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Financial support to companies should move towards indirect support

Business support can be divided into two categories: direct (gratuitous) support and support that must be paid back.
Economicum
Economicum building at Arkadiankatu (Helsinki)

The corona crisis has affected the Finnish economy, but to a lesser extent than originally feared. During the crisis, business activities have been supported both directly and indirectly, including measures such as the easement of lay-off rules. The Government is currently preparing a third cost support packages for companies. However, the Government should consider shifting the focus from direct support such as cost support to indirect support, such as guarantees by Finnvera.

Last spring, the main economic justification for direct business subsidies was (see GSE Situation Room: "Business subsidies as a tool in the corona crisis") to avoid the bankruptcies of viable companies that could result from payment difficulties and a shortage of cash. The prevention of such liquidity bankruptcies is justified because they may lead to external impacts, meaning negative consequences that will spread to elsewhere in society as a result of the company’s bankruptcy, and due to which the overall harm caused by the bankruptcy will exceed the (financial) losses incurred by the owners of the company.

Concerns were voiced already last spring that various forms of support are partly overlapping. The GSE Situation Room business support report and other reports found that, where possible,  companies tend to select the support forms that are most advantageous (least costly) for themselves. In the light of this observation, it is not surprising that demand for Finnvera’s corona support which must be paid back has remained more modest than expected. A possible reason for this is that unlike gratuitous COVID-19 Aid, i.e. Business Finland subsidies, ELY Centres' subsidies, restaurant subsidies or cost support, Finnvera's loan guarantees involve costs (guarantee commission) and a personal contribution related to the guarantee, which will be borne by companies and business owners.

Gratuitous support is based on selection

Business support can be divided into two categories: Direct (gratuitous) support, where public officials grant companies money gratuitously, and indirect support, where the support lowers but does not eliminate the cost of external financing.

The COVID-19 Aid granted by Business Finland and the ELY Centres is an example of direct support based on discretionary decisions meaning selection. In other words, the party providing the aid uses certain criteria and its own competence to select the companies to which it will grant aid. The only reason for companies not to apply for such support is the possible cost associated with applying for the aid, if the company otherwise believes that it fulfils the granting criteria. A weakness associated with selection is that its success requires that the party granting support has sufficient competence and sufficient knowledge to make decisions on support that will benefit society. Making such decisions is challenging even in stable circumstances, not to mention during the corona crisis.

Cost support is an example of aid in which the criteria for granting the support are decided in advance and tied to the observable characteristics of companies (financial statements) and where discretion is no longer used at the time a decision on granting support is made. The decision to grant cost support is a mechanical process as long as the company fulfils the required conditions and applies for support.

Extending the use of the cost support instrument also involves the risk that some companies will learn to trust that they will be granted gratuitous support also in the future. This expectation provides the wrong incentives for developing and adapting the company's operations.

There is reason to believe that each company has the best possible knowledge on its own future prospects and viability. For this reason, as a rule, only those companies that assess their own future prospects in as positive a light as possible will apply for support that must be paid back. Private actors providing external financing, such as financial institutions and venture capital investors, also have a strong financial incentive to determine the viability and liquidity of the company when making a financing decision. Selection-based subsidies aim to utilise these premises. Selection-based indirect support for Finnish corona subsidies are represented by Finnvera guarantees and equity-based investments by Finnish Industry Investment Ltd. Finnvera awards a partial guarantee for loans granted by financial institutions on the basis of a creditworthiness assessment, and in which Finnish Industry Investment Ltd invests mainly together with private sector investors.

Of course, their prospects are not yet bright, but they are significantly less gloomy than a brief time ago. Instead of creating new cost support instruments or using selection-based direct support, the Government should consider shifting the focus to selection-based indirect support. This should be the case at least in situations with no related larger external effects or in which the central government does not directly limit freedom of enterprise.

Ari Hyytinen, Niku Määttänen, Tuomas Takalo (Bank of Finland), and Otto Toivanen

Further information:
Professor Otto Toivanen
+358 503537651

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