Loan guarantee funds can be a powerful tool in helping smallholders access finance, but getting the model right is vital.
A long-established way of helping borrowers with little or no collateral to access finance, loan guarantee funds have been used to support farmers for nearly 100 years. There are now thousands of such schemes globally, targeting various industries. While the model is not always implemented successfully, it remains well regarded and new agri-focused funds continue to launch, determined to learn from predecessors’ mistakes.
The idea behind loan guarantee funds is that lenders will be encouraged to extend finance to borrowers that are considered high risk if a guarantor entity – typically created by a government or donor but, in some cases, a private sector company – commits to guaranteeing repayment of a percentage of the loan if a borrower defaults. Effectively, the guarantor is providing collateral on behalf of the borrower. Under so-called retail schemes (see box), the guarantor also helps screen borrowers and assess their creditworthiness to improve the likelihood that loans will be repaid without the fund needing to compensate the lender.
By sharing and mitigating the risk associated with lending to specific industries or other groups, guarantee funds can enable finance providers to lend to those groups in greater volumes and sometimes at lower interest rates than they normally would. Such finance can be critical for enabling small- and medium-sized farmers and agripreneurs – who are often unable to borrow affordably, if at all – to invest and grow.
Guarantee funds are, however, rarely a perfect solution. According to studies by the International Fund for Agricultural Development (IFAD) (see IFAD’s Loan Guarantee Funds; and the Loan Guarantee Funds papers in IFAD’s How To Do and Lessons Learned series), high costs and defaults are a persistent problem and not enough borrowers graduate to non-guaranteed lending. A mismatch between high administrative costs and net claims paid to lenders makes many schemes unsustainable. Nevertheless, the development community remains confident that the model has real value and that, as more schemes launch, it can be tailored to support agriculture more successfully.
One new fund that will hopefully address some of the cost challenges faced by funds historically is Tanzania’s Smallholder Farmers Credit Guarantee Scheme (SCGS). In March 2018, the Tanzania Agricultural Development Bank announced that it was setting up the fund and is currently seeking financial institutions as lending partners. Under the scheme, commercial banks will be able to apply for a guarantee covering 50% of any debt that borrowers default on for loans of up to TSh 5 million (€1,867) for individual farmers and TSh 500 million (€186,794) for smallholder farmer organisations.
Although as yet untested, the fund’s guarantee size falls in line with recommendations by Calvin Miller, an independent consultant and former head of agribusiness and finance for FAO, that schemes should ideally guarantee around 50% of credit and no more than 70%. Any higher than this and “The cost can start to get really high,” he notes. It also defeats the purpose of trying to attract banks to riskier areas if they shoulder almost no risk at all.
Established in 1977, Nigeria’s Agricultural Credit Guarantee Scheme Fund (ACGSF) has provided valuable lessons. Managed by the Central Bank of Nigeria, it is one of the oldest loan guarantee funds in a developing country but also one of the most expensive – guaranteeing 75% of a loan’s principal in the case of default and subsidising interest rates generously. Administrative and operation costs are also huge. And, while FAO analysis (see FAO’s Four Case Studies on Credit Guarantee Funds for Agriculture) suggests beneficiaries of the scheme do enjoy higher incomes than non-beneficiaries in the country, ACGSF’s model would be unsustainable in a nation with smaller state revenues to tap, Miller emphasises.
A number of eastern European guarantee funds, such as Estonia’s Rural Development Foundation (RDF), also provide good models of cost management and governance for guarantee schemes in ACP countries. Although RDF provides guarantees of up to 80%, this reflects the unusual environment it operates in, with Estonian banks often requiring collateral equal to more than 120% of a loan’s value. Its small size also makes cost control easier. “I really like these systems,” says Miller. “They’re very simple, they’re sustainable and they run as their own profit centres.”
Governance and management
Transparent, professional management and governance is another key criterion for success. From his experience with Germany’s guarantee banks, which helped the country’s micro, small and medium enterprises (MSME) sector become a powerful economic force, Michael Hamp, senior advisor on rural finance at IFAD, is a fan of the guarantee fund concept – but only if schemes are “correctly institutionalised.” Having a strong development partner to assist with initial assessment and implementation of a scheme is crucial, he says. Otherwise, “There is a tendency for a top-down approach and having the solution up front before knowing exactly the developmental problem to be addressed.”
The Danish International Development Agency – which established the African Guarantee Fund (AGF) in 2011, along with the African Development Bank and the Spanish Agency for International Development Corporation – has one of the best track records in terms of supporting guarantee funds, Hamp believes. AGF has signed nearly US$783 million (€667 million) of guarantee agreements with 125 financial institutions in 38 African countries since its launch. One recent deal was with Netherlands-based Oikocredit, which announced in January 2018 that it had been awarded an €8.5 million guarantee over 10 years under the AGF’s Green Guarantee Facility to support microfinance institutions, agriculture and renewable energy SMEs in sub-Saharan Africa.
Independent management of funds can also help combat political interference which, given the often state-backed nature of guarantee funds, can be a problem, and improve transparency. Hiring external providers to support fund staff with technical assistance – for everything from loan assessment to product development – can help.
A fund’s management should also rigorously oversee the loans it guarantees and undertake a double assessment – both upfront and if a default occurs – to manage risk and ensure pay-outs are prompt, adds Miller. Delayed reimbursement to financial institutions is “The best way to kill a guarantee fund,” he says. “You can be subsidising all kinds of stuff, but if you’re slow in reimbursement, that will nullify any of the other benefits.”
A diversified approach (in terms of sector, type of loan and, where possible, country or region) is also essential for successful guarantee funds, with management ensuring that risk is not overly concentrated in terms of sector, loan tenor and, where possible, country or region.
For all their faults, credit guarantee funds are crucial for giving banks confidence to lend – and to remain in markets during and after turbulent times. Kristian Schach Møller, CEO of the Agricultural Commodity Exchange for Africa (ACE), urges any organisation looking to establish a warehouse receipt finance (WRF) system, for example, to engage development and government partners early on to establish or work with a guarantee fund from the outset. While ACE is often lauded as a pioneer model for other African countries, private banks providing finance underpinning its WRF system lost money in 2016 when the market was flooded with imports of maize and pigeon peas, which led local prices to collapse. Banks that had their fingers burned by this price volatility are now reluctant to lend against stored produce in Malawi, he says. And, while ACE is currently looking to develop a fund to take the first hit on any future bank losses related to price volatility, Schach Møller believes that regaining banks’ confidence will take time – and would have been much easier had one already been in place. “When a bank experiences this kind of extreme, they remember it, and it’s hard to get them in again,” he notes.
As Hamp concludes, loan guarantee funds are no ‘silver bullet’, but implemented correctly they can be a “very powerful tool.”
How guarantee funds work
Credit guarantee funds are tools for reducing the risk that financial institutions are exposed to when they lend to borrowers that are considered high risk, for example because they do not own land, property or other collateral. Typically, a guarantor – often backed by a government or donor – commits to paying the lender a percentage or ‘first loss’ of the amount lent if a borrower defaults on a loan. In agriculture-focused funds, the lender could also be a value chain player such as a produce trader, while the borrower could be an individual farmer or a farmer organisation. Under a so-called ‘retail’ scheme (which involves most agricultural funds) the fund is actively involved in the screening and assessment of borrowers. This makes the fund more expensive to run than a ‘wholesale’ scheme, where the lender is given more autonomy. Under both models, the guarantee provided is legally enforceable.