FINANCE FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Best Practices in the Operation of Partial Credit Guarantee Schemes Guide for Policy Makers Valeriya Goffe James Hammersley Elie Rustom January 2021 © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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The risk of claims resulting from such infringement rests solely with you. If you wish to reuse a component of the work, it is your responsibility to determine whether permission is needed for that reuse and to obtain permission from the copyright owner. Examples of components can include, but are not limited to, tables, figures, or images. All queries on rights and licenses should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; e-mail: pubrights@worldbank.org. Graphic Designer: Diego Catto / www.diegocatto.com >>> Contents Preface 4 1. How should partial credit guarantee schemes be 6 regulated and supervised? 2. What are the main ways to fund a public PCGS? 9 3. What is the acceptable leverage ratio for the scheme? 11 4. What is the optimal guarantee coverage ratio? 13 5. How can a PCGS develop an appropriate product mix? 16 6. What are individual and portfolio schemes? 18 7. What are some of the considerations for establishing 20 risk-based pricing? 8. In what cases should the PCGS make a partial payment to the 23 lender on a loan guarantee? Annex 1. Principles for Public Credit Guarantee Schemes 25 (CGSs) for SMEs >>> Preface Financial inclusion, particularly for small and medium enterprises (SMEs), is widely recognized as a key driver of economic growth and job creation in all economies. SMEs represent a significant part of the world economy and are one of the strongest drivers of economic development, innovation, and employment, since most formal jobs in emerging markets are SME jobs. Given that the global economy needs to generate 600 million new jobs by 2030,1 SME development has become a high priority for many governments in both developing and developed economies. Access to finance remains one of the key constraints to the growth of SMEs. The International Finance Corporation (IFC) estimates that 65 million enterprises, or 40 percent of formal micro, small, and medium businesses in developing countries, have an unmet financing need of $5.2 trillion every year.2 Well-designed credit guarantee schemes are one of the means to contribute to the expansion of SME finance. They may also generate positive externalities by encouraging banks and nonbank financial institutions to get into the SME market, thus improving the institutions’ lending technologies and risk management systems. As part of the Technical Cooperation Program agreement with the Saudi government, the World Bank Group (WBG) team has been working with the management and staff of the Kafalah partial credit guarantee scheme (PCGS) to provide technical assistance to strengthen Kafalah’s operations, introduce products innovations, and integrate global best practices. This policy note summarizes best practices on various topics of interest to Kafalah that the WBG provided during 2018–2020. The main sources of information used for preparation of this best-practice guidance include publicly available information about various schemes, Principles for Public Credit Guarantee Schemes for SMEs,3 research reports from multilateral institutions, and various scholarly publications. 1. SME Finance Forum, “Annual Report 2019,” April 2019 (Washington, DC: International Finance Corporation), http://www.smefinanceforum.org/about/annual-report. 2. International Finance Corporation, “MSME Finance Gap: Assessment of the Shortfalls and Opportunities in Financing Micro, Small and Medium Enterprises in Emerging Markets” (working paper, International Finance Corporation, Washington, DC, 2017). 3. The report Principles for Public Credit Guarantee Schemes for SMEs (Washington, DC: World Bank, 2015) was created with input from more than 40 individuals working with PCGSs around the globe. The report lists a series of good practices covering a wide variety of issues, ranging from the independence of the organization to private sector risk exposure to proper governance. The principles are contained in Annex 1 of this policy note. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 4 The policy note discusses approaches to regulation and valuable comments and inputs from Nadeem Karmali (Senior supervision of PCGSs, main ways of funding PCGSs, and Financial Sector Specialist) and Jean Michel Lobet (Senior various operational issues (coverage ratio, product mix, type Financial Sector Specialist). of scheme, and pricing mechanisms). This document is not expected to be a comprehensive guide on the operation of The World Bank team expresses sincere appreciation and PCGSs, but topics covered are relevant for all schemes. The gratitude to officials of the Kafalah Credit Guarantee Scheme main audiences targeted by this note are (a) policy makers in for the excellent collaboration in preparation of these best- various countries where PCGSs already operate or are being practice notes. Kafalah has embraced many of these best designed or rolled out presently and (b) WBG teams working practices as its new management has improved operations on PCGS projects. by increasing lender oversight; working to have the central bank provide oversight of the scheme; increasing its capital This note has been prepared by the World Bank team led by and reaching a self-sustaining level; properly managing Valeriya Goffe (Senior Financial Sector Specialist). The team its leverage rate; and adding new products targeted at key included James Hammersley (Consultant) and Elie Rustom sectors in the economy. It has also implemented IFRS 9 and (Consultant). The report was prepared under general guidance enhanced its collection strategy (including implementation of of Nabila Assaf (Practice Manager) and Manju Haththotuwa an arbitration process), and it is seeking ways for lenders to (Lead Private Sector Specialist). The report benefited from receive capital relief on the guaranteed portion of loans. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 5 1. >>> How should partial credit guarantee schemes be regulated and supervised? The case for independent regulation and supervision of partial credit guarantee schemes The principles for the effective operation of partial credit guarantee schemes (PCGSs) emphasize the importance of good corporate governance, supervision, and risk management. Regardless of whether a scheme is located within a government agency or is an independent entity, good corporate governance as overseen by a regulatory agency will ensure that the scheme continues to be operated in an efficient and focused manner. Principle 1 states that the PCGS should be established as an independent legal entity on the basis of a sound and clearly defined legal and regulatory framework. There needs to be a domestic law or decree authorizing the establishment of the PCGS, either under the corporate or banking legislation or under institution-specific legislation. This legal and regulatory framework needs to indicate the PCGS’s source of funding, clarify where within the government the scheme will reside, establish key requirements, and identify who will supervise it and how the supervision will be conducted. Principle 4 states that the PCGS should be independently and effectively supervised. PCGS supervisory accountabilities should be clearly defined in the relevant legal and regulatory framework and should be separated from the PCGS ownership and management. The principle argues for risk-based supervision, calibrated on the basis of the nature and risks of the product and services offered by the PCGS. Generally, a financial sector supervisor would be the most natural choice for supervision of the PCGS. This is because the banking regulators understand credit, are familiar with the lending market, understand the function of a guarantee with regard to lending, and have staff that already function as onsite evaluators of financial institutions. In Italy, which is Europe’s leader in the provision of partial credit guarantees (PCGs) to SMEs,4 the supervision of the PCGS rests with the central bank. The Bank of Italy supervises a significant number of institutions with a variety of products and markets, including PCGSs. One of the benefits of this broad portfolio is that the central bank is able to understand the entire scope of lending and investment activity in the economy. This gives it a broad picture when it is considering policy interventions.5 4. According to a study by the European Investment Bank, “Credit Guarantee Schemes for SME Lending in Western Europe” (EIB Working Papers 2017/02, European Investment Bank, Luxembourg, 2017), outstanding volume of credit guarantees as a percentage of GDP is the highest in Italy (2.1 percent), followed by Portugal (1.8 percent) and France (0.8 percent). Italy is also the leader by volume of credit guarantees: €33.6 billion, compared with €16.7 billion in France and €5.6 billion in Germany. 