Credit Guarantee Schemes in Sri Lanka --Way Forward

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82Credit Guarantee Schemes in Sri Lanka--Way ForwardSharmini De Alwis 1 and B. M. R. Basnayake 2AbstractAlthough SMEs play a vital role in the economic process, they continue to experienceconstraints when accessing formal sector finance. The four factors that cause market failurein the credit market for SMEs are high administrative costs for small scale lending,asymmetric information, high risk perception on small firms and lack of adequate collateral.This market failure justifies government intervention. Such intervention may take manyforms but credit guarantee is relatively the least distortionery. Survey data indicate thatSMEs Sri Lanka continue to face credit constraints mainly due to collateral based issues. Inthe immediate aftermath of the liberalization of the economy, a compelling need for CreditGuarantee Schemes arose in Sri Lanka as domestic SMEs were faced with heavycompetition from imported goods. Over the years, a number of partial credit guaranteeschemes were operated by the Central Bank of Sri Lanka. Many of these were mandatoryand were set up to promote refinance schemes operated by the Central Bank or otherfinancial institutions. The funds for operating these schemes consisted of seed fundsprovided by the Government or the Central Bank, premium income and investment incomereceived from investing surplus funds. Due to excessively stringent requirements attached tomost of the Credit Guarantee Schemes, a large proportion of claims were rejected and thishas resulted in a loss of confidence in such schemes. As most SME credit guarantee schemeshave now terminated, there is a special need for a new SME credit guarantee scheme.particularly due to the impact of the global financial crisis on SMEs and the adoption ofBasle II standards by the financial sector institutions in Sri Lanka. A new credit guarantee1 Deputy Director, Regional Development, Central Bank of Sri Lanka.2 Senior Assistant Director, Regional Development, Central Bank of Sri Lanka.51

第 13 期scheme for SMEs was designed to meet some of the weaknesses in past schemes. There ishowever further room for improvement. However if such improvements are to be introducedthe Central Bank may not have the capacity to operate such credit guarantee schemes. Adedicated agency such as a credit guarantee corporation needs to be established for thispurpose in Sri Lanka.Key Words: Collateral, Participating Credit Institutions, Moral Hazard, PremiumI. IntroductionSmall and Medium Enterprises (SMEs) perform vital productivity and growthenhancing functions in any economy. Benefits accruing from SMEs include job creation,innovation and improving the general health of the economy. SMEs are usually the source ofnew ideas and products and through such innovation they fuel a nation’s economic engine.Through job creation SMEs contribute towards poverty alleviation, social stability and localand regional development. However, in most economies SMEs face constraints whenaccessing formal sector credit and this prevents them from achieving their full potential. Themarket failure in the credit market for SME’s stems mainly from four factors. These are highadministrative costs of small scale lending, asymmetric information, the high risk perceptionon small firms and lack of collateral. These factors are explained briefly below:A. High Administrative Cost.Most components of administrative costs are independent of the size of the loan, andtherefore in the case of small loans, the per unit cost of extending credit is relatively high.Further, SMEs tend to be located outside main urban centers which make visiting themrelatively more expensive. Moreover, they usually lack high accounting skills and standardsor track records. This makes analyzing their loan applications, and monitoring their loansmore expensive than would be the case with well established large enterprises.52

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82B. Asymmetric InformationIn the financial markets there is always some degree of asymmetric information asborrowers always know more about their projects and their ability and willingness to repaytheir lenders. However, this problem is more serious in the case of SMEs because of poorinformational standards arising from the fact that SMEs do not have to comply withreporting requirements imposed for example on listed firms by regulators etc. Further, theydo not usually have a credit history or a track record. Asymmetric information usually givesrise to adverse selection and moral hazard. Adverse selection arises because paucity ofinformation prevents lenders from distinguishing between good borrowers and badborrowers among SMEs. This results in them imposing high interest rates on loans to allSMEs. Consequently, high interest rates would attract risky borrowers who know that theirprojects are inherently more risky and are hence willing to obtain accommodation at a higherinterest rate. However, high interest rates discourage good borrowers, and thus the adverseselection problem becoming more acute resulting in a high default rate which would in turncause a drastic reduction of the return to the financial institution. Moral hazard could arise ifthe SME is aware that the financial institution is unable to monitor its activity adequately.This could tempt them to undertake risky activities in order to improve their returns.C. High Risk PerceptionInformation shortcomings as well as the high mortality rate among SMEs results inlenders considering them to be high risk ventures. Among the other factors that disadvantageSMEs with regard to risk perception are the facts that they have usually evolved from theinformal sector and are unable to put up sufficient collateral for loans.D. Lack of CollateralDue to asymmetric information problems, financial institutions tend to base theirlending on collateral rather than project cash flow. Collateral is thus used as a screening53

第 13 期device. By pledging collateral the borrower signals the quality of his project and hiswillingness to pay. In the event of default, the lender is able to recoup his loss by foreclosingon the collateral and liquidating it. In the absence of collateral the lender exposes himself toa moral hazard problem as the borrower, having nothing at stake, would be tempted to takerisks in a bid to increase his return. SMEs however frequently lack sufficient collateralbecause the labour intensity of their operations and the low value of their machinery andproperty resulting in their being disadvantaged in the formal credit market.In view of the important socio-economic role played by small enterprises, the marketfailure discussed above justifies government intervention in the credit market for SMEs,Given that the social compulsion in most third world countries is to provide gainfulemployment at reasonable levels of remuneration and to make sure that benefits of growthtrickle down to those in poverty, several forms of intervention have been adopted to promotethe SME sector to achieve the objectives of growth and employment generation.Government intervention has taken many forms such as directed credit, provision ofsubsidized credit and provision of credit guarantees. Subsidized credit has been subject tomuch criticism due to the fact that it distorts the market by reducing interest rates artificially,thereby encouraging excessive use of capital and allowing unprofitable firms to survive.Credit guarantee schemes however are considered less distortionary and more marketfriendly. They accomplish risk transfer and risk diversification. The risk to the lender islessened as part of the risk is assumed by the issuer of the Credit Guarantee. CreditGuarantees also diversify risk by covering loans across different sectors and geographicallocations. However, there are certain criticisms against credit guarantees, the chief of whichis again the moral hazard problem. Since financial institutions will be compensated for lossby the guarantor, it is argued that they would take less care in screening borrowers andmonitoring their activities. Aware of the fact that they are not being stringently monitored,borrowers in their turn could resort to risky behaviors. This situation is exacerbated if theborrower has not put up any collateral for the loan as he/she will not incur any pain bydefaulting. Due to this fact, in most schemes credit guarantee cover is only partial, usually54

