«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
One example of such a company is Mexico’s Fianzas Monterrey Aetna, S.A., a joint venture between Seguros Monterrey and Aetna Insurance of the U.S. It is one of many companies doing a class of business called “fianzas” in Spanish and “bonding” more generally in English. Most of the business of this company (which under Mexican law must be a separate entity from its insurer parent) is issuing fidelity bonds for employees who handle cash and construction bonds to protect against a builder’s default, contract non-compliance or malfeasance. The company however does issue a small and growing volume of financial guarantees. The numbers are difficult to obtain and no information is available on the Eric Nelson in numerous communications with the author has stressed the importance of the policy environment and the role of government in establishing a market for the U.S. guarantee industry. He argues that without the intervention of the government to set up two secondary mortgage markets, the mortgage guarantee industry could not have developed. While this may be true for mortgage guarantees, government intervention did not characterize the development of the bond guarantee industry. Nelson again observes that this is largely a function of the large and deep credit market and implies that it would be difficult to replicate without first developing the credit markets.
structure of the deals, but it is obvious that the collapse of the Mexican Peso in 1995 had a severely negative impact on the credit guarantee business. Recently the company has refocused its credit insurance business on selected clients on a collateralized basis.
Several other countries (Argentina, Brazil, Poland, the Philippines, and Thailand among others) have insurers who do what appears to be a small but growing volume of credit guarantee business. Unfortunately without access to detailed accounts, this business cannot be studied apart from the overall insurance business. To date, none of the companies involved have chosen to provide detailed breakdowns of their credit insurance business.
All of these countries however are characterized both by the fact that credit guarantees are an adjunct to the bonding insurance business and that the deals tend to be one off. They are negotiated on an individual deal-by -deal basis. The lending banks do not usually have an organized credit market into which to sell the deals and thus retain the risk for their own account. Although there are some cases when the deals were securitized and sold in secondary markets, this continues to be the exception rather than the norm.
A MULTILATERAL APPROACH TO CREDIT GUARANTEESBuilding on the U.S.A. Model The small markets and the slow hesitant growth of the private guarantee industry in developing countries may in turn be a strong argument for a designed intervention by a multilateral finance agency, perhaps similar to Asian Development Bank’s capital participation in ASIA, Ltd. If private capital cannot make a profit at the outset because of the size constraint, perhaps the U.S. experience can be tapped again for a model. In the U.S., the major markets for home mortgages, student loans, some farm loans, and even college dormitory construction bonds were initiated as Government Sponsored Enterprises (GSEs) which were later privatized and are now for-profit share holder owned and stock exchange listed companies. The mortgage guarantee companies grew up spontaneously around these secondary markets. While few developing economies are of sufficient size and have a sufficient number of transactions to support a guarantee company, a regional or even hemispheric GSE guarantee company may provide the critical mass. Likewise regional debt markets may provide sufficient depth to place the securitizations and to support one or more credit guarantee companies.
More importantly, the U.S. case is instructive in that while active debt markets and a legal basis for securitization are necessary to establish third party credit guarantees; the relationship between the market and the third party guarantee companies is not static. There is a dynamic exchange between the guarantee companies and the debt markets as the guarantee companies push the frontier of what can be financed, continually bringing new types of securities to debt markets and inventing new financial products in their constant drive for additional sources of revenues.
Implementing a strategy similar to the U.S. model would entail the governments of a region establishing a guarantee company with government capital. The company once it had proved that it could make a profit would then be sold in to stock markets of the region to buyers who would become shareholders in a for profit company.
Would such a system find an adequate market in developing countries? Would the insurance company be profitable? Would banks accept the guarantees? Could the underlying property be securitized and would these instruments find acceptance in debt markets? These are questions to which there are no general answers and which will likely vary according to the development of the financial system of a given country. To a substantial degree, the answer depends upon the capital adequacy of the guarantee company and the confidence of the buyers of the guaranteed debt in the adequacy of prudential supervision of the company.
Building on the ASIA Ltd. Model
In the case of Asia Ltd., the model used a combination of development agencies, international insurers and reinsurers and specialized credit insurers to capitalize the company and to supply the technical expertise. This model is well suited to operating across national boundaries and can engage in both bond and structured financial guarantee businesses. The prudential regulation and the level of capital is such that the company has a Standard and Poor’s rating of “A” which enables it to provide credit enhancements that will make the debt and securities that it guarantees attractive to the primary and secondary debt markets of Asia. The company has the somewhat unusual requirement to do 80% of its business in the “weaker” financial countries and thus foster the development of those capital markets.
As noted above and in the study of Asia Ltd. the capital requirements are of a size that a single credit insurer would not have sufficient market within the boundaries of a single country. However, one could easily imagine that a company similar to Asia Ltd. could operate across the Latin American and Caribbean countries and perhaps another in Africa.
The combined economies of the Central European countries, the Newly Independent States and the Russian Federation would provide a third region of sufficient size to sustain a company similar to Asia, Ltd. On this basis, the capital requirements of about U.S. $100 million could be easily met and the market would likely be of sufficient size to make the company viable.