5. Banca d’Italia (website), https://www.bancaditalia.it/compiti/vigilanza/intermediari/index.html?com.dotmarketing.htmlpage. language=1 - 8. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 6 A strong regulatory and supervisory system is one of the many factors that contribute to the success of the PCGSs. An independent regulator provides a level of assurance to lenders. The existence of an independent regulator informs lenders that the credit guarantee scheme is being reviewed by an outside organization that is responsible for ensuring that the scheme is following its own procedures and being managed in a prudent and fair manner. Engaged external supervision can have a positive effect on the guarantee system, since it will reduce the risk of fund mismanagement. A review of the literature demonstrates that there is a large degree of heterogeneity in the institutions regulating PCGSs in different countries. The regulatory body for PCGSs varies from country to country. In Africa, Asia, and Europe, the financial sector regulator oversees the greatest number of PCGSs. A survey carried out by the World Bank found that the supervisor has the legal authority to enforce conduct and prudential standards when necessary for 86 percent of respondents (figure 1). > > > F I G U R E 1 - Prudential Regulation of PCGSs in Different Countries 80% 70% 60% 50% 40% 30% 20% 10% 0% All CGSs High Upper Low Africa Asia Europe MENA Western Income Middle Middle/ Low Hemisphere Income Income Financial Ministry Ministry Ministry Other None sector regulator of Finance of Economy of Commerce Source: Pietro Calice, “Assessing Implementation of the Principles for Public Credit Guarantees for SMEs: A Global Survey” (Policy Research Working Paper 7753, World Bank, Washington, DC, 2016). Note: CGSs = credit guarantee schemes; MENA = Middle East and North Africa; PCGSs = partial credit guarantee schemes. In Western Europe, many PCGSs are licensed financial institu- most PCGSs in those countries are generally regulated by the tions. A PCGS survey conducted by European Investment Bank central bank or the state.7 in Western Europe showed that more than half of the entities in the sample operated under a bank, a nonbank financial insti- In some countries, the supervision and control of public tution, or some special license. The allocation of the supervi- schemes is performed by central government ministries. For sory authority over PCGSs showed significant variation across instance, in Korea, KODIT (Korea Credit Guarantee Fund), as different countries. Authority is often allocated to the national a government-sponsored organization, is monitored and as- financial supervisor or to the central bank, but in some other sessed by related government departments: the Ministry of cases it lies with other government agencies.6 Similarly, the sur- Strategy and Finance (budget planning), the Financial Ser- vey of PCGSs in central and southeastern Europe notes that vices Commission (operation supervision), and the Small and 6. The survey was conducted by the Working Group on Credit Guarantee Schemes in Central, Eastern and South-Eastern Europe (CESEE), established under the Europe- an Bank Coordination Initiative (EBCI, Vienna Initiative 2), 19. 7. Centre for Entrepreneurship, SMEs and Local Development, “SME and Entrepreneurship Financing: The Role of Credit Guarantee Schemes and Mutual Guarantee Societies in Supporting Finance for Small and Medium-sized Enterprises,” Jan. 30, 2013, http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=CFE/ SME(2012)1/FINAL&docLanguage=En. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 7 Medium Business Administration (capital contribution).8 In the • Confirm that the PCGS performs the activities mandated United States, there is a hybrid system in that the Small Busi- in its charter, legislation, and fiscal budgets; ness Administration (SBA) has an internal inspector general • Support the PCGS’s improvement of its ability to identify, who reviews agency operations but does not have the au- measure, monitor, and control risk exposures through the thority to force management changes because the president supervisory process; appoints the management of the SBA. The U.S. Government • Strengthen confidence in the PCGS; and Accountability Office (GAO) also reviews SBA activity as an • Ensure the long-term sustainability of the PCGS. arm of Congress and makes recommendations for program and structural changes. In addition to the GAO, the House The framework for supervision should be based on the follow- and Senate each have oversight committees that provide the ing broad principles: budget for the SBA, draft legislation, and oversee the activities of the various SBA programs. Congress can use the budget • Prudential supervision: The purpose of prudential super- process to force changes at the SBA. vision is to maximize the efficiency of the PCGS and man- age credit risk to protect the long-term sustainability of the Research on PCGSs shows the importance of effective pruden- program. The supervision will consist of risk assessment; tial regulation in determining whether to issue capital relief for development of a supervision strategy; the conducting of guaranteed SME loans. About half the banks in a recent Euro- supervision activities, including reporting, monitoring, in- pean Union survey feel that capital relief is equally important or spections, and thematic reviews; and the provision of con- even more important than the transfer of credit risk when using structive feedback intended to identify any weaknesses a credit guarantee scheme.9 If PCGSs comply with high pru- early and allow for correction or risk mitigation. dential standards, financial supervisory authorities can consider • Risk-based oversight: The supervisor will perform a cor- PCGS guarantees as credit mitigation for provisioning and capi- porate governance analysis and a risk analysis to deter- tal purposes.10 Basel III regulations allow enterprises to make mine risk areas of prioritization and focus. The supervisor use of collateral and collateral substitutes such as government will also review the PCGS processes for managing risks guarantees, which can reduce or mitigate the risk weights. Un- that could impair earnings, diminish capital, or compro- der the standardized approach, the credit rating of the collateral mise internal controls and operations. or the guarantor will be substituted for the rating of the bor- • Proportional and tailored: The supervisor understands rower for the collateralized portion of the exposure, if certain that although there are similarities between the PCGSs conditions are met. Hence, guarantees issued by entities with a and banks, there are also many differences. Accordingly, lower risk weight than the SME can lead to reduced regulatory the regulator’s supervision must be tailored to the PCGS. capital. Globally, 70 percent of PCGSs are able to offer capital It must also be proportionate to its size, economic signifi- relief to those lenders that use their guarantee products.11 As an cance, risk profile, and mission. example, in Morocco, loans backed by the government PCGS • Adaptable and evolving: Supervision processes and bear a zero percent risk weight. procedures will take into account facts and circum- stances, fluctuations in condition, the development of the PCGS, evolving risk management systems, technological Supervision of PCGS advances, and the vibrant nature of lending to SMEs. • Judgment and discretion: The supervisory agency will exercise its authority using reasonable and appropriate judgment and discretion. Lender trust in the PCGS guarantee will be enhanced by the knowledge that the regulator is reviewing its processes and procedures. The goals of the oversight are to • Ensure the safety and soundness of the PCGS; • Reinforce prudent lending to SMEs; 8. Chatzous et al., “Credit Guarantee Schemes for SME Lending.” 