*Opinions expressed in this presentation are the authors only and not necessarily those of Banco de México. 1 Are Loan Guarantees Effective? The Case of Mexican Government Banks Guillermo Benavides and Alberto Huidobro Banco de Mexico* March, 2008

2 Contents Brief description about Guaranteed Credits Programs in Mexico Motivation The Model Analysis of the results Conclusions

3 Brief Description Guaranteed Credits Programs History of credit guaranteed programs in Mexico. Characteristics. Some banks guarantee about 90% and 100% of total credit. Commissions vary between 0.3% and 9.8%, but the median is 2%.

4 Motivation To our knowledge there are no research studies that evaluate quantitatively if guaranteed programs are self-sustainable. The present study aim is to fill out that gap. We apply a cost-benefit analysis and derive a break-even threshold to justify, from an economic view point, the existence of the program.

5 The Model Assumptions The credit market is perfectly competitive (Horizontal demand curve is assumed). Bankers are risk-averse. Bankers can decide if they enter into the guaranteed credit program or not. No agency problems. No moral hazard or adverse selection. Guaranteed credit program starts in 2001.

6 The Model Total quantity of credit (Q) consists of the guaranteed quantity (Q g ) and the non- guaranteed part (Q n ) In other words, Q = Q g + Q n Considering a Mean-Variance Framework (Copeland and Weston: 1992, Benavides and Snowden: 2006),

7 The Model We have the following net income function for the banker, which is subject to random disturbances: where π is the expected net income of the banker, r g represents nominal interest rate for the guaranteed credit quantity part, r stochastic interest rate for the non-guaranteed credit quantity part (Q n ),

8 The Model Loans are subject of a increasing cost curve C(Q) and the guarantee has a cost of ρ (the premium), which is the amount the banker will pay the guarantor for the quantity of guaranteed credit. Adding and subtracting (where bar represents the expected interest rate by the banker),

9 The Model using the conventional method of mean-variance (with Taylor expansions) and assuming that the banker is correct about her interest rate forecast, we have:

10 The Model Assuming the banker has an exponential utility function: where λ represents an absolute risk – aversion measure (Pratt: 1964) and considering that which implies,

11 The Model the utility of the banker is maximized according to the following objective function, substituting for the expectation and variance of the returns we have, The objective function for the banker.

12 The Model For our simplified case we have that the first order conditions are : Graphically,

13 The Model

14 The Model Optimal increase for a Break-even

15 The Model

16 Analysis of the results

17 Analysis of the results

18 Results Analysis Possible inefficiencies An average of 54.4% of total commercial loans granted by private banks are backed by any form of guarantees. Therefore, 47.2% of the increase is explained by credit guarantees. Premiums and coverage might be incorrectly fixed, that is, away from their fair level [Huidobro (2003)]. Ineffectiveness may appear because they might be failing in promoting additionality or are being received by beneficiaries different from the targeted population (on going research).

19 Results Analysis Possible inefficiencies Since 2001, most of guarantees have been directed to back short-term loans. Delivery of credit guarantees has usually gone together with credit funding, a situation that may distort prices and risk taking in the market [De la Torre, et. al. (2006)].

20 Conclusions Credit guarantee schemes in Mexico, as currently designed, seem like a puzzle. On one hand, they seem to have fostered commercial credits even beyond the optimal increase. On the other hand, we have doubts about they accomplishing the objectives. The most important factor in assessing the impact of credit guarantees Programs seems to be their high average coverage, in spite of their negligible relevance within the total Mexican credit market (10.9%). Additional research should focus on issues like the additionality achieved with these Programs; the perverse incentives and/or agency problems which may arise by using loan-guarantees and the finding of the optimum guarantee premium and coverage.