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ARE LOAN GUARANTEE ARE LOAN GUARANTEE PROGRAMS EFFECTIVE?PROGRAMS EFFECTIVE?

byby

Dale W AdamsDale W Adams

The Ohio State UniversityThe Ohio State University

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OverviewOverview

Three types: retail, portfolio, and Three types: retail, portfolio, and wholesalewholesale

Reasons for loan guarantee programsReasons for loan guarantee programs Why SMEs lack access to formal loansWhy SMEs lack access to formal loans Evaluating guarantee programsEvaluating guarantee programs The benefit-cost analysisThe benefit-cost analysis Strengths and weakness of three types of Strengths and weakness of three types of

programsprograms Discussion TopicsDiscussion Topics

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Types of ProgramsTypes of Programs

SMESME Retail Lender Retail Lender Bank Bank

Retail Portfolio Retail Portfolio WholesaleWholesale

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--Retail Type----Retail Type--

Third party is heavily involvedThird party is heavily involved Large increase in transaction costsLarge increase in transaction costs Sometimes duplicate loan analysisSometimes duplicate loan analysis Effectiveness is difficult to measureEffectiveness is difficult to measure Moral hazard & adverse selectionMoral hazard & adverse selection Opportunities for financial substitution: Opportunities for financial substitution:

in borrower’s portfolio, in lender’s in borrower’s portfolio, in lender’s portfolio, between lenders, between portfolio, between lenders, between formal and informalformal and informal

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--Portfolio Type----Portfolio Type-- Fewer transaction costsFewer transaction costs Third party less involvedThird party less involved Some adverse selection problemsSome adverse selection problems Easier to measure effectivenessEasier to measure effectiveness Substitution problems among lendersSubstitution problems among lenders Heterogeneous loansHeterogeneous loans Similar to wholesale loan guaranteesSimilar to wholesale loan guarantees

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--Wholesale Type----Wholesale Type--

Even less transaction costsEven less transaction costs Third party has little to doThird party has little to do Appropriate when specialized SME Appropriate when specialized SME

lenders are involvedlenders are involved Only useful when retail lenders have too Only useful when retail lenders have too

few funds to lend to all of their few funds to lend to all of their creditworthy SMEscreditworthy SMEs

Not appropriate when borrower and Not appropriate when borrower and lender are deposit-taking organizationslender are deposit-taking organizations

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Program JustificationsProgram Justifications

Stimulate lending to groups who lack Stimulate lending to groups who lack access to formal loans: SMEsaccess to formal loans: SMEs

Overcome imperfections in financial Overcome imperfections in financial markets.markets.

Loan guarantee is a Loan guarantee is a partial collateral partial collateral substitutesubstitute that reduces the lender’s risk that reduces the lender’s risk of not recovering the loan.of not recovering the loan.

Help lenders Help lenders learnlearn about new clients and about new clients and marketmarket

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Why do SMEs lack access to Why do SMEs lack access to formal loans?formal loans?

Risk for lenderRisk for lender: lack acceptable collateral, : lack acceptable collateral, high rate of failure among new SMEs, judicial high rate of failure among new SMEs, judicial system is defective, civil unrest and system is defective, civil unrest and economic turmoil, etc.economic turmoil, etc.

Transaction costs for lender and borrowerTransaction costs for lender and borrower: : SME doesn’t know banks, lender doesn’t SME doesn’t know banks, lender doesn’t know this segment of market, distance, know this segment of market, distance, paperwork, inappropriate lending technology, paperwork, inappropriate lending technology, number of visits, etc.number of visits, etc.

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Evaluating Guarantee ProgramsEvaluating Guarantee Programs

Only the number of loans Only the number of loans guaranteed?guaranteed?

OutreachOutreach Sustainability – subsidy dependenceSustainability – subsidy dependence Benefits and costs: the additionality Benefits and costs: the additionality

problem, the substitution problem, problem, the substitution problem, and the attribution problemand the attribution problem

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Costs of programsCosts of programs

Costs are relatively easy to measureCosts are relatively easy to measure Set-up costsSet-up costs Initial funding and later refundingInitial funding and later refunding Opportunity costs of fundingOpportunity costs of funding Programs cause transaction costs: for Programs cause transaction costs: for

lenders, for borrowers, the guarantee lenders, for borrowers, the guarantee agency, and donor or governmentagency, and donor or government

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Measuring BenefitsMeasuring Benefits

