Does guarantying SME loans work?

How to make banks lend to SMEs? This is a reiterating question for anyone working on private sector development in emerging markets.
From the Harvard’s Entrepreneurship Finance Lab to the World Bank, it seems to be a consensus that supporting SMEs  helps create more jobs and stimulate innovation, in economies starving for growth and social rest. On the other hands, their small size, their risk profile and, often, the absence of appropriate documentation, make SMEs very unattractive clients for banks. In many cases, banks are just fine doing business with big corporations and buying government bonds.  And even the so-called “SME Banks” end up financing the higher range and relying excessively on high collateral, excluding a big chunk of small business clients.
Guaranteeing SME loans as part of the solution
I had the chance to work on the design of an SME guarantee fund in Tajikistan. While the context is very specific there, it allowed me to closely look at similar models world wide. The idea is simple:  if banks are not very eager, why don’t we help them by guaranteeing loans to SMEs (and being paid for it)? Hundreds of guarantee facilities have been implemented (since the 19th century I believe) from Chile to South Korea. Many are government driven, but some are also set by bank associations, development agencies or even by for-profit funds. Results are very mixed, and it is mainly due to the fact that expanding SME lending should go hand-in-hand with improvement of the whole “ecosystem” from tax rules to government engagement. It has to be seen as part of more holistic approach. It also has to comply with some basic conditions.
Success factors to consider
Following are some of the best practices to implement while setting up an SME guarantee facility:
The bank should keep a skin in the game: the guarantee should always cover less then 80% of the loan so the bank is always keen on properly doing the job of assessing the client. They might not bear 100% of the risk, but they still can lose some money in the process;
The end-client should not be involved: Experiences show that when the client knows that his loan is being guaranteed, he tends not to repay it. So keep him out of the loop, and incorporate any guarantee fees in the offered rate;
Stay involved in the credit process: As a guarantor, make sure to stay involved in the credit process of the bank. You do not want to end up with the most toxic loans and loose everything after few years.
A mean not an end
Any guarantee facilities should not stay forever. As mentioned above, it is only a part of a solution and temporary. Objectives to be set might include: improving the credit processes of the banks, improving the SME policy of the government, getting familiar and building up a payment track record etc. Meanwhile, the guarantee structure is set as “bridge”. If a guarantee facility for SMEs has been existing for 40 years, then it might no be very successful from a development policy standpoint!
It is quite challenging to discuss such a broad topic in a blog post, I hope I could highlight the most crucial issues. Feel free to contact me otherwise 🙂
Hatem
 
 

Comments 1

  • Credit enhancements and guarantees work VERY WELL if and only if the recipients are screened properly to appropriate standards. Setting standards and screening consistently is not easy, but I’ve seen lots of successes in SME lending in Asia and the Middle East. Unfortunately, the poorly established or start-up SMEs are the riskiest, but neediest. If the loans are made to them, they are more likely to fail but of course there are exceptions which I’ve seen as well, especially if women play key recipient and administrative and management roles. Go figure.

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