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-8250% to 70% of the loan which results in the financial institution sharing in the loss incurred.However, even in Japan where guarantee cover is 100%, empirical studies have shown thatthe benefits accruing from reducing the borrowing constraints of the SMEs for out-weighany negative effect arising out of the moral hazard problem.II. Structure of Sri Lanka’s EconomySri Lanka is a South Asian nation which celebrated 61years of self rule in February2009. During the period since independence many structural changes have taken place in theeconomy of Sri Lanka, the most important of which was the adoption of open marketpolicies in the 1970s. Agriculture which contributed to over 40 per cent of GDP in the 1950snow accounts for around 12 per cent. The contribution of industry and services is 30 per centand 58 per cent respectively at present. However, the share of employment in agriculture stillremains high at 31 per cent. Moreover, with the rapid food inflation experienced in early2008 greater emphasis is being placed on food security issues and hence on agriculture.Small and Medium Enterprises (SMEs) constitute 80-90 per cent of the total number ofestablishments in Sri Lanka and contribute towards 20 per cent of industrial value added.The labour absorptive capacity of this sector is substantial with 70 per cent of theemployment opportunities generated in the business sector being from SMEs. It is not anexaggeration to state that the SME sector is the backbone of the Sri Lanka Economy.According to the a banking survey of the SME market in Sri Lanka2006/2007 ,undertaken by the South Asia Enterprise Development Facility, one of the chiefconstraints identified by the SMEs was the difficulty of obtaining bank finance owing tothe insistence by banks on collateral when providing credit facilities. Land is the mostcommonly offered collateral for enterprise loans in Sri Lanka and this asset raises difficultiesdue to the lack of secure title especially for enterprises in the rural sector. On the part of thefinancial institution the lack of a well developed land market in Sri Lanka prevents banks55

第 13 期from offering mortgage based financing. Moreover non availability of proper financialrecords and inability of SMEs to submit convincing business plans to banks also leads todifficulties in obtaining finance.The above situation is only to be expected as at present fresh loans issued to SMEs,other than under the New Comprehensive Rural Credit Scheme (NCRCS) scheme do notcome under any credit guarantee scheme as all such schemes have now terminated in SriLanka. It is quite clear from the foregoing that there is great scope for new credit guaranteeschemes in Sri Lanka. Such schemes should be designed after examining the operation ofpast credit guarantee schemes and identifying their strengths and weaknesses to ensure thatsuch weaknesses are not present in the new scheme.III. Sri Lanka’s Financial SystemSri Lanka inherited from its colonial masters a banking system nurtured in traditionalBritish banking which was based on narrowly subscribed security oriented lending, ratherthan project oriented lending. Banks were accustomed to link terms and conditions relatingto loans such as term, amount and cost to collateral and credit references. It is needless tostate that this type of banking practices were not suitable to spur the development of theproductive resources of the country.As at present, Sri Lanka’s Financial System comprises of Licensed CommercialBanks(LCBs) Licensed Specialized Banks(LSBs), Registered Finance Companies(RFCs),Specialized Leasing Companies(SLCs), authorized primary dealers, the EmploymentProvident Fund, the Employees Trust Fund, insurance companies, unit trusts, stock brokersand dealers, venture capital companies, financial markets and financial infrastructure. Table1 reveals that the financial system is dominated by the banking system which accounts fortwo thirds of the assets of the financial system as a whole.56

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82Table 1Total Assets of Main Institutions in the Financial SystemAssetsFinancial Institution SLR Bn. ShareInstitutions Regulated by the CBSL 3,741.2 89.2Deposit Taking Institutions 2,889.8 68.9Licensed Commercial Banks 2,277.0 54.3Licensed Specialized Banks 437.2 10.4Registered Finance Companies 175.6 4.2Other Financial Institutions 851.4 20.3Employees' Provident Fund (b) 655.3 15.6Primary Dealers 86.2 2.1Specialised Leasing Companies 109.9 2.6Institutions Not Regulated by the CBSL 452.5 10.8Deposit Taking Institutions 44.5 1.1Rural Banks 39.3 0.9Thrift and Credit Co-operative Societies 5.2 0.1Contractual Savings Institutions 374.9 8.9Employees Trust Fund 92.4 2.2Private Provident Funds 108.0 2.6Insurance Companies 155.1 3.7Public Service Provident Fund 19.4 0.5Other Financial Institutions 33.1 0.8Venture Capital Companies 1.1 0.0Unit Trusts 6.8 0.2Stock Broking Companies 3.2 0.1Credit Rating Agencies 0.1 0.0Other 21.9 0.5Total Assets 4,193.7 100.0(a) Provisional(b) Managed by the Central Bankn.a. - Not applicable57

第 13 期Although the equity market in Sri Lanka has advanced appreciably, it is still unable toserve as an alternative means of raising credit to complement credit provision by financialinstitutions in Sri Lanka. Therefore, Sri Lanka could be said to have a bank centeredfinancial sector. According to the data as at end 2008 around 5 per cent of bank lending hasbeen to the agriculture and fisheries sectors while 16 per cent has been for manufacturingactivities. Construction, trade and financial services accounted for 17 per cent, 16 per centand 6 per cent respectively. A share of 5 per cent for agriculture is considered to beinadequate in the present context and a mandatory credit requirement of 10 per cent has beenimposed on all banks and banks are expected to be compliant with this requirement from end2009 onwards. As at end 2008, the non performing loan ratio was around 7 per cent. NPL’sfor the agriculture sector were almost the same. However this position could changes fromtime to time depending on the performance of agriculture.IV. Credit Guarantee Schemes in Sri LankaA. BackgroundThis need for intervention by the CBSL to ease constraints to the access to finance bythe SME sector seems to had been envisaged by the drafters of the Monetary Law Act (MLA)of Sri Lanka as the MLA contains provisions (under Section 108(1) MLA) for the CBSL toact as the Agent of the Government and to act on behalf of the Government, in guaranteeing,issuing or participating in the loans of banking institutions operating in Sri Lanka.However, although a development role was envisaged for the Central Bank in terms ofits objectives, the MLA did not expressly provide for the grant of medium and long termfinance/ refinance to credit institutions. As investment and capital formation in the economydemands long and medium term finance, particularly when the capital market was notdeveloped sufficiently to finance such needs, amendments were made to the MLA to permitthe establishment of a Medium and Long term Credit Fund (MLCF). This fund was first58

