«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
• The capital structure of the guarantee organization would militate against under pricing of guarantees or issuing guarantees to high-risk lenders. Involving commercial banks, insurers and reinsurers as well as multilateral banks and other development finance organizations would provide a structure that maximized the market driven orientation for the guarantee organization. Commercial entities would have a strong interest in protecting and growing their capital.
• In cases where the borrowing and the guarantee are in hard currency, the source of the loan could be in any of the international capital markets.
Accessing Debt Markets
The SME or micro lending entity who has obtained capital based on the guarantee would lend this to its clients. The product of this lending could be sold into debt markets with an additional guarantee issued by the guarantee organization. Let us assume that the $3 million were lent in two tranches of $1.5 million with one tranche for 6 months and the other for 1 year at a profitable spread over the cost of funds and the charge for the guarantee. These loans could then be securitized into 6 month and 12 month paper. The guarantee organization could issue an additional full faith and credit guarantee so that these loans could be sold in debt markets. Given the guarantee, these loans should have a higher credit status than most commercial paper and would be attractive to many investors including pension funds looking for short term paper of good quality paying more than the deposit rate.
The lender could use the proceeds either to relend or to reduce the balance with the source of the initial loan. The lender would likely retain the service on the business and make a charge for this service that would be included in the price at which the loans were sold. This would provide a steady service based fee income.
Promoting Savings And Protecting Savers
The guarantee organization would also enable SME and micro finance intermediaries to engage in safe and sound deposit taking by issuing a guarantee to cover the depositors’ funds held by the intermediary. The same application process as above would enable the guarantee organization to issue a financial guarantee that is in effect deposit insurance. The reporting requirements would likely be more stringent and the credit surveillance more intense.
With this full faith and credit guarantee, the buyer could take deposits from the public with the assurance that should for some reason there be a run on the funds or a collapse; all depositors could be paid. If in fact the guarantor were required to pay due to a collapse, the financial records generated by the periodic reporting requirement and the credit surveillance would enable the guarantor to use a local entity such as a bank or accounting firm to pay off the depositors.
The leverage from this type of guarantee would be enormous. The same $100 million in capital could support guarantees of probably well in excess of $1 billion in savings. The leverage could be increased as experience is gained and the probability of a guarantee payment can be calculated with more precision. The fees charged would be capitalized and used to increase the amount of deposit insurance, which the guarantor issued.
This approach takes advantage of the most promising feature found in successful guarantee systems without imposing a substantial burden on the limited regulatory resources of
• It most importantly would enable SME and micro lenders to significantly increase their volume of operations and do so in a safe and sound manner. The volume of lending could increase significantly without the necessity of increasing capital, as the lender would have a callable capital in the form of a guarantee.
• Banks and others who wholesale funds to the guaranteed SME could do so with no risk of default on the principal and interest. This would in effect give SMEs access to all capital markets.
• The volume of deposits captured by SMEs could greatly increase with what is, in effect, private deposit insurance. As SMEs generally lend at substantially higher rates, they could offer favourable deposit rates, thereby attracting savings from the public
• Placing the securitized debt in local and in some cases in international markets would be a significant step in developing more active and deeper capital markets as well as integrating NGO’s and micro finance intermediaries into the financial sector.
• A multilateral, multinational guarantee organization would have a market large enough to develop an economy of scale and to lower the administrative cost per operation. With this large market, it can invest in developing the necessary credit surveillance technology.
• A capital structure that combines development finance capital with private sector capital experienced in guarantees is more likely to produce a market driven organization that will negotiate guarantee terms which will reduce default. The organization will have a commercial interest in conducting adequate credit surveillance, and in guarantee pricing that reflects the riskiness of the guarantee.
NON-INSTITUTIONAL MODELS FOR GUARANTEES
The guarantee institutions operating outside of the USA that were reviewed above have all been variations on a model in which the guarantee is provided by a separate organization to an individual borrower, who can then use the guarantee to obtain a loan. In the U.S. case, we saw that various types of securities sold in secondary markets were the object of guarantees.
In the case of home mortgages, the securitizations grew out of the same “retail” approach to guarantees that characterizes the programmes in developing countries. All of these guarantees were characterized by the creation of a financial intermediary whose costs of operations added to the overall cost of credit. In the U.S. case, the economies of scale are so large that these costs were trivial while in the developing countries, the volumes were and are so small that the administrative costs would greatly increase the cost of credit unless they were borne by a subsidy.
In the proposal above, the “wholesale” approach to issuing credit guarantees is outlined as a means of eliminating many of the difficulties of individual SME and micro guarantees. It too is an “institutional” approach as were all the previous ones. While this is one approach, many of the goals of guarantees can be realized without the creation of a special purpose institution.
Several of these non-institutional approaches may be able to accomplish the same goals that guarantee funds seek without the cost of a separate financial intermediary. The research on non-institutional models for guarantees is in the initial stages. The two models set out below are the first efforts to conceptualize the problem of supporting credit to disadvantaged groups without the necessity of creating both an institution and an on-going call upon external resources from budgets and/or donor. There will surely be many other variations on this theme. The following models are presented primarily to refocus thought and research toward more sustainable models that can accomplish the same goals without the severe financial problems that have characterized guarantees in the developing countries to date.
