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					Market myopia
- Are Credit Guarantee Schemes a suitable financial tool?

1. There is an overwhelming literature on the synergies generated by pooling
financial resources to facilitate the access of underbanked segments of
borrowers to sources of capital. 1 However when the assessors try to measure
the performance and impact of a credit guarantee scheme (CGS) a most
common conclusion shows up mixed results and different indicators point to
different directions. Here we would like to contribute to the debate bo rrowing
from our own experience and suggesting remedies and alternatives to credit
guarantee programmes.

Despite the lack of strong evidence on the sustainability of such intervention,
in low and middle income Countries, sponsors - usually donors and
governments - have been proposing credit guarantee scheme as a suitable
financial tool to provide resources to entrepreneurs to back up their request
for funding. We do think that this is due to lack of either imagination or an
appropriate assessment of the market.

2. Let’s have a succinct look at CGS’s rationale, mechanism, scope and how
it works.

The rationale: basically a CGS allows borrowers to have access to credit and
assist lending providers to be more risk oriented, the welding point being
given by a sponsor backing the operations. In practical terms this means that
a CGS can reduce bank’s reluctance and perception of the repayments’ risk
and meet borrowers’ requirements for lack of collateral security.

The mechanism: usually in whatever scheme there are three main players:
lenders, borrowers and a third contractual partner like government and/or
donor, both supporting the venture in a multifaceted modalities, besides the
so-called “influential” persons (associations, unions, representatives of
various communities).

The purpose: a CGS is supposed to expand credit beyond the lending areas
and this is achieved by transferring full or partial credit risk to third parties
usually the sponsors of the interventions, who accept the burden either
financial or taking additional costs.

Arguments in favour: it stimulates lending and produce additionality, that’s
to say extra lending. It is suitable for first time borrowers and for neglected
sectors of the economy. It reduces the “distance” between borrowers and
makes it easier the fulfilment of the bank’s procedure.




1
 A recent contribution provide an updated review of the debate: Access to finance: the place of risk sharing
mechanis ms, by B. Balkenhol in Savings and Develop ment, n.1 2007


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Arguments against: CGS are costly and not bsustainable in the long run.
Borrowers coulnd't have incentive to repy the loans. Usually lenders are
better placed than an intermediate mechanism to evaluate the risk of non
repayment. Sometime the lenders aren't so much interested to the loans'
repayment and can approve loans without taking the necessary measures.
Additionality is hard to demonstrate and lenders are simply not interested in
doing business with enterprises and or recommended sectors. CGS could be
either a political tool or an instrument to give benefit to particular segment of
population.

Exhibit 2 - Credit Guarantee Scheme’s objectives and assumptions to back up
SME finance

  Partners                          Objectives                             Assumptions
Management U nit’s      To manage        the    Credit   Guarantee    Capability    to    reconcile
Task/Fund               Scheme                                        different, goals, interests,
Manager                                                               objectives,      expectations
                                                                      from various partners

                                                                      Apply best practice
Public   Authorities’   CGS as an instrument               of   the   Political willingness to make
Goals:                  economic policy agenda                        things happen

                        To mitigate the adverse social impact         Favourable           economic
                        of   liberalisation &    privatisation        conditions: inflation under
                        process                                       control,     suitable    legal
                                                                      framework, no interference
                        To provide the final beneficiaries with       & lobby and appropriate
                        an easy access to the source of               credit policy
                        finance
                                                                      Neutral position
Final Beneficiaries’    To facilitate     the    access    to   the   Viable requests for financing
Demand:                 resources
                                                                      Management and technical
                        To make it smooth the application             expertise  to   manage
                        procedure                                     business

                        To pay a cheaper price                        Market perspectives for the
                                                                      production
                        To integrate weak collateral security
                                                                      Economic justification of the
                                                                      project


Lending Partners’       To have     an    additional source      of   Capability to   manage     the
interests               financing                                     change

                        To wide their market share                    Availability to join resources

                        To share credit risk                          Lending and credit policy in
                                                                      line to meeting demand for
                                                                      credit




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What does indicate our direct field experience? 2 Shortsighted assumptions
emerged as a frequent factor affecting the performance of a CGS along with
inappropriate scheme’s implementation. In particular:

-   CGS works till a sponsor is willing to provide the support. The day after a
    sponsor leaves the field, the CGS collapse, the main deficit being given by
    the sustainability of the operations, which is hard to achieve without
    either administrative or financial support.

