Guarantees: An underrated catalytic instrument

Nepal’s total credit portfolio is expected to exceed NRs 6,000 billion ($46 Billion) by FY 2025, accounting for well over 90% of Nepal’s GDP. The portfolio has recorded a remarkable 20% compounded annual growth rate (CAGR) over the last 15 years. 

Despite such expansion, the lay of our land seems blemished by fundamental problems that deter investments into identified growth sectors. The restricted flow of money to these sectors is not primarily due to the unavailability of funds, but rather due to inherent risk in the sectors, limited management bandwidth of fund providers, limited access and usage of risk management tools, and/or inability of fund providers to innovate on structures and instruments.

In developing markets, the advancement of catalytic instruments such as ‘Guarantees’ serves as an ideal tool to spur growth in identified sectors. Guarantees are not new to the investment realm. It is used significantly by governments and development bodies globally to either crowd in investments or incentivise investment flow to riskier sectors. 

In Nepal, the government set up ‘Deposit and Credit Guarantee Fund’ (DCGF) in 2010 with one key objective being to facilitate credit guarantees.

However, over the years, this profitable agency has become only a tool for banks and financial institutions (BFIs) to avail provisioning discounts on sector specific credit portfolios rather than a tool to spur credit growth. 

Nonetheless, it is never too late to revitalise this comfortably numb vehicle for a paradigm shift in credit activities.

Guarantees are uniquely poised to de-risk investment in underdeveloped and underserved markets or sectors. It provides insurance coverage for contingent events of risks and thereby supports crowding in investments by essentially changing the risk return profiles of investors. 

The ability of guarantees to mitigate commercial, credit and even political risk alleviates credit restrictions for underserved borrowers (e.g., facilitating rate subsidies, increased tenor, reduced securitisation), in key sectors of Nepal such as energy, agriculture, technology and tourism. 

There are various types of guarantees that differ based on the types of risk they cover (commercial or political), the nature of instruments (debt or equity) they back and the amount (partial or full) they cover.

Well-known guarantee instruments such as the ‘First Loss Default Guarantee’ (FLDG) and ‘Portfolio Guarantee’ are amongst the many that are discussed frequently.

What is ‘First Loss Default Guarantee’ and ‘Portfolio Guarantee’?

First Loss Default Guarantee is a type of guarantee in which the guarantee provider agrees to bear losses incurred up to an agreed percentage in the event of default by the borrower.

Portfolio Guarantee is a financial instrument designed to help financial institutions manage and mitigate credit risk associated with a portfolio of assets. The guarantee can take various forms (e.g., risk sharing facility, synthetic risk transfer) and cover various risk allocations (up to 100%).

Source: World Bank/World Economic Forum

Both these forms of guarantees facilitate BFIs to deepen their exposure to sectors such as agriculture, women-led businesses, SMEs or technology and technology-enabled businesses while transferring the burden of default to the guarantor.

These sectors, if not for any bridge or catalytic support, would remain underserved. For context, non-performing assets (NPA) in Nepal’s agriculture sector is observed to average north of 10% in today’s time, which deters BFIs to further participate in lending to the sector, if not for the NRB mandate.

A FLDG with an 10% coverage would incentivise BFIs to look at the sector differently, even increase exposure, while over time develop specialisation in financing sub-sectors in agriculture. This would help BFIs develop niche expertise within agri lending as a sector. 

In an ideal scenario, with the catalytic role of guarantees, few banks could develop proficiency in agro-processing lending, while few could specialise in the agricultural input vertical or other sub verticals respectively.

A contextual use case is the credit guarantee facility (CGF) established by the Austria Nepal Renewable Energy Blended Finance Facility (REBFF)) in partnership with NMB Bank Ltd and the federal government’s Alternative Energy Promotion Centre (AEPC).  

