In Collaboration with:

Access to Finance for the Poor Programme

Feasibility Assessment for a Loan

Guarantee Facility Inception Phase Deliverable A1.6–Feasibility Assessment

November30, 2014

DISCLAIMER The Access to Finance for the Poor Programme in Nepal is funded by UK aid from the UK government; however the views expressed in this report do not ecessarily reflect the UK government’s official Policies. This report, including any attachments hereto, may contain privileged and/or confidential information and is intended solely for the attention and use of the intended addressee(s). If you are not the intended addressee, you may neither use, copy, nor deliver to anyone this report or any of its attachments. In such case, you should immediately destroy this report and its attachments and kindly notify Louis Berger. Unless made by a person with actual authority. The information and statements herein do not constitute a binding commitment or warranty by Louis Berger. Louis Berger assumes no responsibility for any misperceptions, errors or misunderstandings. You are urged to verify any information that is confusing and report any errors/concerns to us in writing.

Contents

I. Introduction: Background and Context for the Deliverable ........................................................ 1

II. Introduction to Loan Guarantee Facilities/Programmes and Lessons Learned .......................... 1

III. The Need for a Loan Guarantee Facility to Support AFP Programme Interventions as Well as Long-term MSME Development in Nepal .................................................................................. 2

A. Proposed New Products, Services and Delivery Channel Offerings under AFP Programme that Necessitate the Need for a Robust Guarantee Program ..................................................... 2

B. Type, Scope and Structure of the Loan Guarantee Facility Needed to Support the Above 3

IV. The Present Setup for Loan Guarantee Programmes in Nepal ................................................. 4

A. The Case of the Deposit &Credit Guarantee Corporation (DCGC) ...................................... 4

Background, Legal Basis, Structure and Current Mandate of the DCGC ................................ 4

DCGC Features and Product/Service Offerings ....................................................................... 5

Livestock Guarantee ................................................................................................................. 6

Issues Confronting DCGC ......................................................................................................... 7

B. Other Existing Guarantee Arrangements .............................................................................. 7

The SAFAL Programme ............................................................................................................. 7

Lumanti Programme .................................................................................................................. 8

V. Relevance/Applicability of Above-Mentioned Arrangements/ Programmes to the Requirements of the AFP Programme ........................................................................................ 8

A. DCGC Programme: ................................................................................................................ 8

B. Donor Supported Programme: .............................................................................................. 9

C. Way Forward: ......................................................................................................................... 9

VI. Challenges and Key to Success (Key Success Factors) of Credit Guarantee System (CGS) ...... 9

A. Ownership& Structure .......................................................................................................... 10

B. Type and source of Fund ..................................................................................................... 10

C. Coverage Approach (Selective or Portfolio) ........................................................................ 11

D. Risk Distribution ................................................................................................................... 11

E. Target Market & Products .................................................................................................... 12

F. Fees ...................................................................................................................................... 12

G. Risk Management ................................................................................................................. 13

H. Default and Claim ................................................................................................................ 13

VI. Interim Solutions ....................................................................................................................... 14

VII. Conclusion ............................................................................................................................... 15

ACRONYMS

AFP BFI CGS DCGC GoN MSME MFWDR NGO NRB PFI

Access to Finance for Poor Bank & Financial Institutions Credit Guarantee System Deposit & Credit Guarantee Corporation Government of Nepal Micro, Small & Medium Enterprises Mid & Far Western Development Region Non-Government Organisation Nepal Rastra Bank Partner Financial Institution

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FEASIBILITY ASSSSMENT OF A LOAN GUARANTEE FACILITY TO

SUPPORT AFP PROGRAMME INTERVENTIONS

I. Introduction: Background and Context for the Deliverable The purpose of inception phase deliverable # A 1.6 (Feasibility Assessment of a Loan Guarantee Facility) is to review ongoing activities by various stakeholders such as Deposit & Credit Guarantee Corporation (DCGC), Bank & Financial Institutions (BFIs), Nepal Rastra Bank (NRB) as well as donor agencies. The review will provide the basis to assess whether existing infrastructure and players are well equipped to provide credit guarantee to support DFID Access to Finance (AFP) Programme interventions. If not, the purpose is to recommend for an immediate alternative arrangement to support AFP Programme product and service delivery innovations as well as key success factors for a sustainable guarantee programme.

