Credit Guarantees

Challenging Their Role in Improving Access to Finance in the Pacific Region

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• Publisher: Asian Development Bank
• Year: 2016
• Print ISBN: 9789292575717
• eBook ISBN: 9789292575724
• Topic: Economics
• Subtopic: Development Economics
• Index: Economics

The Pacific Private Sector Development Initiative---a regional technical assistance facility cofinanced by the Asian Development Bank (ADB), the Government of Australia, and the Government of New Zealand---has undertaken landmark secured transaction reforms in eight Pacific Island countries. These reforms have unlocked the value in "movable" assets such as machinery, inventory, and accounts receivable for use as collateral in borrowing. They have the potential to benefit businesses and financial institutions that offer business loans. Yet, despite these reforms, financial institutions remain unwilling to lend. Businesses still find it hard to access the credit they need to grow, which in turn creates jobs and drives the economic activity so desperately needed in the Pacific. Credit guarantees are often proposed as an instrument to overcome this problem. However, as this publication demonstrates, there is no strong theoretical justification for their use.

1.  INTRODUCTION

Banking sectors across Pacific island countries have not yet reached the point where they effectively intermediate between savers and borrowers. Despite adequate liquidity, commercial banks are often reluctant to extend business credit, which is a serious constraint to business operations and broader economic development. In quantitative terms, the ratio of private sector credit to gross domestic product (GDP) in Pacific countries is less than 50%,¹ with the exception of Fiji and Vanuatu. In faster growing and more developed economies, this ratio typically approaches or exceeds 100% (Appendix 1).

SECURED TRANSACTIONS: SOLVING THE PROBLEM OF COLLATERAL

The difficulty in using real assets as collateral has undoubtedly been a major factor affecting banks’ willingness to lend, but this excess liquidity has remained pervasive despite widespread secured transactions reform across Pacific countries over the last decade.² Secured transactions reforms address the problems with collateral: the new secured transactions laws allow security interests to be created in various forms of moveable property, such as equipment, inventory, accounts receivable, crops, livestock, and shares. This enables businesses to pledge moveable assets, making it easier for banks to take on additional forms of collateral as an alternative to real property and reducing the risks of losses in the event of default.

Credit guarantees are often promoted as an instrument to overcome the lack of lending. Credit guarantee schemes have existed for over two centuries, having emerged first in Europe. Today, they are widely prevalent in both the developed and developing worlds.³ Credit guarantee schemes can take several forms, with the main variants being guarantees of individual loans and guarantees of a portfolio of loans. Within these variants, there are many alternatives for allocating risk, ranging from a 100% guarantee of a loan or portfolio, to a lesser proportion, depending on the types of loans, risks, and maturities.

Several credit guarantee schemes already exist in the Pacific (Appendix 2), and proponents advocate for the introduction of schemes, where they currently do not exist. This paper aims to increase awareness of the policy issues surrounding credit guarantees. In so doing, it challenges the arguments for using guarantees and, furthermore, argues that credit guarantees are unlikely to provide an effective solution to the lack of access to credit faced by businesses.

QUESTIONING THE CASE FOR CREDIT GUARANTEES

There is no strong theoretical justification for the use of credit guarantees. However, especially when the reasons for the failure of banks to provide business finance have more to do with an unwillingness to lend than risk aversion. Furthermore, finance theory suggests that when a guarantee is priced correctly to incorporate the risk of non-repayment, a guarantee will have negligible impact on lending. This is because the default risk will be reflected in the cost of any guarantee and ultimately the interest rate charged to a borrower.⁴

Practical experience also suggests that there is a weak case for using credit guarantees to increase business access to finance. There are isolated examples of success, but few rigorous evaluations of guarantee schemes have been undertaken. Where the schemes have been deemed successful, they do not demonstrate an increase in lending relative to what would have occurred without any guarantee. None of the active credit schemes in the Pacific have resulted in any appreciable increase in lending and several have suffered significant losses. Moreover, to make a substantial difference to the amount of credit granted, guarantee schemes would have to be very large, and well beyond the scale of the schemes operating in the Pacific region.

The activities of nonbank credit institutions, such as finance companies and development banks in the Pacific also call into question the case for credit guarantees. In contrast to commercial banks, these institutions, and even some large wholesalers, have either actively embraced the opportunities afforded by secured transactions reforms—the Credit Corporation Group is one such example— or are actively exploring opportunities to introduce new instruments, such as agriculture supply chain financing, secured against buyer contracts, inventory, and accounts receivable. Provident funds—an important source of credit in the Pacific—have also been also been actively searching for lending opportunities. Governments have come to see both development banks and provident funds as essential to financing growth opportunities when commercial banks have been reluctant to do so.

