Economics of credit guarantee schemes

The Credit Guarantee Scheme (CGS) is one of the many international "best practices" designed to augment the flow of formal sector finance to select groups of borrowers, such as, micro and small enterprises. Guarantee funds help shift some risks of default from the banks to the guarantors to induce the commercial banks to lend to the clients perceived to be at higher risks such as micro, small and medium enterprises (MSMEs).
MSMEs perform vitally important economic functions working as major drivers of economic growth and social progress in developing countries. Contributions of MSMEs to employment creation, poverty alleviation, creation of new enterprises, entrepreneurship development and innovation, decentralised industrial growth and social cohesion are widely recognised globally and acknowledged empirically in both developed and developing countries. However, their full potential for growth and expansion are generally compromised to a great extent because of their financial insolvency resulting from restricted access to sources of institutional finance. SMEs everywhere confront difficulties in obtaining formal financing due to market failures in the formal credit markets.
Most SME specialists believe that the market failures resulting in anti-SME bias in the formal financial markets stems primarily from four important factors. These include: (i) high transaction costs of small loans, (ii) asymmetric information, (iii) high perceived risks attributed to SME lending, and (iv) their inability to offer collateral securities. All these four factors work as serious deterrents to the flow of institutional credits to SMEs in the industrialised, emerging and developing countries and seriously impede their long-term growth and development due to capital constraints, under-investment and cash-flow problems.
To overcome these problems of credit crunch facing the SMEs such  as their structural barriers, inherent policy bias and institutional rigidities (i.e. banks' reluctance towards SME lending), various types of credit market interventions such as interest subsidy, direct lending through special credit programmes, and regulative subsidies etc. are used by governments in many countries. A widely used public intervention adopted internationally is the credit guarantee scheme which is considered an effective tool to fill the finance gap facing the SMEs. Credit Guarantee Schemes (CGSs) are designed and set up to remove constraints to bank borrowing by the SMEs through encouraging the participating financial institutions in such schemes to lend to the unbanked MSMEs on the understanding that a government or a quasi-government entity will reimburse a certain percentage of loans of defaulter borrowers.
CREDIT GUARANTEE SCHEMES: RATIONALE, OBJECTIVES AND BENEFITS: CGSs are essentially the instruments used by governments to reduce (upto a certain percentage) the risks associated with lending to new (as well as existing SMEs) or undeserved (or underserved) borrower groups less known to credit markets. This risk-sharing instrument is a powerful catalyst for unlocking financial sector resources to spur economic growth by widening investment opportunities, strengthening skills and learning curve of the banks and financial institutions to lend to the SME borrowers.
Commercial banks in most developing countries are conservative in their lending practices. They normally lend to business organisations and/or individuals who are established customers and have good relationship with the banks. By doing so, they tend to reduce defaults arising from unexpected happenings or a general economic downturn. As a result, start-ups and existing SME borrowers who may be profitable and creditworthy remain unserved by the banks. This adversely affects creation of jobs, stifles expansion of SMEs, and prohibits inclusive growth.
It is thus often argued that healthy financial institutions should extend a certain amount of unsecured credit (i.e. loans without collaterals) on the basis of knowledge and belief in the borrowers' business capacity, expertise, and prospects for enterprise growth.
Against this backdrop, credit guarantee schemes for SMEs may help offset situations where borrowers with an equal probability of success are made to face an unequal probability of obtaining credits due to market failures. Thus besides broadening the opportunities of obtaining credits by the SMEs CGSs may also improve terms of loans for such borrowers. At the same time, CGSs may help reduce social tensions, empower marginalised groups and work as effective instruments for achieving financial dependence and economic additionality.
In order to facilitate creation of additionality through positive impacts created by CGSs in terms of notable increase in the number and amount of loans going to the MSMEs, the participating lending institutions are expected to embrace important changes in their behaviour along the following lines:
First, increasingly greater involvement in SME lending should be a learning process for the commercial banks so that there are gradual shifts in their risk perception of small borrowers. While guarantees will enable lenders to learn about credit worthiness of the borrowers, the latter perceived as excessively risky (especially first-time borrowers) should be able to establish a repayment reputation.
