Secured Lending Stimulants: The Role and Effects of Public Credit Guarantees in Japan

Abstract

Access to credit is crucial for the business growth, and particularly for small and medium-sized enterprises (SMEs). Two mechanisms are widely utilized in economies around the world to channel credit to the SME sector: i) market-based financing facilitated through secured transactions frameworks and ii) government-supported financing through public guarantee schemes. Secured transactions frameworks reduce credit risk by providing the lender with the right to apply the proceeds of the collateral in priority over other creditors. Public guarantee schemes undertake to pay a percentage of the owed amount to the lender upon default of the borrower. The different nature of these protections offer lenders distinct incentives to engage in each type of credit transaction. Guarantee schemes are a viable countercyclical mechanism to address the economic fallout from extraordinary events, including COVID-19. However, their effectiveness during ordinary times has been questioned. While quantitatively such schemes enable a large swath of enterprises to access credit at low rates, qualitatively they channel funds to unproductive borrowers, prolong the existence of SMEs that should be liquidated, and disadvantage ineligible enterprises. In proportion to gross domestic product, Japanese SMEs are the largest users of guarantee schemes in the world. OECD and IMF studies found that public guarantees result in weak profitability, low productivity, and high leverage. At the same time, they dis-incentivize financial institutions from investing in credit screening, valuation, and monitoring techniques necessary to deploy market-based financing products. This article identifies the negative effects of the Japanese guarantee scheme and advocates for modifications to aid the development of market-based financing. It suggests elimination of the incentives for both the financial institutions and borrowers to continuously utilize this form of government-supported financing that sustains zombie companies. Several recommendations are made to induce participating financial institutions to develop expertise in the valuation, monitoring, and disposal of collateral, so as to pave the way for transition of viable borrowers to market-based financing. However, this transition requires a modern secured transactions legal regime that Japan presently lacks. This article contributes to the research and policy debates undertaken within several on-going projects that seek to modernize the Japanese legal framework to facilitate secured transactions.