The capital enhancement guarantee (CEG) operates entirely through the banking system and the bank regulation framework at negligible administrative costs. It is based on the principle that banks require capital to bear risk. The international standard among industrialized countries is that a bank should have at least 8 units of capital for every 100 units of loans it makes, i.e., a bank's minimum capital-to-assets ratio is 8 percent.

The purpose of a loan guarantee is to encourage a bank to make a loan that it regards as being more risky than those that it would make without a guarantee. The guarantee provides a substitute for the bank's capital. The provision of guarantees through guarantee funds is almost without exception very costly in the long run, as suggested by the demise of such funds. They tend to decapitalize slowly, as risks take time to become apparent. In addition, their operating costs per guarantee issued are usually substantial. In spite of this, guarantee funds seldom accumulate expertise at evaluating risk and at reducing or managing the real risks that guaranteed borrowers face (i.e., the things most likely to go wrong for borrowers that will put them in a position of not being able to repay their loans as scheduled).

The CEG simply provides additional capital to bankers willing to make more risky loans in return. Capital is provided by the guarantor through a bidding process: the central bank auctions additional capital. Each bidder indicates the amount of additional capital that would be needed to support a given amount of additional lending that conforms to the requirements of the guarantor. The guarantor's requirements would presumably specify the types of loans, borrowers or loan purposes that the guarantee is intended to support. A bidding bank's "price" is its ratio of additional loan to additional capital. If a bank felt that capital of 20 would be required for it to make an additional, risky loan of 100, the bank's bid would be 5, or 100/20.

If this bid were successful, the bank would receive 20 in the form of subordinated debt, convertible into a capital reserve at the end of three years or as installments on the guaranteed loan fell due, whichever occurs later. The guarantee would be designed to cover loans having maturities of three years or longer or for repeated shorter-term lending for a period of at least three years.

So that the bank does not receive free capital within its present risk-bearing capacity, its bid could not exceed the reciprocal of its actual capital ratio (e.g., 12.5 for a bank having an 8 percent capital-to-assets ratio). A bank would have to have an 8 percent capital-to-assets ratio, the guideline specified by the National Bank of Poland, to be eligible to bid. A decision required in project design is whether bids of banks with different capital ratios should somehow be equalized mathematically so that relatively undercapitalized banks do not obtain a disproportionate volume of guarantees. Or, is the purpose of the guarantee to help precisely these banks?

Conversion of subordinated debt to permanent capital would be permanent unless the bank failed to make the specified loan(s), and would occur regardless of the performance of the guaranteed loan(s). The bank does not have to pay for the guarantee but does have to perform as it undertakes to do as specified in its bid. Failure to do so should be reported by the bank concerned. Bank supervisors in their periodic examinations would check to ensure that loans had been made as specified.

The amount of capital obtained by the bank from the guarantee fund would also be counted as "shadow" or pseudo collateral (where collateral is insufficient) and shadow or pseudo equity investment by the borrower (where the borrower's debt-to-equity ratio is too high to be acceptable to the bank). In this way the borrower's lack of debt capacity is balanced exactly with the lender's capacity to bear risk as reflected in the lender's capital base. Counting the capital enhancement on both sides of the deal enables loan applicants and lenders to come up with deals that conform to regulatory requirements.

The guarantee clearly works incrementally or at the margin. Bankers are empowered to undertake deals that would be just beyond their reach in the absence of a guarantee. The frontier would be expanded beyond their current tolerance of risk, their current credit standards and policies, and the regulatory requirements they face.

CEGs accomplish several objectives:

  1. the analytical focus is on risk and its precise cost,
  2. the guarantee supports the key party to the lending decision who requires support to make the loan,
  3. greater skill in managing risk is accumulated through experience in making more risky loans, representing a permanent enhancement in the skill of banks concerned,
  4. the process is entirely transparent,
  5. administration costs are trivial, consisting of the costs of operating periodic auctions for guarantee funds, banks' costs of submitting bids (the bid sheet should not exceed one page in length), and verification by bank supervisors who would in any event examine a bank's loan portfolio,
  6. donor funds auctioned as capital enhancement guarantees are disbursed very quickly, and
  7. no permanent guarantee organization is created, which means that future losses are contained, no painful transition is required when the scheme ends, and that taxpayers are not burdened, given that virtually all such organizations fail or require continued taxpayer support.

In addition, banks that know and trust each other could create cross-guarantee mechanisms to obtain the benefits of spreading guaranteed risk over a portfolio.
Posted by J.D. Von Pischke [ ] on the DEVFINANCE Network.
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