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82announced in the Budget for 1963/64. MLCF was to be the source of finance for thepromotion of industry and investment needs of the economy as well as credit guaranteeschemes. Several refinance schemes for SMEs were established over the years utilizingresources from the MLCF.Further strengthening Central Bank’s role in credit guarantee operations, in 1974, anamendment to the MLA added the following as Clause 108A.108A. (1) The Central Bank may subject to such directions as may from time to time bemade by the Monetary Board, guarantee loans, advances or other accommodation granted tosmall scale enterprises by credit institutions operating in Sri Lanka.The latter specifically identifies SMEs and empowers the Central Bank to directlyguarantee loans and advances provided by credit institutions in Sri Lanka to SMEs.B. History of Credit Guarantee Schemes in Sri LankaSri Lanka being a predominantly agricultural country, one of its first efforts inimplementing credit guarantee scheme was in respect to cultivation loans advanced bycommercial banks. This scheme was introduced by the government in 1967 andimplemented by the Central Bank of Sri Lanka (CBSL) as the agent of the Government inaccordance with provisions of Section 108 (1) of the Monetary Law Act. The People’s Bankand Bank of Ceylon, two state sector banks, were the credit institutions involved in thiscredit guarantee scheme. However, this scheme did not perform well and was withdrawn in1978 following heavy defaults in repayment of loans granted in Maha Season 1977/78.Subsequently, in the agriculture sector, a Credit Guarantee Scheme which was applicable toall short term loans given for cultivation of crops covered under the New ComprehensiveRural Credit Scheme (NCRCS) was introduced. Even at present a Credit Guarantee Schemeis available for short term cultivation loans provided under the NCRCS.A compelling need for credit guarantee schemes for the SME sector arose in the wake59

第 13 期of the liberalization of Sri Lanka’s economy in the late 1970s. One of the problems posed byliberalization was the influx of imports which resulted in the local industry facing fiercecompetition from finished products with recognized brand names. In some instances, thisresulted in the output of the industrial sector becoming unsalable. While the large industrieshad some flexibility to re-adjust, such flexibility was not available to SMEs. There wastherefore a fear of large scale closure of SMEs which would cause a slowing down in thegrowth of income, employment and the utilization of local raw material for productive enduses.It was in this background, that in April 1978, the Government decided to put in place acredit guarantee scheme for an existing loan scheme under which State Banks in cooperationby the Industrial Development Board (IDB), provided credit to SMEs. This particular loanscheme had commenced in 1972 and had failed to achieve the required progress. Both thislack of progress and the threat to SMEs from the open economic policies were thecompelling factors for the introduction of the Small Scale Industries (SSI) credit guaranteescheme which commenced as a pilot scheme in April 1978. The scheme was implementedby the CBSL acting on behalf of the Government under Section 108 of the MLA. It coveredloans extended to the People’s Bank, Bank of Ceylon and the Development FinanceCorporation of Ceylon in cooperation with the Industrial Development Board and wasintended to improve the credit delivery system. The extent of guarantee cover was 75% ofthe amount in default. As the default rate was high, the claim ratio was also significantlyhigh in this scheme.Subsequently, in 1979, CBSL commenced operations of a credit guarantee scheme forloans made under the Small and Medium Industries-I (SMI-1) scheme. The apex lender forthe SMI-1 scheme was the National Development Bank (NDB). This scheme wasimplemented under an agreement signed between the Government of Sri Lanka (GOSL) andInternational Development Agency (IDA) in July 1979 under which CBSL in terms ofSection 108 A of the MLA was called upon to establish a Credit Guarantee Schemes for SMIProject Loans refinanced by the IDA and administered by the NDB. The extent of guaranteeunder this scheme was 60 per cent. After the establishment of the SMI-1 credit guarantee60

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82scheme, the popularity of the SSI credit guarantee scheme waned. Default levels althoughless than in the SSI credit guarantee scheme, were still high. The SMI scheme was followedby the SMI II scheme in 1982. In this scheme also, the extent of guarantee was 60% subjectto a maximum of SLR 1.2 mn. The claim ratio on the SMI-II scheme came downsignificantly because of close monitoring of project management by PCIs.Experience from operating the SMI-I and SMI-II credit guarantee schemes helped theCBSL to structure the SMI-III credit guarantee scheme which became operational in late1987. For the first time, variable covers of 80, 60 and 40 per cent were extended dependingon the size of the loan. The guarantee liability of the CBSL was also limited to the principalamount in default. In this scheme, several specific conditions were imposed. Among themwas the provision of a certificate of viability, prepared by the PCI or the apex lender (NDB),along with the application for credit guarantee.Meanwhile, credit guarantee schemes became operational in respect of the loansgranted under three ADB funded loan schemes, namely the Mid Country Perennial CropDevelopment Project(MCPCDP), Small Holder Tea Development Project(SHTDP) andAgricultural Rehabilitation Project(ARP) loan schemes, all three for which CBSL was boththe apex institution and the credit guaranteeing agency. All these loans qualified for creditguarantee under the MLCF.In order to encourage PCI lending to private sector bus operators for purchasing busesfor public transport, the Bus Purchase Loan (BPL) scheme was instituted. BPLs wererefinanced by the NDB up to 75 per cent. A guarantee scheme fairly similar to the SMIschemes was introduced for the BPL scheme. In the BPL credit guarantee scheme premiumcollection was undertaken on an annual basis (hitherto premium collection was on aquarterly basis), and the payment of the guarantee was in two stages. A condition wasimposed on PCIs to submit a certificate confirming the execution of the mortgage bond andcertificate of registration of the vehicle with an entry that the mortgage bond has been dulyregistered. PCIs were also required to retain the Certificate of Registration until the loan was61