-   The design of the intervention is unbalanced and too much focusing on
    short run implications, which is associated with grey areas between
    enterprises’ development objectives and income generating activities.

-   The negative effects related to the financial circuits not communicating
    each other, and unsuitable legal and regulatory framework.

-   The inadequacy of the structures to make it easy the marketing of the
    borrower’s production.

In addition to:

Firstly, the behaviour of the key stakeholders isn’t equal to the expectations,
particularly form the lending partners side, which behaviour isn’t in line with
the agreed terms and conditions.

Secondly, both small entrepreneurs and lenders aren’t yet ready to doing
business together, because newcomers in the small credit market and they
know a little bit of each other. This causes lack of reciprocal confidence. In
this situation having a CGS as a filter doesn’t work.

Thirdly, the financial providers although start retail banking hasn’t yet set up
a suitable credit policy on how to deal with small credits and, what's more, in
most cases bankers are not small business oriented.

Fourthly, “banks think big” and this is due to various reasons and in
particular to the following ones:
-      Lack of skills and or attitude to make it happen the small lending,
-      Lack of background in such kind of business,
-      Lack of a true interest in dealing with first time borrowers,
-      Credit Authorities’ strict rules for risky lending,
-      Reluctance to apply sponsors’ conditions
-      Banks has their own scheme for SME
-      Wrong idea that a CGS is for covering losses

2
  The author has accumulated thirty years of work experience in the emerging
economies and got involved in various types of credit guarantee programmes
(risk fund, credit guarantee fund, trust fund, revolving fund, aid fund, grant
facility, etc) in the Caribbean, Eastern Europe, Africa and Russia Federation.




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-      Banks take an extraordinary time to decide whether to join a CGS
-      Banks worry to be under pressure by lobbies and or policy makers
       Banks do not need additional financial resources as they have a
       liquidity situation

Fifthly, much emphasis is on the offer of the financial services side while
much should be done on the supporting the demand side. Indeed, on the
small entrepreneurs side it comes out:
- Lack of managerial expertise,
- Huge gap on marketing the production,
- Poor attention to the profitability and competitiveness,
- Bad repayment behaviour,
- Weak support from the representative bodies/organisations.

4. Above review drive to a two-fold conclusion:

-   CGS most likely isn’t a universal financial tool. In other words, different
    markets/environments realities ask for a different approach and not
    necessarily a CGF is the right answer to the market.

-   Although different yardsticks bring to different conclusions, the problem
    doesn’t lay on the methodology to measure the CGS performance, but on
    the product itself as an appropriate answer the market’s demand.


Figure 3 – Determinant factors of CGS’s poor performance


-  Lending partners’ negative response and/or insufficient
  interest in managing the change
  Donors’ unsuitable intervention and late reaction to
  emerging & changing conditions
- Government’s weak commitment on providing
  enabling environment, political pressure
- Management Unit’s lack of expertise to reconcile interests,
  objectives, demand and expectations of involved actors
  and not applying the requested management practice
- Borrowers’ unviable requests for loans, bad repayment.

                    CGS Poor Performance


Remedies

5. The remedies start well in advance of the field activities. The proposed
CGS should be supported by evidence and figures rather than predications.
In practice a CGS’s feasibility study should be more market oriented and


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should assess implementing agencies’ willingness/availability to carry out the
job as agreed by the promoters. This issue is of utmost importance because
at the end of the day the behaviour of the lending partners makes the
difference.

The launch of a CGS should be treated as a new product and as such it
should go under the scrutiny usually applied under the circumstances:

1. Test the reaction of the potential buyers (borrowers) and sellers (lenders)
   to a proposed scheme
2. Request a lending partners’ commitment to implement the scheme
   according to the agreement
3. Sensibilise lending partners on how to deal with it.
4. Provide potential borrowers with ad hoc support.

The fund manager or whatever entity/body entrusted to run the operations
should commit himself/herself to stay within both credit (terms and
conditions for loans) and lending (to whom, how much and for how long to
lend) policy. For the purpose key indicators should figured out amount of
money to guarantee/lend, repayment rate, portfolio performance, etc. These
golden rules can be adapted from what is called “best practice”. The
management indicators should be written down and undersigned by the
implementing agency/fund manager.

