«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
While almost certainly there will be some creative accounting and a significant number of existing loans will be transferred to the new categories created by these policies, both bank regulators and tax authorities could sanction such behavior as a regular part of their work. Banks found to engage in abuse could be fined or ordered to establish large provision. Tax cheating could be punished the same way as other forms of tax evasion.
Moving credit to target groups through these policy mechanisms is likely to be characterized by the same levels of regulatory and fiscal evasion as characterizes the general environment in which they are set. The regulatory process for these policies is likely to roughly as efficient and corruption free as it is in the rest of the financial system.
The policy reform approach to broadening credit availability trades off some contingent costs against the sure and certain cost of funding a guarantee organization’s (probably depleting) reserve and the costs of staff and administrative overheads to run what is typically a small volume of high unit cost guarantees. The costs of the policy reform approach are contingent.
They are not actually incurred until a financial crisis that imperils the stability of banks arises.
Even then they may be slight, as the loans promoted under this policy reform approach are in almost all cases likely to be a small part of the overall loan portfolio.
The policy reform approach is not without its disadvantages. First, banks still must keep on their books the lower quality credits that this approach would generate. There is no secondary debt market in most developing countries to sell them into. Prudent bankers thus would be reluctant to make large volumes of loans if they must be kept for their net account. However, this is not substantially different than the situation where bankers accept an untried and untested guarantee organization’s guarantee of payment. In the first case, bankers know and understand the capital that supports the loan as it is their own; in the latter, they have to determine the credibility of the guarantee and monitor to guarantee organization for a deterioration in its credit quality.
CHAPTER SIX CONCLUSIONS
Until this study, most of the dialogue concerning guarantees has been set in black and white.
Proponents have argued their point of view that guarantees are required to lend to specific sectors. Opponents have argued that guarantees produce no demonstrable additionality or even if they did produce additionality under some circumstances, that they are too expensive, subsidy dependent, and too subject to political manipulation to be useful as policy tools.
Based on this study of the European, Asian, Canadian, African, Latin American and U.S.
experience, the debate can be refocused and rephrased.
This study speaks to both arguments. The guarantee companies operating in Europe, Asia and Latin America, with perhaps the exception of the ACCION Bridge Loan Fund, do not offer models that can be used in developing countries. With the possible exception of Germany, they are clearly too expensive administratively. While the Canadian experience is certainly worthy of further study to understand more of how guarantee payments are kept to a low level, government run funds have not been successful and would not appear to be models for developing countries. These two and possibly three (if Germany is included, despite its very low volume of guarantees) cases seem to offer the best examples of how costs can be kept to acceptable levels and where additionality, if is to be found, is most likely to occur in the retail level institutions.
The guarantee industry in the U.S. does produce additionality at a cost that the users of the guarantees find acceptable and is quite low by any measure. It produces additionality in fostering and supporting the introduction of new forms of structured corporate finance and asset backed securities. Recently, it has moved into other classes of debt where there are no assets backing the securitization, such as credit card receivables. It does support and foster additionality by reaching ever further into the low income and small individual transactions sectors to find new additional clients with mortgages and other assets and debt pools that can be securitized and guaranteed with an increasing range of guarantee products. These guarantee companies are operated without any subsidy and are in fact for-profit stock companies. The expenses are kept low by both large-scale operations and constant attention to process mechanization and innovation. In the U.S. case, the individual guarantees are done on a retail individual basis but are almost always repackaged to be sold in wholesale debt markets.
The multinational guarantee company model can serve as one approach that has a substantial potential to reach SME and micro lenders and deposit takers in developing countries. The potential benefits of such an approach are significant.
Guarantees are not “magic bullets.” They do not automatically produce additionality. Neither do they automatically achieve subsidy independence and sustainability. Least of all, they do not automatically attract private capital to sustain their growth into new areas of business.
These all happen under a specific set of circumstances and a policy environment largely dictated by governments.
The development of guarantees that both produce additionality and acceptable cost structures appear to march almost lockstep with the development of large and deep credit markets. The U.S. offers no example of guarantees “leading” credit markets. Government first created the preconditions by establishing GSEs to make secondary markets in home mortgages (and later student loans and farm mortgages) and by giving tax-exempt status to certain forms of municipal obligations. Without large markets, guarantee companies could not have been successful as commercial ventures.
Only from this base market did the guarantee industry begin its relentless expansion into other areas of finance and its steady move toward “low end” transactions that characterize SMEs and micro lending. From this process emerged a symbiotic and mutually supportive relationship between credit markets and guarantee companies. In some cases, the initiative seems to come from one side and in others from the other. Irrespective of who deserves the credit for creating new financial instruments, both credit markets and guarantee companies are interested in having new and expanding supply of financial products to move through the secondary markets and both cooperate to produce it.