第 13 期fully paid. (CBSLs liability under the guarantee cover lapsed if the ownership of the bus wastransferred).The SMI IV scheme which came into being in 1994 was very similar to the SMI-IIIscheme. A significant feature of this credit guarantee scheme was that write off of loans forwhich a claim payment had been made was subjected to the prior approval of the CBSL.This condition was included in all the subsequent credit guarantee schemes and made a verysignificant impact on their operations.In the Plantation Sector Reform Project which was launched in the second half of 1996,CBSL was both the apex lender as well as the credit guarantor. As the scheme was to be selffinancing the premium rate was increased to 1.5 per cent and the guarantee cover rangedfrom 70 per cent to 50 per cent for the various activities. PCIs were required to satisfystringent portfolio management criteria including adequate provisioning and maintainingcapital adequacy. The value of loans under this scheme was significantly higher thanschemes undertaken hitherto and no upper limit was imposed on guarantee claim payments.This made the scheme one of the most risky undertaken thus far.The ADB funded Second Perennial Crop Development Project (SPCDP) credit schemebecame operational in August 1998. Under this scheme, loans were provided for severalspecific activities relating to the cultivation of perennial crops. A partial credit guarantee wasprovided for loans under the scheme by the GOSL. Subsequently, a partial credit guaranteescheme was also extended by the GOSL for the ADB funded Tea Development Project (TDP)Credit Scheme which became operative in June 1999. Loans for replanting, infilling andnurseries were covered by the credit guarantee scheme.Small and Medium Enterprise Assistance Project (SMAP) which was launched inSeptember 1997 was very similar to the SMI IV except that the requirements for reporting ofarrears was streamlined. As in the case of SMI IV, credit guarantee cover varied with loansize.62

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82In mid 2005, on behalf of the GOSL, CBSL established a credit guarantee scheme forloans granted by banks to the apparel sector. There was no specific refinance scheme linkedto this loan scheme and all loans granted to the apparel industry for the purpose of upgradinginfrastructure, technology and modernization to comply with quality standards, were eligiblefor the guarantee cover, provided that the borrowers had not defaulted on any previous loangranted by a financial institution. Applications for guarantee cover were required to be madenot later than one month after the disbursement of the 1st installment of the loan. A uniquefeature of this scheme was that no premium was payable by the PCIs.In the wake of the Tsunami of 26/12/2004, several special tsunami relief loan schemeswere established for the purpose of rehabilitating enterprises affected by the Tsunami. In thecase of one such scheme, the “Susahana” scheme, under which refinance was provided bythe CBSL in respect of loans for rehabilitation of SMEs damaged by the tsunami, an optionalcredit guarantee scheme was put in place in August 2005. This credit guarantee scheme wasintended to cover only borrowers who had been categorized as past due at the time of thetsunami and those who were not in a position to provide sufficient collateral. Therefore, itwas mainly intended to promote the flow of funds to borrowers who were perceived as riskyby PCIs, particularly those who had lost all assets due to tsunami destruction and hencebeing unable not able to furnish collateral.In September 2008, with a view to increase access to finance for the purpose ofmodernizing production units of traditional jewellery and small lapidaries the Ministry ofFinance and Planning requested the CBSL to put in place a credit guarantee scheme for thegem and jewellery sector. This scheme covers loans granted by PCIs to small and mediumenterprises in the gem and jewellary sector under the Production Unit Modernization Schemeof the Ministry of Enterprise Development and Investment Promotion.63

第 13 期C. Salient Features of Credit Guarantee Schemes in Sri LankaTable 2Credit Guarantee Schemes in Sri Lanka- a SummaryType of ProjectActive Projectsunder CBSLGuarantee1. Plantation SectorReform Project-PSRP2. Small Holder TeaDevelopment ProjectSHTDPDate ofCommencementDate ofConclusionApex Agencyof LoanSchemeExtent of Liability1996 2002 CBSL 70% of refinanceamount for Tea50% of refinanceamount forprocessing andpurchase of vehicles1989 1998 CBSL 50% of the loan inloss or the amountgranted subject to amaximum of SLR.2.0 Mn.3. Susahana 2005 2012 CBSL 50% 1.0%Active Projectsunder GovernmentGuarantee4.Second PerennialCrop DevelopmentProject5.Tea DevelopmentProject6. NewComprehensive RuralCredit Scheme7.Apparal SectorCredit GuaranteeScheme8. Gem and JewellarySector CreditGuarantee Scheme1998 2004 CBSL 60% of loan in loss oramount grantedwhichever is lowersubject to amaximum liability ofSLR. 1.6 mn1999 2005 CBSL 60% of loan in loss oramount grantedwhichever is lowersubject to amaximum liability ofCurrentInterestSubsidySchemefunded by theTreasury andCoordinatedby the CBSL2008 CBSLrefinance notprovided forSLR. 1.6 mn60% of loan loss orthe amount grantedwhichever is lowersubject to amaximum liability ofPremiumPayable1.5%0.5%1.5%1.5%0.5%50% 0%80% of the principalsloan amount grantedor the amount in0%64

