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Credit Guarantees: A missing piece in expanding SMEs access to finance?

Why Credit Guarantee Companies? There is a notion that small and medium enterprises (SMEs) are the workhorse from which future economic growth and innovation flow in every country. However, in many developing countries, access to capital is a major obstacle to the successful take-off and growth of SMEs. According to a study by the World Bank Group, there exists a credit gap of $1.10trn in lending to SMEs in these economies. This issue arises due to market failure largely on the back of information asymmetry. This means that due to the predominantly informal nature of SMEs, lenders operating under strict regulatory provisions (prudential ratios, etc.) are averse to bearing the risk of extending credit to them. These banks prefer to avoid the unpredictable cash flows, limited hard assets, and thin governance structures that define this category of companies. Several studies show that SMEs in Nigeria suffer the same fate. Available studies show that SMEs in the Nigerian market are not exempt from these financing challenges. The Central Bank of Nigeria (CBN) estimates the annual financing gap for Micro, Small and Medium Enterprises at N617.00bn.

Institutionalised problem-solving approach: Fixing these market problems, however, requires fresh thinking at the policy level. In brief, this would involve market interventions that generate positive externalities by encouraging banks and non-bank lenders to extend credit to SMEs, albeit the real challenges with a lack of credit history and collateral. A solution that has proven successful in other emerging economies is Credit Guarantee Schemes (CGS). These have gained prominence as a common form of intervention in SME credit markets. The CGS provides third-party credit risk mitigation to lenders to stimulate access to credit for SMEs in the marketplace. This happens through CGS’ absorption of a portion of a lender’s losses on loans made to SMEs in the event of default in return for a fee. The CGS’ provides a high level of efficiency in the financial sector by reducing the overall risks in specific sectors of an economy, thus offsetting the adverse mismatch between entrepreneurs and assets used for collateral. In Nigeria, there are two widely recognised CGS – Infrastructure Credit Guarantee Company Limited (InfraCredit) and Impact Credit Guarantee Limited (Impact). InfraCredit is focused on providing guarantees to lenders/investors inlarge-scale infrastructure projects. At the same time, Impact, a subsidiary of the Development Bank of Nigeria (DBN), has the mandate to stimulate lending to SMEs. It is imperative to look at the idea behind CGS, its modalities, and a case study of success to understand the opportunities which can be exploited with the implementation of CGS in the Nigerian SME market.

A brief history of CGSs: Founded in the 1840s, the first known CGSs were the Brussels Credit Union and the Banque Populaire in France. Structured as cooperatives, both used trade and mutual arrangements to guarantee loans to their union members using members’ collective contributions as the underlying security. Similar mutual guarantee arrangements were also prevalent in Germany, Spain, Portugal, and Greece before and following World War II. These mutual guarantees, which were privately owned, relied on financial and social repayments mechanisms; members stood to lose their contributions (financial) and could be expelled from the union (social) in the event of a default on their financial obligations. Indeed, across Europe and parts of Southern America, mutual guarantee arrangements remain dominant.

Types of CGSs: In practice, there are four major types of CGS arrangements – mutual CGS’ as earlier discussed, privately-owned CGS’, public CGS’ and international CGS’.

  • Privately-owned CGSs are managed by entities established mostly by individuals with financial institutions, trade groups and private businesses to provide access to finance for smaller corporations within target sectors

  • Public CGSs reflect interventions by governments in the form of budgeted subventions with the sole aim of expanding access to underserved sectors

  • International CGCs are interventions by bilateral/multilateral international agencies to improve access to finance for neglected sectors. Internationally, however, very different lending objectives have been pursued by CGS’ with most focusing on supporting lending for working or fixed capital while others have remained focused on export support

 

On the face of it, the key distinguishing feature of CGS’ is the operating model and the source of the underlying financing for the guarantees. As the main weakness of public CGS arrangements is moral hazard and adverse selection issues, a middle ground has evolved in recent years. This seeks to combine institutional arrangements that work for private/ mutual CGS’ with public/international financing to deliver a well-aligned CGS model. This concept is increasingly referred to as blended finance. This type of evolving CGS design has two merits. Firstly, it delivers access to finance for underserved segments, and secondly, it ensures access to finance at a relatively lower cost without creating.

