Loan Guarantees for Consumer Credit Markets

A significant share of U.S. households appears strongly affected by credit constraints. These households typically lack pledgable collateral, making unsecured credit markets essential for their consumption-smoothing efforts in the face of life-cycle income variation and uninsurable risk. Recent work suggests, however, that these markets are significantly affected by limited-commitment and private-information frictions. In this article, we study the potential for guarantees on consumer loans to improve allocations in unsecured credit markets. Loan guarantees are already among the most widely used forms of policy intervention in credit markets, especially for household credit. We employ a rich dynamic model where credit allocation is allowed to be affected by uninsurable risk, limited commitment, and asymmetric information. We find that guarantees can indeed be powerful and can yield important welfare gains. However, we show that for this to occur, care must be taken to tailor their size — and household eligibility for them — in light of the limited-commitment and informational frictions present.