A model of guarantees under high moral hazard

Governments in many countries are often faced with the need to provide a guarantee support for the financing of infrastructure projects at the national and municipal levels. This may be a necessary measure, in order to get private financial institutions to lend enough funds to carry out public projects. In the absence of government as a third party in the writing of debt contracts, two problems arise: One, credit is rationed by quantity, causing its equilibrium price to be higher than what comes from meeting supply and demand. Second, borrowers may not have negotiating power to exact the minimum possible cost of money. This paper shows a model for estimating a guarantee rate as a way to implement guarantee agreements. A process of bargaining involving the three parties – the requesting entity, the government and the financial institution – produces an optimal set of values for the fair interest rate and the guarantee rate. This process of bargaining requires that the negotiators agree to a set of inter-period default probabilities, the discrete equivalents of hazard rates, as one of the main outcomes of the negotiation. Finally, we explore different ways to construct such probability structures, and apply these ideas to a model for credit risk, currently under implementation, adapted to the circumstances just described.