9. Youssef Saadani, Zsofia Arvai, and Roberto Rocha, 2011. “A Review of Credit Guarantee Schemes in the Middle 10. East and North Africa Region” (Policy Research Working Paper 5612, World Bank, Washington, DC, March 2011), 22. 11. Pietro Calice, “Assessing Implementation of the Principles for Public Credit Guarantees for SMEs: A Global Survey” (Policy Research Working Paper 7753, World Bank, Washington, DC, 2016). EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 8 2. >>> What are the main ways to fund a public PCGS? The public PCGS should have adequate capital and government financial support to ensure effective implementation of its operations and to achieve meaningful outreach and additionality with financial sustainability. Setting up a PCGS with inadequate financial resources can result in a limited developmental effect and a lack of financial sustainability, thereby seriously undermin- ing the confidence of lenders and endangering the achievement of the PCGS’s policy objectives. The adequacy of funding should be determined by the policy objectives that the PCGS intends to achieve and the volume of business it must generate to remain current on its financial obliga- tions while ensuring long-term financial sustainability. Clear and publicly disclosed rules, proce- dures, or arrangements should clarify the responsibilities of the government or ownership entity to provide the PCGS’s initial capital and commitment to provide additional capital or subsidies during the course of PCGS operations. The legal and regulatory framework establishing the PCGS should set minimum capital adequacy standards for the PCGS. To mitigate fiscal risk for the government, the appropriate legislation should put limits on budget appropriations, subsidies, and guarantees. Such limits should accommodate the PCGS’s policy goals and should be fully consistent with the fiscal resources provided in the government ac- counts. Funding use and existing limits should be reviewed and revised periodically as appropri- ate under a fully transparent process and should be audited by a supreme audit institution or any other mandated institution, according to home-country laws. There are three basic ways to finance a public credit guarantee scheme: (a) a self-sustaining scheme based on fees collected, (b) an annual subsidy from a government, or (c) the use of investment capital earnings and guarantee fees to cover costs. If guarantee fees are the only source of income, losses must be absorbed by the guarantee fee income. Losses early in the life of a loan cost more because the loan balance is higher. Those losses also significantly reduce fee income because the life of the loan is shorter. Furthermore, the amount of losses that can be absorbed is reduced by the cost of operations, which also must be paid from the guarantee fee income. It is therefore difficult to run a scheme on fees only when the average life of the loan is short. Conversely, schemes with a longer average tenor are easier to run because more fee income can be collected. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 9 The U.S. SBA scheme is financed with a variation of this struc- The scheme may charge typical fees and use the subsidy to ture. Each year, the SBA estimates the program losses for its cover any shortfall. A scheme may charge a 2 percent guar- guarantee scheme over the 25-year life of the loans made in antee fee up front and 2 percent annually. If losses and ex- a given year (SBA offers tenors up to 25 years for real estate). penses are low, the fees may be enough to cover the cost of That estimate is converted to an up-front fee and an ongo- operating the scheme. The government may offer to cover any ing fee that change from time to time. If the up-front fee and shortfall, especially if there is an economic downturn and a ongoing fee combine to cover program losses, the program is spike in losses. In those cases, the government may not have determined to be self-funding or, in other words, has a sub- a specific budget allocation, but it does provide a sovereign sidy of “zero.” The U.S. scheme has the backing of the U.S. guarantee to back up the scheme. The guarantee gives lend- Department of the Treasury. If the estimates are not correct ers the comfort necessary to assure them that funds will be and the program costs more than expected, the Treasury will available to meet all obligations. step in and pay lenders if the amount collected in fees is not sufficient. Without this backstop guarantee, it is unlikely lend- Programs for specialized goals may be subsidized. Guaran- ers would be willing to participate in the scheme. Operating tees provided on loans to special sectors (for example, manu- expenses for the SBA scheme are paid from a separate bud- facturing and technology), specific regions of the country (for get. There are logistical issues related to this structure. While example, rural areas), or to people who typically have had dif- Congress tends to keep the up-front guarantee fee stable over ficulty accessing financial services (for example, women and the years, the ongoing fee changes annually. That element certain minority groups), may be subsidized to encourage use of change adds a level of complexity to the process. As the of the scheme by these groups. scheme has become more complicated, vendors have begun offering custom software that tracks all the fee changes. The government backing helps bank regulators grant capital relief under Basel rules. This assistance increases the profit- Depending on the economic goals of the government, it ability of the SME loans without increasing the risk profile of may be appropriate to provide a direct subsidy. There are those loans, and it is a very attractive feature to banks when many ways to provide a subsidy, depending on the goal they measure profits on capital used for various products. This of the scheme. For example, to encourage general lending, subsidy is designed to encourage banks to lend. the guarantee fee may be very low on guarantees to all sec- tors. That strategy encourages borrowers to apply because The earnings from invested capital plus fee income can be there is little cost, and it encourages lenders to participate for used to finance a scheme. A scheme can have a base of capi- the same reason. The fee is intended to cover some costs— tal and use the investment earnings from the capital and the possibly the administrative costs—but it is not intended to cov- guarantee fee income to cover operating costs and program er losses. The government uses general revenues to cover losses. Earnings on the capital can be used to help pay oper- the losses. ating expenses and losses. Ideally, in normal economic times, the fees will offset losses. The earnings on the capital act as a backstop in times of economic distress. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 10 3. >>> What is the acceptable leverage ratio for the scheme? Consideration should be given to the maximum allowable leverage ratio for the scheme. Re- search shows that leverage ratios of guarantee schemes in developing countries are generally lower than those in developed countries. Leverage also varies on the basis of the level of ma- turity of the scheme and its performance. For new schemes, a low leverage ratio is appropriate. As a PCGS builds its experience and strengthens its operations, it may be possible to increase leverage ratio, but the ratio needs to be closely monitored to ensure that high leverage does not lead to high losses in the future. Figure 2 shows leverage ratios in effect in several countries and economies in the Middle East and North Africa (MENA) region in 2011.12 Lebanon had the highest leverage rate at the time at 5.79, with the Arab Republic of Egypt, Morocco, and Tunisia between 3.75 and 5. These rates would be typical leverage rates for schemes with a few years of history. 12. Saadani, Arvai, and Rocha, “A Review of Credit Guarantee Schemes.” No recent data are available. