2017 -10-15 by Prakhar Misra
Prakhar is a Resident Fellow at Roma Entrepreneurship Development Initiative, a think-tank that aims to improve employment opportunities amongst the Roma in Europe.
One of the goals in the EU 2020 strategy framework is to have ‘75% of the people aged between 20-64 to be in work’. Among the many strategies the EU is employing, the Guarantee Instrument under the EU Program for Employment and Social Innovation (EaSI) seeks to improve self-employment opportunities for the citizens of the EU. The scheme targets Small and medium enterprise (SME) owners who are unable to take loans due to non-availability of real assets that could be used as collateral. EIF, therefore, guarantees a loan of up to 80% provided the financial intermediary retains a material interest on the portfolio of a minimum of 20%. While this credit guarantee scheme is well-intentioned and in fact, to some degree does help the community it isn’t entirely sustainable and, more worriedly, holds the possibility to create a bubble in the microfinance sector.
This isn’t a novel intervention- the first public guarantee scheme was set up in Holland in 1915 and Japan established one in 1937. Many guarantee schemes were set up in the 1990s and 2000s and especially after the crisis, many were looked at as a way to absorb the effects and rejuvenate the economy with different areas of focus and various conditions of intervention. However, the peculiarity in this one is the absence of any fees charged on the guarantee to the financial intermediary. A commitment fee and a compliance fee may be levied if certain conditions are not met, but by no means are they final nor do the prices show any indication in shaping the risk preferences of the financial intermediary. Essentially, the guarantee is free of cost to the loaning institution.
I call this well-intentioned because the European Investment Fund (EIF) probably wants all the money (96 million euros) to be disbursed and that is why the zero-fee idea. But, this is as good as throwing money off a helicopter with the hope that it leads to some results. Or maybe just slightly better than that.
The big blunder European Investment Fund (EIF) is committing with the no-fee clause is distorting the market by sprouting the problem of moral hazard on behalf of the loaning institution. The interests of the financial intermediary to spend resources in conducting the due diligence before disbursing the loan are significantly reduced, as its losses are remarkably diminished. Thus, the danger of lending subprime loans is notably exacerbated. If we rewind to the 2008 financial crisis, its seeds were sown when the Glass-Steagall legislation was repealed in 1998. The law permanently separated regular banks from investment banks and its withdrawal allowed their merger. So the banks could now use the depositors’ money, which was insured by FDIC, to engage in highly risky investments. Of course, there were other factors at causing the crisis like low-interest rates, unregulated derivatives, and over-writing of the anti-predatory state laws, but the insurance on the depositors’ money indeed increased the tendency to engage in risky transactions by the bankers. This is the problem even today with the public guarantee schemes at no fee. South China Morning Post reported how a unique guarantee scheme in Hong Kong, worth $5 billion, was likely to attract bad risk.
A review of the credit guarantee schemes in the Middle East and North Africa (MENA) region conducted by the World Bank in 2010 states explicitly, “fees should be related to the risk exposure and contribute to the financial sustainability of the guarantee scheme.” They review various guarantee schemes and note that a basic fee ranging from 0.8% p.a. to 2.3% p.a. is charged in the MENA countries. This is a standard practice in the region. But not just the MENA region, even in Europe, free guarantees aren’t recommended. The Vienna Initiative, in its re-launch as ‘Vienna 2’, also mentioned something similar in its 2014 report of credit guarantee schemes, “the design and pricing of credit guarantee products should also ensure that the transfer of credit risk from the lender to the guarantor does not lead to excessive risk-taking. ” Yet, the EIF has apparently ignored the recommendations.
Even if we were to consider that EIF would conduct due diligence on their part as they claim by analysing ‘expected impact, financial standing, financing capacity, and operational capabilities’ of the financial intermediaries, it certainly doesn’t absolve them of a bad design in the policy. John Maynard Keynes in his 1936 magnum opus coined a term called ‘Animal Spirits’ which explained that the psychology of financial decisions is based on emotions and instincts rather than mathematical and rational calculations. Thus, the structuring of incentives becomes of prime importance while creating a financial instrument to control for tendencies to bet based on sentiments. We can always go the back to the early 2000s when the derivatives and swaps were created on the underlying presumption that real-estate prices will still rise and thus the value of the collateralised asset would not be affected by the bets placed on it. Irrespective of how watertight the primary assessment of the financial intermediary, there is nothing to stop them from making investments with poor apriori knowledge leading to a catastrophic use of the funds.
A price mechanism, in this case, would restructure incentives and rectify the information asymmetry problem. Thus, setting a price for a credit guarantee not only seems to be rational but also a fundamental principle of insurance. In the interest of long-term sustainability of the credit guarantee scheme, the scheme should be reworked to incorporate a financial burden on the intermediary. Otherwise, the creation of a bubble in this sector is imminent. It could have grave political and economic consequences for the EU.