II. Introduction to Loan Guarantee Facilities/Programmes and Lessons Learned A wide variety of loan-guarantee programmes have been implemented around the world with different objectives and outcomes. Advancing economic growth is often an objective, but other considerations lead to additional objectives, such as augmenting credit in certain underserved regions or aiding groups/borrowers that have traditionally been unbanked or have been victims of discrimination. Many guarantee schemes have also suffered from moral hazard, a lack of additionality or excessive administrative costs and claims that rendered the guarantee program unsustainable. Guarantee programmes are often implemented after technical assistance or policy reform efforts have been introduced to help overcome market imperfections. Some technical assistance efforts have focused on overcoming the market imperfections that impede lending into creditworthy sectors by training local banks in understanding new market segments and target borrowers. Banker training also seeks to familiarize banks with more rigorous cash-flow analysis techniques and more advanced risk assessment and loan monitoring techniques. The combination of banker training and a funded guarantee is often used to facilitate lending to small enterprises and the disadvantaged. Technical assistance is also used to improve the financial record-keeping of targeted borrowers/businesses so that lenders can more readily understand their activities and assess the credit risk of lending to such businesses. The combination of technical advisors working with firms to improve their financial record-keeping and a guarantee on a portfolio of loans by a bank to these businesses/groups can facilitate lending to borrowers that were previously denied credit. Generally a partial loan guarantee reduces a lender’s perceived level of risk for new types of loans. The guarantee lowers the lender’s potential loss from defaults. Lenders may agree to different terms and conditions for a loan due to the presence of a partial guarantee. The provision of the guarantee can reduce the lender’s collateral requirements and thereby enable businesses or entrepreneurs that lack substantial collateral to obtain loans. The

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guarantee can also cause the lender to offer a longer repayment period for the loan which enables borrowers to make costly investments in equipment, technology or infrastructure that enhance productivity. Without a long repayment period, borrowers will not have enough time to generate sufficient revenue from costly investments to repay loans. Guarantees are generally offered through three different products – loan guarantees, bond guarantees, loan portfolio guarantees and portable commitment guarantees. • Loan Guarantees are designed to cover 50-80% of the risk on an individual loan from a

lender to a pre-determined borrower. The purpose of the loan and the use of proceeds are set forth in both the loan guarantee agreement between loan guarantee facility and the lender and a separate agreement between bank and the borrower.

• Bond guarantees cover 50% of the risk to bondholders. The guarantee agreement is generally entered into between the loan guarantee facility and the trustee or agent for the bondholders. The trustee is responsible for pursing collections on behalf of the bondholders following a default. The identity of the borrower (often called the bond “issuer”) is known in advance.

• Loan Portfolio Guarantees usually cover not less than 50% of the risk to a lender from a portfolio of loans that it plans to make to “eligible borrowers” who satisfy certain predetermined criteria. The identity of the borrowers is not known at the time the loan guarantee agreement is signed. For example, a guarantee facility may guarantee a portfolio of loans by a bank to small businesses operating in a certain region to which the lender has not previously extended credit.

Several types of businesses and sectors in Nepal that can play a significant role in economic growth or poverty reduction but have traditionally suffered from a lack of access to credit are micro, small and medium enterprises (MSMEs), micro-enterprises and market infrastructure. They can each benefit immeasurably from more robust local credit markets. By reducing risk-perception, lowering collateral requirements, and extending loan repayment periods, partial loan guarantees have the potential to increase the amount of credit provided for SMEs, micro-enterprises and anchor firms (input suppliers, processors, distributors, etc.) in underserved regions of interest to the AFP Programme.

III. The Need for a Loan Guarantee Facility to Support AFP Programme Interventions as Well as Long-term MSME Development in Nepal

A. Proposed New Products, Services and Delivery Channel Offerings under AFP Programme that Necessitate the Need for a Robust Guarantee Program

One of the main objectives of AFP Programme is to promote innovation in financial sector so that the rural population, especially poor people living in the priority districts, have access

