How Loan Guarantees Can Help Both SMEs and Banks
Business Option
Manila Bulletin
January 24, 2002

        Banks today have been characterized as very reluctant to lend to small and medium businesses. Under very tight economical conditions, this may be understandable. What hurts, however, is that today’s credit crunch is in an environment where banks are perceived to be very liquid. If that may be assumed to be true, then the banks’ non-lending not only hurts the small entrepreneurs. In a way, the banks themselves are badly affected because it translates to non-optimal use of their funds.

        The financial system works well when it is able to channel funds from those which are labeled surplus units (the savers) to those that have a deficit (the borrowers). Ideally, the flow of funds should be to those with the best use of funds, or to the borrowers which have an excess of investment opportunities that will provide the best return for the systems resources.

        A large part of the funds flows are handled by intermediaries which, in this instance, are our banks. And the banks must therefore provide the channel for the efficient and effective redirection of the funds.

        Unfortunately, the funds flow does not happen automatically and is not as simple as it seems. To illustrate, a wealthy person starts off by depositing money in a bank which, in turn, makes a loan to a business enterprise. The depositors claim on the loan is not a direct one. The deposit has a risk and liquidity feature different from the banks loan to the business enterprise, which by the way is now an asset of the bank.

        The depositor’s fund is theoretically safe and liquid; but the bank’s asset is now subject to risk and uncertainty, especially of default. It is likewise not so liquid. Here lies the major mismatch.

        Thus the characteristics of the funds flow changes the risk and liquidity feature of financial instruments utilized. Someone has to absorb the risk of loans. Banks normally do this as part of their risk taking activity.

        In the normal course of its business, the bank makes a lot of loans and not all loans will be good ones. Some borrowers will eventually default on its obligations. The banks factor this into their analysis and under the law of large numbers, the defaults must be kept at low level. The losses out of these classes constitute the cost of the asset transformation and the risk.

        Banks normally set aside a portion of their income to cover such losses. The problem with the present situation is that the provisions appeared to have been insufficient with the loan loss ratios reaching the 20% level. As a reaction, banks are holding bank on their loans as they concentrate on improving their existing finances.

        The first to be hit are small borrowers. There is a considerable cost of administration for small loans and the risks associated are presumed to be higher.

        Given these issues, the presence of guarantees are intended to reduce the cost of administration as well as the risks involved. Loan losses are effectively reduced, even if the guarantee is not 100%. The banks should find it easier to address the concern of SMEs lending, even when its other loan products are not performing as well.

        We need to have strong guarantee institutions to make this functional to the system. Oftentimes, financial sector institutions are concerned about the financial and administrative strength of the guarantee institutions. Hence, the guarantee institution must have a strong capital base and must be managed using the same prudential standards of regular financial institutions. Freedom from political intervention must be assured.

        Accordingly, loan guarantees help funds flow to SMEs while it reduces the cost and risk of banks. We, therefore, have to make better use of this important resource for the financial system to efficiently allocate scarce resources from savers to borrowers.

   
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