The Sri Lankan government has already outlined its medium term economic plan aimed at accelerating the economic growth and it was endorsed in the 2016 budget by introducing several measures including the establishment of a Credit Guarantee Scheme for Micro,Small and Medium Enterprises (MSMEs) towards this end.In most countries governments intervene to improve the credit [...]

The Sunday Times Sri Lanka

Designing a credit guarantee scheme to promote lending to SME sector in Sri Lanka


The Sri Lankan government has already outlined its medium term economic plan aimed at accelerating the economic growth and it was endorsed in the 2016 budget by introducing several measures including the establishment of a Credit Guarantee Scheme for Micro,Small and Medium Enterprises (MSMEs) towards this end.In most countries governments intervene to improve the credit flow to MSMEs in several different ways. Establishment of government sponsored credit guarantee schemes is one of the most effective ways of government intervention. Considering the important role that the MSME Sector plays in the economy and realizing the problems faced by this sector in accessing credit from the banking sector the government has proposed to implement this Credit Guarantee Scheme for MSMEs in 2016 with Rs. 500 million contributed by the Government. In his budget speech Finance Minister Ravi Karunanyake has made the following statement.

” I note that the established financial institutions including banks have shown a marked reluctance to lend to innovative MSMEs due to high administration costs and high risks involved in these sectors. Financial institutions have become over reliant on collateral based financing which new entrepreneurs as well as existing entrepreneurs are not in a position to provide. Therefore I propose to implement a MSMEs Credit Guarantee Scheme in 2016 with Rs. 500 million contributed by the government as initial capital together with assistance of selected financial institutions. Under this scheme the 75 percent of the principal amount if in default of the total facility will be guaranteed”

What is credit guarantee
A credit guarantee is a form of insurance that helps to protect the interest of a lender in the event of non-payment by a borrower. The credit guarantee covers the risk of default by borrowers . The person or the entity who guarantees a loan granted by a lender is obligatory to honour the guarantee unconditionally, if and when the borrower defaults. A credit guarantee scheme is a tool for credit risk mitigation and credit enhancement. It substitutes at least for part of the collateral required from the borrower. If the borrower fails to repay what he borrowed, the lender could resort to CGS to recover the losses incurred by him due to the default by the borrower. CGS will not extend any credit direct to borrowers and its role is to ease the interaction between the potential borrowers and the lenders. The credit guarantee schemes are mainly launched to support lending by banks and other financial institutions to Micro, Small and Medium enterprises (MSMEs). Credit guarantee is a substitute at least for part of the collateral required by banks from the borrower. There is a general perception among bankers that lending to SMEs is risky and availability of a credit guarantee scheme will change that mindset of bankers with regard to lending to SMEs. Since the guarantor is providing a risk cover banks are motivated to lend to MSMEs. The credit guarantee schemes will make it possible for a large number of MSMEs to access credit from banks.

History of Credit Guarantee
schemes in Sri Lanka
The history of Credit Guarantee schemes (CGS) in Sri Lanka dates back to 1967 when the Central Bank of Sri Lanka (CBSL) introduced the first credit guarantee scheme to guarantee loans extended by local banks to farmers for paddy and other crop cultivations. All credit guarantee schemes operated in Sri Lanka since 1967 were financed and operated by CBSL. The first credit guarantee scheme for the Micro, Small and Medium Enterprises (MSMEs) was introduced by CBSL in 1978. This was done to expedite the lending under a credit program funded by CBSL and implemented through two state-owned commercial banks and a Development Finance Institution (DFI) in 1972. For the first time in 1979, Government of Sri Lanka received a credit line from International Development Association (IDA) of the World Bank (WB) exclusively to provide credit to SMEs. This credit programme was known as Small and Medium Industries lending Program (SMI-1). GOSL used an apex institution (National Development Bank – NDB) to lend the proceeds of the credit line through a network of around 10 Participating Credit Institutions (PCIs). One of the conditions of the IDA credit line was that on lending to SMEs under the credit line should be covered with credit guarantees. CBSL set up and financed a CGS in 1979 to guarantee loans extended by PCIs to MSMEs

Obtaining of refinance from NDB under the credit lines was a condition of the CBSL guarantee scheme. The initial capital contributed by CBSL was LKR 25.0 mn. After the completion of SMI-I, the Government received three more credit lines from IDA (SMI-II, SMI-III and SMI – IV) . Lending by banks under these three credit lines to SMEs were also covered by the CGS of CBSL. After the completion of IDA lending programs , ADB extended a credit line to GOSL for financing of SMEs in 1997. This program was known as Small and Medium Enterprise Assistance Program (SMAP) . Lending under SMAP was also covered by CGS of CBSL. In 2004, CBSL introduced its owned credit program to provide refinance to PCIs on their lending to rehabilitate MSMEs affected due to Tsunami. The program was known as ” Susahana”. CBSL also launched a credit guarantee scheme to guarantee loans granted by PCIs under this programme. The credit guarantee schemes implemented by CBSL in Sri Lanka have produced mixed results . As most of the PCIs were not happy with the CBSL’s Credit guarantee scheme for SMEs financed under credit lines, it was discontinued at the request of the majority of PCIs. The main areas of criticism of the PCIs were the high claim rejection rate, excessive paperwork and long delays in processing claim applications.