Owing to that credit alone isn’t enough to bridging the gap to reach the small
enterprises, it is a requirement a concerted effort of all concerned actors.
Usually, restoring and/or building up confidence between players is a crucial
point. All parties have to make a concerted effort: a) Lenders should adapt
the credit delivery methodology, b) Associations & Representatives of the
Entrepreneurs should have a more business-like approach, c) Borrowers
should be aware that paying back the money isn’t an optional, d)
Government should create a conducive environment.

Some times good intentions are not enough, so that there is a need of a
tangible contribution of the borrowers to build up or restore their credibility.

The entrepreneurs have to organise themselves in a way to overcome the
main deficit of the applications for credit, namely the lack of an appropriate
collateral security. While considering a great number of small borrowers this
approach can be converted into a Reserve Scheme. In other words, the
Representative Bodies of the entrepreneurs should establish it with either a
compulsory savings or liable responsibility. The des ign of such support should
be strictly close to the enterprises reality.

In addition to, soon after a reasonable span of time (pilot period) emerging
distortions or deviations from the target should be promptly addressed. While
in the implementation phase start working on a exit strategy or how to carry
on the operations without the external support (donor and/or government).


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Moreover, the team (Fund Manager) must have a proven capability to match
the various interests of the stakeholders and the expertise to apply the best
lending practice.
The design of a suitable management and organisational structure is a crucial
factor. The existent of pre-conditions such as appropriate micro credit policy
and/or the existent of flexible credit regulations are an other casting factor.

Alternatives

6. If and when the real lending problem is the transfer of risk, besides
embarking in setting up a costly CGS it could be advisable to look for
alternative avenues with the objective to investigate how and at which
conditions alternative financial products could better meet the potential
demand.

Too often we witnessed situations where the mandate to bridge the gap
between lenders and borrowers was just to verify the feasibility of a choice,
which has already be done, namely setting up a credit guarantee
programme.

On the contrary, it should be a must to look for an appropriate product that
objectively respond the market needs. In this new approach the mandate
shouldn’t be to study the merely feasibility of a guarantee scheme but to
study ways and means to reach the objective to match financial
sustainability, outreach and cost.

This is a very crucial point in the sense that not always it is clear the true
cost of the setting a CGS. To this regards the elements of the cost shouldn’t
be limited to the cost of capital; it should also be considered the implications,
which emerge from the setting of a CGS. Indeed it is frequent a situation
where a CGS creates a distortion in the credit market in terms of either a
subsidy or advantage to participating lenders.

In this understanding the real target of a preliminary study should be the
comparison of different sources of funding.

A further step should be done by inquiring on the viability of other collateral
instruments such as groups of interest, accounts receivable, inventories,
warehouse receipts, factoring and leasing. Last but not least investigate on
the linkages between banks system and micro finance providers.

The implementation of strategic alliances in all their multifaceted modalities
could be an area where both parties – micro lenders and banks - could be
actively committed along with advisory services and venture capital.

The search of new products, innovative management tools and strategic
alliances should be appreciated not for themselves, but for their capability to




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meet the real demand from the potential borrowers and be easily handled by
the lenders’ staff.

Sometimes, the search of new products/services doesn’t require much
imagination but could be only a matter of looking at what is going on in the
market. In theme of finding out new avenues, lenders could take on board
the tradesmen.     We do think that the financial providers could take
advantage of the tradesmen’s expertise and experience in financing small
trade.

This suggestion does emerge from the field reality and could be a cost-
effective approach to the market. The tradesmen are very familiar with the
local environment and this could make them reliable clients and get them
involved in the financing process. In so doing the lending providers can take
advantages of the way tradesmen do business and indeed they have a word
to say: they know very well the business community as well as enterprises’
production and marketing costs; moreover, their reputation is such that it
would be difficult to default on payments. In this approach instead of directly
financing hundreds of borrowers, the lender can have traders as loan
applications filter.

An other avenue to explore could be given by the conversion into a mo re
appropriate scheme the way of doing business of the informal lenders and
make the traditional schemes transparent and affordable. In the emerging
economies there are credit practice in countryside that can be converted into
a formal scheme, which could be managed by formal lenders.

