Galetovic A., Sanhueza R. (2008).

Additionality and Collateral Substitution with Government-Financed Guarantee Funds. World Bank.

Abstract:

We study banks collateral substitution behaviour in the presence of a government-financed guarantee program where banks have enough information to distinguish between good and bad borrowers, but a preexisting distortion caused by prudential regulation, excludes some good borrowers that otherwise banks would like to finance. We show that in order to avoid collateral substitution and increase additionality a government-financed guarantee program should consider large individual loan coverages but at the same time the amount of public gurantee allocated to each bank should be small. When the individual coverage rate is small, it is more profitable for a bank to use the public guarantee to fully collateralize borrowers with enough illiquid wealth who would receive credit without a public guarantee, and extract the additional surplus with a higher interest rate. By contrast, when the individual coverage rate is large the cost of prudential regulation becomes irrelevant for all borrowers and the bank only compares how much surplus it can extract from a borrower. Finally, we also show that the total amount guaranteed by the public fund for a particular bank should be limited because once all formerly redlined good borrowers obtain credit further additions only lead to collateral substitution.