Benefits are more difficult to measure Benefits are more difficult to measure than coststhan costs

Number of loans guaranteed is not a Number of loans guaranteed is not a reliable measure of benefitsreliable measure of benefits

Measuring Measuring additionality is main problemadditionality is main problem If no additionality, no benefits from If no additionality, no benefits from

programprogram Two additionality cases,Two additionality cases, A substitution case, and A substitution case, and A case illustrating attribution problemA case illustrating attribution problem

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Case ACase A

Objective: increase loans to SMEsObjective: increase loans to SMEs Bank X made 100 loans to this group Bank X made 100 loans to this group

before program, total value US$ before program, total value US$ 100,000100,000

With guarantee program same bank With guarantee program same bank made 100 new guaranteed loans + 100 made 100 new guaranteed loans + 100 regular loans to SMEs, total value US$ regular loans to SMEs, total value US$ 200,000200,000

100% additionality in number and value100% additionality in number and value

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Case BCase B

Same objective as Case ASame objective as Case A Before program Bank X makes loans to Before program Bank X makes loans to

100 SMEs for total value of US$ 100,000. 100 SMEs for total value of US$ 100,000. With guarantee program, Bank X shifts 50 With guarantee program, Bank X shifts 50

of its riskiest SME loans to guarantee, and of its riskiest SME loans to guarantee, and makes 50 SME loans without guarantee. makes 50 SME loans without guarantee. No change in total value of SME lending.No change in total value of SME lending.

Zero additionality for number of loans and Zero additionality for number of loans and valuevalue

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Case B continuedCase B continued

Bank shifts the most risky SME borrowers Bank shifts the most risky SME borrowers to guarantee in order to capture risk to guarantee in order to capture risk subsidy (adverse selection).subsidy (adverse selection).

Most evaluations of loan guarantee Most evaluations of loan guarantee programs ignore the additionality problem programs ignore the additionality problem and assume that all loans guaranteed = and assume that all loans guaranteed = additional loans made because of the additional loans made because of the program. This results in substantial program. This results in substantial overestimates of the benefits of these overestimates of the benefits of these programs.programs.

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Substitution ProblemsSubstitution ProblemsCase CCase C

Same objective as Cases A and BSame objective as Cases A and B Bank X makes 100 SME loans worth US$ 100,000 Bank X makes 100 SME loans worth US$ 100,000

before guarantee programbefore guarantee program Bank Y makes no SME loans before guarantee Bank Y makes no SME loans before guarantee

programprogram After subsidized guarantee program for Bank Y After subsidized guarantee program for Bank Y

makes 100 SME loans for US$ 100,000, on more makes 100 SME loans for US$ 100,000, on more favorable terms than Bank X, Bank Y takes all of favorable terms than Bank X, Bank Y takes all of Bank X’s SME clientsBank X’s SME clients

No additionality in SME lending, although 100 No additionality in SME lending, although 100 loans are guaranteedloans are guaranteed

Ignoring substitution results in overestimate of Ignoring substitution results in overestimate of benefitsbenefits

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Attribution ProblemsAttribution ProblemsCase DCase D

What would the lender have done What would the lender have done over time without the loan guarantee over time without the loan guarantee program?program?

Isolating the effect of the guarantee Isolating the effect of the guarantee program on lender behavior from the program on lender behavior from the effects of other changes in the effects of other changes in the economy over time is difficult.economy over time is difficult.

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Case D continuedCase D continued

Same as Case A, except no loan Same as Case A, except no loan guarantee program. guarantee program.

Economic reforms increased the Economic reforms increased the profitability of economic activities of profitability of economic activities of SMEs and lenders voluntarily decide it SMEs and lenders voluntarily decide it is good business to expand lending to is good business to expand lending to this group.this group.

Some of the additional lending Some of the additional lending associated with the guarantee associated with the guarantee program may be due to other factors program may be due to other factors

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Case D continuedCase D continued

Attributing all increases (over time) Attributing all increases (over time) in lending to SMEs to a loan in lending to SMEs to a loan guarantee program, also guarantee program, also overestimates the benefits of the overestimates the benefits of the guarantee program. At least some of guarantee program. At least some of the changes in lending might have the changes in lending might have occurred without the guarantee.occurred without the guarantee.

