AG:TCP/POL/5611 TECHNICAL COOPERATION PROGRAMME DESIGN OF LOAN GUARANTEE/INSURANCE MECHANISM FOR AGRICULTURAL LENDING POLAND Terminal Statement the Food and Agriculture Organization of the United Nations Rome, 1998 |
AG:TCP/POL/5611 TECHNICAL COOPERATION PROGRAMME DESIGN OF LOAN GUARANTEE/INSURANCE MECHANISM FOR AGRICULTURAL LENDING POLAND Terminal Statement the Food and Agriculture Organization of the United Nations Rome, 1998 |
Although agriculture and agriculture-related industries amount to approximately 20% of the gross domestic product of the Polish economy, significant parts of the rural economy are deprived of adequate access to formal bank credit. The Government of Poland and, in particular, the Ministry of Agriculture have expressed concern that many new agricultural enterprises, as well as those being transformed from former state-owned farms into large-scale productive enterprises, are unable to obtain adequate bank credit to enable them to develop profitable, well-capitalized operations. Many young farmers also find it difficult to obtain the necessary finance to acquire land and machinery, upgrade infrastructure or buy livestock. Existing farming operations with the land and physical resources for more efficient production are often unable to upgrade their operations because of lack of credit. The roots of these difficulties are seen as lying in the lack of adequate collateral to enable banks to make secured term loans to the rural productive sector. The Government of Poland therefore approached FAO to help design a guarantee fund for Poland.
The Project Agreement for this Technical Cooperation Programme project, TCP/POL/5611, "Designing of Loan Guarantee/Insurance Mechanism for Agricultural Lending", was signed by FAO and the Government, with a budget of $US 257 000. It began in March 1996 and had a scheduled duration of one year. The Ministry of Agriculture and Food Economy was designated the government agency responsible for project implementation.
FAO mobilized a team of international and Polish specialists to study the situation and to design several credit options to be presented to the Government.
The overall objective was to improve the availability of investment credit to agricultural producers and agro-processing industries. The project was intended to indicate how a loan guarantee fund/credit insurance system could promote credit-financed agricultural investment and to provide basic preparations for the establishment of an institution to operate such a system.
A number of alternative models for guarantee funds were developed, ranging from the most traditional mutual guarantee association, closely resembling the western European model, to new and more innovative methods based on an "insurance" approach and a "credit scored guarantee auction". The most innovative model, that of Credit Enhancement Guarantees (CEGs), was designed to achieve the policy goals of the Ministry of Agriculture and to avoid almost all the costs and difficulties that characterized other models. A workshop held in Warsaw refined these models to two, at opposite ends of a spectrum ranging from tried and problematic mutual approaches to untried and innovative ones. The models were the mutual model and the capital enhancement model.
The mutual guarantee model for Poland could be structured along lines similar to European mutual guarantee associations. These associations operate in most western European countries and were developed largely to assist small and medium enterprises (SME) to access credit at acceptable terms, including maturities and the interest rate.
In Europe, the formation of small, local-level, mutual guarantee associations (MGAs) is usually guided by a central organization. In turn, the national organization tends to be supported by a budget allocation and capital from the state budget. The local MGA is the lowest tier in the national mutual guarantee structure. Some countries, such as France, possess regional mutual guarantee organizations, while others have no intermediate level between the local MGA and the national level. In Europe, regional and national guarantee organizations serve both as a conduit for public budget subsidies and as a mechanism for retro-guarantees for local MGAs.
The European and Asian experience has shown that, although guarantee funds can support SME loans, the costs are somewhat high. Before launching a programme, two sets of funds need to be identified: reserve funds and an administrative subsidy.
To establish a mutual guarantee system, a reserve needs to be created. The amount necessary has been estimated as approximately $US 50 million. These funds would both support the guarantee activities of the mutual organization, through interest and investment income earned on the invested reserve, and would make the organization's guarantee more credible to banks.