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 11 > > > F I G U R E 2 - Leverage Ratios for Select Schemes in the MENA Region 25 20 20 15 15 12.4 10 10 8.5 5 5 5 5.79 5 3.75 4 4.1 0.45 0.7 1.2 0 t ce an q a n a y le ia a e a sia co yp tin ar Ira si re no bi bi i an Ch an oc iw ni ay om ra Ko ng Eg ba les m or Tu Fr Ta iA al Hu l Le Ro M Pa Co M ud Sa Source: Youssef Saadani, Zsofia Arvai, and Roberto Rocha, 2011. “A Review of Credit Guarantee Schemes in the Middle East and North Africa Region” (Policy Research Working Paper 5612, World Bank, Washington, DC, March 2011). Note: MENA = Middle East and North Africa. “Korea” refers to Republic of Korea. Information on leverage ratios in various regions is presented 4.1 compared with 1.0 leverage in lower-middle-income and in figure 3.13 These averages do not include all the schemes in low-income countries. As expected, schemes in Africa have a particular region or income group but have been aggregated a lower leverage at 1.7, which would be expected given that from the responses received from various schemes. It is evi- default rates are the highest in this region (17 percent versus dent that leverage is higher in established schemes in devel- less than 4 percent in other regions). The average leverage in oped countries: the high-income group shows the leverage of 2014 in MENA was 4.4. > > > F I G U R E 3 - Leverage Ratios by Region and Income Group SMEs Outreach Leverage Default Productivity** served (%)* (X)*** rate (%)**** All CGSs 1,383 1.6 29 3.3 2.5 Income group High Income 6,507 2.0 30 4.1 2.9 Upper Middle Income 1,139 0.9 29 2.9 3.0 Lower Middle Income and Low Income 887 1.6 21 1.0 1.0 Region Africa 77 0.3 8 1.7 17.1 Asia 17,293 2.7 33 3.2 1.2 Europe 1,139 0.9 17 3.8 2.9 MENA 829 2.2 22 4.4 3.8 Western Hemisphere 6,531 3.4 164 3.0 2.0 * Number of SMEs served divided by total SMEs in the country. ** Number of gyarantees issued divided by number of emplyees. *** Outstanding guarantees divided by total caputal. **** Nonperforming guarantees divided by outstanding guarantees. Source: Pietro Calice, “Assessing Implementation of the Principles for Public Credit Guarantees for SMEs: A Global Survey” (Policy Research Working Paper 7753, World Bank, Washington, DC, 2016.) Note: CGSs = credit guarantee schemes; MENA = Middle East and North Africa; SMEs = small and medium enterprises. 13. Calice, “Assessing Implementation.” EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 12 4. >>> What is the optimal guarantee coverage ratio? The guarantee coverage ratio is a key feature of any guarantee scheme. Care must be taken to provide enough coverage to encourage lenders to participate in the scheme while retaining sufficient risk to ensure that a thorough credit analysis is performed and that the bank uses the same level of care when servicing the loan that it uses on its nonguaranteed loans. The coverage ratio must be high enough to induce lenders to participate. If lenders do not feel the coverage is sufficient, they will not have an incentive to complete the additional steps neces- sary, including paperwork, to obtain the guarantee. Instead, they will decline the loan application because it does not meet conventional loan standards. The coverage ratio must not be so high that the bank has no risk of loss. If the coverage ratio is 100 percent or close to that level, the lender has very little incentive to properly analyze the credit application. Furthermore, after the loan is approved, the lender has little incentive to spend staff time and money on the proper servicing of the loan. Bankers have several ways to offset their losses. Bankers will sometimes look at their risk from a cash standpoint. They will frequently charge fees for the application and document processing associated with a loan. In addition, bankers can raise the interest rate to help offset their risk. These two sources of revenue do not exist for the guarantee scheme. Beck, Clapper, and Mendoza conducted a survey of 76 PCGSs in 2008.14 The schemes were in 46 developed and developing countries. The survey found that the median guarantee percent- age was 80 percent. 14. Thorsten Beck, Leora F. Klapper, and Juan Carlos Mendoza, “The Typology of Partial Credit Guarantee Funds around the World” (Policy Research Working Paper 4771, World Bank, Washington, DC, 2008). EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 13 Some schemes have guarantee coverage ratios as low as 50 There is a substantial difference in risk exposure between an percent. A 50 percent ratio works well in some circumstances. 80 percent guarantee and a 90 percent guarantee. Although In a banking environment in which SME lending is not very the difference is only 10 percentage points, from the bank’s per- competitive and the banks are collateral lenders that require spective the difference is quite large. If the coverage ratio is 200 percent to 400 percent collateral, the 50 percent guaran- lowered from 90 to 80, the bank’s risk rises from 10 to 20. This tee can encourage banks to lower the collateral requirement. In is a 100 percent increase in the risk to the bank. It also doubles markets with a well-developed credit registry and where credit the amount of capital needed to support the unguaranteed por- bureaus work well and banks use credit scoring models, a 50 tion of the loan, thus reducing the profitability of the loan. percent guarantee can encourage lenders to approve riskier credits. In those cases, banks can use the guarantee to allow Table 1 shows coverage ratio of schemes from some of the them to accept a lower credit score, thus approving more loans. members of the G-20. The chart does not list every guarantee scheme in each G-20 member because there are hundreds of Guarantee coverage ratios of 90 percent or higher are used guarantee schemes around the world. Some are specific to an when creating a self-sustaining scheme is not the goal. It may industry, whereas others are open to all types of businesses. be that the goal of a program is to provide financing to the econ- For example, there are dozens of mutual guarantee societies omy quickly. In such cases, a coverage ratio of 90 percent or in Italy that were created after World War I to help rebuild the 100 percent will encourage banks to make as many loans as economy. Some countries, such as Japan, have regional as possible. Clearly, such coverage ratios are appropriate only in well as national schemes. Others have specialized schemes unusual circumstances, such as a severe crisis situation. for start-ups or high technology firms. > > > T A B L E 1 - Guarantee Coverage Ratios in Select Economies Country or Economy Maximum Guarantee Percentage Argentina Fogaba 75% Australia Does not have a scheme Brazil 80% for FGI (Fondo de Garantía de Inversión) Government will pay 85% of the loss on defaulted loans up to the sum of 90 percent of the Canada first Can$250,000 in loans registered, 50% of the next Can$250,000, and 12% of all loans in excess of Can$500,000 China 100% in some cases, 90% and 80% in others France 70% for start-ups, 50% generally Germany 70% for loans up to €150,000, German Bürgschaftsbank Mecklenburg-Vorpommern India 75% up to Rs 50 lakh (85% up to Rs 5 lakh (micro), 80% for MSEs owned/operated by women Indonesia 80% for People’s Business Credit Italy 80% for state-guaranteed revolving fund for SMEs (Italian Ministry of Economic Development) Japan 80% for Credit Guarantee Corporation of Tokyo Korea, Repub. 85% up to 10-year tenor, 80% over 10-year tenor for best credits Coverage ratios depend on the program, with a final auctioned coverage ratio in the case of the global Mexico massive programs, and they go up to 80% in the case of sectoral directed credit programs Russian Federation 70% of principal for Moscow fund; there are 79 regional funds, of which the Moscow fund is the largest South Africa Up to 90% maximum Spain 50% guarantee provided by a scheme supported by the Kingdom of Spain and the European Investment Bank Turkey Maximum guarantee is 100% United Kingdom Enterprise Finance Guarantee Scheme—maximum guarantee is 75% United States Maximum for loans less than US$150,000 is 85%; maximum for loans greater than US$150,000 is 75% European Union 75% for Eurofund Source: Respective PCG schemes. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 14 Coverage ratios in the MENA region range from 50 percent to 90 percent (table 2). The 50 percent level is used on loans to larger firms in Egypt and on working capital loans in Morocco. The 90 percent loans are available in the United Arab Emirates and on loans to innovative firms in Lebanon. The rest of the guarantee coverage ratios in the region are in the 60 percent to 80 percent range. > > > T A B L E 2 - Guarantee Coverage Ratios in the MENA Region Country or Economy Minimum (%) Median (%) Maximum (%) Egypt, Arab Rep. 50 60 70 Iraq 75 75 75 Jordan 70 70 70 Lebanon 75 82.5 90 Morocco 50 65 80 Palestine 60 60 60 Tunisia 60 67.5 75 United Arab Emirates 90 90 90 Source: Youssef Saadani, Zsofia Arvai, and Roberto Rocha, 2011. “A Review of Credit Guarantee Schemes in the Middle East and North Africa Region” (Policy Research Working Paper 5612, World Bank, Washington, DC, March 2011). Note: MENA = Middle East and North Africa. It is typical for schemes to have multiple coverage ratios for exposure in the transaction to ensure that the credit analysis different products. Some schemes have higher coverage ratios and loan servicing will be satisfactory. Lenders can offset some for targeted groups (for example, start-ups or women-owned of their risk by charging fees during the application process (ap- businesses). In most cases, the listed ratio is the highest one plication fee, document preparation fee, collateral appraisal fee, that will be used for most loans. or credit report fee) to applicants for various services. When the lender’s exposure is only 10 percent, this cash income can Globally, a coverage ratio of 50 percent to 80 percent is consid- offset a significant portion of the lender’s risk on smaller loans. ered typical and provides a good balance between providing a When the lender’s exposure is 20 percent, there is still a rea- guarantee to a lender and requiring the lender to have sufficient sonable level of exposure even after accounting for the fees. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 15 5. >>> How can a PCGS develop an appropriate product mix? Getting the product mix right is not an easy task for a PCGS. On the one hand, there is a tempta- tion to introduce various products to attract more lenders and better serve the needs of the mi- cro, small, and medium enterprises, but on the other hand, managing a large number of special products is a challenge. It is appropriate for a PCGS to streamline its list of products yet retain its ability to produce products tailored to special situations. It is difficult for a PCGS to manage a large number of different products. This variety of offerings complicates training needs for staff and makes dealing with the PCGS more difficult for lenders. The key to streamlining the product mix is elimination of variables. An analysis of the products is necessary to determine which variables can be combined to reduce the number of special circumstances that lenders and the PCGS must track. Each additional variable increases the number of possible errors. Finally, eliminating variables should include an analysis of any ad- ditional risk caused by the removal of the variable. There is marketing value in having a product for a specific sector, type of business, or lender. By providing a customized product, the PCGS is being responsive to the needs of ministries and others that are looking for a product designed to meet a specific policy objective. Simplicity in operations helps the PCGS and helps lenders. Keeping program structures simple helps reduce the amount of training necessary for the PCGS staff and makes the products easier for the lenders to use. It also reduces the number of mistakes that can be made. (This is key because it would be embarrassing for the bank to discuss a guarantee product with a client and find that the client is not eligible.) In addition, it reduces the number of data input errors at the bank and the PCGS. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 16 A sophisticated IT system is necessary to keep track of mul- and special products could have a 1 percent fee. Products tiple products. Ideally, the IT system would be programmed to should have either a US$1 million maximum or a US$5 mil- prevent errors by checking, for example, whether the guaran- lion maximum loan size. More than two values for each vari- tee coverage was appropriate for the lender and for the prod- able can lead to confusion. It is important to understand that uct each time a guarantee is approved.15 lenders participating in the PCGS programs do not do a guar- anteed loan every day and have several other products that There are likely to be recurring requests for special products. they are selling. When the product description is simple and Because small businesses are everywhere in the economy, it consistent, it is easier for loan officers to learn the details of is likely that ministries and lenders will ask for special prod- the product. ucts. The PCGS should design any new offerings so that they are similar to existing special programs, using the same pro- By implementing the aforementioned recommendations, the gram variables. PCGS will have two values for each variable (guarantee fee and coverage rate), which will simplify its product offerings. As It is recommended that the PCGS have no more than two val- new products are requested, the PCGS should use the same ues for each variable: one for regular products and one for structure as existing special products to maintain consistency. special products. For example, all regular products could have On an annual basis, the PCGS should check the volume of an 80 percent guarantee percentage (coverage rate), while each special program and decide whether to maintain or elimi- special products could be offered with a 90 percent guarantee. nate it. All regular products could have a 1.5 percent guarantee fee, 15. Beck, Clapper, and Mendoza, “The Typology of Partial Credit Guarantee Funds,” 16. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 17 6. >>> What are individual and portfolio schemes? There are two primary types of partial credit guarantee schemes: an individual (loan-by-loan) scheme and a portfolio scheme. In a loan-by-loan scheme, each application from a lender is sent to the scheme for a credit review. This type of scheme is appropriate when lenders are not familiar with SME credits or where there is a greater reliance on collateral as a repayment mechanism rather than the expected cash flow of the business. In a portfolio scheme, the credit decision is fully delegated to the lender in exchange for limits on the amount of loans a lender can approve and controls on future production based on the performance of the portfolio. A port- folio approach is usually more attractive for the banking community because it is faster to use: it does not involve sending an application to the PCGS for review, waiting for the decision on the guarantee, and transmitting the decision back to the lender. In addition, there is the hybrid approach, which combines characteristics of both of the primary types of schemes. The hybrid approach can involve delegation of the credit decision to the lend- er on most loans, with the scheme participating in the credit decision on large loans or becoming more involved with a loan during the servicing or foreclosure process. There is a wide variety in mechanisms that are used to provide efficient placement of the guar- antees. Beck, Clapper, and Mendoza report that 72 percent of schemes surveyed use the indi- vidual approach, 14 percent the portfolio approach, and 9 percent the hybrid approach. Mature schemes tend to use portfolio approaches. As an example, Canada, Chile, the Nether- lands, and the United Kingdom have adopted a portfolio approach, while France; Hungary; Korea; Taiwan, China; and the United States practice the hybrid approach. The central theme in these mechanisms is approval of the loan quickly and by solely using the credit analysis skills of the lenders. Some of the schemes, such as those in France and Romania, have specific limits on the amount of the loan that may be approved unilaterally by the bank. Others, such as those in Hungary and India, permit approval by the lender if the applicant meets certain preset conditions. Portfolio schemes work well in an environment in which lenders have expertise in performing SME credit analysis. Experienced lenders that have successfully lent money to the more credit- worthy SMEs are good candidates to participate in a portfolio scheme. In such markets, lenders EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 18 focus on borrowers with a robust cash flow and substantial benefit of seeing each individual credit application, the PCGS collateral. Lenders tend to support businesses that are in sta- cannot see a decreasing credit quality until loan performance ble or expanding sectors of the economy, where the prospects deteriorates. This makes monthly reporting by lenders critical of survival