Second, guarantee schemes should help develop institutional capacity of the lenders in small business lending. The experience of handling small loans is also likely to enable them to develop ways to lower transaction costs and make small business lending more profitable.
Finally, increasingly greater involvement of the commercial banks in SME lending may introduce an element of competition in the banking system and lead to strengthening of their market share in an emerging profitable market segment.
All these, however, will depend on how efficiently the guarantee schemes are organised, administered, operated and managed to make them profitable and sustainable. We shed some light on these dimensions by looking into recent global experiences with CGSs in different countries.
GLOBAL EXPERIENCE WITH CGSS: Establishment and operation of credit guarantee programmes though dates back to 1840s (in Belgium and France), CGSs providing partial (50-75 per cent) as well as full (100 per cent) coverage became popular over the past decades as mechanisms for broadening SME access to financing. The number of estimated credit guarantee programmes was found to be over 2250 in 100 countries by 2003 (quoted in Asraful Alam, 2014, Bangladesh Bank). Depending on the specific country circumstances and specific purposes, there have been a broad spectrum of CGS typologies around the world (a comprehensive global survey covering 46 countries and 76 CGSs is available in Beck, T-et al, "Bank Financing for SMEs Around the World," Nov. 2008). Commensurate with the large variety of schemes in indifferent countries, their ownership and management, sources of funds, levels and pricing of guarantees, sharing of risks by the guarantor and the lenders, claims settlement procedures etc. also vary significantly. The CGSs tend to emerge everywhere to achieve three common outcomes: (a) overcome information asymmetry involved in SME lending and reduce costs of lending to certain borrower groups; (b) help reduce and diversify risks across lenders; and (c) provide leverage to the regulators.
As to the issues of additionality and long-run sustainability, concrete evidence is scarce as well as mixed. While positive evidence of financial additionality of varying degrees is available from countries such as Japan, U.K., Canada, Malaysia, India and South Korea, economic additionality (i.e. increase in employment, profitability, sales, exports etc.) is considered more important, but difficult to estimate and monitor on a continued basis. Long-term financial sustainability of CGS programmes, especially in the developing countries, presents serious budgetary challenges due to increasing costs of subsidies, budgetary support of the government etc. which tend to erode capital base and affect continuity of the programmes.
BANGLADESH PERSPECTIVE: Development potential of MSMEs in Bangladesh is enormous. Bangladesh's industrial canvas is thickly populated by these industries. According to the provisional figures of the latest BBS Economic Census 2013, there are an estimated 7.9 million micro, small, and medium enterprises (with employment size 1-99 persons) employing roughly 18.2 million persons in Bangladesh. They account for over 98 per cent of the industrial establishments, provide more than 80 per cent of industrial employment and contribute to around 25-30 per cent of the country's GDP (gross domestic product). But their potential long-term contributions to industrial development and national economic growth remain stunted due to financial insolvency faced by them because of restricted access to formal financing, especially by the banks.
Though perceptible improvement in bank lending to SMEs is currently taking place under a favourable policy regime, especially through Bangladesh Bank initiatives (i.e. Refinance Schemes), the current availability of institutional credits from the banking sector still remains grossly inadequate, leaving a huge magnitude of credit demand of the SME sector unmet. While roughly around 25 to 30 per cent of the total outstanding bank loans is now going to the MSME sector - a big stride from only 10.6 per cent in 2006 - much more remains to be done to meet institutional credit demands of SMEs at affordable prices from the formal credit market. This underscores the urgent need for setting up a credit guarantee scheme for easing and widening SME access to bank financing. Given the socio-economic compulsions to create substantial job opportunities, alleviate poverty and raise the living standard of the millions, several forms of government interventions such as directed credit, subsidised credits, and provision of credit guarantees need to be made to accelerate growth of the SME sector.

Prof Momtaz Uddin Ahmed is a teacher of Economics at Dhaka University.
 ahmed_1947@hotmail.com