 

According to the World Bank and the Financial Sector Reform and Strengthening Initiative (FIRST) Initiative, developing CGS for SMEs requires sixteen (16) principles as the foundation layer. These sixteen principles cover four key areas, namely the legal and regulatory framework, corporate governance, risk and operational framework, and monitoring and evaluation. These requirements give additional credence to the establishment of a CGS through a blended finance approach; using this approach, CGSs’ will be promoted using sound corporate governance principles that will aid transparency to its investors - public, philanthropic and/or private capital providers. Case study of South Korea Credit Guarantee Funds South Korea, just like other economies, is characterised by a booming SMEs sector, which comprises about 90 per cent of the enterprises. For decades, SMEs in South Korea have had similar challenges in accessing finance like insufficient collateral, high default risks, high transaction costs and asymmetric credit information. This led to limited access to finance, low bank credit allocation, high-interest rates, and a lack of long-term financing.

The underdevelopment of the SME financing market showed a need for government intervention in the SME sector. Two major national guarantee funds operate in Korea: Korea Credit Guarantee Fund (KODIT) provides a general guarantee facility for all business loans, and the Korea Technology Credit Guarantee Fund (KOTEC) focuses on guarantee facilities for projects involving an element of new technology. They are both independent not-forprofit institutions and operate loan approval systems for guarantees. KODIT’s corporate objective is to enable SMEs without adequate collateral to obtain funds and make headway in financial or business transactions. To meet SMEs’ demand for financing services, KODIT provides enterprises with credit guarantee services to repay liabilities assumed by business enterprises in transactions with other companies or institutions. At KODIT, credit guarantee services involve a series of interactions among three (3) parties: the guarantor (KODIT), the debtor (SMEs), and the creditor (Banks, Enterprises, etc.). As of 2021, KODIT maintains a capital fund of US$7.5bn and has provided credit guarantees to over 205,361 companies in South Korea. KODIT and KOTEC operate, in part, a revenue model that involves payment of a guarantee fee that is determined based on the size of the credit facility to be guaranteed. Evidence from the South Korean CGS’ is generally positive, with a stronger impact recorded by the technology-oriented KOTEC. KOTEC’s success owes a lot to its two-part evaluation process that covers creditworthiness and the quality of the borrower.

A possible operational model: the central function of a CGS is that the risk of loss is shared in an agreed proportion between the CGS and a lender. Ideally, the borrower is typically a company with a viable project but unable to satisfy usual lending criteria either due to a lack of collateral or established credit ratings. In this situation, and subject to some investigation of the company’s creditworthiness, a third-party guarantee is made available to reduce lenders’ exposure to risk. A practical application is an establishment of a ‘CGS Entity’ – which may comprise public sector agencies, financial institutions, and other investors as promoters, to develop, provide capital and operationalise the CGS entity. This is to ensure a system with a professional unbiased assessment of obligors’ loans and management of the guaranteed loan portfolio within present targets for underserved sectors. To scale the rate of successful offtake, the CGS Entity could operate a model where lenders participate in a way that allows them to enrol and subsequently renew their membership with the CGS entity annually. Available research shows that this form of ‘CGS–Lender’ relationship has four advantages. It allows the CGS to conduct a first-level appraisal, institute uniform underwriting standards on loans to be guaranteed, generate revenue, and most importantly, avail itself with the relevant information on participating members’ financial records, governance, risk management practices and overall capacity to support the objectives of the CGS. As the CGS entity generates revenue from its core business and builds on its operations, the CGS Entity can commence a capacity-building solution to create the appropriate governance and control structures for SMEs. This is expected to allow SMEs to deepen their ability to access various finance sources. Subsequently, the CGS entity can diversify its revenue profile as more loans are guaranteed. CGS Entity can then look to raise first loss capital from public or bilateral development agencies after a few years to scale and deliver additional guarantee solutions. In summary, CGSs can play an important role in developing countries by (i) improving the information on SMEs, (ii) building the credit origination and risk management capacity of lenders, (iii) fostering innovation and building the internal capacity of SMEs through technical assistance/capacity building programs) and (iv) helping to drive countercyclical financing to SMEs in economic downturns. It is high time that the Central Bank of Nigeria and other financial system regulators give a careful look at CGS’ as a pathway to unlocking credit for SMEs.

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