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

We derive a model and provide empirical evidence on the role of loan guarantee. Using a proprietary database of third-party loan guarantees, we find strong evidence that guarantors and banks disagree on loan credit risk, which appears puzzling but is consistent with our model predictions. Given the low collateralization and high default risk of guaranteed loans, the divergence in risk assessment results from guarantors taking collateral and over estimating borrower credit quality. Additionally, we show that guarantors and banks share rents from guaranteed loans, supported by the positive relation between guarantee fee and loan rates. Different from existing theories which focus on guarantor information advantage, risk sharing and regulatory arbitrage, our findings suggest that the main rationale for third-party guarantors is to screen SME loans outsourced by lending banks, given guarantors’ comparative advantages in screening small borrowers.