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Conference on SMEs financial inclusion Guarantee schemes as Credit Risk Mitigation: a demanding opportunity Cairo, Egypt May11th 2016 Jean-Louis Leloir Special Expert to the Board of Directors Basel 2and 3 : Challenge and opportunity . Guarantee schemes, have now a direct effect on enabling banks to reduce their capital requirements and improve the risk rate of the guaranteed part. • The BaselBasel 2 and 3 rules, aiming at creating more discipline and stability in the financial sector are now impacting banks and financial intermediaries; • The rules attend mostly the objectives of allowing a better knowledge on the nature and weighting of all possible risks faced by lenders, and provide stronger equity resources in order to face them. • Considering the trade of the guarantee business, specializing in covering SME risks, the consequences of Basel rules can be seen in two different aspects: • as an opportunity, but of what possible effect? • as a demanding but indispensable constraint, which will increase the risk management skills of guarantee organizations. The new fact: guarantee schemes are recognized as a tool enabling banks to reduce their capital requirements and improve the risk rate of the guaranteed part. • The Basel 3 brings several constraints to banks… • Increased capital requirements (4,5 % in core tier one, plus a security cushion of 2,5 %, together making the „common equity“) , and a • higher solvability ratio (10,5 % objective). A Risk based capital ratio, and Liquidity Coverage Ratio : defining permanent resources needed to cover weighted assets; loans to SMEs are weighted at 100 % (contrary to mortgage loans, which are weighted in the bracket 65- 85 %) • And an opportunity for guarantors : from the “Substitution approach”: Generally allows a banking organization to substitute the risk weight of the protection provider for the risk weight ordinarily assigned to the exposure, provided certain conditions are satisfied. Consequently, several factors create more importance for the presence of guarantors • An obligation for banks to obtain better risk coverage for ist loans, by some form of guarantee: unguaranteed loans are assets wheithed at 100 %, guaranteed loans are weighted at 50%. • The traditional unsufficiency of assets, for most SMEs, make them unable to provide the required guarantees, is favorable to a greater use of loan guarantee schemes. • The present low (or negative) interest rates reduce banks proceeds, and makes their profits more sensitive to risk cost. • The attitude of banks since the global crisis remains strongly risk adverse, increased selection of possible borrowers, not in favor of SMEs : the presence of guarantors, when helping to improve risks selection is quite welcome.. • Does Basel impacts on guarantors‘ volume of business ? • This may vary from one Institution to the other : • It depends whether the guarantee scheme is officialy giving, according to the Central Bank, or another regulatory authority, a valid coverage, weighted at 100 % of the covered risk. • The covered risk is taken off the banks liabilities, for the computation of their capital adequacy ratio. • • Not all guarantee companies can offer such advantage The impact of Basel 3 also depends on other factors: • Banks equity constraints, according to its existing financial profile • Banks‘ stategic and commercial objectives concerning SMEs (a volontary policy to grow SME clientele will be a motive). • The potential maximum risk volume that could be covered by the guarantee actor for each bank. • The importance of the “guarantee appeal” varies between different banks • Banks attitude depends on their type, and the part of risks shared with guarantors can be extremely different: • Best target banks for guarantors are the Smaller , regional , and so called popular banks (for VSME and craftsmen). • Large banks have other commercial objectives. They deal with most of the market of Corporate and large firms, for risks size too high for most guarantors. • The amount of risks covered by guarantors is a small part of banks risks on SMEs. • Even in a country with a successful LGS, like in France, the outstanding risk covered by the guarantee actors represents 8,5 % of the amount of outstanding SME medium and long term bank loans (source OECD SCOREBOARD 2014). • Consequently, reduction of capital requirements is not in itself sufficient to modify the attitude of banks towards SME financing, and particularly for the major actors. • For guarantors, development business with large banks must come from a convincing quality image of their risk assessment. • A better risk selection obtained from a dual decision (banker’s plus guarantor’s) operates risk mitigation, by a reduction of default probability in the portfolio of guaranteed loans. • This feeling must be perceived obviously at branch level by local banks managers, who can be the strongest advocates for using guarantors. • At head office level, banks should convinced of an efficient risk mitigation value of the partnership, through a convincing, statistics based message. • This brings importance to the definition of the guarantee offer, and to the quality factor for all operational rules, organization and processes of any guarantee company. Examples in Europe of the value of operational success on the relation with banks and financial intermediaries . • The French public guarantee scheme • It is managed by Bpifrance, which is not a Government Sponsored Entity, but now a bank, rated AA . • But it does not satisfy usual conditions to be considered as a “pure” guarantee (the guarantee should be unconditional, immediate -at first demand - and irrevocable); the last two conditions are not met. • Still, it covers yearly some 8 billion of financing, on some 70 000 guarantees. • What explains the success ? • Emphasis on assisting the high risk projects (start ups, innovative SMEs,, rapid growth “gazels”, immaterial investments, equity investments in risk capital), with a high guarantee quota. • • image of know-how and skill on assessing