The position of Asian Development Bank in the capital structure is of crucial importance for two reasons. First, as a condition of bank participation, Asia Ltd. agreed to place at least 80% of its guarantees in weaker countries. Second, the probability of default when the Asian Development Bank is involved is far less likely, as this would have far reaching implications for the country. Similarly, if the model were to be applied in other areas, the involvement of international financial institutions and regional banks would be of considerable importance, both as a source of capital and to help meliorate the default risk.
For organizations prepared to supply capital in return for a certain percentage of guarantees being issued in a given sector, a multilateral guarantee company could be a viable approach to developing guarantees. While it has yet to be done, an organization interested in guarantees on pools of SME loans could supply capital in return for a promise by the company to issue a specified volume of guarantees on securitized SME loans. Similarly, other types of loans (agricultural production, for example) could be securitized and guaranteed in return for supplying capital to the guarantee companies.
A variation on this model would be to establish a central facility where deals could be brokered. Borrowers seeking credit enhancements and guarantors from both the banking and insurance industries could come together and work out guarantee deals. This approach would be both low cost and require almost no capital commitment, but would have the disadvantage of having no source of revenue to support its operations.
Building on the Canadian Model
The Canadian model seems to be particularly interesting as it is both a government run system and is characterized by costs that are quite modest by comparison to guarantees extended by government in Europe and in Asia. Furthermore, the clients are both SME and start-up and young companies, which, as a result of the guaranteed loan increase their employment substantially. While it is not clear how this is achieved at such reasonable costs and whether the loans would have been made in the absence of the guarantee, clearly the Canadian experience is one of the more promising avenues for research.
NEW APPROACHES TO GUARANTEES: A MODEST PROPOSAL FOR
A FIELD TRIAL OF FINANCIAL GUARANTEES FOR SME AND
MICRO LENDERSIn the preceding sections, a number of approaches, both unsuccessful as well as those that offer some prospects of being able to foster SME and micro lending have been discussed. In this section, elements successful in several countries are combined into a proposal to test in a modest field trial the utility of financial guarantees for SMEs and micro lenders.
LEVERAGING DEVELOPMENT CAPITAL
Financial guarantees would be written by a special purpose organization that would be funded by international banks, commercial banks, donors, insurers and other interested parties. The purpose of the organization would be to offer financial guarantees to qualified NGO and other micro lenders to enable them to leverage the guarantee and obtain capital in their domestic markets as well as to market syndicated paper in the debt markets. The guarantee company would operate world wide in order to achieve a significant volume of guarantees and thus to lower the transaction costs. While the SME and micro sector would constitute the primary focus of activities, the company could also engage in other financial guarantee transactions when those transactions are determined by the board of directors to foster development.
The initial capital could consist both of some “hard” capital and soft capital in the form of callable capital and/or reinsurance and/or re-guarantees from banks. The initial capital to create an operation that could enjoy an economy of scale is still relatively modest by international standards. It would likely not exceed $100 million.
Both the amounts of capital and the shareholders in the guarantee organization would be important to provide the necessary confidence in the guarantees. The buyers would have to be confident that the guarantor is financially capable of meeting its obligation. Those who use the guarantees as security for lending (as below) would have to accept the guarantees and account for them on their balance sheets and in their risk weighted capital adequacy calculations as being high quality assets.
A SME or micro lender that wanted to use the guarantees would submit an application. The guarantee organization would first conduct an audit and then ensure that the applicant had an acceptable accounting and reporting system in place and could supply the guarantor with regular financial reports. It would further verify that the applicant had established prudent rules for both lending and provisioning of potential losses.
With these safeguards in place the guarantee organization would issue an unconditional endorsable guarantee for which it would make a charge based upon the risk of default on the guarantee. The unconditional guarantee would then be used to borrow from a commercial lender and/or money markets in the country of the applicant. This guarantee would have the full faith and credit backing of the guarantor to the funding bank and would thus represent a very high quality guarantee that could be called should the borrower not pay either principle or interest as stipulated in the loan agreement.
Through an agreement with the regulatory authorities of the country in which the lender is located, it could be agreed that the guarantee would be counted as capital for regulatory purposes. In effect, the lender would be renting capital that could serve to remove the capital constraint on lending and would also overcome the difficulty of a mismatch between deposits and loans.
As an example, let us take a case where a micro lender could lend an additional $3 million.
The lender would first comply with the applicable rules of the guarantor as to accounting and internal management and then obtain a guarantee for $2 million. This guarantee would then be used to borrow $3 million in the home country from banks or money markets or other sources.
This guarantee has several advantages over direct lending:
• First and most important the guarantee organization could leverage its capital significantly. If the initial capital were $100 million, it could with a conservative strategy write $300 million of guarantees. With a somewhat more risky strategy, the volume of guarantees could increase to $500 million. These guarantees would further be leveraged in the home country of the buyer of the guarantee.
• The credit surveillance conducted by the guarantor will in many cases be superior to the existing prudential supervision of regulatory authorities. As the guarantor has a financial interest in the operation of the buyer of the guarantee, the guarantor will be motivated to negotiate the conditions of the guarantee both to minimize the likelihood of default and ensure that it can maintain adequate credit surveillance. Unlike regulators, guarantors are strongly motivated to take actions at the first sign of financial troubles rather than waiting until the guarantee has to be paid.
• The guarantee mechanism enables SME and micro lenders to intermediate funds from capital markets and sustain lending to the sector. This further integrates them into the national financial system.