Guarantees for "risky business"?

Banks and social investors are often reluctant to provide financial services to producer organizations, rural microfinance institutions or small businesses because they are perceived as too risky. ICCO’s guarantee fund challenges that view.

It is often difficult, if not impossible, for producer organizations, rural microfinance institutions (MFIs) or small and medium enterprises (SMEs) in developing countries to access financial services from local or international banks or even social investors. Start-up businesses in particular have no proven track record or tangible assets they can use as collateral, and so are perceived as being high risk.

ICCO, a Dutch cooperative, is convinced that many financial service providers perceive the risk of investment in producer organizations, MFIs and SMEs as being unrealistically high. In 1999, ICCO therefore created a guarantee fund that aims to reduce the risk of lending to this group of clients. Each guarantee serves as partial collateral for a loan, allowing the financial service provider and the producer organization or entrepreneur to get to know each other, build trust, and explore win−win opportunities for both sides. The Guarantee Fund is managed by ICCO’s business unit, ICCO Investments.

ICCO’s guarantee fund
The fund works with local banks and social investors such as Oikocredit and the Triodos Sustainable Trade Fund to provide partial, shared-loss guarantees on loans to small organizations and businesses that would otherwise be regarded as too risky. Experience has shown that after one or more loan cycles, both the lending bank and the borrower have learned to trust each other, and the bank is more willing to continue the relationship without such guarantees.

By 31 December 2014, the fund had issued a total of 300 guarantees, in the value of € 44 million. This allowed for € 120 million in loans for MFIs, producers’ organizations and SMEs, a leverage factor of 1:3. In other words, for every €1000 temporarily invested (guaranteed) by ICCO, banks and investors had provided financing (loans) amounting to €2727.

ICCO provides maximum 50% guarantees. For guarantees in place on 31 December 2014 the average was 34% of the value of the loan. The fund provides shared-risk guarantees only. The reasoning behind ICCO’s ‘shared-risk-policy’ is the wish to work only with those banks that are committed to sharing the risk of investments. If the fund were to provide 100% guarantees, there would be no risk for the lending bank, except for reputational risk and the time invested. If the fund were to offer first loss guarantees, there would be little incentive for the bank to recover the last part of the loan or to pursue repayment in full.

Which form of guarantee works best?
The fund provides guarantees in various forms – a framework agreement or a bilateral contract between ICCO and the lending bank, a guarantee in the form of a bank guarantee or a standby letter of credit (SBLC) – depending on the level of trust between the lending bank and ICCO. If a bank has not previously worked with the fund and is not aware of ICCO’s reputation or financial position, it might require an SLBC from ICCO’s bank in order to secure the guarantee provided. Supplying an SBLC, however, requires (part of) the guaranteed amount to be ‘frozen’ in ICCO’s bank account, and SBLC-fees to be paid by guaranteed party.

Alternatively, if ICCO and a local bank or social investor have worked together for some time and numerous loans have been repaid, they may choose to work through a framework agreement specifying the target group of borrowers, the type of loans, standards regarding the guarantee percentage, etc. Such a framework agreement can greatly simplify the process for arranging the guarantee.

Since the early years of the fund, ICCO has worked with a number of local banks in Africa and Asia. Some of them have required ICCO to deposit the value of the guarantee in a jointly controlled account, which has led to some practical problems. In some African countries, for example, it is difficult to recover the funds once the loan has been repaid. In other cases, despite contractual agreements, banks have used the deposit without informing ICCO or requesting its approval. In such situations, it is difficult for a Dutch organization to force the bank to disclose evidence of the rightful use of the deposit. The fund therefore no longer provides guarantees in the form of deposits in foreign banks; standby letters of credit have proven to be an acceptable alternative.

Establishing trust
The amount of time and effort ICCO needs to put into contracting and monitoring the guarantees are to a large extent also determined by the level of trust, but this time that of ICCO in the lending bank. If ICCO knows the bank as a partner that can be trusted, it will base its investment decision and do its monitoring based on the bank’s information. In cases where a relationship of trust has not yet been established, ICCO Investments will need to do the full investigation and monitor the borrower’s progress throughout the period of the guarantee. Over time, when trust has been established, ICCO is able to rely on the bank’s information. This reduces ICCO’s transaction costs significantly.

Through quarterly monitoring and risk assessments, ICCO assesses the total risk of guarantees that may be called. Based on this calculation, provisions are made for ICCO’s balance sheet. For guarantees secured through a standby letter of credit, the guarantee balance is frozen in ICCO’s bank account, providing 100% security. The risk assessments and provisions made by ICCO are closely monitored by external auditors. Because of these provisions, the ICCO guarantee fund is not unlimited in size, and in recent years it has been stretched to its maximum. The future growth of the fund will depend on the organization’s ability to raise additional funds.

A small research done in 2013 revealed that out of the 236 guarantees issued between 2006 and 2012, 51% were issued to producer organizations and SMEs and 49% to rural MFIs. Of these, 107 (mostly long-term) loans were still outstanding by then, and 119 had been repaid in full. In 10 cases guarantees were called and paid.

Out of the 119 clients who repaid their loans, seven did not apply for a repeat loan with the same financial service provider, probably because they did not need one or because they had found another provider. Of these 119 repaid loans, 51 clients received a repeat loan from the same provider with a (lower) guarantee, and 61 received a repeat loan without a guarantee.

These results indicate that ICCO’s efforts to encourage financial service providers to get to know the market segment comprising producer organizations, rural MFIs and SMEs is successful. Financial service providers are starting to discover the attractiveness of these clients, as proven by the 61 repeat loans they have offered without requiring a guarantee. The fact that so far only 10 out of the 236 guarantees issued by ICCO have been called indicates that lending to (well selected) organizations and entrepreneurs is not as risky as many financial service providers believe.

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