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to financial services in a cost effective way. Innovation in the form of new products, services, delivery channels and outreach will be promoted under the Programme. In many parts of the country, especially in the Mid and Far Western Development Region (MFWDR), presence of Banks & Financial Institutions (BFIs) are comparatively thin (against national average of 7,646 population per branch the region has 16,593 population per branch).1 Most of these branches of BFIs are located in the main market catering to the more well-off population. Further credit products on offer are not customised to fulfil the local needs of the population. For more than 80% of the people living in the area, agriculture is the main source of income.2 And most of the BFIs don’t have products catering to this sector. Agriculture is traditionally considered as a risky sector to lend. Also, most of the FIs want fixed assets collateral, mainly land and/or building with motorable access-as security for their loans and majority of the farmland in rural areas doesn’t meet the criteria. A large portion of target beneficiaries of the programme are not able to take their viable business plans to implementation as they lack acceptable collateral. Terms of credit for most of the MSME and individual borrowers are also likely to be less favourable than those for larger institutions. Be it in the form of pricing or tenure and so on. This makes MSME less competitive in the market. Generally, shortage of collateral is the consequence of unequal distribution of wealth in a society. Assets that are most likely to be accepted as collateral are not present with MSME promoters. Hence, in order to encourage BFIs to lend in the focus area and partially substitute the shortfall in collateral requirement, the AFP Programme proposes to provide guarantees on loans which are extended in the region by its Partner Financial Institutions (PFI). The Guarantee programme is also likely to help MSMEs get better terms of credit as part of the credit risk will be covered by the guarantee. The AFP Programme Credit Guarantee programme will also address the issue of social inclusion through substitution of collateral requirement.

B. Type, Scope and Structure of the Loan Guarantee Facility Needed to Support the Above

In order to achieve the above objectives, the Programme will initiate a credit guarantee programme to provide partial coverage for the credit extended by PFIs in the AFP Programme area. Initially, the guarantee will cover credit facilities provided to MSME and individual farmers and others involved in income generating activities in the MFWDR. The coverage may be increased based on the uptake of the facility by the PFI and demand. The proposed credit guarantee will cover working capital as well as fixed term loan.

1Nepal Rastra Bank 2National Sample Census of Agriculture 2011-12

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IV. The Present Setup for Loan Guarantee Programmes in Nepal

A. The Case of the Deposit &Credit Guarantee Corporation (DCGC)

Background, Legal Basis, Structure and Current Mandate of the DCGC Deposit & Credit Guarantee Corporation of Nepal was established in 1974 to support Priority Sector Lending Programme of Government of Nepal (GoN).3 During that year, Nepal Rastra Bank (NRB), the central bank, issued circular mandating banks to insure their entire portfolio under the Priority Sector Lending Requirement with the DCGC. DCGC was established as a limited liability company with a paid up capital of NPR 3 Million. Nepal Rastra Bank and two other commercial banks were the promoters of the company. Of the two commercial banks, one was wholly owned by the GoN and the other was majority owned by the GoN. Initial shareholding pattern of DCGC was as follows (Figure 1)4:

Figure 1. Initial Shareholding Pattern of DCGC Shareholder Paid Up Capital (in NPR Million)

Nepal Rastra Bank 2 Nepal Bank Ltd. 0.5 Rastriya Banijya Bank Ltd. 0.5 Total 3 In 1985, the GoN decided to take partial ownership in DCGC and invested NPR 5 Million (40% shareholding), which was increased to 45.98% in 2010. Since the introduction of Deposit Insurance as a service provision, the capital base of DCGC has been substantially increased and GoN has infused most of the capital. As of July 2013, shareholding pattern of DCGC stood as below (Figure 2).5

Figure 2. Current Shareholding Pattern of DCGC

The initial mandate of DCGC was to provide credit insurance only and the entity was called the Credit Guarantee Corporation. Later, the name of the entity was changed to Deposit and Credit Guarantee Company. In 2009, Nepal Development Bank Ltd., a Class ‘B’ FI was

3 A Directed Lending Programme of the GoN 4 Five Year Strategic Plan of DCGC 5 Annual Report FY 2012-13

Shareholder Paid Up Capital (In NPR Million

Shareholding %

Government of Nepal 1,370 91.37% Nepal Rastra Bank 113 7.53% Nepal Bank Ltd. 11 0.73% Rastriya Banijya Bank 5.5 0.37% Total 1,500

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put into liquidation and many small depositors’ savings were at risk. To safeguard the savings of small depositors in the future, the Government in its annual Budget Speech of FY 2009/10, announced that it would introduce deposit insurance scheme for small depositors (covering deposits up to NPR 200,000.00). Following this announcement, deposit insurance was institutionalised through the promulgation of a Deposit Insurance Bylaw 2010. The NRB has made it mandatory for Class A, B and C Banks and FIs to insure deposits of an individual depositor of up to NPR 200,000.00 through the DCGC.