these types of projects A well established feeling of confidence in payments amongst partner banks Other examples in Europe, showing the value of operational consequences on the relation with banks . • The Italian Confidis, have an essential role local small mutual (so privately owned) financial entities), are backed by a strong structuring of regional, professional and national counter guarantees. • They are currently restructuring, creating two level of entities, the 25 larger being regulated by the Central Bank, and the smaller, confined in attending only local VSMEs. • The Portugal has mutual guarantee companies working under the umbrella of SPGM, a national level entity managing public a counter guarantee scheme. • The German “Guarantee banks”, regionally based (Lander), are heritage of trade corporations, are also very efficient through a strong “regional development philosophy”, a high skill level and excellent ground connections with the banking sector. From the observation on existing experiences, how should any guarantee schemes manage risk coverage issues to ensure commitment to its liabilities? Basel 2 and 3 rules do impact guarantors themselves. • They have to satisfy rules and conditions to become well rated, and to be able to play a true role in accompanying banks in an increase of their lending to SMEs. • From the same quality process, the guarantee company builds ist image of useful safeguard partner for the banks. • Three main aspects have to be attended to: • A clear Vision on the risk policy : • Its consequences in the Action of the guarantor : • An efficient risk Measurement and visibility : Vision • Define a Risk policy: in accordance with: • • Existing resources (funds) • According to their availability and whether tey are expendable, or not • The net income, in the busines model, allocated to risk covering Aptitude to master the risk analysis factor : • staff quality (skills adapted to the kind of projects and type of financing) and size (network) • technical maturity of financial intermediaries (banks) • Aptitude to get proper visibility on borrowers, through processes and proximity (relationship withbusiness environment • The expectations and potential demand of banks • The (KYC)2 Action • Set the risk policy • Express it in precise terms, detailing on clientele segments, partners, types of financing guaranteed • Fully communicate internally, through reference manuals, getting beyond the oral culture, still too much in use. • Use a risk rating instrument, in order to assess risk weighted liabilities • allowing visibility on individual risks, on their viability (PD) and the risk coverage by traditional guarantees (LGD) • • Setting a common risk measurement, • Bringing a common attitude in decisions Organize adequate permanent control on operations • • on the credit risk and on the operational risk Integrate a process of permanent adaptation of management decisions, • reacting to alerts, to stop issuing new guarantees on categories if necessary, or to modify the decision making process • Build up staff capacity, in a structured way (documented, and in training) Measurement : • Measurement : • A Risk Management Department must man this topic, distinct from production departments • It must set up accurate reporting on production flow • quantitative and qualitative • At regular and frequent intervals • With a permanent screening and interpretation by the top management • The company must develop predictive models and simulation instruments, in order to check respect of all regulatory ratios, avoid liquidity risk. Role of counter-guarantee and co-guarantee and other risk coverage issues. • An indispensable element of the guarantee chain • Guarantee institutions can be great actors for their technicality, but also can be dwarfed by their financial size (frequent problem, either through limited mutual resources, constrained equity base or public budget limits). • A counter- guarantee or co-guarantee can create a leverage effect • Differences: counter guarantee is usually on a portfolio, (agreement based) leaving management of decisions to the guarantee company. • co guarantee frequently means two decisions, and so case by case; sometimes the guarantor can provide a service on decision making process, and risk management. • Both forms are used to provide important support to the guarantee profession from Donors Role of rating agencies in the guarantee industry and how this role could enrich the guarantee industry as well as their experiences • Rating is concentrated on non- public guarantee companies • Guarantors depending totally on national public support should normally be rated at the same level than the State • But aspects of governance and political interference in their activity can alter the quality of their undersigning • The viability of „non public guarantors“ is usually more scrutinized by their partner banks • A rating can strongly influence the attitude of banks • Examples: • The direct guarantees provided directly by EIB group to banks in Europe create a strong appeal for their use • As a complement) to rating, regulation of guarantors by Central Banks can provide similar appeal • Example: the Italian Confidis Conclusion • The Opportunity of basel 2 and 3 for guarantee companies: • SME representatives and governments are concerned about the attitude of the banking sector attending the needs of SMEs. • SMEs are more and more challenged in the present global economic situations, and still hold the key to more employment and GDP growth. • The opportunity is great, as available donors‘ resources are willing to be offered to guarantors playing a dynamic role in stirring banks towards lending more to SMEs. • Still, Basel 2 and 3 create a demanding challenge for guarantee institutions to adapt internal organization, processes, and risk management. • They must get to the technical and operational level needed for a good rating, • But also convince partners of the rightful adaptation of their offer and processes to cover market gaps, for categories of borrowers and projects that fit the banks objectives.