A bill to reform Japan's credit guarantee program for small and medium-sized enterprises (SMEs) came into law on June 7, 2017, bringing into force a set of drastic reform measures proposed by the government. In this article, I would like to outline the reform measures and discuss the challenges going forward.
The credit guarantee program is a mechanism designed to smooth the way for SMEs to access private-sector loans by providing government guarantees. More specifically, prefectural and other local credit guarantee corporations (CGCs) serve as guarantors of private-sector bank loans taken out by SMEs (i.e., CGCs promise to repay loans on behalf of SMEs in the event of their default), and the government provides a financial backup, for instance, in the form of reinsurance. For many SMEs, the availability of such guarantee has been a crucial factor, without which they would not have been able to take out loans.
Today, out of approximately 250 trillion yen in loans outstanding to SMEs, those covered by CGC guarantees account for more than 10%, amounting to 26 trillion yen. In the past, the government twice introduced a large-scale temporary credit facilitation scheme amounting to more than 30 trillion yen— the first in response to the domestic financial crisis in the late 1990s and the second in the wake of the global recession in the late 2000s. While many other countries also have similar systems, Japan stands out in that guaranteed loans account for a significant portion of SME loans.
Meanwhile, the government's contributions to the credit guarantee program from FY1998 through FY2011 amounted to more than seven trillion yen (Okada 2013), prompting some observers to point to some of its problematic aspects. For instance, Ono, Uesugi, and Yasuda (2013) noted the possibility that private-sector banks might be selectively extending government-guaranteed loans to high-risk corporate borrowers, to which they are the leading lender, without taking on any risk of their own. The Organisation for Economic Co-operation and Development (OECD) (2015) noted that "generous government support delays restructuring by keeping non-viable enterprises (so-called ‘zombie’ firms)." However, these criticisms did not lead to immediate reform partly because of rising expectations on the role of the public sector as a provider of funds in the wake of the global financial crisis and the Great East Japan Earthquake. Now that things have returned nearly to normal, the government has set a direction for reform based on a comprehensive discussion on ways to improve the credit guarantee program including how to operate in normal times.
Three pillars of reform
The key elements of the reform are as follows:
- A new credit guarantee facility (100% coverage) will be established as an emergency safety net, which would be invoked only in the event of an emergency such as a major economic crisis, and, in principle, remain in effect for the duration of 12 months. At the same time, the government will lower the coverage ratio applicable to some of the existing safety net guarantees, i.e., those extended to otherwise non-viable borrowers whose quick recovery is unlikely even if supported by CGC-guaranteed loans.
- The government will expand a credit guarantee scheme for startups and small businesses that are viable but have difficulty in accessing bank loans.
- In the case of a partially guaranteed loan, where a CGC and a private-sector bank share the credit risk of the borrower, the CGC will get the full picture of the loan, not only the guaranteed portion but also the non-guaranteed portion. CGCs will be responsible for collecting and disclosing information on the portion of loans extended by private-sector banks at their own risk.
Objectives of reform
Presumably, these changes aim to achieve the following three objectives respectively. The first set of measures are to make a clear distinction between credit guarantees available in normal times and those applicable only in emergencies. Government intervention in the lending market improves economic welfare only in cases where private-sector banks are unable to take credit risks due to their balance sheets being weakened by a crisis, and such emergency measures need to be put to an end quickly once the crisis is gone. However, the government has been unsuccessful, having failed to end its two large-scale emergency credit guarantee schemes as originally planned, likely due to the operation of institutional inertia. The introduction of the new temporary facility and the reduction of the coverage ratio applicable to some of safety net guarantees, which have often been made available for loans to those in depressed industries, are designed to make improvements in this regard.
The second scheme is to channel more funds to companies about which private-sector banks are not producing sufficient information. Startups and small businesses have greater information asymmetry and thus face greater financial constraints compared to their larger and more established counterparts. Therefore, it is to some extent reasonable for the government to intervene. It is expected that the enhancement of measures targeted at startups and small businesses will ease their financial constraints and hopefully lead to an increase in the number of new startups.
