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ARE LOAN GUARANTEE PROGRAMS EFFECTIVE? by Dale W Adams The Ohio State University
Overview • Three types: retail, portfolio, and wholesale • Reasons for loan guarantee programs • Why SMEs lack access to formal loans • Evaluating guarantee programs • The benefit-cost analysis • Strengths and weakness of three types of programs • Discussion Topics
Types of Programs SME Retail Lender Bank Retail Portfolio Wholesale
--Retail Type-- • Third party is heavily involved • Large increase in transaction costs • Sometimes duplicate loan analysis • Effectiveness is difficult to measure • Moral hazard & adverse selection • Opportunities for financial substitution: in borrower’s portfolio, in lender’s portfolio, between lenders, between formal and informal
--Portfolio Type-- • Fewer transaction costs • Third party less involved • Some adverse selection problems • Easier to measure effectiveness • Substitution problems among lenders • Heterogeneous loans • Similar to wholesale loan guarantees
--Wholesale Type-- • Even less transaction costs • Third party has little to do • Appropriate when specialized SME lenders are involved • Only useful when retail lenders have too few funds to lend to all of their creditworthy SMEs • Not appropriate when borrower and lender are deposit-taking organizations
Program Justifications • Stimulate lending to groups who lack access to formal loans: SMEs • Overcome imperfections in financial markets. • Loan guarantee is a partial collateral substitute that reduces the lender’s risk of not recovering the loan. • Help lenders learn about new clients and market
Why do SMEs lack access to formal loans? • Risk for lender: lack acceptable collateral, high rate of failure among new SMEs, judicial system is defective, civil unrest and economic turmoil, etc. • Transaction costs for lender and borrower: SME doesn’t know banks, lender doesn’t know this segment of market, distance, paperwork, inappropriate lending technology, number of visits, etc.
Evaluating Guarantee Programs • Only the number of loans guaranteed? • Outreach • Sustainability – subsidy dependence • Benefits and costs: the additionality problem, the substitution problem, and the attribution problem
Costs of programs • Costs are relatively easy to measure • Set-up costs • Initial funding and later refunding • Opportunity costs of funding • Programs cause transaction costs: for lenders, for borrowers, the guarantee agency, and donor or government
Measuring Benefits • Benefits are more difficult to measure than costs • Number of loans guaranteed is not a reliable measure of benefits • Measuring additionality is main problem • If no additionality, no benefits from program • Two additionality cases, • A substitution case, and • A case illustrating attribution problem
Case A • Objective: increase loans to SMEs • Bank X made 100 loans to this group before program, total value US$ 100,000 • With guarantee program same bank made 100 new guaranteed loans + 100 regular loans to SMEs, total value US$ 200,000 • 100% additionality in number and value
Case B • Same objective as Case A • Before program Bank X makes loans to 100 SMEs for total value of US$ 100,000. • With guarantee program, Bank X shifts 50 of its riskiest SME loans to guarantee, and makes 50 SME loans without guarantee. No change in total value of SME lending. • Zero additionality for number of loans and value
Case B continued • Bank shifts the most risky SME borrowers to guarantee in order to capture risk subsidy (adverse selection). • Most evaluations of loan guarantee programs ignore the additionality problem and assume that all loans guaranteed = additional loans made because of the program. This results in substantial overestimates of the benefits of these programs.
Substitution ProblemsCase C • Same objective as Cases A and B • Bank X makes 100 SME loans worth US$ 100,000 before guarantee program • Bank Y makes no SME loans before guarantee program • After subsidized guarantee program for Bank Y makes 100 SME loans for US$ 100,000, on more favorable terms than Bank X, Bank Y takes all of Bank X’s SME clients • No additionality in SME lending, although 100 loans are guaranteed • Ignoring substitution results in overestimate of benefits
Attribution ProblemsCase D • What would the lender have done over time without the loan guarantee program? • Isolating the effect of the guarantee program on lender behavior from the effects of other changes in the economy over time is difficult.
Case D continued • Same as Case A, except no loan guarantee program. • Economic reforms increased the profitability of economic activities of SMEs and lenders voluntarily decide it is good business to expand lending to this group. • Some of the additional lending associated with the guarantee program may be due to other factors
Case D continued • Attributing all increases (over time) in lending to SMEs to a loan guarantee program, also overestimates the benefits of the guarantee program. At least some of the changes in lending might have occurred without the guarantee.
Other Measures of Program Performance • Additionality alone is not sufficient • Is additionality sustained? • Outreach: number of loans guaranteed compared to total number in target group • Sustainability of guarantee program: subsidy dependence
Conclusions • Unclear if retail programs are effective • Risk only one of a number of problems that limit SME access to formal loans • Transactions costs may be more important • Costs may be greater than benefits • Benefits difficult to document and are often overestimated • Increase overall transactions costs in system • Other policy options might be more effective
Discussion Topics • Is there evidence showing retail loan guarantees anywhere result in additional SME lending? • Are transaction costs a major problem in SME lending for both lender and borrower? • Do retail loan guarantee and reinsurance programs increase transaction costs? • Are portfolio or wholesale loan guarantees appropriate where large amounts of deposits are mobilized by potential SME lenders? • Importance of microlending in Asia
Discussion Topics continued • Do loan guarantee programs eliminate most problems that block creditworthy SMEs from accessing loans? • Would a supervising agency have the skills and information to second-guess the decisions of guarantee agencies, who, in turn, second guess the lending decisions made by the ultimate lender? • Instead of loan guarantee programs, why not charge higher interest rates on loans? This is what many successful NGOs and informal lenders do.
References • Graham Bannock and Partners Ltd. “Credit Guarantee Schemes for Small Business Lending: A Global Perspective,” unpublished report prepared for ODA, London, England, April 1997. • Vogel, Robert C. and Dale W Adams, “Costs and Benefits of Loan Guarantee Programs,” The Financier, 4(May 1997): 22-29.
References continued • Meyer, Richard L. and Geetha Nagarajan, “Credit Guarantee Schemes for Developing Countries: Theory, Design and Evaluations,” unpublished report prepared for the African Bureau, U.S. Agency for International Development, Washington, D.C. April 15, 1996. • Department of International Development, “Do Credit Guarantees Lead to Improved Access to Financial Services? Recent Evidence from Chile, Egypt, India, and Poland.” Policy Division Working Paper, Department for International Development, London, February 2005. • Orbeta, A.C., C.G. Lopez and Dale W Adams, “An Assessment of Loan Guarantee Programs for Small-scale Borrowers in the Philippines,” Working Paper No. 12, Credit Policy Improvement Program, Secretary of Finance, Manila, Philippines, September 1998.