Credit Guarantees for Small Business Lending

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1 Credit Guarantees for Small Business Lending -Experiences of a small business credit guarantee company

2 Contents Importance of SMEs in the Chinese economy SMEs current access to finance Current status of the credit guarantee industry and commonly used credit guarantee models Chengdu CGC s credit guarantee model Chengdu CGC s successful experiences with SMEs

3 Importance of SMEs in the Chinese Economy In China, SMEs play a very important role in the economy. SMEs account for 98% of the total number of enterprises 75% of newly created job opportunities 60% of export-related foreign currency earnings 40% of tax revenues 50% of GDP

4 SMEs Current Access to Finance In China, about 80% of bank loans are issued to large-sized enterprises, and only 20% are to SMEs. More than 80% of SME owners think that access to finance is the most serious issue limiting their development. The main reasons are: Lack of sound legal & organizational structure; Lack of internal management controls, especially weak financial management; Lack of transparency: most SMEs are unwilling to release information; Small size with high growth prospects but consequently high uncertainty; High operational costs for banks but reflect banks priority in lending; No collateral or guarantees acceptable to banks to secure loans.

5 Relationship Between Business Cycles and Credit Guarantees Financing Business cycles Early Stage Startup Stage Growth Mature Stage Public listing Financing Channel Self-financing (SF) Venture capital (VC) SF SF SF SF VC VC VC VC Bank lending /CGF Bank lending /CGF Bank lending Direct financing

6 Current Status of the Credit Guarantee Industry Most Chinese credit guarantee institutions were set up after 1999, when the government issued preferential policies to encourage their development. After five years of a rapid development, the industry is characterized by insufficient capital resources, an incomplete risk compensation mechanism, and is facing high systematic risk. There are about 4,000 credit guarantee companies (CGCs) in China with guarantee funds amounting to CNY50 billion. The average size of each CGC is only CNY12.5 million. CGCs with capital of less than CNY50 million account for 80% of all CGCs. About 60% of all CGCs cannot, for diverse reasons, conduct normal business activities. It is estimated that CGCs in China provide over CNY100 billion in credit guarantees to SMEs every year and consequently create about 100,000 jobs. This accounts for about 0.5% of the total amount of bank loans.

7 Commonly used Credit Guarantee Models At present, domestic CGCs can be divided into two categories: the first provides various types of guarantees to SMEs, while the other provides various consumer loan guarantees to individuals. Guarantee fund is deposited in partner bank Guarantee fund amounts to 5 times the CGC s capital Joint liability credit guarantees No risk sharing

8 Chengdu CGC s Funding First stage ( ) funding Capital from the local government and DFID Technical assistance from DFID and IFC-CPDF Operational costs coverage from DFID Second stage (2003 to now) funding Capital from the local government and SECO Technical assistance from SECO and IFC-CPDF

9 Chengdu CGC s Targets 1. Macro-economic targets Provide access to finance for SMEs Encourage banks to lend to SMEs Increase job creation Promote economic development Support SME startups Promote high-tech development 2. Micro-economic targets Sustainability (in terms of HR, finance and business, etc.) Cost recovery (operating costs, guarantee losses) Profitability

10 Chengdu CGC s Target Markets Sectors: Processing and manufacturing industries; Trading; Services; Other sectors. SMEs who meet at least two of the following three conditions: Total assets of less than CNY50 million Annual sales of less than CNY50 million Number of employees less than 500

11 Chengdu CGC s Guarantee Model Principle: Risk sharing: Mutual benefits and risk sharing Borrower, creditor and guarantor share the risk; the guarantor assumes less than 70% of the default risk. Model For example : A project requires CNY1 million The borrower provides own funds of at least 20% of the total projected and applies for a loan CNY 800,000 investment; The borrower self-finances CNY200,000 The creditor assumes 30% of the risk; The guarantee company assumes 70% of the risk. =800,000X30%= CNY240,000 =800,000X70%= CNY560,000 In the case of default, the creditor will first exhaust all other means (guarantees and collateral) before turning to the guarantee company

12 Chengdu CGC s 5P-Principles in Credit Guarantee Evaluation Personal Purpose Payment Protection Prospects

13 5P-Principles in Practice Good Protection D A C B Bad People, Purpose, Payment, Prospects Good A:Cannot meet any of the 5P criteria: no credit guarantee B:Lacks collateral but meets all other criteria: CGC s target client C:Meets all criteria: direct bank financing D:Only meets protection criteria: bank considers whether to issue a loan (no need for credit guarantee)

14 Chengdu CGC s Guarantee Conditions Mandatory conditions: Creditworthy enterprise and entrepreneur, without bad credit records, without legal claims; Business growth trends stable and profitable; Risk grade above 50 (out of 100). Desired conditions: More than two years in this business Funds will be used for main business operations Asset/liability ratio is less than 65% In past half-year, net cash inflows/outflows above 110%

