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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.

Do Loan Guarantees Alleviate Credit Rationing and Improve Economic Welfare?