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82Expired Projectsunder CBSLGuarantee9 AgricultureRehabilitationProject-ARP10 Mid CountryPerennial CropDevelopment Project-MCPDP11 Small andMedium* Industries-SMI12. Bus PurchaseLoan Scheme-BPL13. Small andMedium EnterpriseAssistance Project-SMAPthe loan.default whichever isless.Maximum loan sizecovered under thescheme is SLR. 1.2mn.1990 1995 CBSL 50% of loan in loss orthe amount grantedwhichever is lower0.5%1988 1995 50% of loan in loss or 0.5%the amount grantedwhichever is lowersubject to amaximum liability ofSLR. 1.6 mn1979 1997 NDB 90% 1.0%1990 1992 NDB 100% 1.0%1997 2000 NDB 90% 1.0%*SMI credit guarantee schemes have been amalgamatedIf the above discussed guarantee schemes are categorized, the SSI credit guaranteescheme could be considered to be an "economic change" scheme as it was primarily intendedto protect the SME sector from the forces of competition unleashed consequent to theliberalization of the economy. Most of the subsequent credit guarantee schemes implementedcould be categorized as "creation/expansion" schemes which were specifically aimed atfacilitating new business creation and/or expansion, as they were linked to loan schemes putin place for creating and expanding existing enterprises. The Susahana credit guaranteescheme could be categorized as a "disaster" scheme which was instituted to rescue SMEsaffected by a natural disaster (Tsunami).It should also be noted that credit guarantee cover is partial in the case of all theschemes discussed above, thus mitigating the moral hazard problem to a certain extent.There following two features in these credit guarantee scheme deviates from most65

第 13 期conventional credit guarantee schemes found globally.1. Mandatory cover- Many of the credit guarantee schemes operated in the past weretied up with a refinance scheme. Actually, the credit guarantee schemes wereoperated mainly to promote the refinance scheme. To become eligible for refinance,it was mandatory to pay the first premium. The idea behind this was to avoid adverseselection and promote the sustainability of the credit guarantee scheme. If the creditguarantee scheme was optional, it was argued that PCIs would seek guarantee coverfor their most risky loans resulting in a high claim rate. In order for Credit GuaranteeSchemes to be sustainable, it would then be necessary to charge a very high premiumrate.In the above circumstances the borrower (and even the lender) has no say inobtaining credit guarantee. As the credit guarantee scheme is mandatory and tied toa refinance scheme, there is no interest rate advantage going to the borrower onaccount of the credit guarantee scheme itself, as the refinance was in any case at aconcessionary rate. This deviates from the practice followed in some countries suchas Japan where the borrower applies for a credit guarantee independent of the PCIand when granted that facility uses it to obtain more favourable terms and conditionson his loan.2. Recovery of loan subsequent to claim paymentThe recovery of the loan after the payment of the claim in the above discussedschemes is left entirely to the PCI concerned and the Guarantor (CBSL) plays no partin the recovery process. The PCI has to submit CBSL’s share of recoveries as andwhen it obtains recovery. In schemes operated in several countries, after payment ofthe claim, the guarantor subrogates the loan and pursues recovery. However such asituation is not practical in Sri Lanka under the present institutional set-up whereonly a small unit within the CBSL handle credit guarantee operations.66

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82D. Activities undertaken by the Credit Guarantee Division of CBSLThe main activities undertaken by the Credit Guarantee Division are the following:1.Issuing Guarantees and Operating Instructions to PCIs2.Collection of premium3.Investment of funds4.Receiving claims and processing such claims5.Settlement of claims6.Recovery after litigation7.Follow-upE. Relationship between the CBSL and the PCIIn most loan programmes for which credit guarantee is mandatory the CBSL acts asboth the apex agency for disbursement of refinance and the credit guarantee authority. Insome programmes such as the SMI programmes, refinance was provided by a separateagency (NDB) with the CBSL acting as a credit guarantor only. The relationship betweenCBSL and the PCIs is depicted in Figure 1 below:67

第 13 期Figure 1 Mapping of Relationship between PCIs and CBSLRDD/CBSLRepayment of RefinanceAppexInstitutionsClaimsGuaranteeClaimsGuaranteeRefinancePCIsPCIsSub-borrowersSub-borrowersF. Steps involved in obtaining a claim payment under Credit Guarantee SchemesOperated by CBSLThe steps involved in seeking credit guarantee cover maintaining and obtaining claimpayments vary with the type of credit guarantee scheme involved. The under mentionedsteps pertaining to the Tea Development Project Credit Guarantee Scheme and the SecondPerennial Crop Development Project Credit Guarantee Scheme are fairly typical. A loanrefinancing scheme is available for these schemes and credit guarantee cover is mandatory.1. Upon disbursement of the loan, PCIs are required to submit an application forrefinance together with the premium payment for the remainder of the year inwhich refinance is sought.2. Premium is required to be paid annually on the outstanding balance of the loan at theend of the previous year, before March 31st of the subsequent year, to keep theguarantee valid.68

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-823. In the event the loan is transferred to the past due category, PCIs should submit aclaim to the CBSL within 6 months of the loan being transferred to the past duesection. The claim should include the following documents:a) A copy of the ledger sheet of the loan account held in the PCI branch;b) Copies of Notice of Demand served on the borrower and the guarantors by thelegal officer of the PCI;c) Copies of Inspection Reports periodically undertaken by the PCI as specified in theoperating instructionsd) Copies of Statement of Accounts showing the payment of Credit Guarantee madeduring the period up to the time of lodging the claim.e) Any other documents/information that the CBSL may require in connection withany loan guarantee under the scheme.(At this stage the CBSL will pay 75 per cent of the claim payment)4. Legal action should be initiated and the number pertaining to the legal action shouldbe furnished to the CBSL to obtain the balance 25 percent of the guarantee claim.5. Legal action has to be pursued and CBSL’s share of any recoveries (in proportion tothe sharing of the loss between CBSL and PCI) has to be forwarded to the CBSLuntil the CBSL's claim payment is fully recovered.6. CBSL's prior approval for write-off of the loan has to be sought and will be givenonly in very exceptional circumstances where there is no possibility of recovery.G. Source of Funds for Payment of Credit Guarantee SchemesFunds for payment of credit guarantee claims are sourced as follows:1. Seed funds provided by the CBSL or GOSL69

