Sovereign loan guarantees and financial stability

Abstract
We analyze the effects of sovereign loan guarantees on financial stability in Portugal using a DSGE model. Sovereign loan guarantees decrease the default rate of banks and increase credit. On the other hand, guarantees increase the leverage and default rate of firms. These effects are larger the lower the sensitivity of the capital of banks to capital requirements. Behind these results are the reduction in regulatory risk-weights and the transfer of loan losses from banks to the sovereign brought by sovereign loan guarantees. A decomposition of the impact of sovereign loan guarantees suggests that insuring banks against loan losses can complement and enhance conventional macroprudential policy.

Sovereign guarantees on firm loans are among the policy measures adopted to mitigate the effects of economic and financial crises, and they have been used extensively during the COVID-19 pandemic. This brief is an abridged version of De Lorenzo Buratta and Pinheiro (2025) in which we measure the impact of sovereign guarantees on Portugal’s financial stability after an economic crisis. We focus specifically on how the guarantees affect the probability of default of banks and the level of credit to the economy.

To measure the effect of sovereign guarantees we use and extend the DSGE model in Clerc et al. (2015). We hit the model’s steady-state with a series of shocks that mimic the forecasts of the evolution of the economy after the onset of the most recent crisis – the COVID-19 pandemic – and we compare the response of variables of interest in two scenarios: one with and another without sovereign guarantees. The sovereign guarantees are calibrated to match the terms and conditions of the COVID-19 sovereign guarantee program.

We find that sovereign guarantees reduce the default risk of banks, increase credit, and have a small and positive impact on output. On average, guaranteeing one percent of the banks’ credit to firms over a year decreases the default rate of banks by 0.48 percent, increases credit and output by 0.32 and 0.01 percent, and has a fiscal cost of 0.005 percent of output.1

Figure 1. The impact of the Portuguese COVID-19 sovereign loan guarantee scheme

(A) on credit and banks’ default rate (B and C) and its cost (D)

The sensitivity of the banks’ capital to capital requirements is an important determinant of the policy’s impact on the default rate of banks. Compared to the baseline calibration, if the elasticity of banks’ capital to capital requirements is 60 percent smaller, then the decrease in the default rate of banks due to the sovereign guarantee scheme is 260 percent larger. Similarly, the guarantee fee is a key driver of the policy’s fiscal cost. When the fee drops by 100 percent relative to the baseline calibration, the yearly fiscal cost increases by 65 percent.

Our results are explained by two key effects of sovereign guarantees. Guarantees transfer loan losses from banks to the sovereign and reduce the regulatory risk-weights on firm loans. Banks, operating in a competitive environment, respond to lower losses and lower risk-weights with more credit to firms and less bank capital. Firms use the additional credit to invest more than they would in a setting without sovereign guarantees, and output recovers faster. At the same time, the additional credit to firms implies higher leverage and higher firms’ default rate. In contrast, the default rate of banks decreases. The capital of banks reduces by less than the expected credit losses transferred to the sovereign, thus increasing the banks’ capacity to withstand losses on the loans without sovereign guarantees.

To further understand the impact of sovereign loan guarantees, we decompose it into a ‘capital requirement’ effect and a ‘loan insurance’ effect. The capital requirement effect measures the impact from reducing regulatory risk-weights on guaranteed loans. The loan insurance effect measures the impact from transferring to the sovereign banks’ loan losses on guaranteed loans. In this decomposition we use fiscally-neutral sovereign guarantees. We want to exclude effects arising from subsidies implicit in the level of the guarantee fee.

Figure 2. Decomposition of the impact of sovereign loan guarantees

We find that the ‘capital requirement’ effect leads to an increase in the banks’ default rate and to a temporary increase in the firms’ credit and output in the initial stages of the loan guarantee program followed by a posterior decrease – a typical stabilizing effect. The ‘loan insurance’ effect, on the other hand, decreases the banks’ default rate, more than compensating the ‘capital requirement’ effect. It significantly increases credit to firms throughout the entire loan guarantee program, and it also contributes to the increase in output.

This decomposition is informative for macroprudential policy because the ‘capital requirement’ effect is akin to a macroprudential capital buffers’ release. Results suggest that the positive effects of a conventional loosening macroprudential policy can be enhanced and the negative effects can be compensated with an insurance on banks’ loan losses. We interpret results with caution. Loan loss insurance has costs even if it is fiscally neutral – e.g. moral hazard costs in loan origination and monitoring – which are not considered in our analysis.

The dual role of loan guarantees as both a substitute and complement of buffers’ release is a novel insight that contributes to the growing literature on the interaction between fiscal measures and macroprudential policy. Additionally, it is consistent with the results in Mathur et al. (2023), Wong et al. (2024) and Dursun de Neef et al. (2022). They find that the impact of capital buffer releases on credit during the COVID-19 crisis was stronger in sectors or countries with less loan guarantees support.2 This empirical result suggests that lenders prefer to expand credit with guarantees, even though releasing buffers provides an opportunity to increase credit without needing additional capital.

We explore alternative designs of the scheme to assess the impact of its size, duration and timeliness. Increasing the scheme’s size enhances its effect on bank default, on credit, and on economic recovery but entails higher expected fiscal costs. Extending the maturity of sovereign guarantees has a negligible effect on bank default and credit. But it increases the benefits to the economy and postpones the drop in output associated with the phasing out of the scheme. Finally, delaying the implementation of the scheme past the quarter of the COVID-19 shock would lengthen the economic recovery and increase the banks’ default probability at the time of the shock.