«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
Traditional guarantees are a slow and complex process. CEGs would avoid that process entirely through the capital auction. The guarantor provides capital through a bidding mechanism managed by an existing financial agency. No additional, permanent institution is required to administer CEG operations, thus minimizing costs. The sealed bids from the participating banks would indicate the amount of additional capital needed to support a given amount of additional lending that conforms to the requirements of the guarantor. The guarantor’s requirements would define eligible loans based on types of loan recipients, amounts, maturities and purposes that the guarantee is intended to support.
A bank’s bid “price” is the ratio of additional capital to additional loans. If a bank wanted to make an additional loan of 100 and believed that capital of 20 would be required to support the risk involved, the bank would bid 5 (or 100/20). If the bid were successful, the bank would receive 20 from the guarantee fund in the form of subordinated debt.
Successful bidders would be those submitting the highest bids, offering the most leverage for guarantee capital. A bank would have to have at least an 8% capital-to-assets ratio to be eligible to bid and its bid could not exceed the reciprocal of its actual capital-to assets ratio.
Thus a bank with a 10% capital- to- assets ratio could not submit a bid larger than 10 while a bank with an 8% capital-to-assets ratio could submit a bid of 12.5 to 1 ratio.
Those banks submitting the highest bids would receive a transfer of subordinated debt (Tier 3 regulatory capital) to support the new lending that the bank committed to undertake in its bid document. The subordinated debt obtained through the CEG auctions would convert into permanent (tier 1) capital at the end of three to five years or on a pro rata basis as installments on the guaranteed loan or loans fell due. The amount of a Tier three capital cannot exceed 50% of its Tier 1 or permanent capital under most banking laws, which serves to keep guarantee operations within prudent limits. Guaranteed lending would have to have maturities of at least three years, or the bank would have to agree with respect to revolving short term loans for activities such as cropping for cycles of at least three years.
The transfer of capital to a successful bidder would be permanent unless the bank failed to make the specified loans or irregularities were discovered. Bank supervisors in their periodic examinations would check to ensure that banks made loans as specified in their bids.
A variation on this strategy would be to permit banks to bid both a multiplier, as above, as well as an interest rate to the final borrower. The bid ratio would be multiplied by the interest rate to determine the final score and the subordinated debt would be allocated to the banks with the highest scores. The spread that the bank earned on these loans would be divided into two components. The first would be the normal spread that the bank earned on its loan portfolio. The second component would be the income over and above the average interest earned, or the risk premium for the more risky loans. These funds either would be placed in a segregated account to support further lending to the sector or would be used to capitalize a fund that would be held by the trustees and periodically auctioned. This would allow the CEGs to be allocated to the banks that could use them most profitably and would create a source of earnings to recapitalize the fund, while still allowing banks a reasonable profit margin equal to that earned on the rest of the portfolio.
The Multiple Roles Of CEGS In The Banking System
The subordinated debt provided to banks through the capital auction would serve multiple
roles. The new subordinated debt obtained by the bank would be:
• “Shadow” or pseudo collateral provided by the loan applicant.
• Shadow or pseudo equity on the loan applicant's balance sheet. A bank's increased capacity to bear risk would exactly offset an equal amount of a loan applicant's deficiency in risk bearing capacity as determined by bankers in the application of their credit policies or as defined by regulators.
• Shadow or pseudo equity on the loan applicants balance sheet.
• Leveragable capital on the bank’s balance sheet Targeting The Ultimate Borrower The auction process makes it impossible (except through collusion) for those responsible for operating auctions and setting conditions for guarantees to direct guarantees to specific borrowers. Administrative direction of guarantees would corrupt the system and usurp lenders' role and responsibilities in credit allocation and risk management. While the guarantees could support lending to a specific sector or industry, the CEGs would not be subject to political influence to guarantee specified persons or loans but instead would depend upon an independent banker’s evaluation of the viability and profitability of the loan.
The purpose of the CEG is to use market based, risk sensitive measures to direct subsidies to lenders and their clients (the ultimate borrowers) that qualify for guarantees. Accordingly, criteria must be provided for the types of borrowers who are supposed to benefit. Relevant variables may include location, size of assets or sales or workforce, the type of economic activity or function performed by the borrower, loan purpose and other features favoured by the owner of the guarantee fund. The selected targeted characteristics defining eligible borrowers should be specified in the funding agreement(s) between the provider(s) of funds and the owner.
Selecting Auction Rules A bank would have to have an 8% risk weighted capital-to-assets ratio to be eligible to bid.
What is an "eligible bidder"? The first requirement would be specification of criteria for banks' participation in the auction. The guarantee is designed to help banks make more risky loans, yet the funding provided by the guarantee is only a fraction of the additional risk that a bank would incur in a loan supported by a CEG. Hence, banks should meet minimum regulatory requirements regarding their capital adequacy. To offer CEGs to undercapitalized banks could place them at greater risk if their guaranteed lending performs less well than implied by their bid.
A procedure for ascertaining a bank's capital ratio would be required. Ascertaining the capital ratio could be done most easily by certification by the bank examination arm of the Central Bank. Lacking this, the report of a qualified independent auditor could be used Subordinated debt (Tier 3 regulatory capital) obtained through CEG auctions would be convertible into permanent (Tier 1 and 2) capital at the end of three years or on a pro rata basis as installments on the guaranteed loan or loans fell due, whichever occurs later. The amount of a bank's Tier 3 capital cannot exceed 50% of its Tier 1 and 2 or permanent capital under most countries’ banking law, which would keep guarantee operations within feasible limits. Guaranteed lending would have to have maturities of at least three years, or banks would have to agree, with respect to short-term loans, to continue cycles of such lending for at least three years.