for the SME are very high. In many cases, these so that changes in the portfolio can be detected promptly. An loans are collateralized by real estate with a value between automated process for lender reporting is key to getting 100 200 percent and 400 percent of the loan amount. In some percent compliance with the reporting requirement. Lenders more competitive environments, the collateral value may be should be able to upload their portfolio report into the web por- as low as 150 percent of the loan amount. In these situations, tal directly. Low-activity lenders should have the ability to ac- lenders need the PCGS to give them an opportunity to provide cess their portfolio on the PCGS’s website and input monthly credit to those applicants that have less collateral available, payment information directly on a loan-by-loan basis. In coun- are in a sector that is unfamiliar to the lender, or perhaps have tries with strong credit reporting systems, it is possible for the a debt service coverage ratio (sometimes known as the pay- PCGS to develop a scoring system based on credit bureau ment to the free cash flow ratio) that differs from the level at data and lender experience to provide an early warning sys- which the lender is comfortable. tem of potential problem areas. The performance of the lending community is also a factor in The PCGS must set a maximum loss rate for each lender deciding whether a portfolio scheme is appropriate. For ex- that will trigger a stop on the ability of the lender to approve ample, in a market in which the nonperforming loans (NPL) additional loans. In exchange for the delegation of the credit range to 10 percent or more, it is not appropriate to establish decision to the lender and the expedited nature of the credit a portfolio scheme. Such NPL levels are not sustainable in a decision, a portfolio scheme should have a stop-loss feature, traditional banking environment and would be challenging to in which the ability to approve additional guaranteed loans will work with in a PCGS. There would have to be substantial fee be stopped when the losses on the portfolio reach a prede- and investment income to support an NPL level of 10 percent termined level. For example, assume a lender is granted a in a self-sustaining PCGS. In these situations, a loan-by-loan US$50 million portfolio by the scheme. In the event of a de- mechanism is more appropriate because the PCGS staff can fault, the lender would receive up to 80 percent of the balance review each application individually and offer assistance with outstanding on each individual loan that defaults. If the total the proper structuring of the loan. In such situations, one of paid reaches 10 percent of the initial value of the portfolio or the PCGS’s missions is capacity building with the local lend- US$5 million, the lender will not be able to approve additional ing community, particularly with the development of cash flow loans. For a bank with a loss rate of 2 percent on its conven- lending skills. tional portfolio, a stop-loss rate of 10 percent would be five times the conventional rate. A lender oversight function is critical for a portfolio scheme because it delegates the lending decision to the participat- To improve the usability of a portfolio scheme, a sophisticated ing lending institutions. It is important for lenders to know that web portal that is easy for lenders to use is advised. The web oversight is a part of the delegation process. The participating portal would be used for the registration of guarantees, col- lending institution’s office must be properly staffed in the areas lection of information, submission of documents, submission of credit evaluation and risk management and should receive of reports, requests for payment on the guarantee, and any adequate IT resources. other communication between the PCGS and the lender. In addition, it should have a function that accesses an electronic Because the credit decision is made by the lender in a port- money transfer platform that permits the transfer of money folio scheme, the PCGS must track lender activity to detect both ways between lenders and the PCGS. problems in the portfolio as early as possible. Without the EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 19 7. >>> What are some of the considerations for establishing risk-based pricing? Guarantees are used to reduce the credit risk of SME loans. Banks that lend to SMEs with guar- antees have more probability of recovering the principal of the loan. In addition, if the bank regu- lator permits a reduced capital charge against the guarantee given that the guarantee provides a lower credit risk rating for a SME loan, this means that guaranteed loans are more profitable than ordinary SME loans because they are less capital-intensive. Guarantee schemes should be self-sustained through an appropriate pricing mechanism and risk-taking measures. The scheme should consider improving the credit quality or increasing the pricing fee, or a combination of both. To help with the long-term sustainability of the scheme, a risk-based pricing mechanism should be considered. Globally, annual fees charged by some of the more mature schemes range from 0.8 percent to 2.3 percent on an annual basis. Some examples are presented in table 3.16 16. To ensure comparability across guarantees schemes in table 3, flat fees were converted into per annum rates, assuming a loan maturity is four years. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 20 > > > T A B L E 3 - Guarantee Fees from Several Schemes Country or Basic Standardized Rate Feesa Link to Risk Economy (% per annum)b 2% of the loan amount + 1.25% p.a. Canada 2.3% No scalability. calculated on the loan balance Higher fees for banks with higher Chile 1% to 2% p.a. 1.5% default rates. Fees are linked to the Colombia 0.95% to 3.85% p.a. 70 product and coverage ratio. France 0.6% to 0.9% p.a. of the loan value 1.3% Fees are linked to the coverage ratio: Hungary 1% to 5% p.a. of guarantee amount 2% 0.6% (40% coverage ratio), 0.9% (70% coverage ratio). For loans over €350,000, fees vary India 1.5% up front + 0.75% p.a. 1.5% according to firms’ credit ratings. Fees are lower for loans up to Korea, Rep. 0.5 % to 3% p.a. 1.2% US$10,000 (1.25% per annum). Higher fees for low credit rating along Malaysia 0.5% to 3.6% p.a. 1.5% with higher coverage ratio. Netherlands 2% to 3.6% one-off 1.7% Higher fees for low credit rating. Romania 1.5% p.a. 1.5% Fees are linked to the coverage ratio. Taiwan, China 0.75% to 1.5% p.a. 0.8% Fees are linked to the coverage ratio. 2% to 3.5% of the loan amount + annual United States rate of 0.55% of the outstanding 1.9% Fees are linked to risk profile. guarantee balance a. When several fee rates exist, the fee of the most important guarantee product (the “basic rate”) was used. b. The “standardized fee rate” is expressed as a percentage of the guarantee amount. Source: Youssef Saadani, Zsofia Arvai, and Roberto Rocha, 2011. “A Review of Credit Guarantee Schemes in the Middle East and North Africa Region” (Policy Research Working Paper 5612, World Bank, Washington, DC, March 2011). Note: p.a. = per annum. There are several possible risk-based pricing mechanisms for pricing scheme. The multiple fees for different sectors would a PCGS to consider. Risk-based structures could be based on increase the chances of mistakes by lenders. Loan files would sectors, lenders, loan sizes, guarantee percentages, or the have to be reviewed thoroughly to make sure the proper sector methods of guarantee approval. In addition, the PCGS could was chosen, and many small businesses could fit in more than consider offering various services to those lenders that meet one sector.17 Lenders and borrowers would have a financial in- certain default criteria, thus reducing their cost of participa- centive to make their business fit into the lower-priced sectors. tion as an incentive for a well-performing portfolio. Conversely, The PCGS must provide guidance on how to determine which those lenders with a poorly performing portfolio would have a sector to use.18 It must also provide guidance on what happens higher cost of participation. if an incorrect guarantee fee was paid because the wrong sec- tor was selected. Sectors would have to be regularly monitored It is widely known that loans to businesses in certain sectors of to determine whether performance is remaining constant or is the economy do not perform as well as