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Other Measures of Program Other Measures of Program PerformancePerformance

Additionality alone is not sufficientAdditionality alone is not sufficient Is additionality sustained?Is additionality sustained? Outreach: number of loans Outreach: number of loans

guaranteed compared to total guaranteed compared to total number in target groupnumber in target group

Sustainability of guarantee program: Sustainability of guarantee program: subsidy dependencesubsidy dependence

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ConclusionsConclusions

Unclear if retail programs are effectiveUnclear if retail programs are effective Risk only one of a number of problems that Risk only one of a number of problems that

limit SME access to formal loanslimit SME access to formal loans Transactions costs may be more importantTransactions costs may be more important Costs may be greater than benefitsCosts may be greater than benefits Benefits difficult to document and are often Benefits difficult to document and are often

overestimatedoverestimated Increase overall transactions costs in systemIncrease overall transactions costs in system Other policy options might be more effectiveOther policy options might be more effective

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Discussion TopicsDiscussion Topics Is there evidence showing retail loan Is there evidence showing retail loan

guarantees anywhere result in additional guarantees anywhere result in additional SME lending?SME lending?

Are transaction costs a major problem in Are transaction costs a major problem in SME lending for both lender and borrower?SME lending for both lender and borrower?

Do retail loan guarantee and reinsurance Do retail loan guarantee and reinsurance programs increase transaction costs?programs increase transaction costs?

Are portfolio or wholesale loan guarantees Are portfolio or wholesale loan guarantees appropriate where large amounts of appropriate where large amounts of deposits are mobilized by potential SME deposits are mobilized by potential SME lenders?lenders?

Importance of microlending in AsiaImportance of microlending in Asia

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Discussion Topics continuedDiscussion Topics continued Do loan guarantee programs eliminate Do loan guarantee programs eliminate

most problems that block creditworthy most problems that block creditworthy SMEs from accessing loans?SMEs from accessing loans?

Would a supervising agency have the skills Would a supervising agency have the skills and information to second-guess the and information to second-guess the decisions of guarantee agencies, who, in decisions of guarantee agencies, who, in turn, second guess the lending decisions turn, second guess the lending decisions made by the ultimate lender?made by the ultimate lender?

Instead of loan guarantee programs, why Instead of loan guarantee programs, why not charge higher interest rates on loans? not charge higher interest rates on loans? This is what many successful NGOs and This is what many successful NGOs and informal lenders do.informal lenders do.

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ReferencesReferences

Graham Bannock and Partners Ltd. Graham Bannock and Partners Ltd. “Credit Guarantee Schemes for Small “Credit Guarantee Schemes for Small Business Lending: A Global Perspective,” Business Lending: A Global Perspective,” unpublished report prepared for ODA, unpublished report prepared for ODA, London, England, April 1997.London, England, April 1997.

Vogel, Robert C. and Dale W Adams, Vogel, Robert C. and Dale W Adams, “Costs and Benefits of Loan Guarantee “Costs and Benefits of Loan Guarantee Programs,” Programs,” The FinancierThe Financier, 4(May 1997): , 4(May 1997): 22-29.22-29.

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References continuedReferences continued Meyer, Richard L. and Geetha Nagarajan, “Credit Guarantee Meyer, Richard L. and Geetha Nagarajan, “Credit Guarantee

Schemes for Developing Countries: Theory, Design and Schemes for Developing Countries: Theory, Design and Evaluations,” unpublished report prepared for the African Evaluations,” unpublished report prepared for the African Bureau, U.S. Agency for International Development, Bureau, U.S. Agency for International Development, Washington, D.C. April 15, 1996.Washington, D.C. April 15, 1996.

Department of International Development, “Do Credit Department of International Development, “Do Credit Guarantees Lead to Improved Access to Financial Services? Guarantees Lead to Improved Access to Financial Services? Recent Evidence from Chile, Egypt, India, and Poland.” Recent Evidence from Chile, Egypt, India, and Poland.” Policy Division Working Paper, Department for International Policy Division Working Paper, Department for International Development, London, February 2005.Development, London, February 2005.

Orbeta, A.C., C.G. Lopez and Dale W Adams, “An Orbeta, A.C., C.G. Lopez and Dale W Adams, “An Assessment of Loan Guarantee Programs for Small-scale Assessment of Loan Guarantee Programs for Small-scale Borrowers in the Philippines,” Working Paper No. 12, Credit Borrowers in the Philippines,” Working Paper No. 12, Credit Policy Improvement Program, Secretary of Finance, Manila, Policy Improvement Program, Secretary of Finance, Manila, Philippines, September 1998.Philippines, September 1998.