DCGC Features and Product/Service Offerings DCGC started and continued with a single product, Priority Sector Loan Guarantee, for the first 13 years of its operation until it introduced Livestock insurance in 1987. Later, it added other credit guarantee products such as SME- and Micro- and Deprived Sector- credit Insurance. After the phase out of Priority Sector Lending Requirement, credit insurance was made voluntary to BFIs. Limited products, lack of marketing, limited understanding of financial institutions about the benefits of credit guarantee, institutional rigidity of DCGC (exacerbated by majority ownership by government and lack of professionalism) etc., led to substantial declines in the revenue base of DCGC. Since the introduction of Deposit Insurance in Nepal in 2010, the focus of DCGC has shifted to deposit insurance. The mandate to insure deposit has given a new lease of life to DCGC. Besides deposit insurance, DCGC offers the following Credit Insurance Products:

Small & Medium Enterprise Credit Guarantee The product is offered under SME Credit Guarantee Bylaw 2006 (Third Amendment) of DCGC. The main features of the product are:

• FI has to enter into a framework agreement with DCGC. • The product guarantees up to 75% of the loan (including interest amount) on the

loans provided to SMEs by the partner banks. • The product covers loans of up to NPR 1.5 Million per borrower. • Fee has been set at 0.375% pa (or 0.1875% semi-annually). • Claim settlement is done in two parts:

o 50% of the claim at the time of claim submission o Balance amount after the certification of loan loss by the statutory auditor of

the partner institution • Before lodging a claim, following condition must be fulfilled, among other things:

o The maturity date of the loan must have expired o An auction process or other recovery measures must have been carried out.

The product is not very popular and only four commercial banks were using the product as on FYE 2012/13. The total amount insured under the product was NPR 65.2 Million and the

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total fee collected during the FY was NPR 0.7 Million and no claim was made during the financial year.6

Microfinance & Deprived Sector Credit Guarantee The product is offered under Microfinance & Deprived Sector Credit Guarantee Bylaw 2007 (Third Amendment) of DCGC. The main features of the product are:

• FI has to enter into a framework agreement with DCGC. However, in case of commercial banks, they must have entered into a framework agreement for the service of SME Credit Guarantee product before they can enter into an agreement for this product.

• The product guarantees up to 75% of the loan (including interest amount) on the loans provided to Microfinance & Deprived Sector Borrower by the partner BFI.

• The product covers loans of up to NPR 0.15 Million per borrower provided under Group Guarantee, up to NPR 0.4 Million per borrower on loans backed by collateral and up to NPR 0.5 Million per borrower on loans provided to women (with pre fact approval of DCGC) backed by project collateral, individual collateral or group guarantee.

• Fee has been set at 0.5% per annum (pa). • Claim settlement is done in two parts

o 50% of the claim at the time of claim lodgement o Balance amount after:

Submission of the evidence that recovery actions have been taken Certification from the statutory auditor of the partner institution that

the loan has not been recovered after such action • Before lodging a claim, the following conditions must be fulfilled, among other

things o The maturity date of the loan must have expired o Recovery measures must have been initiated

This product is also not very popular and only seven FI have been using the product. The total amount insured under the product was NPR 544.4 Million and the total premium collected during the FY 2012/13was NPR 4.9 Million. No claim was made during the FY.7

Livestock Guarantee The product is offered under Livestock Insurance Bylaw 2011 (Second Amendment) of DCGC. The main features of the product are:

• BFI has to enter into a framework agreement with DCGC. • The product covers loss of up to 80% of the loan on death and up to 40% in case the

livestock becomes unproductive. The coverage amount will depend on type of livestock.

• The product covers loans up to NPR 0.09 Million per livestock. • Fee has been set at 3% pa (to be recovered from the borrower).

6 Annual Report 2012-13 7 Annual Report 2012-13

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• Full claim settlement in the first instance after the lodging of a claim. However, an observation period of two months will be required in case of an unproductive claim.

• Before lodging a claim, following conditions must be fulfilled, among other things o The borrower must lodge the claim with the partner institution within 7 days

of the death of the livestock and the partner institution must forward such claims within the next 15 days.

This is the most popular product and 43 BFIs were using the product. The total amount insured under the product was NPR 388.0 Million and the total premium collected during the FY 2012/13 was NPR 31 Million. DCGC also paid NPR 7 Million as claims during the FY.8

Issues Confronting DCGC The 5 year Strategy Plan paper of DCGC outlines the following shortcoming and challenges for the entity:

• Launch of new policies and programmes without addressing ineffective implementation of internal policies and practices

• Inability to diversify activities by identifying appropriate sector and strategies • Inability to analyse clear working areas despite the huge contraction in the credit

guarantee business in the last five year period • Weak corporate government practices • Excessive political interference • Absence of administrative accountability • Lack of clarity in job distribution and insufficient motivation of employees • Administrative delays by GoN on day to day matters • Lack of clarity on part of GoN on whether a deposit insurance is a subject of national

priority or not

Further, the following issues have also been identified as reasons for DCGC’s inability to create a vibrant credit guarantee programme:

