How to Design a Credit Guarantee SchemeJuly 26, 2022
The design of a credit guarantee scheme must be carefully considered. It should offer incentives for lenders to learn and reduce their risk by sharing the risk. It should also be temporary and phased out after the financial institutions have acquired the necessary experience and information to provide loans without guarantee support. Generally, a credit guarantee scheme should not be used as a substitute for traditional credit rating agencies. This is because such institutions have a limited ability to evaluate the value of a credit guarantee scheme in the long run.
Countries can increase their total funding for a credit guarantee scheme several times over the initial amount. For instance, the Government of Israel increased its guarantee scheme from NIS 4 billion to NIS 22 billion, or about 1.7% of its 2018 GDP. Similarly, the European Union’s Temporary Framework for State Aid permits Member States to provide 100% guarantees for loans. However, it is important to note that such increases can cause higher losses if the recovery process drags on.
In order to accurately measure whether the credit guarantee scheme increases firm growth or reduces unemployment, researchers should know the conditions of borrowing without a scheme. Empirical studies of credit guarantees have generally compared firms that receive guaranteed loans to firms that do not. Most of the existing studies have found evidence of financial additionality. The authors of Technical Working Paper No. 10 are concerned with identifying conditions that may make the scheme economically harmful to firms. They also point out that the effect of credit guarantee schemes is not consistent across sectors.
The LGFs’ success depends on corporate governance and ownership profile. The private sector should be given preference for LGFs as they are better positioned to provide additional collateral to creditworthy borrowers. Additionally, the LGFs should give banks more practice in lending to new types of customers and encourage further lending once the guarantee period is over. The LGF scheme should leverage scarce public resources and unlock private capital for lending to new types of borrowers. It should also improve the borrower’s capacity to repay a loan.
A credit guarantee scheme’s coverage ratio is a crucial metric. A high coverage ratio suggests that the loan guarantor is not taking a large amount of credit risk. If the scheme is low on coverage, the lender will still be at risk of default. Moreover, the guarantee scheme should be transparent about its criteria. However, the risk ratio should not be too low as the lender will be able to assess the risk of the borrower.
Although credit guarantee schemes are an essential tool in addressing the liquidity needs of SMEs, many of them remain unserved by conventional lenders. In fact, 68% of formal SMEs in emerging markets are underserved by financial institutions, creating a $1 trillion credit gap. This is why public credit guarantee schemes are an important form of government intervention that unlocks finance for SMEs. More than half of nations have a CGS for SMEs.