The development of Plastic cards has the potentiality to cut the physical
distance from users in rural areas and financial providers. So, before
stepping on embarking in a CGS it could be advisable to take stock of the
Country’s experience in micro credit matters.

Besides the introduction of new products, an interesting and promising
avenue could be the linkage of micro finance providers with the banking
system.

The entry to the micro loans market of the traditional bankers should be
welcome and nowadays this has been happening in the emerging economies,
in the light of the fact that the big names of the financial world have been
moving to this direction.

The benefits of such entry will be for all main actors: banks, MFI, final
beneficiaries along with the financial market. On one hand, banks can expand
the areas of intervention and, most important in our view, they can borrow
on how to market financial services; indeed it seems to us that MFI’s market
oriented approach is without any doubt a casting asset they can spend out.
On the other hand MFIs can improve skills and be more acquainted with the



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banker profession. In a word we can say that management and marketing
expertise will be dynamically matched.

The dividends of the partnership will be for the borrowers who will have
additional chances to get what they need at competitive price. How to
achieve that? MFIs could operate as driving belt between sources of capital
and final beneficiaries. In doing so the two finance engines will pool
resources and share risks.

Besides above, the financial market as a whole will benefit from the
collaboration between banks and micro lenders, the ultimate goal of such
partnership being to enhance efficiency and effectiveness of the financial
market. In this understanding it has to be noticed that CGS’s
promoters/founders aren’t putting resources for the institution itself but for
upgrading local financial market and be in condition to encounter a wider
capital demand.
To better achieve above goal MFI should upgrade their institutional capacity
to forge links with banks.

As far as banks are concerned, the CGAP has suggested the following direct
and indirect approaches to enter the microfinance market, respectively:
- An internal microfinance unit
- A specialized financial institution
- A microfinance service company.

* Outsourcing retail operations
* Providing commercial loans to MFI
* Providing infrastructure and systems.

The CGAP (Focus Note, June 2005) has identified the following areas as a
practical way to start cooperation: the bank could: a) use the MFIs net work,
b) refinancing and sharing risk, c) promote a guarantee fund, d) downscale
operations.

To conclude, in proportion of the sophistication of the local financial market,
a great variety of financial tool could be designed and implemented in
alternative or as a complement of the credit guarantee schemes.

In our view the link between microfinance and banks could be a successful
alternative to a CGS aimed at financing SME, also on the grounds of the
positive implications in deepening the financial market.

Ascanio Graziosi
Senior Banking Consultant & Micro Finance Specialist
www.cambridgedata.com.GraziosiAscanio/




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Summary

The Author contributes to the debate on the credit guarantee schemes (CGS)
issue borrowing from his own experience and suggests remedies and
alternatives.

Although different yardsticks bring to different conclusions, the author
concludes that the problem of CGS doesn’t lay on the methodology to
measure performance and impact, but on the product itself as a good answer
to the market’s demand.

Wrong assumptions along with inappropriate scheme’s implementation
emerge as a frequent factors affecting the performance of a CGS.

The behaviour of the actors involved is a very important element that affect
scheme’s poor performance, which can be synthesized as follows:

   -   Lending partners’ negative response and/or insufficient interest in
       managing the change,
   -   Donors’ unsuitable intervention and late reaction to emerging &
       changing conditions
   -   Government’s weak commitment on providing enabling environment
   -   Management Unit’s lack of expertise to reconcile interests, objectives,
       demand and expectations of the actors and not management practice
       not always equal to the task
   -   Borrowers’ unviable requests for loans, bad repayment.

The remedies to the situation start well in advance of the field activities by
   - Carry out a feasibility study more market oriented. Moreover,
   - Investigate on the real availability/willingness of participating lenders
      to implement the job as agreed by the promoters.
   - Treated CGS as a new product and as such it should go under the
      scrutiny usually applied under the circumstances.
   - look for alternative avenues with the objective to investigate how and
      at which conditions alternative financial products could better meet the
      potential demand.
   - Fund manager commitment to stay within both credit and lending
      (policy. For the purpose key indicators should figured out and
      undersigned by the responsible person/body.

The alternative to a CGS should investigate for new products, innovative
management tools and strategic alliances, which should be appreciated for
their capability to meet the real demand from the potential borrowers.

An interesting and promising avenue could be the linkage of micro finance
providers with the banking system, which in the Author view is a real
alternative to a CGS.


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