Government subsidy policies for guarantee financing: Risk compensation vs. fee reduction

Small and medium-sized enterprises (SMEs) often rely on credit guarantee companies (guarantors) to obtain financing from banks. To encourage guarantors' engagement and reduce SMEs' guarantee costs, governments commonly implement two subsidy policies: risk compensation, which shares a fraction of guarantors' losses, and fee reduction, which reimburses SMEs for a fraction of their guarantee fees. This paper formulates a game theoretical model to analyze the impact of these two policies on the decisions and profits of a capital-constrained SME firm and a profit-maximizing guarantor, and how a government should choose between the two policies. We find that under each policy, the total expected profit improvement of the firm and the guarantor is greater than the government expected expenditure incurred if and only if the firm's default probability is below a threshold. Comparing the two policies with a budget constraint, we find that if the government's objective is to maximize the firm's expected profit, risk compensation outperforms fee reduction. But if the objective is to maximize the total expected profit of the firm and the guarantor, which policy performs better depends on the firm's default probability. Moreover, if the government aims to maximize social welfare, risk compensation performs as well as or better than fee reduction. We also consider the case where the guarantor is publicly owned and not-for-profit; in this case, under each policy, the expected profit improvement of the firm is always lower than the government expected expenditure.