Most European systems require an ongoing subsidy to sustain their operations. In both Europe and Asia (with Germany and Japan as partial exceptions), these costs can be 7-14% of the value of the loans guaranteed. This administrative support, which can take the form of a subsidy or periodic contributions to capital, is used to generate additional investment income. From the European and Asian experience, it is likely that this subsidy will be required for the foreseeable future.
The Polish credit guarantee associations would be structured as MGAs serving the rural areas and small towns of a specific region. Membership would be open both to individuals and corporate entities and the basic philosophy would be mutual self-help for MGA members. Regional and local MGAs would operate under the charter drafted by the Polish Guarantee Central Organization (PGCO) and approved by the local and provincial associations. Both would obtain technical assistance and financial support from the national organization, as well as being subject to financial and management audits by the national organization and its external auditors.
The PGCO's Board of Directors would be elected by the Regional Associations. The National Guarantee Organizations Board would have at least one representative from each region and an equal number elected at large. This board would be responsible for overseeing all policy decisions and for maintaining the financial integrity of the entire system. The Board would appoint the manager and would supervise the implementation of the decisions taken by the Board. The PGCO would also be responsible for publishing an annual report and audited balance sheet and income statements.
The great strength of the local mutual guarantee association is that it is made up primarily of volunteer staff from the local communities. These people are endowed with a deep knowledge of local people, customs and conditions.
The request for a guarantee could originate with either the bank or the borrower. A bank reviewing a credit application could decide that additional guarantees were required and would pass the application to the MGA. The two would jointly review and approve the operation. When the request for a guarantee came from a bank, the borrower would need to join the MGA before a guarantee could be issued and would agree to remain a member to support the work of the MGA for at least five years. Guarantees would normally be for 50% of the amount approved by the PGCO as the maximum loan size. In exceptional cases, the MGA could request, and the PGCO approve, guarantees of up to 60% of the loans and interest.
In order to establish a mutual guarantee system for Poland, foreign donors would need to contribute an initial capital of $US 50 million, while local authorities would need to contribute $US 2 million per year for five years to the central fund.
The capital enhancement model provides a mechanism that avoids the disadvantages of traditional guarantees while offering a basis for lenders to explore and assume risk on an incremental basis. CEGs operate entirely through commercial and cooperative banking systems and the bank regulation framework, at negligible administrative costs.
CEGs are based on the principle that banks require capital to bear risk. The international standard among industrial countries is that a bank should have at least eight units of capital for 100 units of outstanding loans. CEGs provide that capital and, to the extent that international standards are respected, banks may be able to provide up to 12.5 units of loans for each unit of capital provided, although prudence may dictate a less leveraged ratio.
Polish banks are required by the National Bank of Poland to match the maturities of their loans to those of their deposits. Most deposits in Poland are still relatively short-term and thus are useful to banks only for supporting short-term loans. CEGs provide banks with capital in a manner that enables them to extend the maturities of the loans that they originate.
Donor and national funds provided for auction as CEGs can be placed in a special account and disbursed very quickly. No permanent guarantee organization is created, which means that future losses are contained. Nor are taxpayers burdened, as is the case with permanent guarantee organizations, since virtually all such organizations either fail or require continued taxpayer support.
Guarantee funds must be obtained from a donor or from the Government and their ownership must be established, since the owner acts as the guarantor. Possible owners include the donor, the Government, a trust, or an official agency such as the Central Bank. CEGs would be allocated through capital auctions. Capital is provided by the guarantor through a bidding mechanism managed by an existing financial agency. The sealed bids from the participating banks would indicate the amount of additional capital needed to support a given amount of additional lending conforming to the requirements of the guarantor. The guarantor's requirements would define eligible loans based on types of loan recipients, amounts, maturities and the purposes that the guarantee is intended to support.