others. Creating a sector- changing enough to require an adjustment in the fee. Finally, based fee would require collecting extensive data on the perfor- sectors that typically have the most difficult time finding financ- mance by loan sector of the PCGS guarantees. Once the data ing end up paying the highest fees, and those may be the busi- are analyzed, it becomes possible to develop a range of fees. nesses that the PCGS is trying hardest to help. Charging a different fee in relation to the degree of performance The PCGS could charge each lender a different fee on the of the loans given to the different industries avoids subsidiz- basis of its past performance. This idea combines the simplic- ing poor-performing industries but inserts complexities in the ity of one fee for each lender with the benefit of discourag- 17. An example is any kind of retail establishment that include a place to eat or a service shop (for instance, auto or farm machinery) that sells a significant amount of parts. Is it a service business or a restaurant? Is the business a car repair facility or an auto parts retailer that repairs cars on the side? 18. Examples of factors that can be used to determine the appropriate sector include the part of the business with the highest revenue, the part using the most assets, or the part with the most employees. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 21 ing those lenders sending in the least creditworthy loans from The PCGS could offer liquidation services to those lenders participating in the scheme. Because all loans from the bank that maintain a certain delinquency rate. It may be appropri- would be charged the same fee, it would be easy for loan of- ate to use this liquidation feature as a benefit for those lend- ficers to stay current with the terms of a guarantee. A potential ers that perform well. Doing so would provide an incentive concern is that applicants may be confused by the differences for lenders to carefully service loans to keep the delinquency in fees when shopping among lenders for credit. A mechanism percentage low. For those lenders, the PCGS would offer to would have to be developed to permit a lender to begin sub- perform the liquidation, thus keeping the bank’s cost of partici- mitting loans again at a lower guarantee fee after a set amount pation low. Conversely, it would raise the cost of participating of time. Otherwise, once a lender has a higher fee, it is dif- for those lenders with poorly performing portfolios, giving them ficult to lower that fee by approving more loans because that an incentive to improve their operation or discontinue partici- lender’s fees would be higher than those of its competitors. pation. The PCGS could provide liquidation services to those lenders that did not exceed a certain default rate (for example, While past performance cannot be manipulated easily, current the overall average default rate). performance can be. If the PCGS uses loans made two or three years ago to determine the fee being charged currently, there The PCGS could provide a small fee rebate for loans that pay is a risk that credit quality has changed since those loans were to term or prepay. As long as a loan has passed its one-year approved. Conversely, if more recent performance is used, a anniversary, the PCGS could rebate a portion of the fee (for lender could easily approve a substantial number of loans to example, half a percent). The rebate would be available only increase the denominator used to calculate loan performance for loans that do not require payment on the guarantee. The and show very good performance, at least until those loans importance of the one-year anniversary is that it ensures that start to miss payments. Although bad loans will ultimately catch the PCGS has received at least two guarantee fee payments. up with a lender, an increase in volume can cover a poor port- folio in the short term. The calculation of the fee would have to Generally, a simple system is preferable. Simplicity makes be very objective because lenders will complain if their fee is outreach easy and reduces possibilities of error. Charging a higher than those of their competitors. This type of structure is different fee for each lender has the benefit of simplicity for the difficult to model because it is hard to predict the extent of an lender, although it is more work for the PCGS. This is finan- individual lender’s responses to changes in its fees. cially beneficial for lenders and the PCGS. Charging various fees by sector or other borrower characteristic requires data It may be appropriate for the PCGS to charge different fees for to develop and monitor the fee and adds a level of complexity the different products (for example, letters of credit) to prop- to the guarantee scheme. erly price for the risk. Products performing better than others would have a lower fee, which could improve the sustainabil- Incentives for good performance provide benefits. Offering ity of the scheme. Poorly performing products would have a lower guarantee fees (with the rebate) or offering to perform higher fee, which would provide additional revenue to offset the liquidations both benefit banks with the best portfolios. The the losses on that product. caution here is to ensure that the bank is not manipulating its performance by using the guarantee for borrowers that would The PCGS could also alter the guarantee percentage on its have obtained credit without a guarantee. products. Another type of risk-based change is to reduce the guarantee percentage on the portion of the portfolio that is per- Financial incentives must be balanced against the goal of self- forming poorly, lowering the PCGS’s risk on those loans. This sufficiency. Because one of the main goals of the PCGS is to action would result in a slight reduction in revenues because be self-sufficient, the desire to reward well-performing banks the guarantee percentage would be less, but the lower guar- must be weighed against the need for the revenues to equal antee would be expected to improve the credit quality, which or exceed expenses. would reduce overall guarantee claims. One of the self-sus- taining models uses the different guarantee fees and different A self-sustaining business model is necessary to obtain capital guarantee percentages along with an improving recovery rate relief for lenders. The basic guidance that the regulator will be to reach the break-even point. Although the banks will complain reviewing to determine whether to grant capital relief is an anal- about this change as well, it could be offset by the provision of a ysis of the odds of the guarantee having value when a lender capital break by the regulator on guaranteed loans. files a claim. If there is a concern that the PCGS may not have sufficient funds to pay, in the absence of a specific sovereign guarantee, it is unlikely that capital relief would be approved. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 22 8. >>> In what cases should the PCGS make a partial payment to the lender on a loan guarantee? An important aspect of running a PCGS is making timely and fair payments on guarantees when a loan defaults. The only reason a lender will purchase the guarantee product is if it believes the PCGS will pay on the guarantee if the underlying loan defaults. If the PCGS develops a reputa- tion for paying slowly or for it being difficult to file a proper claim, it will ultimately fail because lenders and regulators will see little to no value in the guarantee provided. It is important for the PCGS to develop an operating procedure that would permit the partial pay- ment of a loan guarantee. It happens that sometimes banks make changes to the terms of the PCGS guaranteed loan without proper notification to the PCGS. Some of those changes may be administrative in nature and have little impact on the outcome of the loan, while others have a greater impact on potential losses on the loan. The partial payment of a guarantee is fairer to lenders, will help with their discussion with regulators regarding a capital break and provision- ing, and will encourage lenders to use the guarantee more frequently because it will increase their confidence that they will be paid. Some guarantees schemes do not have procedures in place to enable partial payments to lenders, and they pay either a full amount or nothing. This affects their reputation in the lending community and ultimately affects the regulators’ decision on whether to grant capital relief for guaranteed loans. U.S. experience with establishing partial payment on a loan guarantee is presented in box 1. