«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
An assessment of the state of knowledge
and new avenues of research
AGRICULTURAL SERVICES BULLETIN 129
The designations employed and the presentation of material in this
publication do not imply the expression of any opinion whatsoever on
the part of the Food and Agriculture Organization of the United
Nations concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries.
M-63 ISBN 92-5-104173-3 All rights reserved. Reproduction and dissemination of material in this information product for educational or other non-commercial purposes are authorized without any prior written permission from the copyright holders provided the source is fully acknowledged. Reproduction of material in this information product for resale or other commercial purposes is prohibited without written permission of the copyright holders. Applications for such permission should be addressed to the Chief, Publishing and Multimedia Service, Information Division, FAO, Viale delle Terme di Caracalla, 00100 Rome, Italy or by e-mail to copyright@ fao.org © FAO 1998 ii
Among the substitutes for traditional collateral is the loan guarantee. Guarantee systems for loans have been proposed, planned and implemented in various countries. The assumption made by proponents of such a service is that the guarantee organization is either better informed about the risk of the loan than the lender or it is better structured financially to be able to manage the risk. Despite the apparent attractiveness of a loan guarantee, the empirical evidence available gives little encouragement. Nevertheless, interest in guarantees continues.
This book, the production of which was initiated in this Division, attempts to address the main issues with guarantee funds and the advantages and disadvantages of traditional guarantee systems. It comes to the broad conclusion that there are few instances in which a traditional loan guarantee service adds value in a sustainable way. The book then considers some examples from a highly developed economy, i.e., the United States, where guarantees are structured in such a way as to make them economically attractive to all concerned, and draws more general lessons from these examples. Finally, new approaches to the guarantee concept are aired and proposals made as to how these innovative mechanisms could be implemented in various situations.
John H. Monyo Director Agricultural Support Systems Division
Although primarily the work of Michael Gudger, this book develops ideas which have been put forward by many others, especially subscribers to the Development Finance Network, run by the Ohio State University. To all those who have contributed on the subject of credit guarantees our thanks and appreciation. We hope that their views have been faithfully reflected and adequately included in the debate.
THE RATIONALE FOR CREDIT GUARANTEESThe introduction of credit guarantees has been widely advocated by development finance professionals to address difficulties facing individuals, households, farms and other small firms, which wish to borrow from banks. Small and Medium Enterprises (SMEs) and microenterprises that face credit rationing by formal sector lenders. SME and micro borrowers together with other credit rationed groups such as farmers, rural industries, and women have particular difficulty in developing countries around the world in obtaining formal sector credit. When they do obtain such credit, it is often on comparatively disadvantageous terms. Credit guarantees supported by donor and/or government subsidies have been recommended as a means of addressing these difficulties.1 Advocates advance six arguments in favour of public sector investment or donor involvement in developing and operating credit guarantees. These are as follows: guarantees can overcome collateral constraints, offset the risks of lending to SMEs and micro borrowers, address information constraints, compensate for low profit margins, modify intrinsic characteristics of small business, induce learning, and produce additionality. Each of these
arguments for guarantees is summarized below:
Overcoming Collateral Constraints
Proponents of guarantee funds argue that lenders have difficulty in originating and collecting loans due to a lack of collateral, and that guarantees in effect become a “substitute collateral.” This substitute collateral is viewed as being superior to physical collateral that SMEs and micro borrowers cannot offer or offer in sufficient quantities to secure a loan. The guarantee offered by a third party is both secure and liquid. Should the loan default, the guarantee is easily and quickly called by the lender under the terms of a legal contract that specifies how the lender can recover his money. The third party guarantee is not subject to the problems presented by physical collateral, such as its maintenance in good condition, verification of its value and safekeeping.
Many of the arguments for and against guarantee funds can be found in Juan Jose Llisterri and Jacob Levitsky, editors, Sistemas de Garantias de Credito: Experiencias Internacionales y Lecciones para America Latina y el Caribe, Banco Interamericano de Desarrollo, Washington, 1996. An English version is found in The Financier, Vol.4, No. 1& 2, February/May 1997. Several of the articles also appear in Small Enterprise Development Vol. 8 No. 2, July 1997.
Proponents argue that guarantees compensate for:
• Inadequate registries for collateral and the high costs for registering collateral ;
• Absence of secure land titles ;
• Slow, costly and corrupt legal systems that impede the realization of collateral by a lender;
• Destruction or deterioration of the collateral whether accidental or intentional and borrowers’ disposal or hiding of collateral; and
• Social and political pressure to not vigorously collect loans.
Furthermore, the guarantee fund is a financial entity that publishes its audited financial data, making it easy for a lender to determine the guarantor’s solvency, liquidity, and claims paying capacity. Thus, from most points of view, a third party guarantee by a solvent and liquid guarantor is superior to physical collateral and should enable a lender to make a loan with the confidence that the loan will be recovered in case of default.
