Boosting credit: Public guarantees can help mitigate risk during COVID-19

The coronavirus (COVID-19) crisis has led to a collapse in firms’ cash flows, especially in sectors that require face-to-face interaction. Millions of businesses are now in need of cash to navigate the current lack of revenue. Many of them have the potential to return to good health once regular activity restarts, but as credit risk has increased significantly, bank lending is not flowing smoothly to creditworthy firms.

Because of the highly uncertain economic outlook and severe downside risks, public backstops might be needed for banks to provide credit to the real economy. That’s why public credit guarantee schemes (PCGSs) have become a prominent policy response to support firms’ financing needs that are stemming from COVID-19. According to our estimates, PCGSs around the world amount to about $1.8 trillion, or 2% of global GDP.

A credit guarantee scheme provides third-party credit-risk mitigation to lenders with the aim of increasing access to credit. Through this mechanism, a lender’s losses on the loans made to firms are partially absorbed in case of default. The reduction in expected losses offered by a public guarantee—along with potential regulatory capital relief—should help incentivize lenders to provide financing to firms. 

There is a wide range of organizational and operational issues that governments need to consider. The Principles for PCGSs for SMEs, a set of good practices developed by the World Bank in collaboration with the industry, offers guidance. Still, some of the parameters must be adapted to the circumstances, including:

• Institutional framework: PCGSs should be used only if a credible institution or program is already in place that can be easily scaled up and adapted. If a legal entity or program does not exist, the government could create a guarantee fund or a trust and outsource its management to a private company based on clear operational parameters.
• Funding: It is essential that enough paid-in capital is available to ensure an effective launch of PCGSs and their subsequent viability. Unfunded schemes, or schemes that are funded exclusively through budgetary allocations, should be avoided. In addition to government funds, PCGSs could be capitalized with voluntary contributions from the private sector, while multilateral and bilateral funding could help leverage the scheme.
• Prudential regulation: If PCGSs are regulated and supervised by financial authorities, regulation should not be relaxed. It is important that the public guarantee itself meets certain minimum legal conditions to qualify as a credit-risk mitigation technique and provide lenders with capital relief and favorable provisioning. For banks operating internationally, when authorities in their home countries do not recognize the preferential treatment applied by host authorities for subsidiaries, a counter-guarantee by a multilateral or bilateral entity may be required to enhance the credit quality of the public guarantee.
• Leverage: The leverage of a PCGS—or the ratio of total outstanding guarantee commitments to the size of its capital—is one of the main arguments in favor of using guarantees. During the COVID-19 crisis, when default rates are expected to be much higher than usual, an appropriate leverage should not be more than four to six times. The leverage effect of a PCGS could be boosted by a partial counter-guarantee provided by multilateral or bilateral organizations.
• Distribution: In times when firms’ survival is more important than true economic additionality and when speed is of the essence, a portfolio approach is preferable to a loan-by-loan approach. In addition to banks, it is also important to include non-bank financial institutions in the scheme—possibly benefiting micro enterprises and individual entrepreneurs. In any event, it is essential to streamline and clarify upfront the application process.
• Risk sharing: The share of losses underwritten by a PCGS should be high enough to induce banks to participate, but it should not eliminate risk entirely. Banks should retain skin in the game. Currently, because risks associated with underlying portfolios are higher than normal—and probably higher than in other crises—higher-than-usual coverage ratios might be needed to attract banks. Yet, high coverage rates of 100% seen in some countries lead to moral hazard and have a sizeable fiscal impact.

Well-designed and implemented PCGSs can help creditworthy firms navigate the liquidity crisis induced by the COVID-19 shock, but their role should not be overemphasized.  Governments should consider their fiscal space, so that they can size a scheme capable of making a difference while minimizing their contingent liabilities. Besides, PCGSs depend on the existent legal and market infrastructure to be effective—as well as on the degree of uncertainty about the shock and the economic outlook.

While there is no blueprint for the design of PCGSs during COVID-19, it is essential that these schemes are part of an integrated and comprehensive policy response that combines transparency, effective market discipline, and preserved capacity of financial intermediation.