The availability of credit can make or break small businesses, who generally lack an established credit history and don’t have enough collateral to pledge to the bank. Faced with financial scarcity, owners or managers are often led to personally guarantee their business loans, risking their personal assets, such as homes and future wages, if the business fails.

“My father founded a small business 25 years ago back in Japan, and from the start he got loans with personal guarantees from banks,” said Yoko Shibuya, an assistant professor of strategy at Duke University’s Fuqua School of Business. “And I could see, even as a child, how this affected him, our family, and his business decisions.”

Banks need to protect themselves from businesses taking on too much risk, Shibuya said, and with personal guarantees they share some of the financial burden with the borrower.

Regulators are also interested in limiting systemic financial risks for the economy, she said, and may consider personal guarantees as one of the tools to reduce this “moral hazard” problem, the idea that borrowers may use the loans carelessly and put whole economies at risk.

But in the paper “Personal Guarantees on Bank Loans and SMEs Risk-Taking,” Shibuya and her colleague Takeo Hoshi of the University of Tokyo argue that an excessive use of personal guarantees may dampen economic growth by reducing necessary risk-taking in small and medium enterprises (SME). 

The researchers built a model that predicts SMEs’ loan choice, risk-taking and firm performance. They found that the presence of personal guarantees would limit the risk the managers wanted to take on, and as a consequence, the excessive cautiousness would percolate into lower firm performance and an overall lower productivity in the economy.

How a Japanese government’s policy led to a decline in the practice of personal guarantees

In the researchers’ model, when SMEs need to finance a project, they face a trade-off. They either put personal guarantees on the loan, or they choose a loan without personal guarantees but pay higher interest rates. Based on the loan choice, the business managers decide what kind of risk they can take on.

To test their model, the researchers took advantage of a 2014 Japanese policy reform which “strongly advised” financial institutions to reduce the use of personal loan guarantees, Shibuya said. After the guidance became effective, the SME unit of the Japan Financial Corporation — the largest governmental financial institutions in SME lending in Japan — complied with the recommendation and began offering both choices to loan applicants, loans with and without personal guarantees, she said.

“Japanese authorities were concerned about the mental burden of personal guarantees on business managers, but also about the problem of low economic growth in Japan,” Shibuya said. The government thought that an excessive use of personal guarantees would affect SMEs’ strategies and reduce their risk-taking, she said.

Using data provided by the Japan Financial Corporation, the researchers confirmed their model’s predictions.

“We found that firms with better credit rating — firms with higher probability of success and higher performance — were those who would choose loans without personal guarantees,” Shibuya said. Additionally, these firms showed “a superior overall performance” due to their risk-taking attitude, she said, enough to make up for their higher chance of default.

They also found that managers with lower stakes in their company were more likely to choose loans without personal guarantees. This suggests that firms with certain attributes—such as better credit ratings and lower managerial stakes—are more likely to select loans without personal guarantees. The availability of these loan options can influence managers’ incentive to pursue riskier but more performing strategies,” Shibuya said.

Why more loan choice would benefit the economy and managers’ mental health

There are two ways to get away from personal guarantees when your business goes bankrupt, Shibuya said. One way is to repay the loan using your personal wealth, and the other way is to file for personal bankruptcy. As a result, the effectiveness of personal guarantees in limiting moral hazard depends on the leniency of the personal bankruptcy laws, Shibuya said. “In Japan, going bankrupt means you can’t possess a credit card or receive a loan for almost the next 10 years, and you and your family incur a lot of reputational burden,” she said. “Basically, you cannot be an entrepreneur again.” 

In the U.S., bankruptcy laws tend to be more lenient, and therefore, the issues related to personal guarantees might be less salient, she said. But even in the U.S., “the dark side” of personal guarantees emerged during COVID, during which small businesses faced a significant performance decline, she said.

In the EU, the 2011 change in bank capital requirements has also driven a spike in the use of personal guarantees of loans, Shibuya said, with increases from 10% to 70% of total loans in Spain, for instance.

But this lack of choice on loan contracts may hurt economic growth, and governments in Europe started noticing that the SMEs are not taking risks, she said.

“In March 2024, the UK's Financial Conduct Authority started an investigation on financial institutions on the excessive use of personal guarantees and they might start publishing new guidelines for banks on reducing the use of personal guarantees, as Japanese authorities did.” 

Shibuya also highlights the significant social costs associated with excessive personal guarantees, particularly concerning managers’ mental health. “The personal burden of these guarantees can increase the risk of suicides when companies fail and may also deter potential entrepreneurs from starting new businesses,” she said.

She said that even though regulators may be reasonably concerned that eliminating the guarantees may increase systemic risks, this research shows that, given the choice on which loan to take, “good firms” are the ones that choose loans without personal guarantees, and in the end they will increase their financial performance.

“Instead of banks choosing which financial contract to offer to which company, let companies choose,” Shibuya said. “That's going to be better for firms and for the economy.”