第 13 期2. Premia3. Investment income on premia collection and seed funds1. Seed funds provided by the CBSL or GOSLAt the initial stage, the Central Bank established Credit Guarantee Funds for eachguarantee scheme to provide funds to settle the claims submitted by PCIs in respectof defaulted loans as the premium collection income was inadequate to service thescheme. These funds were sourced from its general reserves. The CBSL accordinglytransferred SLR 25 mn., SLR 75 mn., and SLR 116 mn. in respect of SMI-I, SMI-II and SMI-III schemes respectively. With the completion of SMI I, II and IIIschemes, the seed funds amounting SLR 216 mn. were transferred to SMI IV scheme.BPL credit guarantee scheme was established with a capital of SLR 22 mn..All above projects have been completed. Other than these there are ten otherguarantee schemes established which are in existence. Out of these ten schemes, fiveschemes viz, Agricultural Rehabilitation Project (ARP), Mid Country Perennial CropDevelopment Project (MCPDP), Plantation Sector Reform Project (PSRP), SmallHolders Tea Development Project (SHTDP) and Post Tsunami ReconstructionProject (Susahana Project) are under liability of the CBSL. CBSL has providedseed capital of SLR 250 mn. for Susahana Projects but seed funds have not beenprovided specifically for the other projects.The remaining five credit guarantee schemes are sponsored by the Government. Theyare Apparel Sector Credit Guarantee Scheme, Second Perennial Crop DevelopmentProject (SPCDP) Credit Guarantee Scheme, Tea Development Project (TDP) CreditGuarantee Scheme, the New Comprehensive Rural Credit Scheme (NCRCS) and theGem and Jewellary Credit Guarantee Scheme. The Government has provided seedcapital of SLR 100 mn. for the NCRCS Credit Guarantee Scheme, the TDP CreditGuarantee Scheme and the SPCDP Credit Guarantee Scheme. SLR 10 mn. has been70

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82provided as seed funds of the Apparel Sector Credit Guarantee Scheme while SLR48 mn. is to be provided for the Gem and Jewellary Credit Guarantee Scheme ofwhich SLR 20 mn. has been provided initially.2. Premia Collection:All PCIs are obliged to pay a premium which varies between 0.5% to 1.5% of theoutstanding value of the loan for the different projects. Premium for the guarantee ispayable annually at the beginning of each calendar year for all schemes other thanthe NCRCS scheme, which is a seasonal short term cultivation loan scheme. Underthe scheme a one-off premium is payable. For each and every credit guaranteescheme, premia collected is maintained in a separate account by CBSL.3. Investment IncomeAll surplus funds lying in the credit guarantee premium account and the creditguarantee fund account are invested in government securities. As interest rates havebeen relatively high, investment income has grown substantially expanding the fundsin the credit guarantee fund accounts and the credit guarantee premium accounts andthis together with the high rejection ratio has resulted in an absurdly low leveragerate as seen in Table 3 below:Table 3Overall Leverage of Credit Guarantee Schemes Operated by CBSLYear Equity Funds (SLRs Mn.) Contingent Liability (SLR Mn.) Leverage Ratioa b b/a2005 4411 4925 1.12006 5089 3761 0.72007 5990 3179 0.52008 7087 3133 0.4V. Assessment of the Effectiveness of Credit Guarantee SchemesIt is difficult to assess the success of credit guarantee schemes operated thus far in Sri71

第 13 期Lanka in enhancing the flow of funds to the SME sector as most credit guarantee schemeswere tied up with specific refinance or interest subsidy loan schemes. Credit guarantee coverwas made mandatory and the PCIs were forced to obtain credit guarantee cover to becomeeligible for refinance. Obviously, the refinance schemes would have contributed towards theexpansion and creation of new enterprises in the SME sector. To what extent the creditguarantee schemes also contributed towards "additionality" is difficult to determine. It isobvious however, that some additionality would have been achieved as the credit guaranteeschemes provide temporary liquidity to PCIs, enabling them to expand lending. (In theabsence of such liquidity such banks would have had to curtail loans to new applicants).Collateral requirements, requirements regarding taking legal action against defaulters andother excessively stringent requirements stipulated in the operating instructions pertaining tocredit guarantee schemes would however have prevented the full realization of the objectiveof enhancing financial access to SMEs. These are discussed below:A. Collateral RequirementsOperating instructions relating to typical credit guarantee schemes operated thus farspecify that PFIs “should observe normal care and prudence in disbursing loans and takesteps necessary to reduce and minimize any loss to them. Accordingly, they are obliged totake proper securities as mentioned in their guarantee application and also to furnish CBSLa certificate confirming that the securities documentation pertaining to the loan guaranteedhas been completed in conformity with the undertaking given in the credit guaranteeapplication, within a period of 09 months from the date of disbursement of the firstinstallment of loan”.Obviously collateral requirements specified above do nothing to encourage lendingbased on cash flow and project viability alone. On the other hand however, these stringentcollateral requirements were imposed in the past to avoid the moral hazard problem to thebanks; borrowers not providing collateral have nothing at stake and would be free to takerisks which would result in the bank facing a high default. However, given the declared72

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82difficulty of SMEs furnishing collateral, some relaxation seems to be warranted.B. Requirements relating to legal actionCBSL expects the PCIs to diligently pursue legal action/parate procedure to liquidatethe assets provided as collateral. Litigation requirements have been imposed as borrowershave a tendency to treat development oriented loans as hand outs provided on theintervention of the GOSL and therefore neglect to adhere to the due dates for repayment etc.Whenever the PCI recovers any part of the loan, it is required to submit to the CBSL itsshare of the recovery proceeds. No distinction is made between willful and non-willfuldefaulters in the procedure to be followed after payment of a claim. Seizing of assets andliquidation of the same is mandatory. As very often these assets are productive assets tied upwith the SME, there is no possibility for a SME to resume activities after defaulting on aloan, even if such default was due to circumstances beyond the control of the entrepreneur.In such circumstances, it would be natural for SME’s to be reluctant to borrow. To mitigatethis situation, some flexibility could be permitted to non-willful defaulters.C. Other stringent requirementsFrequently, claim applications have been rejected due to non-conformity withconditions imposed in operating instructions. Some of the frequent reasons for rejection arethe following:1. Non submission of claims by PCIs on time.2. Poor monitoring by PCIs both at the lending stage and after the loan has beendefaulted.3. Abnormal delay in serving Demand Notice once the loan goes into arrears.4. Non exercise of prudence in credit operations especially on project evaluation.5. Procedure followed when accepting securities not being prudent.73