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 23 > > > B O X 1 - U.S. Experience with Establishing Partial Payment on Guarantees Similar to other PCGSs, the Small Business Association (SBA) in the United States was faced with a problem in which banks would make various mistakes while servicing an SBA guarantee loan, but many of those errors would be technical violations that had little effect on the outcome of the loan. It did not seem fair to refuse to pay the entire loan guarantee because of a technical violation. The SBA was concerned that bank regulators would modify the capital break available on SBA loans. When Basel I was established, SBA loans received a 20 percent risk rating because the chance of refusal to pay was very low but not zero. The SBA saw the benefit of this capital break for lenders and wanted to protect it. Although implementation of the Basel guidance under Basel III is much more sophisticated, it is still most advantageous to program growth if lenders can qualify for the maximum capital break. The SBA established a partial denial of liability. The SBA has historically labeled the refusal to pay on a guarantee a “de- nial of liability,” meaning that the SBA would deny that it is liable to pay the guarantee because of negligent actions on the part of the lender. The partial denial has allowed the SBA to set the penalty to the bank on the basis of the impact of the bank’s negligence on the outcome of the loan. For example, if a lender failed to take a lien on a vehicle and the vehicle had a value of $10,000, the SBA would subtract $10,000 from the amount paid to the lender in the event of a borrower default. The failure to secure a lien meant that the vehicle could not be sold to offset the losses on the loan. The SBA also determined that it is appropriate that the negligent action on the part of the bank have a measurable effect on the ability to collect on the loan. If a bank failed to maintain one of the covenants, the SBA would make a determina- tion regarding whether that failure had an impact on the loan. For example, most loans require life insurance on key em- ployees. Failure to pay the life insurance premium would be a violation of the guarantee agreement. If the borrower died and the lack of life insurance caused a loss, the SBA would refuse to pay on the guarantee. If, however, the borrower did not die, even though the life insurance was not paid, the SBA would fully pay on the guarantee because the lack of life insurance had no measurable effect on the ability to collect on the loan. The basic idea behind this policy is that the SBA can point to a violation of the guarantee terms and to the amount that the violation cost in terms of recovery on the loan. Use of a partial denial of liability does not mean that the SBA never denies liability. There are still circumstances in which the violation is so serious or has such a significant effect on the ability to collect on the loan that the SBA will refuse to make any payment. Examples of situations in which the SBA would refuse to make any payment include situations in which the borrower did not use the loan proceeds for the purposes identified in the loan documents, in which there was fraud on the part of the borrower or the lender, or in which the lender did such a negligent job in processing the loan that it was clear from the information available at the time of application that the loan should never have been approved. Those circumstances are rare, and the number of complete denials of liability are small relative to the size of the portfolio. The PCGS should adopt a guarantee payment process that Generally speaking, the PCGS may refuse to pay on a guar- is fair to lenders and fair to the PCGS. The PCGS should un- antee purchase request in full or in part if the lender derstand the importance of lenders being able to know with • Failed to comply materially with the loan documents; certainty that the guarantee payment will be made when a loss • Failed to make, close, service, or liquidate the loan in a is suffered on a guaranteed loan. When the loan has been prudent manner; serviced properly, or when a mistake may have been made • Failed to disclose a material fact to the PCGS in a timely but did not have an impact on the outcome of the loan, the manner; PCGS should establish a policy that will pay lenders back. • Misrepresented a material fact to the PCGS regarding the The payment to the lender can be reduced on the basis of a loan; determination of financial impact of the mistake. For example, • Sent a written request to the PCGS to terminate the guar- if a lender forgot to obtain a lien on a piece of real estate worth antee; US$50,000, then the amount paid on the guarantee would be • Failed to pay the guarantee fee within the period required reduced by US$50,000. However, the lender should still be by the PCGS; or entitled to receive the remaining amount. • Was paid in full by the borrower or other party. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 24 >>> Annex 1. Principles for Public Credit Guarantee Schemes (CGSs) for SMEs PRINCIPLE 1. The CGS should be established as an independent legal entity on the basis of a sound and clearly defined legal and regulatory framework to support the effective implementation of the CGS’s operations and the achievement of its policy objectives. PRINCIPLE 2. The CGS should have adequate funding to achieve its policy objectives, and the sources of funding, including any reliance on explicit and implicit subsidies, should be transparent and publicly disclosed. PRINCIPLE 3. The legal and regulatory framework should promote mixed ownership of the CGS, ensuring equitable treatment of minority shareholders. PRINCIPLE 4. The CGS should be independently and effectively supervised on the basis of risk-proportionate regulation scaled by the products and services offered. PRINCIPLE 5. The CGS should have a clearly defined mandate supported by strategies and operational goals consistent with policy objectives. PRINCIPLE 6. The CGS should have a sound corporate governance structure with an independent and competent board of directors appointed according to clearly defined criteria. PRINCIPLE 7. The CGS should have a sound internal control framework to safeguard the integrity and efficiency of its governance and operations. PRINCIPLE 8. The CGS should have an effective and comprehensive enterprise risk management framework that identifies, assesses, and manages the risks related to CGS operations. PRINCIPLE 9. The CGS should adopt clearly defined and transparent eligibility and qualification criteria for SMEs, lenders, and credit instruments. PRINCIPLE 10. The CGS’s guarantee delivery approach should appropriately reflect a trade-off between outreach, additionality, and financial sustainability, taking into account the level of financial sector development of the country. PRINCIPLE 11. The guarantees issued by the CGS should be partial, thus providing the right incentives for SME borrowers and lenders, and should be designed to ensure compliance with the relevant prudential requirements for lenders, in particular with capital requirements for credit risk. PRINCIPLE 12. The CGS should adopt a transparent and consistent risk-based pricing policy to ensure that the guarantee program is financially sustainable and attractive for both SMEs and lenders. PRINCIPLE 13. The claim management process should be efficient, clearly documented, and transparent, providing incentives for loan loss recovery, and should align with the home country’s legal and regulatory framework. PRINCIPLE 14. The CGS should be subject to rigorous financial reporting requirements and should have its financial statements audited externally. PRINCIPLE 15. The CGS should periodically and publicly disclose nonfinancial information related to its operations. PRINCIPLE 16. The performance of the CGS—in particular its outreach, additionality, and financial sustainability—should be systematically and periodically evaluated, and the findings from the evaluation publicly disclosed. Source: Principles for Public Credit Guarantee Schemes for SMEs (Washington, DC: World Bank, 2015). Note: SMEs = small and medium enterprises. EFI INSIGHT | Best Practices in the Operation of Partial Credit Guarantee Schemes <<< 26