The procedure adopted to ascertain a bank's capital ratio would have to be applied throughout the period in which auctions are conducted. Annual updates would be required, supported by banks' undertaking with the submission of each bid that their capital position is not materially weaker than at the last certification. Banks that had exhausted their capacity to issue subordinated debt would have to report this condition and be disqualified from further bidding until they obtain more Tier 1 and 2 capital.
The process is entirely transparent, diminishing possibilities for corruption and perpetuation of bad practices and making it possible to identify additionality, which is the difference between what would happen with a guarantee and what would occur in the absence of a guarantee. Transparency and additionality are benefits that increase welfare for the economy and society as a whole.
CEGs can also assist banks with adequate capital ratios, but which lack a sufficient quantity of additional capital, or sufficient liquidity, or both to make loans eligible for CEGs. By providing capital to such banks, their capacity to increase their lending and to attract more deposits or other sources of funds would expand. However, loans supported by CEGs made by such banks would still have to be otherwise nonconforming.
Bids should not be accepted for loans that are unlikely to be made within a reasonable period of time, such as six months after the award. This would curb pre-emptive behavior by bidders and would also simplify CEG administration. Allowing a reasonable time limit would also permit unsuccessful bidders to resubmit their rejected proposals, possibly modified, to subsequent auctions prior to the time the funds are required to fund their client or prospective client with a CEG-supported loan.
These enhancement measures offset the loan applicant's collateral deficiencies, long viewed as the basic problem for which guarantees are required. This feature would enable banks to make loans that they would otherwise like to make but which, without the guarantee, would not conform to their credit standards or to regulatory guidelines. Clearly, this would influence banks' bids as they endeavor to obtain sufficient shadow or pseudo enhancement for applicants. (This compensating feature could require changes in Polish banking regulations.) Awarding capital on the basis of bids approaching the reciprocal of banks' own capital ratios means that banks would be led to explore risks incrementally, dealing first with loan applications that would otherwise be rejected by narrow margins. This is consistent with good risk management, which makes risk a source of profit for lenders; failure at risk management creates losses for lenders.
The CEG simply provides additional capital to bankers willing to make more risky loans in return. A bank does not have to pay for the guarantee but does have to perform as it contracts to do under the guarantee. Whether or not a bank suffers a loss on guaranteed loans, the amount of the guarantee obtained is transferred to the bank to compensate the bank for bearing an otherwise unacceptable risk.
Bidders' eligibility would have to be monitored, as noted above. Likewise, their performance in making guaranteed loans would have to be reviewed. Performance monitoring requirements and sanctions against unacceptable behavior by bidders should be specified in participation agreements between banks and the owners of the guarantee fund.
The transfer of capital to a successful bidder would be permanent unless the bank failed to make the specified loan or irregularities were discovered. The bank concerned should report such failure or irregularities. Bank supervisors in their periodic examinations would check to ensure that banks made loans as specified in their bids.
Regulators would routinely check ex post that the bank did not make similar nonconforming loans at the same time without a guarantee, or adjust credit policy opportunistically in order to obtain a CEG.
Banks using CEGs would be required to maintain records to show that their performance conformed to the regulations of the guarantee scheme. They would also be required to make these records available to the guarantee fund's owners or designees.
Penalties would be required as an incentive to promote competitive bidding and responsible reporting. Penalties for collusion, misuse of funds and deceptive reporting should range from loss of eligibility to participate in further auctions for less serious infractions, to return of the funds obtained from the guarantee fund for serious violations. Civil suits could also be instituted by the guarantee fund if it assumes a legal personality.
It would be expected that banks would charge higher effective interest rates on guaranteed loans than on similar loans, because the risks remain higher. Also, guaranteed loans might have longer maturities than other loans because these borrowers' cash flows may be insufficient to repay quickly. Otherwise, guaranteed loans should not differ, after shadow or regulatory adjustments, from non-guaranteed but similar, conforming loans in a bank's portfolio.
Greater skill in managing risk, not merely transferring it, is accumulated through experience in making more risky loans, creating a permanent enhancement in the risk management skills of participating banks that would be reflected in improved credit policies and lending strategies. Better risk management techniques developed from experience with guaranteed lending are likely to be applied to lending in general and to be adopted and adapted across the banking community, creating social benefits as experience is gained.
CEGs leverage financial capital: better risk management should increase bank's bid ratios enabling guarantee funds to underwrite even more lending.
Being market-based through the auction process, CEGs will fail to satisfy promoters of certain projects and activities, which they feel, should be supported by banks or by taxpayers at all costs. This is in fact one of the strengths of capital enhancement guarantees. For credit allocation to be efficient and developmental, lenders have to be skilled at identifying bad, unremunerative projects as well as good projects and activities that are rewarding.
Banks' losses from guaranteed loans would provide extremely important information in judging the performance of CEGs. In other words, the impact on a bank's capital resulting from its lending supported by CEG would have to be calculated by the bank and reported periodically over the period for which CEG-supported loans were outstanding. This information should be reported to the owner of the guarantee fund and made public.
The CEG Compared To Traditional Guarantee Programmes
• Capital enhancement guarantees are significantly different both in structure and operation from traditional approaches to guarantees.
• They focus analysis on the real problem, which is risk, and its precise cost
• The guarantee is given to the key party in the decision who requires capital to support the loan.