Thus, the issue of guarantees can be refocused from are guarantees useful to development finance to a more complex question of under what conditions are guarantees useful instruments for financial development?
The answer would appear multifaceted and the policy implications significant for policy makers and their advisors engaged in guiding the development of financial markets in developing countries. It appears from the U.S. case that guarantees can be developed on a self-sustaining, even profitable basis, but certain basic conditions should be met. These are
• Guarantees require both an economies of scale and deep and large and liquid credit markets. The creation of the large credit market in the U.S. case preceded the development of a guarantee industry. In the developing countries, almost no single country is large enough to provide an adequate market and no single debt market is likely sufficiently large; collectively across a region these conditions may be met.
• Guarantees successfully establish a symbiotic and supportive relationship with credit markets and support the expansion of these into new areas of finance. This growth in turn creates new markets for guarantees. The easiest transactions to guarantee in the U.S.
were home mortgages and municipal debt. These however were the springboard for expansion into a wide variety of guarantee activities.
• The capital requirements to establish efficiently sized guarantee companies are so large that they are unlikely to be met in a single developing country. The amounts of capital required to build the infrastructure for large scale operations that can achieve low per unit administrative costs and to build the sophisticated credit analysis and surveillance systems required so that the guarantee companies can risk their capital is very large. One of the smallest players in the mortgage guarantee market, Triad with less than a 2% share, began with over $20 million of stockholder equity and grew to nearly $100 million in 5 years. Its largest competitor has assets of over $2 billion. Capital of the same magnitude characterizes the bond insurance industry with the smallest just under $100 million of capital and the largest over $2 billion. These amounts of capital argue strongly for multilateral, regional, hemispheric or even global approaches to developing guarantees to support debt markets.
• Guarantee markets can saturate quite readily as they concentrate in the substandard credit risks. In the U.S., guarantees are issued on the small percentage of mortgages that have high LTVs. In the bond insurance market, the initial market was for tax advantaged municipal bonds. When these markets were saturated, the guarantee companies had to create additional sources of revenue by expanding their range of products, the extent of their guarantees, as well as by geographical expansion into Europe and Asia. This in turn requires a policy environment supportive of structured corporate debt, securitization and financial innovation in general. Especially, it argues for structuring guarantee companies that can operate across international boundaries.
• Guarantees require the intervention of government and in the case of developing countries perhaps also the intervention of international development organizations to help create the conditions under which guarantees can work both to increase SME and micro lending, and to develop the debt markets in which the securitized products can be placed.
• Guarantee products can be offered entirely by the private industry without reliance on ongoing subsidy; they can be both self sustaining and profitable under the above circumstances. The capital is raised principally from shareholders. This in turn implies that the capital markets are the chief source of this capital and should they be weak or non-existent, it is difficult to see how the amounts of capital required can be raised in a single country. A larger base of shareholders can be found in the international arena both in the international development finance organizations and in specialized financial organizations with experience in guarantees.
• Sustaining growth and profitability requires both expansions of markets and products as well as continuing process innovation. So clear is the U.S. case of market driven growth and innovation that the role for government intervention in the supply of guarantees must be severely questioned, if not discarded. The role of government is the creation of the financial market structure within which guarantees can operate successfully.
Guarantees have a role in financial development. However, they require a supportive policy environment to grow and flourish as an important part of the financial sector. From the U.S.
case, pushing guarantees as a solution to constricted credit markets, before promoting policies for attacking that constricted market would appear to be unproductive public policy and counter productive as public investments. Creation of national guarantee industries set within the boundaries of often quite small economies are unlikely to produce success. Regional, hemispheric or international approaches can provide the economy of scale required of modern financial service industries.
Finally, there are strong arguments in the guarantee programmes reviewed here against imposing the restrictions of public sector finance and the inevitable politically motivated targeting. The goal of developing a viable and sustainable financial guarantee industry that can support SME and micro intermediaries in accessing financial markets and in mobilizing savings is most likely to be realized by a combination of a multilateral guarantor as outlined above combined with some of the non-institutional approaches. This mix of institutions and policies would both support and be supported by credit markets which could reach further and deeper into the economy to extend credit to smaller borrowers on more favourable terms than can be achieved without the third party guarantees. These goals can best be realized by developing guarantees as a private company, which can operate across international boundaries and access the credit markets of both the developing and developed countries.