Legal Form of the CGS
Governments have three options in deciding the legal form of a credit guarantee scheme. Different options and advantages and disadvantages of each option is given below:Option One : To set up the CGS as a separate Unit/cell within the Central Bank of the country. Option Two : It can be incorporated as a Limited Liability Company under the Companies Act and or through an Act of Parliament. The initial capital of the entity is to be held by the Government. It would be easier and flexible to set up as a limited liability company.Option Three: To set up the CGS as a separate unit within a Government ministry such as the Ministry of Finance or Ministry of Industries or the Ministry of Economic Development. Although PCIs had some issues with the CBSL in the past when previous SME credit guarantee schemes were in operation, it would be still advisable to entrust the implementation and the management of the proposed CGS to CBSL.

Initial Capital
There are two types of credit guarantee schemes known as non-funded schemes and funded schemes. Non-Funded schemes are always owned and operated by the governments and the respective governments assure lenders that it will meet any amount of liability arising out of the guarantees issued. Funding to meet the commitments comes from the budgetary allocations as and when a need for funds to meet claims arises. The non-funded schemes are not preferred today internationally since this system ignores the commercial viability of the scheme and also it results in “moral hazard” among lenders. The international trend now is for commercially viable and sustainable funded credit guarantee schemes. Funded schemes are operated by independent entities (some may be owned and managed by governments) and the guaranteeing entity (the guarantor) will have a specific amount of capital. Under this type of scheme, it is essential that sufficient starting capital is available to ensure effective launching of the scheme and for its long term sustainability and viability. The capital of the CGS should be large enough for PCIs to have confidence that financial obligations arising out of guarantee could be met. The volumes of lending to MSMEs under the CGS will depend on the extent of the initial capital of the CGS. Since not all borrowers receiving guarantees will default, a given amount of capital can be used to achieve a much larger amount of lending. This is known as leverage Ratio ( very similar to capital adequate ratio of banks).

Very high leverage facilitates higher volumes but it might result in high defaults threatening the viability of CGS. Giving more guarantees will generate more charges but there will be more claims. Therefore, it is necessary to work on a more realistic leverage for new credit guarantee schemes. The empirical studies carried out by UNDP reveals that in developed countries where the macroeconomic environment is perfect, credit guarantee schemes in these countries have achieved very high leverage of more than 20 times. The UNDP report recommends for developing countries with unstable macroeconomic conditions, to restrain the leverage to around 5-10 times. One factor that should be considered in deciding the leverage ratio is the Non-Performing loans Ratio (NPL Ratio) of the banking sector. It is known that the national average of the non performing loans (NPL Ratio) in Sri Lanka is around 4per cent and hence in Sri Lanka it is realistic to assume a leverage of around 10.The government has agreed in its Budget Proposals 2016 to contribute Rs. 500 mn as the capital of proposed CGS which can be supported around Rs 5.0 bn of lending to MSMEs.

Sustainability of CGS
It is now an international practice to operate credit guarantee schemes with financial viability irrespective of its ownership. Financial viability is essential to ensure long term survival and also to retain the confidence of the PCIs. The operating incomes of a CGS will come from two different sources namely; the fee income charged from the PCIs / MSME borrowers and from the investment of capital funds. CGS will charge a fee for each and every guarantee cover issued. Fees can be two types: a onetime fee as processing fee and annual premium payments on the outstanding loan amount. Similarly, the operating expenses of a CGS also can be divided into two; the first category is the administrative expenses including staff cost. The second category is the cost of claims. Most credit guarantee schemes attempt to cover their administrative expenses within their operating incomes (fees and charges) and claim costs within the income from capital fund investments. It is never the intention of CGSs to use the capital funds to meet either operational expenses or the claim expenses.

