Public Sector Partial Credit Guarantee Programs:What, Why, When and a little bit of How?

Frank NiederLead Financial Markets SpecialistCapital Markets and Financial Institutions Division

What?

• Public sector offers a partial guarantee of loans made by financial institutions to specific markets or types of loan. (eg. SMEs, agricultural, longer terms loans, energy efficiency projects.)– Guarantees on individual loans or portfolio.– Independent separate fund or supported by balance sheet of operating

institution.

• Widely used throughout the world and Latin America.– In Latin America: 15 countries have experience with public sector credit

guarantee programs and 10 countries have operating programs.

• 2nd tier financial mechanism.– Participating financial institutions should make credit decision with final

borrower.

– Coverage levels and guarantee fee key financial variables in determining incentives faced by participating institutions and thereby effectiveness and financial sustainability of programs.

Financial Market without Market Failure (S0)Interest Rate (r)

Risk

r0

S0

Loan Volume

D

L0

• Bank can accurately estimate risk of loan.• Interest rate reflects actual risk. • Largely the case, for well developed financial markets and in

regional markets for larger firms.

Financial Market with Market Failure (S1)Interest Rate (r)

Risk

r0

S0

Loan Volume

D

L0

• Banks cannot at a relatively low cost estimate or mitigate the risk of loans/firms.

• Interest rates overestimate actual risk.• Lower risk firms cannot access credit or at higher interest rates.

r1

r*

L1L*

S1

Credit Constrained Firms

Financial Market with Credit Guarantees(SCG)Interest Rate (r)

Risk

r0

S0

Loan Volume

D

L0

• Credit guarantee partially reduces risks for financial institutions, and thereby increase their willingness to lend.

• Interest rates better reflects actual risk of lending. • By maintaining incentives for prudent lending, a credit guarantee program can assure

lower risk firms gain access.

r1

r*

L1L*

S1

SCG

LCG

rCG

Increased access

Partial Guarantee in Financial Markets without Market Failure (SCG)

Interest Rate (r)

Risk

r0

S0

Loan Volume

D

L0

• Interest rate underestimates actual risk.• Non-creditworthy projects get funded, resulting in financial losses, and need

for subsidies to maintain scheme. • Funding for creditworthy firms in other markets constrained.

rCG

LCG

Losses - Subsidy

SCG

Evidence for ConclusionsCountry Impact

(Average for participating firm, compared to similar non-participating firm)

Fund Financial Performance

Credit Access Firm Performance Subsidy Required

Developing Financial Markets (Market failures)

Chile: Credit Levels: 40% increase

Sales: 6% Profitability:4% No

Colombia (FNG)

Sales:8%Employment: 9%

No

Malaysia Credit levels: 35% increase.

Mexico: NAFIN Productivity: 5% per amount of guarantee.Employment:

No

Highly Developed Financial Markets (Limited Market Failures)

Japan None Yes

Korea None Employment: -1.4%Productivity: -29% per amount of guarantee

Yes

US: (SBA) None No impact. Yes

Why and How?

• Can increase access to credit constrained firms without distorting markets (crowd in the private sector), and,– if priced correctly, are financially sustainable with no or limited

subsidies. – Price of guarantee (guarantee fee/coverage) needs to reflect risk of

portfolio (expected payment of guarantee), and if possible risk of portfolio of participating financial institution. (see CORFO and NAFIN for good practices)

• Can be targeted to specific market segments, terms, or product types.

• Encourages learn-by-doing, improving financial institutions ability to address causes of market failure, economies of scale leading to permanent reduction of credit constraints and degree of market failure.

When?

• For financial market segments characterized by market failures where financial institutions cannot, at a sufficiently low cost, estimate accurately and/or mitigate the risks of loans. – Eg. lack of easily available information on firms, and high cost to

establish enforce collateral them relative to amount of loans.

• Green financing ? What is the market failure? Does it increase perceived risk above actual risks? How?

• Not a substitute for institutional, legal and regulatory reforms that reduce the causes of the market failures. (greater and lower cost access to information on firms, more efficient and effective securing of financial transactions, etc.)