An Economic Analysis of the Guaranty Contract

Abstract

Guaranty arrangements, in which one person stands as surety for a second person's obligation to a third, are ubiquitous in commercial transactions and in commercial law. In recent years, however, scholarly attention to the topic has been scant; and there is still no theoretical treatment of this body of law or practice from a economic policy perspective. This paper, accordingly, attempts to outline the basic economic logic underlying the guaranty relationship, and applies the results to a variety of specific issues in government policy and private planning. It poses and answers three main questions: First, why would a creditor prefer to make a guaranteed loan rather than an unguaranteed one? The answer is not as obvious as might first appear, given that market competition over credit terms tends to adjust the interest rate paid by an individual borrower to reflect the specific default risk that he presents. Second, given that they bear the residual risk of debtor default, why would guarantors prefer to guarantee loans rather than make loans directly, thus foregoing the opportunity to earn interest payments that could help to compensate for the risk they bear? Third, even if it is efficient for one creditor to provide funds and another to provide insurance against default, why would the parties prefer to implement this arrangement through the triangular form of a guaranty, instead of simply having the former creditor lend to the latter and the latter lend to the ultimate borrower?

JEL Classification: K12