Secured Lending Stimulants: The Role and Effects of Public Credit Guarantees in Japan
Entrepreneurship, market-creating innovations and business growth rely on various support mechanisms, one of which is access to credit. Different measures are taken to facilitate access to credit for businesses. These include establishing legal frameworks and registries that facilitate the creation of security interests in movable assets to secure the performance of an obligation (collectively ‘secured transactions frameworks’). Credit risk is borne by the creditor, but reduced through a priority proprietary interest in the collateral. In contrast, public credit guarantee schemes (‘guarantee schemes’) transfer credit risk to a public institution. On default, the creditor lodges a claim with the guarantee scheme operator and receives a compensation up to 100% of the outstanding amount. Secured transactions frameworks and guarantee schemes target particularly small and medium-sized enterprises (SMEs), which is the predominant type of business around the world. In Japan, more than 99% of all businesses are SMEs, providing more than 70% of private sector jobs.
In our article (forthcoming in University of Pennsylvania Asian Law Review), we examine the interaction between secured transactions frameworks and guarantee schemes. Our analysis and conclusions reflect the research conducted when Dr Dubovec was a visiting scholar at the Institute of Monetary and Economic Studies of the Bank of Japan in the fall of 2019. We interviewed a number of stakeholders to better understand the reasons for the operation and uses of the Japanese guarantee scheme, including local academics who study various effects and aspects of the scheme. Our original research was updated in light of the COVID-19 pandemic that led to an exponential growth of this type of support to the economy in Japan, and globally.
Guarantee schemes have been deployed in many economies to address temporary market dislocations caused by extraordinary events, including by the COVID-19 pandemic. They primarily assist the underserved segment of businesses whose risk profile does not meet the lending requirements of financial institutions. Some schemes also provide support to businesses that wish to penetrate foreign markets. These types of situations pose risks that may be difficult for financial institutions to assess and manage. As a result, credit might not be extended without a transfer of risk to a guarantee scheme. However, many schemes have been scaled to such an extent that they support a significant proportion of loans where the creditworthiness of the borrower is such that it would be expected to meet the lending criteria for either secured or unsecured loans. Overreliance on credit guarantees causes many market distortions. The World Bank examined 60 schemes in 54 countries, 22 of which were high-income economies, and found that improperly designed schemes could be costly and provide limited value. Japan and Korea are the global leaders in the use of credit guarantees. In Japan, guaranteed loans represent 7.3% of its GDP as compared to Canada’s0.1% of its GDP.
The Japanese scheme has been criticised as generating a number of negative effects. While it enables a large swath of enterprises to access credit at low rates, our own research, the findings of local academics as well as studies of the IMF and OECD uniformly conclude that the scheme supports unproductive borrowers, dampens growth, prolongs the existence of SMEs that should be liquidated, and disadvantages ineligible enterprises. The scheme is one of the causes for the proliferation of zombie companies in Japan. One study published by a local academic highlighted that ‘[G]enerous guarantees likely helped firms that had fundamental difficulties but did not conduct serious restructurings, so-called “Zombie” firms, to remain alive. The existence of Zombies decreases the efficiency of the economy.’ Specifically, IMF and OECD studies found that public guarantees result in weak profitability, low productivity and high leverage of Japanese businesses. The design of the scheme reduces the incentives of financial institutions to invest in credit screening, valuation, and monitoring, techniques necessary to administer asset-based loans.
Japan has been taking steps to upgrade its secured transactions framework that is composed of a patchwork of security devices governed by laws of general application, such as the Civil Code, special statutes enabling the use of specified assets as collateral for loans, and case law that created a non-possessory security known as ‘joto-tanpo’. These steps resulted in the reform of its law of obligations that facilitated the transfer of receivables by limiting the effect of contractual restrictions on assignment. Several working and study groups have been organised to formulate recommendations for a reform.
Our contribution to the growing literature on the effects of the Japanese public guarantee scheme is in formulating recommendations to modify its design to aid the development of market-based financing and reduce market distortions. We first identify the incentives for both the financial institutions and borrowers to continuously rely on this form of government-supported financing. Then, we formulate recommendations to induce financial institutions to develop expertise in the valuation, monitoring, and disposal of collateral, so as to pave the way to market-based financing. However, we highlight that this transition is dependent on the implementation of a modern secured transactions regime that Japan presently lacks. Otherwise, nudging financial institutions away from credit guarantees would expose them to risks that they are yet unable to effectively manage. This article contributes to the research and policy debates undertaken within several on-going projects that seek to modernise the Japanese legal framework to facilitate secured transactions. The experience with the outsized dependence of the Japanese business sector on guaranteed loans and their negative effects should be a lesson for those economies that have ramped up the use of credit guarantees to address the economic fallout from the COVID-19 pandemic.
Marek Dubovec is the Executive Director of the Kozolchyk National Law Center (NatLaw), Tucson, Arizona.
Shogo Owada is a former researcher of the Institute of Monetary and Economic Studies, Bank of Japan and MBA student at the University of Cambridge.
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