Outsourcing Bank Loan Screening: The Economics of Third-Party Loan Guarantees

Abstract

We provide the first theoretical and empirical study on third-party loan guarantees, a prevalent financing channel worldwide for small borrowers. In our model, the project default probability is unobservable but can be probabilistically discovered with a screening cost. Guarantors, who are more cost-effective in screening than banks, investigate borrowers and facilitate the financing of borrowers with insufficient collateral. Our data support this outsourcing theory: guarantor's risk measure predicts firms' default losses. Patterns of guarantee fees and loan rates are consistent with model predictions. Our findings illustrate how guarantors produce information and increase the efficiency of small business lending.