• Emphasis on Deposit Insurance • Majority Ownership by Government • Inefficient guarantee review processes • Limited uptake and Interest from Commercial Banks • High premiums, slow pace of reviews • Guarantor of the last resort type mentality • Inordinate delay with the Draft Act

B. Other Existing Guarantee Arrangements

The SAFAL Programme

Background, Structure, Guarantee Programme Features& Issues Sustainable Access for Finance & Livelihood (SAFAL) is a DFID Funded programme being implemented by a consortium of Mercy Corps and Blueberry Hill Charitable Trust. The programme’s objectives are to:

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• Stimulate demand for financial services by strengthening community institutions and providing financial literacy training, livelihood support and market linkages

• Strengthen supply of financial services by supporting financial institutions design and deliver commercially viable products and services.

Under the SAFAL Programme, a credit guarantee programme is also being piloted with few commercial banks to provide coverage for loans to community based institutions such as cooperatives as well as individual farmers. It is our understanding that the guarantee programme is being piloted with Himalayan Bank, Laxmi Bank and NMB Bank Ltd. Under the pilot programme, up to 20% of the loans are being guaranteed on a portfolio basis. The programme is in the initial stage of implementation.

Lumanti Programme

B.2.1 Background, Structure, Guarantee Programme Features & Issues Lumanti-Support Group for Shelter was registered in 1993 as an NGO dedicated to alleviate urban poverty in Nepal through an integrated approach to improving shelter conditions.9

Lumanti has entered into agreements with commercial banks to facilitate credit for construction of low cost housing in urban/semi urban areas such as Pokhara, Biratnagar and Syangja. The potential borrowers were previously living in squatter land or in rented shelters without basic amenities. To encourage banks to provide financing for these people--whose main source of income are daily wage--Lumanti has guaranteed up to 70% of the loans extended by these FIs. Lumanti is working closely with Laxmi Bank and NMB Bank and credit flow of more than NPR 70 Million has been disbursed under the arrangement. Lumanti maintains a Guarantee Fund, proportionate with the loan disbursed amount with the respective bank in an escrow account. The banks adjust the default amount on a semi-annual or annual basis.

V. Relevance/Applicability of Above-Mentioned Arrangements/ Programmes to the Requirements of the AFP Programme

A. DCGC Programme: The AFP Programme team has various rounds of discussions with executives of the NRB, DCGC and commercial banks on the scope and potential of a vibrant credit guarantee programme in Nepal. It appears that the focus of DCGC is almost exclusively on deposit insurance and all its resources are geared towards that business. DCGC offers only three credit guarantee products. Its most popular product on credit side is livestock insurance which is, in a true sense not a credit guarantee product as it covers risks associated with death and injuries/unproductivity of the livestock. Despite the central bank providing incentives to BFIs to guarantee their credit exposure, BFIs are allowed to provide only 1/4th of the required Loan Loss Provisioning on the guaranteed loan; and the uptake of credit guarantee is very minimal. During the course of the AFP Programme’s discussions with BFIs on this issue, most of them had mixed 9 lumanti.org.np

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experiences when dealing with the DCGC. Delays in guarantee processing and bureaucratic procedures for claim settlement were cited as major reasons by all the entities consulted. Additionally, these institutions pointed to the following issues:

1. The premium charged was too high. 2. Lack of marketing of the products by DCGC. 3. Staff of DCGC is less active and lacks the experience required to deal with private

sector BFIs 4. Weak MIS systems (most of the record keeping is done manually) 5. Lack of motivation and incentive for staff of DCGC- evident from their lackadaisical

attitude to new business Based on these observations, the AFP Programme team concluded that BFIs were not that eager to work through DCGC for any of the programme’s proposed initiatives. Further, it would take a lot longer for the AFP Programme team to channel its programming through this bureaucratic institution.

B. Donor Supported Programmes- Safal and Lumanti: Both these are in the pilot stages and have yet to complete a full cycle. Rolling out AFP Programme’s initiatives through these initiatives does not make sense at this time.

