Banks vs. firms: who benefits from credit guarantees?

Many countries implemented large-scale programs to guarantee private credit in response to the outbreak of COVID-19. Yet the role of banks in allocating guarantees - and thus in shaping their effects - is not well understood. We study this role in an economy where entrepreneurial effort is crucial for efficiency but it is not contractible, giving rise to a debt overhang problem. In such an environment, credit guarantees increase efficiency to the extent that they allow firms to reduce their repayment obligations. We show that banks follow a pecking order when allocating guarantees, prioritizing riskier, highly indebted, firms, from whom they can extract more surplus. The competitive equilibrium is constrained inefficient: all else equal, the planner would tilt the allocation of guarantees towards more productive, safer firms, and would fully pass-through the benefits of guarantees to firms in the form of lower repayments. We confirm the model's main predictions on the universe of all credit guarantees granted in Spain following the outbreak of COVID.