第 13 期High rejection rate of claims on technical ground has result in PCIs losing confidence incredit guarantee schemes. Therefore, if confidence is to be restored some flexibility mayhave to be infused. On the other hand, non-imposition of conditions would be a disincentivefor close monitoring by PCIs which would in turn result in high defaults and threaten thesustainability of credit guarantee schemes. A delicate balance requires to be achieved in thisarea to ensure maintainence of confidence in Credit Guarantee Schemes while preventinglapses in monitoring by PCI. One possibility is making the monitoring requirement morestringent with the increase in loan size. Given the low leverage achieved so far, there isample scope for relaxing conditions etc.VI. Proposed Credit Guarantee Scheme for the Micro Small and MediumEnterprise (MSME) SectorGiven that the SME sector are continuing to experience problems in accessingfinance almost all credit guarantee schemes for SME credit have now been terminated, thereis ample scope for instituting credit guarantee schemes to grow the SME sector. Inparticular, PCIs are following BASLE II standards in Sri Lanka and as a result the riskweight for lending to SMEs is 75 per cent. If such loans are under credit guarantee the riskweight will be much less allowing the PCIs to expand lending to the sector. Further with theglobal recession the some subsectors of the SME sector are facing severe problems in SriLanka and the Government has already designed a stimulus package for the sector. Thiswould be made even more effective if a well designed credit guarantee scheme is also put inplace simultaneously.Even before the present global crisis, the CBSL had designed a new credit guaranteescheme for lending to the Micro Small and Medium Enterprise (MSME) sector at the requestof the GOSL. The features of this new scheme as agreed between the CBSL and GOSL areoutlined below:A. The scheme is to be voluntary and application for guarantee will be opened to both74

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82credit institutions and borrowers themselves, through credit institutions.B. All LCBs and LSBs will be eligible.C. Loans granted for the purpose of promotion, expansion or upgrading of microenterprises, (including self-employment projects) and SME would be eligible underthe Credit Guarantee Scheme. Here an MSME enterprise is defined as one which hasan annual turnover less than SLR 150 mn..D. Maximum size of the value of loan disbursed would not exceed SLR.500,000/-.E. Lending institutions would be specifically advised not to reject applications forloans due to non-availability/unsatisfactory nature of collateral. In such instancesthe loan would be granted on the basis of the viability and cash flow of the project.F. For the guarantee to be effective and valid, the PCIs should have followed prudentbanking practices throughout the whole lending operations from credit appraisalstage to loan recovery stage and the bank should conform to all other requirementsstipulated by the CBSL in the operating instructions on the scheme.G. The lending institution should obtain documentary evidence to establish that the loanhas been used for the required purpose.H. The extent of the guarantee will be 60% of the loan granted or the amount in losswhichever is less, to ensure that the PCI shares in the loss in the event of a default.Here, the amount in loss will be deemed to be the principal in default and the interestaccrued thereon for a period not exceeding 6 months at the normal rate and in thecase of willful defaulters interest accrued at penal rate for a further period of 6months (to cover the period of awaiting a response to the of demand notice andcompletion of other formalities). In the case of non-willful defaulters, interestaccrued at the normal rate would be permitted until approval for the write-off of theloan is obtained from the bank’s Board (or relevant authority for that purpose),subject to a maximum of 12 months. (In the case of non-willful defaulters lending75

第 13 期institutions will not charge interest at the penal rate).I. In the case of willful defaulters, 50% of the claim will be payable on serving thedemand notice against the borrowers and guarantors and the balance 50% will bepayable on production of the case number of the legal action filed in Court. Theclaim will be paid on the condition that the bank pursues recovery action in all waysopen to it.J. In the case of non-willful defaulters, 50% of the claim will be payable on submissiona claim after twelve months have elapsed from the first date of the default subject tothe conditions that:1.The PCI has diligently followed up recovery of the loan in default at each stageincluding forwarding of reminders to the borrower and/or the guarantors from thepoint at which the loan first went to arrears, undertaken field visits etc. andexamined the feasibility of rescheduling of the loan; and2.The PCI is of the opinion that the loan is in default and the default is due to reasonsbeyond the control of the borrower owing to any of the under mentionedcircumstances and therefore possibility of recovery through legal action is remote.The following reasons could be considered to be reasons beyond the control of theborrowera)Complete destruction of project (including agricultural projects) due to naturalcauses.b)Complete destruction of enterprise due to man made causes (terrorism, bombing,arson etc.)c)Destruction of cultivation due to disease, pest, animal destruction or any otherreason beyond the control of the borrower.d)Death, total/partial permanent disability or long-term illness of the entrepreneur76

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82sufficiently serious enough to completely impair his ability to continue withproject activities, and the absence of an alternative person to undertake theproject.K. The balance 50% will be payable when the relevant authority for writing off loans(e.g. Board of Directors) makes a formal request to the CBSL to permit them towaive legal action and write off the outstanding balance of the loan including interest,utilizing the credit guarantee payment received, owing to one of the followingreasons.1.Despite the bank having rescheduled the loan, the rescheduled loan falling intodefault with no prospects of recovery of the outstanding amount.2.The bank having considered and rejected the option of recovery throughrescheduling of the loan, owing to the circumstances of the borrower being suchthat recovery through such rescheduling is impossible.VII. Some Reflections on the Proposed SchemeThe payment of 50 per cent of the claim in the case of both willful and non willfuldefaulters in the manner specified would ease the liquidity problems of PCIs and encouragefurther MSME lending. The relaxation of the collateral requirement will be welcomed by theMSME sector as the lack of collateral, on their own admission, is one of the greatestconstraints to accessing credit. However, in the absence of collateral requirements, aneffective system of monitoring of the activities of MSMEs should be put in place to avoidmoral hazard situations. In cases of MSMEs with no collateral, the PCI could be reluctant togrant the loans. Under this scheme the entrepreneur will have the option to apply for thecredit guarantee cover, though the PCI, and the CBSL would have to judge whether theproject is viable or not before approving guarantee cover. For this purpose, the CBSL willeither have to make use of project appraisal report provided by the PCI or one prepared byan external agency as the CBSL does not have the staff strength or capability to conduct an77