Capital Enhancement Guarantees
A new model for credit guarantees developed from an FAO project carried out for the Ministry of Agriculture of the Republic of Poland was developed by J.D. Von Pischke. After studying the experience of guarantee funds in Europe and in the developing world, it became apparent that they did not present a viable model for Poland. The costs were clearly too high and the volume of operations was clearly too low for the guarantee fund to not be heavily dependent upon on-going donor and/or government support. Furthermore, it appeared little if any additionality arose from the schemes operating in other countries and most were unattractive to banks and bankers, who consequently guaranteed only a small portion of the total loans. Moreover, the loans guaranteed were usually the poorest quality loans, those most likely to default, further raising the cost of guarantees through the process of adverse selection.
In these circumstances, a new model was needed to accomplish three goals simultaneously:
• move lending to a targeted broad sector, in this case, the agricultural sector
• function with reduced operating costs at sustainable levels and
• encourage sound banking practices To achieve these goals, the Capital Enhancement Guarantee (CEG) model was developed as a model to utilize development resources supplied by donors and/or national governments.
The description that follows is a slightly edited and modified version of the original Von Pischke proposal.
Credit guarantees as currently practised are not effective because they do not address the principal problems of banks. Instead they focus upon the supposed collateral constraint. It is not this constraint that is the major obstacle to a bank making a loan. CEGs on the other hand
attack the real problem of rejected loans. Banks reject loans because they are:
• too risky
• inconsistent with a bank’s business strategy and credit policy
• unlikely to meet the standards of banking regulators The traditional approach to guarantees is to create a third party guarantor of provide credit enhancements. The Capital Enhancement Guarantee has numerous advantages over
• CEGs transfer the decision-making responsibility to banks that have superior information.
• The CEGs require almost no staff
• Overhead costs are trivial when compared to the amount of guarantees issued.
• CEGs avoid moral hazard, a process by which the riskiest loans are presented for guarantees.
• CEGs provide superior and permanent leverage of donated or budgetary resources channeled to guarantee funds by transferring to banks the capital required supporting loans on a permanent basis.
• CEGs provide the strongest possible incentive to banks to make additional loans to the targeted sector but to make loans that are consistent with prudent banking practice.
• CEGs can be implemented very quickly without the necessity of creating a large and expensive organization.
• CEGs require no on-going budget subsidy for either losses or administration over and above the initial amount required to create the fund.
Implementing Capital Enhancement Guarantees
Capital enhancement guarantees (CEGs) provide a mechanism that avoids the disadvantages of traditional guarantees while offering a basis for lenders to explore and assume risk on an incremental basis. CEGs operate entirely through commercial and cooperative banking systems and the bank regulation framework at negligible administrative costs.
Capital CEGs are based on the principle that banks require capital to bear risk. The international standard among the industrial countries is that a bank should have at least 8 units of capital for every 100 units of loans outstanding. CEGs provide that capital and to the extent that international standards are adhered to, for each unit of capital provided, banks MAY be able to provide up to 12.5 units of loans, although prudence may dictate a less leveraged ratio.
Maturities Banks are often required by the Central Bank to match the maturities of their loans to those of their deposits. Most deposits in developing countries are still relatively short term and thus are useful to banks only for supporting short-term loans. CEGs provide banks with term capital that enables them to extend the maturities of the loans that they originate.
Loan Quality Loan quality is a critical to a bank. Banks often require what appears to be excessive collateral because they are concerned that the bank auditors or the Central Bank may not view the security supporting a loan as adequate and may require the bank to create a provision. These provisions are very expensive to banks as they reduce loanable capital and create entries on the liability side of the balance sheet. CEGs avoid this problem as the capital that banks acquire in effect goes to the asset side of the balance sheet and is very much like any other capital that the bank has on its balance sheet in its ability to support additional lending.
Establishment Of The Guarantee Fund
Donor and national funds provided for auction as capital enhancement guarantees can be placed in a special account and can disbursed very quickly under the rules described below.
No permanent guarantee organization is created, which means that future losses are contained and that taxpayers are not burdened, given that virtually all such guarantee organizations fail or require continued taxpayer support.
Guarantee funds must be obtained from a donor or from the government. Their ownership must be established. The owner acts as the guarantor. Possible owners include the donor, the government, a trust, or an official agency such as the Central Bank.
If a trust were created it could be administered by three trustees: one appointed by the funder(s), one by the government and one by the domestic banking community. The trustees would require no payment for their services. The trust agreement should contain a "sunset clause" indicating that the trust will be dissolved not later than one year after the last guaranteed loan has been repaid.
• A fiduciary intermediary such as a bank, national or abroad, would hold the funds and execute transactions requested by the owner or the owner's designee.
• The owner would establish an accounting system and design reports that would indicate the activities of the fund to the satisfaction of provider(s) of funds, official agencies and banks participating in or interested in participating in CEG auctions.
• The owner would be responsible for periodic audits of the guarantee fund by independent auditors.
Capital Auctions To Create CEGS To Support SME Lending