The third scheme is an attempt to see public intervention in SME lending from a broader perspective. Up to now, the government has focused solely on terms and conditions for guaranteed loans to examine under what conditions—i.e., coverage ratio, guarantee fees, and loan amount—private-sector banks would be ready to extend loans by leveraging credit guarantees. However, private-sector banks also provide ordinary, non-guaranteed loans at their own risks. Therefore, in order to optimize risk sharing between the public and private sectors, it is necessary to gain a complete view of lending by private-sector banks, including both guaranteed- and non-guaranteed loans. If local CGCs could properly collect and accumulate information on non-guaranteed loans made by private-sector banks, it would hopefully make it possible to accumulate evidence that provides important implications in considering the desirable risk sharing between the public and private sectors and how the credit guarantee program should operate.
Can the credit guarantee program make SME finance more efficient?
These are positive changes aimed at achieving efficient operation of the credit guarantee program. Will this reform lead to more efficient SME finance? This depends on what changes we will see in a set of figures presented in the course of relevant discussions at a government council.
What I am referring to here is the default rates for guaranteed loans aggregated by risk category and the size of outstanding loan amounts guaranteed, as shown in the Table below. With risk categories shown as column headings and the size of outstanding loan amounts guaranteed as row headings, the percentage figures represent the ratio of borrowers that defaulted and had their debt paid by CGCs (default rate) in FY2014. A conspicuous peculiarity observed in this table is the relationship between the size of outstanding loan amounts guaranteed and the default rate for higher risk borrowers. For those classified into Categories I through III, the larger the amount of outstanding loans guaranteed, the higher is the default ratio. Normally, the size of outstanding loan amounts guaranteed increases with the size of the company. Since larger companies are less likely to fail, the larger the size of outstanding loan amount guaranteed, the lower the default rate should be. However, in the case of companies in Categories I through III, the likelihood of failure and hence disbursement from CGCs is greater for bigger borrowers of guaranteed loans.
| Risk category | I | II | III | IV | V | VI | VII | VIII | IX |
|---|---|---|---|---|---|---|---|---|---|
| Outstanding loan amounts guaranteed at beginning of period | |||||||||
| 12.5 million yen or below | 4.9% | 2.9% | 1.7% | 1.1% | 0.7% | 0.5% | 0.4% | 0.3% | 0.2% |
| 12.5 million yen - 20 million yen | 9.4% | 4.9% | 3.1% | 2.1% | 1.0% | 0.6% | 0.4% | 0.3% | 0.1% |
| 20 million yen - 30 million yen | 9.8% | 5.3% | 3.0% | 1.9% | 1.0% | 0.5% | 0.4% | 0.2% | 0.1% |
| 30 million yen - 50 million yen | 10.8% | 5.7% | 3.4% | 2.0% | 0.9% | 0.5% | 0.3% | 0.2% | 0.1% |
| 50 million yen - 80 million yen | 12.5% | 5.8% | 3.7% | 1.7% | 0.8% | 0.3% | 0.2% | 0.3% | 0.1% |
| 80 million yen - 100 million yen | 12.3% | 5.4% | 2.7% | 1.7% | 0.9% | 0.5% | 0.1% | 0.4% | 0.2% |
| Above 100 million yen | 12.0% | 5.3% | 3.1% | 1.3% | 0.6% | 0.3% | 0.2% | 0.2% | 0.1% |
| Source: Material presented to the Council for Small and Medium Enterprise Policy’s working group on SME finance on December 20, 2016. | |||||||||
One possible factor behind this is the presence of companies that continue to obtain guaranteed loans despite deteriorating business performance. These companies might have already been aware of their bleak future at the time of borrowing, or their business performance might have deteriorated due to the occurrence of an unpredictable event subsequent to their borrowing. However, the problem is that it seems the government has done nothing to prevent failing companies from taking out additional guaranteed loans, or that no efforts have been made on the part of those borrowers to turn around their business. If this observation is correct, it means that to the extent guaranteed loans have been made to companies with a high probability of failure, other companies in need of guaranteed loans could not obtain them under the credit guarantee program prior to the reform this time around.
The latest reform includes some measures that may successfully address this problem, thereby changing the current problematic situation where companies with greater outstanding loan amounts guaranteed are more likely to fail, and normalizing the flow of funds under the credit guarantee program. Measures designed to facilitate business improvement and turnaround at poorly performing companies are expected to lower the probability of their failure, while the monitoring of risk sharing between CGCs and private-sector banks in providing loans to corporate borrowers may prevent an increase in guaranteed loans to companies on the verge of failure. It is important to continue to monitor the effects of those reform measures quantitatively.