第 13 期appraisal by itself. The above features incorporated in the new scheme are all animprovement to the schemes operated hitherto. However, given the recent high inflationexperienced in the country it would be prudent to raise the upper cap for loans (SLR.500,000) so that this scheme will cover the needs of the medium scale enterprises as well.VIII. Way Forward for Guarantee Schemes in Sri LankaIn order to design credit guarantee schemes in the future, it is necessary to examine pastpractices and identify strengths and weaknesses which would help to draw guidelines forfuture schemes. The following are some thoughts on the way forward.A. Application for Credit GuaranteeIn the shortly to be introduced MSME credit guarantee scheme the borrower couldapply for a credit guarantee on his own behalf through a bank, even if the bank is not willingto do so. In this case the borrower will be paying the premium from his own funds throughthe bank. As mentioned earlier, CBSL might have to depend on a project appraisal made bythe PCI or an external agency to come to a decision with regard to the credit guarantee. Anideal situation would be for the borrower to approach the guarantor (CBSL) direct to seek acredit guarantee and thereafter "shop" among PCIs and choose the PCI which gives the bestterms and conditions based on the guarantee cover. This is the system prevalent in Japan andother more advanced countries. However this would require expansion in the staff and thecapacity of the guarantor (CBSL) as administrative duties such as premium collection wouldbecome more complex and labour intensive while the staff would have to be fully conversantwith project appraisal methods. In the alternative, a separate agency should be entrusted withthe task. However, in early SME lending when the IDB was responsible for project appraisal,there were issues with the appraisals provided. Any agency which did not share in the lossinvolved in the guarantee payment cannot be expected to do a very good job in this regard.Therefore the ideal situation is for the Guarantor to have sufficient staff with the requisiteexpertise.78

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82B. PCI participationThe proposed MSME scheme is open to all LCBs and LSBs at the request of the GOSL.However, if the sustainability of a credit guarantee schemes is to be assured, it would bedesirable if an eligibility criteria be specified for PCIs. For example participation could beconfined to PCIs with adequate capitalization, acceptable debt-equity ratio, clear proceduresand acceptable performance level of the SME loan portfolio. Also PCIs that do not conformto reporting requirements etc should be debarred from participating in credit guaranteeschemes. It is suggested that the PCIs chosen should have the following characteristics:1.A principal collection ratio exceeding 70 per cent in the SME loan portfolio.2.A portfolio infection level below 20 per cent (infected portfolio is defined as SMEportfolio with arrears of 6 months or more).3.Availability of adequate staff in the SME lending section.4.Availability of staff with expertise in credit appraisal.Promoting AdditionalityGuarantee cover for loans to new projects and existing projects could vary so thatlending to new projects is encouraged. This is the practice in some countries. It issuggested that the guarantee cover be 50 per cent for lending to existing projects and 65per cent for lending to new projects.Regional Variation in CoverWith the end of the war situation in Sri Lanka, the development of the North and Easthas become a priority. It should be noted that most of the enterprises operating in theNorth and East have suffered collateral damage. Therefore, in addition to establishingspecial loan schemes for that region, the credit guarantee cover pertaining to those loanscould be enhanced to around 75 per cent to encourage lending to the region.79

第 13 期Varying Premium RatesPremium rated could be changed during the lifetime of the loan. Once 75 per cent of thecapital is repaid, premium could be reduced by 0.5 per cent. Also if a SME ratingagency is set up in Sri Lanka, it would be possible to vary the premium paid by theenterprise depending on the rating of the SME.At present only around half a dozen officers located in the Regional DevelopmentDepartment (RDD) of the CBSL are involved in all activities related to implementingcredit guarantee schemes. Figure 2 gives the present structure of the Credit GuaranteeDivision of RDD.Figure 2Present Organization Structure of the Credit Guarantee DivisionDirector RDDDeputyDirector RDDDivision Head(SO III)Senior AssistantDirector (SO II)Senior AssistantDirector (SO II)AssistantDirector (SO I)BankingAssistant80

Credit Guarantee Schemes in Sri Lanka--Way Forwardpp. 51-82If the above improvements in the credit guarantee regime are to be implemented asdiscussed administrative activities will expand substantially. Therefore, staff strength wouldhave to be augmented. Further, if the credit guarantee unit is to appraise projects itself beforemaking a decision then the staff will have to have specialist skills on project appraisal aswell. Also the availability of refinance for development loans in the future will be much lessand CBSL will not need to promote specific loan schemes by providing credit guaranteetailored to specific loan schemes. The national imperative would be to promote the flow offunds to MSME sector in general. Therefore, to design and implement effective creditguarantee schemes to achieve this objective it may be desirable to set up a credit guaranteeagency outside the Central Bank to handle this work.ReferencesBeck T., Klapper L. F. Mendoza J. C., 2008. The Typology of Partial Credit Guarantee Fundsaround the World. Journal of Financial Stability.Central Bank of Sri Lanka, 1998. Central Banks New Credit Guarantee Schemes for Smalland Medium Enterprises, Central Bank News Survey.Central Bank of Sri Lanka, 1994. Rural Credit and Rural Banking. Central Bank NewsSurvey March/April.Central Bank of Sri Lanka, 1992. Credit Guarantee Schemes. Central Bank News SurveyNov/Dec.Fernando S. T. G., 1978. An appraisal of the Credit Guarantee Scheme for Small ScaleIndustrial Projects Operated with Industrial Development Board Participation, CentralBank of Sri Lanka Staff Studies.Green Anske, Credit Guarantee Schemes for Small Enterprises. SME technical workingpaper series United National Industrial Development Organisation.Levitsky Jacob, 1997. Credit Guarantee Schemes for Small and Medium Enterprises anInternational Review. Small Enterprise Development, 8(2).81

第 13 期Sirisena N. L, 1988. Credit Guarantee Schemes in Sri Lanka. Journal of Small EnterpriseDevelopment, 9(4).Uesugi Iichiro & Sakai Koji, 2005. The Special Credit Guarantee Programme in Japan.Nitai Miwanko & Rudy Allen, 2002. Encouraging Entrepreneurial Activity Using LoanGuarantee: the Credit Supplementation System in Japan. Paper Presented at theInternational Council for Small Business, June: 16-19.82