Third-Party Credit Guarantees and the Cost of Debt: Evidence from Corporate Loans
Review of Finance, Volume 26, Issue 2, March 2022, Pages 287–317, https://doi.org/10.1093/rof/rfab012
A recent stream of literature highlights the importance of the assets that firms own in their financing decisions. These studies argue that a negative shock to the value of a firm’s assets can have long-term consequences for the firm, as the firm will experience difficulty pledging collateral and therefore is not able to obtain credit or obtain credit at an increased cost. The issue is compounded when the firm relies on its assets, not only for financing purposes but also to cover future payments to hedging counterparties.
My research is motivated by the anecdotal evidence that suggests many borrowing firms, especially smaller and growing borrowers, do not have sufficient high-quality assets to pledge as collateral, or are not willing to pledge collateral to have more flexibility to sell or redeploy assets for other purposes. In this study, I focus on third-party credit guarantee, an arrangement used by many corporate borrowers instead of or in addition to pledging their own assets as collateral. In the presence of a third-party credit guarantee, a lender is protected from adverse idiosyncratic shocks to a borrower’s assets.
I use the data collected by the Federal Reserve under Y14Q schedules containing details of all USD commercial and industrial loans with $1 million or more in commitment that are issued by large bank holding companies in the United States. My first finding is that third-party credit guarantees are frequently used in U.S. bank lending: Over 46% of corporate loans (equivalent to over 40% of all bank exposures in USD through corporate loans) are fully or partially guaranteed by a legal entity separate from the borrowing firm.
Using an empirical strategy that accounts for time-varying firm and lender effects, I find that the existence of a third-party credit guarantee is negatively related to loan risk, loan rate, and loan delinquency. Moreover, I find that third-party credit guarantees alleviate the effect of collateral constraints in credit market. Firms (particularly smaller firms) that experience a negative shock to their asset values are less likely to use collateral and more likely to use credit guarantees in new borrowings. The prevalence of credit guarantees challenges the extent to which the “collateral” channel of bank lending explains a firm’s financing and investments.
Further, I find that, consistent with the notion that different types of guarantors have different credit risks, a government agency-guarantee provides the highest discount on cost of debt for a borrower reducing it to a rate of return close to the risk-free rate. A corporate guarantee generates a discount that is equivalent to about 9% of the cost of debt for an average borrowing firm. I find that personal credit guarantees (those provided by a shareholder or a manager) are less effective in reducing the cost of debt for a corporate borrower.