C. Way Forward: The additionality and the multiplier effect a properly run credit guarantee programme can have on the financial sector and entire economy has escaped the sight of policy makers. DCGC’s focus is on deposit insurance only and it lacks institutional capacity. To unleash the full potential of a credit guarantee system, it has become imperative to separate credit guarantee activities from deposit insurance, and to create separate entities for these two distinct purposes. It may be right time to explore possibility of establishing a separate credit guarantee institution. Most plausible sponsors of the initiative could be BFIs and the NRB with support from the donors. There are many instances of institutions created under this model in Nepal with good performance records such as Credit Information Bureau, Nepal Clearing House Ltd., Nepal Bankers Training Institute, etc. There are various stand-alone credit guarantee programmes being piloted by different donor supported programme. These initiatives could be institutionalised in the new Credit Guarantee Company. Various studies including those carried out by multilateral institutions have also suggested that deposit and credit guarantee activities are carried out by two separate entities.

VI. Challenges and Key to Success (Key Success Factors) of Credit Guarantee System (CGS) The main objective of any Credit Guarantee System is to ensure that viable business venture especially MSME initiatives are not rejected by BFIs due to insufficient collateral. The primary aim of CGS is to offset situation in which borrowers with an equal probability of default have an unequal probability of obtaining credit since some have insufficient

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collateral.10 In the process, the Guarantee System is also expected to provide better credit terms including pricing and loan tenure, encourage investment in sectors or areas where traditionally BFIs have been reluctant to invest (such as rural areas and/or agriculture sector) and also make the credit market more inclusive. Further, CGS is also expected to demonstrate additionality as it facilitates loans to entities which otherwise would not have been considered as a bankable proposition by BFIs. However, many CGS in the past, especially during 1980s, found their business unviable and were discontinued due to various reasons, inter alia, to faulty fee structure, political interference, under capitalisation, risk concentration, poor MIS system, etc. It is imperative that a CGS is designed in such a way that it meets the unique requirements of a local market. At the same time, it will be beneficial to learn from the past mistakes and integrate best practices that can serve as general guideline for the system. A well-functioning and sustainable CGS has to address the following issues:

A. Ownership& Structure In many countries, including Nepal, Credit Guarantee Company is owned by the government. Even though the government ownership gives lots of credibility to the initiative, it is likely to suffer from various drawbacks. It may result in a lack of transparency with respect to the finances needed to sustain the scheme. Public officials might be unmotivated and inexperienced in working with small firms and with guarantee schemes and the bureaucratic procedure inherent in government set-ups will increase the unwillingness of banks to participate.11 Hence, it is advisable that a separate legal entity is created to carry out credit guarantee function. The initiative can be a joint participation of central bank, BFIs and business associations (chambers of commerce) with support from donors.

B. Type and source of Fund The ownership of the company will determine the major source of fund. Initially, start-up capital is the major source of fund and once the programme starts operation, fees levied to its customers and investment income are the other sources of income. Equity, direct support by the government through budgetary appropriation (USA), one time lump sum contribution by donors (FOGAPI of Peru) and levy on participating banks (Korean Credit Guarantee Fund till 2000) are some of the forms of funding the programme. However, for the long term sustainability of the programme, it is always good to have some initial funding support through government and donors, even if the programme is partially or fully owned by non-government entities. The presence of such fixed amount will increase the confidence of the participating BFIs and income from the fund can greatly help to make the programme sustainable without continued subsidies. 10 Credit Guarantee Scheme For Small Enterprises-UNIDO 11 ibid

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A CGS with majority participation from the private sector and with initial funding support from donor and/or government is preferred over government and/or donor only supported programme.

C. Coverage Approach (Selective or Portfolio) In the Selective or Retail Approach each guarantee request is reviewed and decided by guarantee issuer on an individual basis. A borrower may approach a potential lender who reviews the application and makes the loan dependent on guarantee. The lender then applies for the credit guarantee. Or the potential borrower directly approaches the Credit Guarantee Company and submits application for loan to potential lender along with the guarantee. In the Portfolio or Global Approach, automatic coverage is provided on loans extended by partner BFIs who have entered into an agreement with the Credit Guarantee Company. The eligible borrower, type, ticket size, tenure, etc. of the loan will be pre agreed between the lender and Guarantee Company. The guarantor receives reports on a periodic basis after grant of loan (ex post information). The approach will depend on the objective and other consideration such as cost. Generally, in the Selective Approach, the quality of the guaranteed portfolio will be high (also due to double scrutiny by the lender as well as the guarantor) but its coverage will be limited and will carry high intermediation costs. Whereas in the Portfolio Approach, high number of customers can be served at lower cost but the rate of default may be higher than Selective Approach. Due to higher intermediary cost and low uptake of guarantee programme in the past, Portfolio Approach of coverage is recommended.