A bank's bid "price" is the ratio of additional capital to additional loans. If a bank wishes to make an additional loan of 100 and believes that capital of 20 is required to support the risk involved, the bank bids five (or 100/20). If the bid is successful, the bank receives 20 from the guarantee fund in the form of subordinated debt.
Successful bidders would be those who submit the highest bids, offering the most leverage for guarantee capital. A bank would need to have at least an 8% capital-to-assets ratio to be eligible to bid and its bid would not be allowed to exceed the reciprocal of its actual capital-to-assets ratio. Thus a bank with a 10% capital-to-assets ratio could not submit a bid larger than ten, while a bank with an 8% capital-to-assets ratio could submit a bid with a ratio of 12.5 to 1.
Banks submitting the highest bids would receive a transfer of subordinated debt (tier 3 regulatory capital) to support the new lending that the bank committed to undertake in its bid document. Consistent with Polish law, the subordinated debt obtained through the CEG auctions would convert into permanent (tier 1) capital at the end of three years, on a pro rata basis as instalments on the guaranteed loan or when loans fell due. The amount of regulatory capital cannot exceed 50% of permanent capital under Polish law, which serves to keep guarantee operations within prudent limits. Guaranteed lending would need to have maturities of at least three years, or the bank would have to agree to revolve short-term loans for activities such as cropping for cycles of at least three years.
The transfer of capital to a successful bidder would be permanent unless the bank failed to make the specified loans or irregularities were discovered. Bank supervisors in their periodic examinations would check to ensure that banks made loans as specified in their bids.
Bidders' eligibility would be monitored and their performance in making guaranteed loans would be reviewed. Performance monitoring requirements and sanctions against unacceptable behavior by bidders should be specified in participation agreements between banks and the owners of the guarantee fund.
Banks using CEGs would be required to maintain records to show that their performance conformed to the regulations of the guarantee scheme. They would also be required to make these records available to the guarantee fund's owners or designees.
It is recommended that the Polish authorities prefer the Capital Enhancement Guarantee model to the mutual guarantee model. Since CEGs are significantly different both in structure and operation from traditional guarantees, it is worth enumerating some salient points.
CEGs focus analysis on the real problem, which is risk and its precise cost.
The guarantee is given to the key party in the decision, who requires capital to support the loan.
Greater skill in managing, rather than merely transferring, risk is accumulated through experience in making more risky loans, creating a permanent enhancement in the risk-management skills of participating banks. This would be reflected in improved credit policies and lending strategies.
Better risk-management techniques developed from experience with guaranteed lending are likely to be applied to lending in general and to be adopted and adapted across the banking community, creating social benefits as experience is gained. Improved risk management should also increase the bank's bid ratios, enabling guarantee funds to underwrite even more lending.
Moral hazard is greatly reduced or eliminated, since banks would have undiminished incentives for good credit decisions and loan administration as their capital remains at stake. Furthermore, the process is entirely transparent, diminishing possibilities for corruption and the perpetuation of bad practices and making it possible to identify additionality, that is, the difference between what would happen with a guarantee and what would occur in the absence of a guarantee. Transparency and additionality are benefits that increase welfare for the economy and society as a whole.
The auction process makes it impossible (without deliberate collusion) for those responsible for operating auctions and setting conditions for guarantees to direct guarantees to specific borrowers. The administrative direction of guarantees would corrupt the system and usurp the lenders' role and responsibilities in credit allocation and risk management.
Donor funds for action as Capital Enhancement Guarantees can be disbursed very quickly and administrative costs are minimal. No permanent guarantee organization is created, which means that future losses are contained and taxpayers are not burdened.
When guarantee funds are exhausted through auctions, they remain at work in the banking system as capital or as experience with losses, or both. There is no social loss, discontinuity or painful transition requirement created by the termination of the guarantee programme.
Finally, for a country that wishes to modernize the agricultural sector as rapidly as possible, bringing the sector up to a level that will allow it to be integrated into the European Union, CEGs can be implemented far more quickly than a traditional guarantee mechanism, which may take years to establish.