Alistair Darling is expected to announce a state guarantee scheme to underpin credit insurance – vital for small firms – in his budget next Wednesday.

The scheme will form an important part of a host of budget measures designed to help small and medium-sized businesses through the recession. It is expected to offer guarantees for companies that have seen insurance cover reduced but not withdrawn, the Financial Times reported today.

Companies have warned of a "domino effect" of bankruptcies among suppliers due to the reduction or withdrawal of credit insurance, which protects companies that supply goods on credit against the risk that they will not get paid.

The directors of Steel & Alloy Holdings, a car parts supplier, have written to Lord Mandelson, the business secretary, to alert him to the insurance crisis and its implications for the wider economy. The company said insurers were withdrawing policies that protect suppliers if a customer goes into administration. Without insurance cover, the market becomes paralysed as companies fear that they will not receive payment.

"Without credit insurance, any business downstream in the supply chain can easily cause a domino effect, taking down all of the businesses further up the supply chain and multiplying the negative effects on the economy many times over, with catastrophic results," Steel & Alloy wrote in the letter.

As the recession deepens, insurers have been withdrawing credit insurance from the higher-risk end of the market and raised the cost of insurance in other areas.

Industry has been urging the government to intervene for months. France adopted a state guarantee scheme protecting companies unable to get cover elsewhere last year.

The government has also moved closer to approving a scrappage scheme that would offer motorists a £2,000 discount on a new car in exchange for ditching a vehicle more than nine years old. The initiative, which mirrors similar incentives adopted across the continent and in Japan, is expected to be announced in next week's budget. In Germany, car sales shot up by 40% after the introduction of a €2,500 premium towards new car purchases.