VIEW: Guarantee programs better than liquidity boosting measures

Economic impact due to the ongoing pandemic is likely to be severe and long-drawn. In the Indian context, we were already amidst a slowdown and that makes the timing even more hard-hitting. Slow business cycles come with a string of adverse consequences. Demand compression, scarce capital availability, unemployment, margin reduction and bankruptcy are some of these unfortunate outcomes.

The regulator is trying to infuse liquidity in the market through a slew of measures meant to equip lending institutions with the ability to lend freely. However, with a pessimistic economic outlook, the risk belt is only likely to be tightened since aggressive lending might prove imprudent. There are various means to mitigate risk and lend responsibly. One of the commonly followed measures is the use of guarantee programs.

The modus operandi is simple. When an account turns NPA the guarantor steps in to make repayments on behalf of the defaulting borrower and typically takes the first loss. The duration of repayments is contractually decided based on the commercial arrangement. Repayments are either made in the form of real-time cash flow support or during the crystallization of losses.

Guarantee schemes are operated by government entities and private players alike. In the case of the latter, there are regulatory norms to ensure capital adequacy. These guarantee companies help maintain countercyclical capital buffers since long term capital buffers are required in dealing with economic downturn events. Guarantee usage helps broad base systemic risk since a third entity steps in to absorb some part of the losses. In the run-up to the global financial crisis of 2008 and beyond, mortgage insurers in the US paid $39 billion dollars worth of claims!

There are three specific benefits of using guarantee schemes. Firstly, it helps lenders increase risk appetite (or at the very least retain them at pre-pandemic levels) by using guarantees as a backstop. This will ensure access to capital for a larger segment of potential borrowers. In a recessionary scenario, lenders tend to compete to find the safest borrowers. That acts at cross-purposes with the objective of increasing credit offtake for the larger economy.

The second challenge is that of liquidity. A well-oiled securitization market can help channelise liquidity to a larger lender base by giving them access to a different form of capital. Guarantees could certainly act as a viable credit enhancement tool for slightly risky portfolios to be securitised. Smaller lenders without the benefit of strong ratings could also leverage the instrument effectively. The Basel framework formally recognises guarantees as a credit risk mitigant.

Lastly, the overall economic capital can be more efficiently utilised with some dispensation. Guarantees should enable lenders to maintain lower provisions (and minimize double provisioning on the same asset). Alternatively, risk weights could be lowered for portfolios with guarantees. There are several global precedents around these in developed and developing countries.

Housing is a key sector for reviving the economy. Apart from direct contribution to GDP, there are numerous backward linkages that get catalysed by growth in housing. At sub 10 percent Mortgage to GDP ratio, there is a lot of ground to cover even with comparable Asian economies.

There is also an important social benefit by making housing more affordable. The legislative push to promote housing has been consistent and impactful. The Pradhan Mantri Awas Yojana has been hugely successful with over 1.04 crore homes sanctioned under this scheme. Most lending institutions are now committed to growing their affordable housing book. There is a pressing need to provide even greater impetus to housing finance.

Housing demand has slowed down in the last few years. V-shaped recoveries in equity markets are far more common than v-shaped ones in housing. The impact of COVID-19 could lead to lower risk appetite among banks given financial uncertainty. Owing to the risks associated in lending to certain segments, lenders could also start exercising extra caution and tighten underwriting norms. Institutional arrangements can mitigate some risks, revive demand, and expand home ownership.

The importance of carefully monitoring guarantee schemes at the operational level cannot be overstated. The safety net that a guarantee provides lends itself to misuse, especially during recoveries. This creates a moral hazard and can also lead to reckless lending practices. It is important for guarantee organisations to tightly monitor servicing standards to prevent portfolio deterioration.

Widespread use of guarantee programmes eventually benefit the industry by standardising many business practices. There are four credit default guarantee companies in India currently — the CGTMSE promoted by SIDBI for the MSME sector, ECGC for the export sector, CGTF, and India Mortgage Guarantee Corporation (a public-private partnership between NHB, IFC, ADB and Genworth). We hope to see widespread use of each of these schemes to meet the twin objective of leveraging the financial system to revive the economy while ensuring cautious growth.