1 ARE LOAN GUARANTEE PROGRAMS EFFECTIVE? by Dale W Adams The Ohio State University

2 Overview Three types: retail, portfolio, and wholesale Three types: retail, portfolio, and wholesale Reasons for loan guarantee programs Reasons for loan guarantee programs Why SMEs lack access to formal loans Why SMEs lack access to formal loans Evaluating guarantee programs Evaluating guarantee programs The benefit-cost analysis The benefit-cost analysis Strengths and weakness of three types of programs Strengths and weakness of three types of programs Discussion Topics Discussion Topics

3 Types of Programs SME Retail Lender Bank Retail Portfolio Wholesale Retail Portfolio Wholesale

4 --Retail Type-- Third party is heavily involved Third party is heavily involved Large increase in transaction costs Large increase in transaction costs Sometimes duplicate loan analysis Sometimes duplicate loan analysis Effectiveness is difficult to measure Effectiveness is difficult to measure Moral hazard & adverse selection Moral hazard & adverse selection Opportunities for financial substitution: in borrower’s portfolio, in lender’s portfolio, between lenders, between formal and informal Opportunities for financial substitution: in borrower’s portfolio, in lender’s portfolio, between lenders, between formal and informal

5 --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

6 --Wholesale Type-- --Wholesale Type-- Even less transaction costs Even less transaction costs Third party has little to do Third party has little to do Appropriate when specialized SME lenders are involved Appropriate when specialized SME lenders are involved Only useful when retail lenders have too few funds to lend to all of their creditworthy SMEs 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 Not appropriate when borrower and lender are deposit-taking organizations

7 Program Justifications Stimulate lending to groups who lack access to formal loans: SMEs Stimulate lending to groups who lack access to formal loans: SMEs Overcome imperfections in financial markets. Overcome imperfections in financial markets. Loan guarantee is a partial collateral substitute that reduces the lender’s risk of not recovering the loan. 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 Help lenders learn about new clients and market

8 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. 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. 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.

9 Evaluating Guarantee Programs Only the number of loans guaranteed? Only the number of loans guaranteed? Outreach Outreach Sustainability – subsidy dependence Sustainability – subsidy dependence Benefits and costs: the additionality problem, the substitution problem, and the attribution problem Benefits and costs: the additionality problem, the substitution problem, and the attribution problem

10 Costs of programs Costs are relatively easy to measure Costs are relatively easy to measure Set-up costs Set-up costs Initial funding and later refunding Initial funding and later refunding Opportunity costs of funding Opportunity costs of funding Programs cause transaction costs: for lenders, for borrowers, the guarantee agency, and donor or government Programs cause transaction costs: for lenders, for borrowers, the guarantee agency, and donor or government

11 Measuring Benefits Benefits are more difficult to measure than costs Benefits are more difficult to measure than costs Number of loans guaranteed is not a reliable measure of benefits Number of loans guaranteed is not a reliable measure of benefits Measuring additionality is main problem Measuring additionality is main problem If no additionality, no benefits from program If no additionality, no benefits from program Two additionality cases, Two additionality cases, A substitution case, and A substitution case, and A case illustrating attribution problem A case illustrating attribution problem

12 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 regular loans to SMEs, total value US$ 200, % additionality in number and value

13 Case B Same objective as Case A Same objective as Case A Before program Bank X makes loans to 100 SMEs for total value of US$ 100,000. 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. 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 Zero additionality for number of loans and value

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

15 Substitution Problems Case C Same objective as Cases A and B Same objective as Cases A and B Bank X makes 100 SME loans worth US$ 100,000 before guarantee program Bank X makes 100 SME loans worth US$ 100,000 before guarantee program Bank Y makes no SME loans 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 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 No additionality in SME lending, although 100 loans are guaranteed Ignoring substitution results in overestimate of benefits Ignoring substitution results in overestimate of benefits

16 Attribution Problems Case D What would the lender have done over time without the loan guarantee program? 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. Isolating the effect of the guarantee program on lender behavior from the effects of other changes in the economy over time is difficult.

17 Case D continued Same as Case A, except no loan guarantee program. 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. 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 Some of the additional lending associated with the guarantee program may be due to other factors

18 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. 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.

19 Other Measures of Program Performance Additionality alone is not sufficient Additionality alone is not sufficient Is additionality sustained? Is additionality sustained? Outreach: number of loans guaranteed compared to total number in target group Outreach: number of loans guaranteed compared to total number in target group Sustainability of guarantee program: subsidy dependence Sustainability of guarantee program: subsidy dependence

20 Conclusions Unclear if retail programs are effective Unclear if retail programs are effective Risk only one of a number of problems that limit SME access to formal loans Risk only one of a number of problems that limit SME access to formal loans Transactions costs may be more important Transactions costs may be more important Costs may be greater than benefits Costs may be greater than benefits Benefits difficult to document and are often overestimated Benefits difficult to document and are often overestimated Increase overall transactions costs in system Increase overall transactions costs in system Other policy options might be more effective Other policy options might be more effective

21 Discussion Topics Is there evidence showing retail loan guarantees anywhere result in additional SME lending? 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? Are transaction costs a major problem in SME lending for both lender and borrower? Do retail loan guarantee and reinsurance programs increase transaction costs? 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? Are portfolio or wholesale loan guarantees appropriate where large amounts of deposits are mobilized by potential SME lenders? Importance of microlending in Asia Importance of microlending in Asia

22 Discussion Topics continued Do loan guarantee programs eliminate most problems that block creditworthy SMEs from accessing loans? 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? 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. Instead of loan guarantee programs, why not charge higher interest rates on loans? This is what many successful NGOs and informal lenders do.

23 References Graham Bannock and Partners Ltd. “Credit Guarantee Schemes for Small Business Lending: A Global Perspective,” unpublished report prepared for ODA, London, England, April Graham Bannock and Partners Ltd. “Credit Guarantee Schemes for Small Business Lending: A Global Perspective,” unpublished report prepared for ODA, London, England, April Vogel, Robert C. and Dale W Adams, “Costs and Benefits of Loan Guarantee Programs,” The Financier, 4(May 1997): Vogel, Robert C. and Dale W Adams, “Costs and Benefits of Loan Guarantee Programs,” The Financier, 4(May 1997):

24 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, 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, 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 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 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 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.