D. Risk Distribution In order to reduce ‘Moral Hazards’ associated with programmes like credit guarantee, risk (default risk), must be distributed among lender, guarantor and the borrower. For this very reason, a guarantee programme with 100% coverage is not advised (Please also refer to Figure 3 for an example), except in special circumstances as this will lead to high default rate. Figure 3. An example of a 100% Loan Guarantee System with Unintended Consequence The Rural Credit Guarantee Fund established by the Lithuanian government for example, offered 100% coverage for loans aimed at financing the purchase of tractors and other agriculture equipment, and required the goods to be pledged directly to the fund. Within three years, it had become the major machine and tractor station in Lithuania. Masses of loans had gone bad and after market prices of second-hand agricultural machinery plummeted (Rute, 2002, p. 3)unido

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In a typical credit guarantee programme, around 60-80% of the risk is assumed by the programme and balance is shared between the borrower and lender. From the guarantor’s perspective, a lower risk assumption will always be preferable. However, a low risk coverage, say below 50% may not entice enough lenders and is likely to defeat the purpose of establishing a guarantee company. Further, it is also important to decide whether the guarantee is issued as a first loss (liability) or second loss. In case of first loss guarantee, lender calls on the guarantee as soon as the loan is in default and receives the claim amount. Whereas in second loss guarantee, the lender has to sell borrower’s pledged assets and claim guarantee for the unrecovered amount. For the priority regions in Nepal, a portfolio guarantee programme with coverage of up to 80% that issues first loss guarantee may be more appropriate.

E. Target Market & Products Target Market could be defined in terms of geography, size of the borrowing company, ownership type, sector, loan ticket size and so on. Most of the credit guarantee schemes are targeted at addressing market imperfection seen in the credit demand of MSME (Credit Guarantee Fund Trust for Micro and Small Enterprises, India) .Similarly , credit guarantee schemes can be targeted at start-up ventures (Korea) and agriculture (Rural Credit Guarantee Fund Romania). Credit guarantee programmes are also launched to reduce political or social tensions (CGC of Malaysia and Khula Enterprise Finance Ltd. of South Africa). Besides defining the target market, the programme also has to be clear about the type of loan products it will cover. It has to decide whether to cover only working capital loans or fixed assets investment loans or the both. As both types of loans are essential to sustain and grow business activities, it is advisable to cover both types of loans.

F. Fees In order for the programme to work in a market condition and be financially sustainable, fees must be recovered for the guarantee service rendered. Fees can be charged upfront based on the value of the loan or as an annual membership fee or a combination of both. If the fees are not subsidised by the government or donor agencies, then directly (actual fee) or indirectly (in the form of higher interest rate), the fee is recovered from the borrower. Too low a fee doesn’t remunerate the risk assumed by the guarantee. On the other hand, remuneration of the risk should not be too high because, in this sense it will attract into the portfolio of only high risk cases and discourage debtors with a ‘standard’ risk grade. There would be a perverse effect that might push of cost up still higher.12 Generally, guarantee fees will be higher in a Selective Approach than in a Portfolio Approach. Similarly, fees are charged on the entire loan or on the guaranteed portion only.

12 SMEs’ Credit Guarantee Schemes in Developing & Emerging Economies-GIZ

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In some of the programmes (Fondo National de Garantia, Colombia), a risk based pricing structure is adapted and some programmes levy fee based on tenure of the loan (SEBRAE of Brazil)13 Guarantee fees anywhere from 0.5 to 3% per annum is considered normal.

G. Risk Management For the successful operation of Guarantee Programme it has to take into account the following risk and have mitigating factors in place (Figure 4).14

Figure 4. Risk Management Matrix Risk Definition Mitigation

Counterparty Risk Possibilities of increased default of guaranteed loans

Rigorous due diligence process in selecting individual guarantee request or partner BFIs

Portfolio Risk Jeopardising a guarantee scheme as a result of an undiversified loan portfolio that is covered by guarantee

Portfolio diversification, through different geographical area, credit products, counter parties, etc. and limiting share of a single risk

Liquidity & market Risk Unexpected calls by credit institutions for payment of guarantee may exceed the liquidity levels of the guarantee scheme and fluctuation in value of financial investment

Proper risk assessment and investments in highly liquid assets such as government securities

Operational Risk Loss due to failure of system, technology and fraud, corruption and other offences