These actions undermine the case for a more extensive use of credit guarantee schemes in the Pacific. Furthermore, and even more troubling, is the real prospect that resorting to credit guarantees will stifle the development of credit assessment and risk management capabilities in Pacific banks, including the development of credit assessment methodologies better suited to the reality of Pacific business conditions. Rather than seeing credit guarantees as the solution to access to credit constraints, the paper promotes a comprehensive reform of the business environment, alongside a greater use of secured transactions frameworks, and the promotion of other nonbank credit instruments, such as trade credit.

The paper is structured as follows: Section 1 gives a brief introduction of the issues. Section 2 provides the starting point for the discussion with an outline of a conceptual approach to barriers to lending. Section 3 provides an overview of the design features of credit guarantees. The Pacific experience with credit guarantees is addressed in Section 4, and this is followed by a discussion of the wider international experience in Section 5. These experiences with the use of credit guarantees in the Pacific region and elsewhere are not encouraging but, as discussed in Section 6, an increased use of trade credit and deeper business environment reform will underpin a sustained increase in credit. The paper concludes with a summary of the main arguments provided throughout.

2.  THE CHALLENGES OF LENDING

In order to lend profitably to businesses, lenders need to be confident that loans will be repaid in a timely fashion, in accordance with lending covenants. In any financial system, lenders face three critical problems in making lending decisions:

(i)	Asymmetric information. Recipients of loans always know more about their businesses than lenders ever can. (This is one of the main sources of lending risk).
(ii)	Moral hazard. Since borrowers are using another party’s finance, their incentives to take risks increase.
(iii)	Adverse selection. If lenders overprice risk, the only borrowers to which they can lend are those who earn very high rates of return on their investments. The risk of nonrepayment of loans increases in these cases.

Lenders have typically dealt with these problems by requiring borrowers to pledge collateral as security against nonrepayment of loans. The fact that default leads to the forfeiture of the collateral reduces the chances of risky behavior or fraud. In almost all lending to smaller businesses, lenders also require a personal guarantee from borrowers so that business owners risk not only their business assets but also their personal assets.

Effectively dealing with these problems requires a sound legal framework for lending, which makes it simple and inexpensive to pledge assets as security, ensure that assets have not been pledged to another lender, and repossess them in the event of default. Pacific lenders have traditionally preferred real estate as collateral. Two problems with using real estate exist, however. First, much of the land in the Pacific is communally owned, which makes pledging difficult, even for those who hold land leases. Second, it is costly and time-consuming to repossess real estate in the event of default.

REVOLUTIONIZING BUSINESS LENDING THROUGH SECURED TRANSACTIONS

To address the problems of using real estate as collateral, extensive reforms of secured transactions frameworks have been undertaken in many of the Pacific island economies in recent years (footnote 2). These reforms have implemented a collateral framework for lending against movable assets that is among the most modern in the world.⁵ Since lenders place substantial reliance on collateral in managing risk, these reforms have the potential to revolutionize business lending in the region. While the reforms have led to a significant number of new loans, they have not yet resulted in a substantial expansion in the availability of finance for businesses.

Many bankers have failed to appreciate how the reforms bring legal certainty to the priority surrounding a security interest and the ease of enforcement procedures. Not surprisingly, the continued reluctance of many commercial lenders to utilize the new framework has promoted a search for additional instruments that will potentially lead to more lending,⁶ hence the interest in guarantees.

3. GUARANTEES IN PRACTICE

Guarantee schemes typically take one of three forms:

(i)	Mutual guarantee associations or societies, which are formed by a group of businesses or organizations, and which extend collective guarantees to loans issued to the members of the association.
(ii)	State schemes, which involve budget support for lending to small and medium-sized enterprises (SMEs), or other target groups, or for particular purposes.
(iii)	Counter guarantees, which are, in effect a form of reinsurance, and generally found in developed countries. Under this mechanism, a guarantee agency reduces its risk exposures by buying counter-guarantees for a portion of the guarantees it has issued.

Of interest is the rationale for these schemes, how the guarantee is structured, the risks, and ways in which these risks can be managed.

A CRITIQUE OF THE RATIONALE FOR CREDIT GUARANTEES

Credit guarantees have been justified on three main gr...

Table of contents

• Front Cover
• Title Page
• Copyright Page
• Contents
• Abbreviations
• About The Pacific Private Sector Development Initiative
• 1 Introduction
• 2 The Challenges of Lending
• 3 Guarantees in Practice
• 4 Could Guarantees Increase Business Credit in the Pacific?
• 5 International Experience with Credit Guarantee Schemes
• 6 Trade Credit and Business Environment Reform for Small and Medium-Sized Enterprises
• 7 Conclusion
• Appendixes
• References
• Back Cover