Credit guarantee schemes (CGS), one of the main instruments European governments used to support businesses and mitigate the economic impacts of the Covid-19 crisis, have long been used to ease access to financing for businesses. They also provide third-party credit-risk mitigation and capital relief to lenders. In contrast to direct fiscal support through subsidised loans and grants, credit guarantees limit the immediate burden on public finances as their fiscal cost only materialises if the borrower fails to meet debt repayments.

“Risk-sharing agreements, borrower eligibility criteria and guarantee pricing are the essential parameters of credit guarantee schemes,” said Thibault Vasse, a sovereign and public-sector analyst at Scope. “Sovereigns are likely to honour guarantees even at times of financial distress. Still, treatment between different guaranteed obligations in highly stressed cases can depend on multiple factors, including the degree of spillover risks via the sovereign-corporate-banking nexus and contractual aspects.”

Importantly, Scope’s definition of sovereign default includes missed coupon or principal repayments on non-sovereign debt benefitting from an irrevocable and unconditional guarantee issued by the sovereign.

One challenge emanating from the increase in government guarantees to non-financial corporates is they have intensified interdependencies between sovereigns, banks and firms. This has effectively created two potential negative feedback loops: public finances are more exposed to developments in the corporate and financial sectors; and banks and corporates have become more dependent on government support.

“A premature withdrawal of government support could lead to cliff effects, severely impacting the corporate sector and giving rise to financial instability. Such a scenario would likely trigger corporate defaults, a rapid rise in non-performing loans and tighter financing conditions, which could spill over to the banking sector. Here, the economic environment would worsen, government revenues would fall and public debt would rise, putting potential pressure on the sovereign’s credit rating,” said Vasse.

Public CGS are increasingly present in structured finance pools, either on a loan-by-loan basis, or more often in the form of dedicated guarantee funds. This trend could last as the appearance of Covid-19-related guarantee programmes could spur securitisation.

Cyrus Mohadjer, a senior structured finance analyst at Scope, says consideration of public guarantees includes the sovereign rating, “but analysis is also driven by an assessment of the legal framework and operational features of the guarantee mechanism, on top of the guarantor’s incentives and ability to honour its obligations. Additionally, various qualitative factors are analysed, such as the alignment of interests between the operator of the guarantee and the lender”.

“Credit given to the guarantee scheme should not be limited to a mechanistic link to the sovereign rating. Instead, the incentives and ability of the ultimate guarantor to honour its obligations should be scrutinised. Scenarios in which the guarantee does not operate as projected typically bear a low weight and imply a certain level of macroeconomic stress, which is also correlated with the likelihood of local SMEs defaulting.”

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