigate this problem.