Off-setting Risks of Lending to SMEs and Micro Borrowers
Lenders are said to have a perception that SMEs and micro-borrowers are inherently higher risk clients. Bankers point to the high failure rates of small businesses, which are almost by definition more vulnerable to market and economic changes. In addition, the small and microenterprise operators are relatively inexperienced and seldom have the resources to survive a sustained economic downturn. Guarantees can share these risks with banks and thus reduce lender’s perception of risk and their exposure to loss in case of default.
Addressing Information Constraints
Credit-rationed groups are unable to obtain loans because of lenders’ lack of information and because of the high cost of collecting such information by lenders. Lenders without adequate information have difficulty in assessing the riskiness and profitability of the loans.
Guarantees, particularly those issued by grass roots level organizations, can work closely with the target group of prospective borrowers and develop a sufficient amount of information about them, which enable banks to lend.
Compensating for Low Profit Margins
Lenders are reluctant to deal with credit constrained groups due to reduced profit margins.
Most banks are not prepared to cope with a large volume of small loans and generally lack the ability to evaluate applications of many small borrowers whose financial characteristics do not fit easily into the credit evaluation and scoring techniques that they use for larger borrowers. Few lenders are prepared to make the investment in loan technology to gear up for a SME and micro lending programme and fewer still are prepared in loan technology and additional staff required to process many small loan applications. As a result, these additional costs make loans to SMEs and micro borrowers less profitable and less attractive to lenders.
Guarantors can address this difficulty by providing data for the loan work up, and presenting these data to banks in the format that they are accustomed to, reducing the bank’s administrative costs of loan work ups.
Modifying Intrinsic Characteristics of Small Businesses
Credit guarantees can compensate for some of the inherent difficulties faced by small borrowers, proponents argue. Small businesses are often characterized by erratic and seasonal cash flow. They may be subject to sudden and unpredictable price swings of the products they use or produce. Farmers are a classical case of this market price and cash flow risk.
Furthermore, as many small businesses are operated by a sole owner or are family businesses, the accounting system is elementary or even absent. Small businesses in many countries have little incentive to develop accounting systems as this would risk being taxed, a risk that is largely avoided in the informal sector. Without a guarantee, banks would be reluctant to lend where accounts are not kept or are dubious; with a guarantee these issues do not influence the credit allocation decisions. As we will see in the case of FUNDES, some guarantee agencies also perform an advisory role for their clients, helping them manage their businesses to overcome these difficulties that precluded their access to credit.
Once banks are induced to lend with their risks reduced by guarantees, they will discover that some portion of the clients who borrow with guarantees are in fact not as risky nor as unprofitable as originally thought. These clients will “graduate” from the guaranteed loan group and borrow without guarantees. Subsidizing guarantee funds is justified on the grounds that especially first time borrowers are most often excluded from lending. Substantial additionality can be achieved by introducing them to lenders that after a period of satisfactory performance on the part of a new client will be prepared to provide further loans without guarantees.
“Producing Additionality” Guarantees are cited as a policy instrument that produces additionality. A small investment in a guarantee institution’s capital and/or on-going administrative support to guarantee institutions, it is argued, can produce a significantly larger volume of lending to a credit constrained sector than would have been achieved without such guarantees. Guarantees can modify the terms of the loan by allowing banks to extend more credit for longer periods.
ARGUMENTS AGAINST GUARANTEE FUNDS
The arguments for guarantee funds given above have generated counter arguments.
Numerous scholars and development professionals are opposed to guarantees. They have argued with equal force that credit guarantees in general and in particular for SMEs and micro borrowers are a waste of precious development resources and a policy unlikely to produce the results held out by proponents. The critics of guarantees argue that promoters of guarantees overlook several very important theoretical and practical points: banks do not lend to farms and SMEs and micro for reasons that have little to do with the issues cited above.
Characteristics of Third World Banking
Banks in many developing countries are quite dissimilar to banks in more developed countries. Large industrial and commercial groups often own the banks. These groups are the principle clients of “their” house bank, and most lending is in effect inter-firm lending.
Some house banks act primarily as the deposit and asset-gathering arm of large commercial and industrial groups of which they are a part. These banks have little interest in retail lending, and especially to small clients, because they can place all their loanable funds with large clients that are tied to the bank via cross shareholding and interlocking boards. Other, more broadly-based banks, are traditionally geared to the finance of trade and wholesale/retail business conducted by larger, well-established firms.
Closed Financial Markets and Lack of Competition
In many countries the demand for loans is much larger than the supply of loanable capital, providing little incentive to seek out small retail clients. Furthermore, many banking industries have long been protected from foreign competition. Foreign banks, if allowed to enter the local market, would compete by taking away some of their larger clients. The foreign banks would offer superior service and perhaps lower prices, thus forcing local banks to seek out newer and smaller clients. Some observers have remarked that many third world banking industries have yet to make the transition from “Gemeinschaft” to “Gesselschaft” and are unlikely to make such a transition until confronted with a more competitive capital market.
Lending requires capital. Most countries require a risk-adjusted capital adequacy ratio of 8%.
Often the demand for loans is such that banks are fully loaned out. They cannot make additional loans without additional capital. In this situation, guarantees would not produce additional lending.
Costs of Guarantees