The CGF of €750,000 was designed for Karnali Province with the goal of facilitating finance and capacity enhancing activities for renewable energy projects while achieving shared environmental, social and gender benefits. The fund, backed by a cash deposit into the partner bank rather than a non-funded guarantee, established a 25% first-loss guarantee/reserve.

Investors and BFIs alike, struggle to finance intangible heavy sectors such as technology despite reports that outline their potential. Instruments such as equity guarantees are equipped with the capability to crowd in international commercial investors by back stopping their investments or by providing coverage for the returns gaps expected. 

Such instruments complement the existing funding offerings that development finance institutions (DFIs) provide to many of the BFIs in Nepal, in the form of tangible sector directed lending mandates. 

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Due to their intangible nature, these sectors are beyond the scope of traditional credit, hence full or partial portfolio guarantee instruments are well positioned to facilitate and incentivise BFIs to test those waters of potential. 

Case in point, Sarulla Geothermal Power Project in Indonesia leveraged a risk guarantee from the Japan Bank for International Cooperation and a 20-year business viability guarantee letter from the Indonesian government to crowd in commercial funding.

Guarantees as instruments serve as a vital component in the blended finance tool kit too. They facilitate the foundational pillars of blending i.e., concessionality, additionality and help de-risk private investors.

While most economies in the post pandemic world are prophesying the dominant role of blended finance for developing economies, most of these schemes and vehicles are empowered by guarantee tools to start with. 

As per reports from the Organisation for Economic Co-operation and Development (OECD), guarantees have mobilised more private finance than any other financial instruments.

DFIs like BII, FMO, KfW/DEG, USDFC, Norfund, Proparco; multilateral development banks (MDBs) like World Bank, MIGA, ADB; aid agencies like SIDA and USAID; and specialised guarantee providers already facilitate the provision of guarantees. 

Specialised institutions such as GuarantCo and InfraCredit are known institutions with a dual mandate of both development impact and financial returns that can support the facilitation of guarantee provision.

Despite the appeal, guarantees have made less progress in Nepal due to many reasons. Foremost, guarantees are not official development assistance (ODA) eligible, thereby limiting their use case for development agencies. 

Further, guarantees have complex structures and would require expertise which is scarce within the development agencies currently active in Nepal. 

Lastly, limited awareness and availability of guarantees as an instrument along with issues on pricing those guarantees, limit their use case.

In the past, many programs supported by development agencies have attempted to pilot and test guarantees to facilitate credit flow to selected sectors. However, unfortunately, most of these efforts have been limited to pilots. 

Sakchyam, an access to finance initiative funded by FCDO, worked with private sector BFIs and businesses to facilitate and improve the access to finance for MSMEs. The program piloted a partial loan guarantee scheme in the context of a challenge fund to support MSMEs access finance. 

The scheme guaranteed a percentage of the total amount disbursed for a period of up to two years. Although the performance of the pilot was found to be good, participating banks did not continue providing guarantees after the financial support from Sakchyam ended.

Similarly, NMB Bank Ltd in partnership with the AEPC/Central Renewable Energy Fund (CREF) agreed through an MoU for a loan loss funded guarantee under the Sustainable Energy Challenge Fund for financing the renewable energy sector in Madhes, Lumbini and Karnali provinces. The fund was supported by FCDO. 

The arrangement was to scale up renewable energy financing in the country with the bank being able to secure 20% of the losses with the guarantee support.

Lastly, Micro Hydro Debt Fund, set up under the supervision of AEPC, partnered with NMB Bank Ltd and Himalayan Bank Ltd to provide access to finance to local communities who intended to set up and operate micro hydropower plants. The fund was supported by GIZ through a funded guarantee to cover loan loss up to 50% of the portfolio.

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Overall, guarantees as an instrument, have not had their moment in the sun yet. However, in the evolving economic context of Nepal with the recent sovereign rating of BB-, stagnancy in business fundamentals and excessive liquidity, guarantees seem to be an opportune instrument to explore without costing an arm and a leg for the funder.