Fee Structure
In deciding the fee structure, a balance should be struck between the sustainability and the willingness of lenders and borrowers to participate. It is recommended that MCGS should charge its fees and charges from PCIs and not from the borrowers. The PCIs should decide whether to recover the fees and charges paid to the Guarantor. It is appropriate to have different fee structures for different size of enterprises. Generally Guarantors charge higher rates for smaller loans (micro enterprises) and lower rates for Small and medium enterprises(SMEs). This is because the transaction cost relative to the loan amount is higher in micro loans.
The standard rates adopted by most credit guarantors are shown below:

Micro Enterprises :
Onetime Processing Fee – 1.5% to 2.5% of the loan Amount
Annual Premium – 2.0% to 3.5% on the loan balance outstanding
SMEs :
Onetime Processing Fee – 1.0 %to 2.0% of the loan amount
Annual Premium – 1.5% on the loan balance outstanding

Risk Sharing in CGS
It is internationally accepted that credit guarantee schemes lead to moral hazard among lenders (lowering of lending standards) and borrowers (lowering of investment standards). This is because lenders are aware that if the loan is defaulted, CGS will bear the risk and that the borrowers are aware that if the business is failed, lender and CGS will bear the loss. For the success of a CGS, the risk should be distributed among the CGS, lender and the borrower in such a way that default and claim rate is kept as lower as possible. The method used to assign a portion of credit risk to the lender is to guarantee only a percentage of the loan granted (partial guarantee) and get the lender to bear the risk of the un-guaranteed portion of the loan. A part of the risk can be assigned to the borrower by getting him to contribute part of the cost of the investment and obtaining mortgage of whatever the assets the business owns such as land and buildings, plant and machinery, other movable fixed assets and trading stocks. Most of MSMEs will not have land and buildings but they will have movable assets. The internationally accepted claim rate is 1 to 3 per cent of the amount guaranteed. Credit guarantee schemes with a claim rate of more than 5 per cent may not be viable. Generally it is accepted that claims are to be met from the operating incomes of the CGS (fees and investment incomes). If the initial capital is used to meet the claims, the long term sustainability of the CGS will be in danger.

Approaches for Issuing
Guarantee Cover
Different CGSs in different countries adopt different approaches in issuing guarantee cover. The two main approaches used internationally are: Selective Approach (also known as retail) and Portfolio Approach (also known as wholesale). Selective Approach refers to the system where guarantee cover is issued by the CGS based on an independent appraisal by the CGS of individual applications submitted by a PCI. The PCI will undertake an in-depth appraisal of the loan application and then submit it to CGS for its approval of the guarantee cover. Before issuing the guarantee cover CGS will also undertake an independent appraisal. The selective approach will reduce the lowering of credit standards (moral hazard) by the lenders. Under the Portfolio Approach, CGS will not undertake a detail appraisal of individual loans and it will accept the lending decisions of the lender. Before accepting a lender as a participating credit institution, CGS will undertake a detail diagnostic of the lender to ascertain lender’s capability to undertake proper MSME lending.

Once the lender becomes an approved PCI (accredited lender) all its subsequent lending will get automatically covered with the guarantee cover. Portfolio approach is more suitable for developed countries where most lenders maintain very high level of lending standards. The selective approach is more suitable for CGSs in developing countries where the lenders lack proper credit skills. In addition to the above two main approaches widely used in developing countries, in some countries two other different approaches known as ex-ante and ex-post are also used . Under ex-ante approach the borrower first approaches the guarantor and the guarantor issues a guarantee cover pursuant to an independent appraisal of the loan application by the guarantor. The borrower takes the approved guarantee to a lender and obtains the loan. Under ex-post the lender approaches the guarantor after approving the loan. Ex-post approach is similar to selective approach.
The best approach for the proposed CGS in Sri Lanka would be the selective approach. This approach will compel banks to maintain high level of lending standards.

Extent of the credit
guarantee Cover
The guarantee coverage should be high enough to induce PCIs to participate in the scheme and low enough to avoid moral hazard. High coverage of 100per cent or slightly lower leads to moral hazard meaning that PCIs would lower its lending standards as they would not lose anything in a default situation. In a high coverage situation CGS will bear almost all the loss of a default. Therefore in deciding the extend of the coverage, it is necessary to ensure that at least a small portion of the risk of default is borne by the lender and compel them to maintain an acceptable level of lending quality. International experience shows that 60-80 per cent coverage is acceptable.

Note: Writer currently works as an ADB consultant advising Maldives Monetary Authority on the establishment of a credit Guarantee scheme. He was former Vice President of NDB, CEO of Nationwide Microbank – Papua New Guinea, General Manager of SPBD Microfinance – Fiji and Programme Advisor at IFC. He has a BSc in Business Admin and MA in Economics. He is also an ACMA .He can be reached on lionel.somaratne@ gmail.coms

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