Implementation of an robust internal control system

H. Default and Claim The default rate is the prime determinant of a credit guarantee programme’s viability. Defaults and claims are not only a financial liability for the scheme; they also threaten its credibility if not handled properly. 15As a rule of thumb, a sustainable programme should not have a default rate of more than 3% per annum. However, it will not be unrealistic to encounter higher rate of default, in the range of 5% or more, in a newly established programme during the initial years. It is to be noted that a prolonged default rate will threaten the programme’s viability. Higher guarantee coverage, lower fee rate and lenient 13Credit Guarantee Scheme For Small Enterprises-UNIDO 14SMEs’ Credit Guarantee Schemes in Developing & Emerging Economies-GIZ 15Credit Guarantee Scheme For Small Enterprises-UNIDO

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credit review standard are the major contributing factors for the higher default rate. Even though low default rate is always preferable, it may also imply that the guarantee programme is overly cautious in underwriting and is not adequately performing its supportive role. A timely, efficient and transparent procedure for triggering claims is essential to gain the confidence in the programme. Explicit clauses in unambiguous language must lay out the terms which will trigger claim under the guarantee. One of the attractions of a guarantee programme is its perceived timeliness in invoking security as compared to other types of security such as land and building which may be subject to various issues. If there is inordinate delay in settlement of claims due to bureaucracy, lack of adequate staff or well trained staff to handle the claim, etc. then BFIs will be very reluctant to use the services of the guarantee programme in the future.

VI. Interim Solutions Due to the priority of DCGC in deposit insurance and its structural rigidity, AFP Programme is of the view that a credit guarantee product tailor made to meet the objectives of the Programme cannot be launched through DCGC. Further, if the enabling environment and buy in of major stakeholders, especially the GoN, NRB and BFIs are there, then a separate Credit Guarantee entity has to be established and made operational. However, based on experience, in a very optimistic scenario, it is likely to take anything from 2-4 years to establish such an entity. In the interim, to support the initiatives of the Programme as outlined above, it is recommended that we establish a Guarantee Fund to be housed and managed within/among the PFI that will serve as AFP Programme partners. The AFP Programme will have two sets of Guarantee Fund, the first to support initiatives launched through the MFDBs and the second to support initiatives launched through BFIs. The modus operandi of the Fund will be as follows (the arrangement outlined below is only a proposal; actual arrangement will largely depend on the discussion and negotiations with the PFIs):

• The two sets of funds will be housed within the PFIs (commercial banks). Bidding will be undertaken among the PFIs and the fund will be held with the PFI offering the highest rate of interest for the next six months (which should not be less than the lowest rate of interest it offers to deposits of similar tenures). The bidding will be done not earlier than on a semi-annual basis.

• Two separate Guarantee Fund Administration Committees (one for MFDBs and the other for BFIs) will be formed to manage the Guarantee Funds with proper representation. The committee will meet on a regular basis and will also decide on claim disputes, if any. A representative from the AFP Programme will attend the committee meeting as an observer.

• The Guarantee will cover up to 80% of the loans (including interest) provided to MSMEs and individual borrowers in the AFP Programme target areas involved in income generating activities.

• The guarantee will cover up to NPR 5 Million per borrower (stop-loss limit of NPR 5 Million).

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• The guarantee will cover agreed portfolio of individual PFI and coverage will be on a first loss basis.

• AFP Programme will enter into a framework agreement with PFI to extend guarantee cover.

• The Guarantee will cover working capital loans as well as Fixed Term Loans provided under the agreement.

• The Guarantee Programme may not charge fees till the time the capital base of Guarantee Fund is not eroded by more than 25% (due to claim settlement). Thereafter fee will be applied on new coverage as agreed with the PFI.

• Once the loan (principal and/or interest) is in past due status for more than 180 days and has been provided with minimum loan loss provisioning of 50% in the books of the PFI, it can lodge a claim for Guarantee with Guarantee Fund Administration Committee or AFP Programme. The claim will be honoured within 7 business days of claim lodgement. In case of dispute, decision of Guarantee Fund Administration Committee will be final.

• Subsequent to the settlement of claim by the Guarantee Fund, any amount recovered from the borrower will be reimbursed to the Guarantee Fund on the proportionate basis of the coverage.

VII. Conclusion The AFP Programme is looking at various initiatives to launch innovative credit products in different value chains--especially in agriculture sector--in the priority districts of the Programme. Most of these priority districts are in MWFWR where footprint of BFIs is very thin. In order to incentivise BFIs to expand their business in these new frontiers, credit guarantee is likely to be an attractive tool. Based on the deliberation above, the AFP Programme will supplement its initiatives with credit guarantee programme. During the implementation phase, the AFP Programme will further review the above considerations with the various stakeholders interested in participating in this endeavour. Inception Phase deliverable #A1.6a provides additional information for operationalising the loan guarantee programme.