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

1. Public Sector Partial Credit Guarantee Programs:What, Why, When and a little bit of How? Frank Nieder Lead Financial Markets Specialist Capital Markets and Financial Institutions Division

2. What? • Public sector offers a partial guarantee of loans made by financial institutions to specific markets or types of loan. (eg. SMEs, agricultural, longer terms loans, energy efficiency projects.) • Guarantees on individual loans or portfolio. • Independent separate fund or supported by balance sheet of operating institution. • Widely used throughout the world and Latin America. • In Latin America: 15 countries have experience with public sector credit guarantee programs and 10 countries have operating programs. • 2nd tier financial mechanism. • Participating financial institutions should make credit decision with final borrower. • Coverage levels and guarantee fee key financial variables in determining incentives faced by participating institutions and thereby effectiveness and financial sustainability of programs.

3. Financial Market without Market Failure (S0) Interest Rate (r)Risk • Bank can accurately estimate risk of loan. • Interest rate reflects actual risk. • Largely the case, for well developed financial markets and in regional markets for larger firms. S0 r0 D L0 Loan Volume

4. Financial Market with Market Failure (S1) S1 Interest Rate (r)Risk • Banks cannot at a relatively low cost estimate or mitigate the risk of loans/firms. • Interest rates overestimate actual risk. • Lower risk firms cannot access credit or at higher interest rates. S0 r1 r* r0 D L* L1 L0 Loan Volume Credit Constrained Firms

5. Financial Market with Credit Guarantees(SCG) S1 Interest Rate (r)Risk SCG • Credit guarantee partially reduces risks for financial institutions, and thereby increase their willingness to lend. • Interest rates better reflects actual risk of lending. • By maintaining incentives for prudent lending, a credit guarantee program can assure lower risk firms gain access. S0 r1 r* rCG r0 D L* LCG L1 L0 Loan Volume Increased access

6. Partial Guarantee in Financial Markets without Market Failure (SCG) Interest Rate (r)Risk • Interest rate underestimates actual risk. • Non-creditworthy projects get funded, resulting in financial losses, and need for subsidies to maintain scheme. • Funding for creditworthy firms in other markets constrained. S0 SCG r0 Losses - Subsidy rCG D L0 LCG Loan Volume

7. Evidence for Conclusions

8. Why and How? • Can increase access to credit constrained firms without distorting markets (crowd in the private sector), and, • if priced correctly, are financially sustainable with no or limited subsidies. • Price of guarantee (guarantee fee/coverage) needs to reflect risk of portfolio (expected payment of guarantee), and if possible risk of portfolio of participating financial institution. (see CORFO and NAFIN for good practices) • Can be targeted to specific market segments, terms, or product types. • Encourages learn-by-doing, improving financial institutions ability to address causes of market failure, economies of scale leading to permanent reduction of credit constraints and degree of market failure.

9. When? • For financial market segments characterized by market failures where financial institutions cannot, at a sufficiently low cost, estimate accurately and/or mitigate the risks of loans. • Eg. lack of easily available information on firms, and high cost to establish enforce collateral them relative to amount of loans. • Green financing ? What is the market failure? Does it increase perceived risk above actual risks? How? • Not a substitute for institutional, legal and regulatory reforms that reduce the causes of the market failures. (greater and lower cost access to information on firms, more efficient and effective securing of financial transactions, etc.)