15 Chengdu CGC s Risk-Based Pricing Principle: pricing based on risk Strategy: encouraging short-term finance Payment: with up-front payment (small amount), with installments (large amount) Other factors considered: risk grade, loan maturity, guaranteed amount, industry prospects and competencies of the enterprise

16 Guarantee Fees Based on Risk Grade Maturity Risk (mts) grade % %

17 Chengdu CGC s Guarantee Business ( ) Number of applications accepted: 1,213 Number of applications approved: 986 (acceptance rate of 81%) Number of guarantees issued: 921 (approval rate of 93%) Amount of guarantees issued: CNY550 million (average size: CNY600,000) Overdue or rescheduled loan amount: CNY4 million (i.e. 0.73% of total guarantee issued) Payments to banks: CNY980,000 (i.e % of total guarantee issued) Collection after bank payments: CNY610,000 (i.e. 62% of amount paid to the bank) Real loss: VERY LOW

18 Performance of Chengdu CGC Operational costs/ guaranteed amount 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% % 1.84% 0.90% 0.49% Note: Chengdu CGC was established in 2001, a year in which the guarantee business had not yet fully started.

19 Partner Bank Selection How to select a suitable partner bank? A guarantee company must be very prudent in selecting a partner bank; Potential partner bank must be motivated to co-operate; CGC should look for those with the highest commitment; Should not limit the cooperation to a single bank. Our Partners: Chengdu City Commercial Bank Chengdu Rural Credit Cooperatives Other joint-stock commercial banks State-owned commercial banks A guarantee company relies on, but should not depend on partner banks only.

20 Why would a bank cooperate with Chengdu CGC? (1) With the liberalization of interest rates, banks can now set prices according to the incurred risk, so borrowers with insufficient collateral will be more likely to access finance, albeit at a higher price. In this environment, what are the prospects for Chengdu CGC? How should it respond to the challenge? The cooperation between Chengdu CGC and its partner banks is a win-win situation: Sharing credit risk of bank; Improving the bank s efficiency and reducing risks through Chengdu CGC s evaluation; Having a more thorough investigation and loan monitoring, receiving more borrower information; Providing additional services to improve SMEs management competencies and market competitiveness in order to reduce risks.

21 Why would a bank cooperate with Chengdu CGC? (2) To reduce the bank staff s moral hazard and to improve the quality of the bank s loans; To improve market share and competitiveness of the bank; To reduce the bank s transaction costs: the main obstacle for banks to provide loans is not the lack of collateral, but the high costs associated with it. Therefore, Chengdu CGC s involvement can reduce the bank s transaction costs. CGF assumes the main liability and risk. This is a very attractive proposition to banks. All these reasons show that Chengdu CGC s model is attractive to banks.

22 CGC-Bank Cooperation: Enhancing Risk Management Separation of application review and guarantee issuance; Borrower, creditor and guarantee share risk; Use credit limits authority and regular evaluation; Sound and complete investigation; Control credit guarantee amount; Risk-based pricing; Loan loss reserves and client participation; Bad debt responsibility system.

23 CGC-Bank Cooperation: Enhancing Monitoring Successful monitoring and guarantee management include: Ensuring the correct issuance of guarantees; Well-managed guarantee files; Regular project supervision and on-site reviews; Regular reviews of clients financial conditions; Activities recording system; Proactive management; Effective and timely management.

24 CGC-Bank Cooperation: Providing Value-Added Services In SME finance, Chengdu CGC plays three functions: intermediation, enhancing creditworthiness and sharing risk. Besides, it can also provide additional services: Issues Insufficient collateral Incomplete financial information Poor internal management Weak corporate governance Insufficient capital Provided Solutions Guarantees Financial guidance Management guidance Structural recommendations Recommend investor

25 CGC-Bank Cooperation: Win-Win Relationships Keep long-term and regular contacts; Share information freely; Concerted risk prevention & solution search; Trust each other. All ensure the creation of win-win relationships

26 Case Study: A Win-Win Cooperation Model Cooperation background: cooperation partner is a sub-branch of Chengdu City Commercial Bank. At the beginning of our cooperation, its deposits reached almost CNY100 million, loans amounted to only CNY50 million, with 20 borrowers, its NPL ratio was 35%, and an unclear target client group. Cooperation included: Preparing the marketing strategy and implementing it jointly; Determining the main target clients; Providing guarantees to those clients meeting the loan criteria but lacking acceptable collateral; Independent evaluation; Sharing of client and sector information; Enhanced communication.

27 Case Study: A Win-Win Cooperation Model Cooperation results: after two years Bank s branch: Deposits amount to CNY500 million (i.e. a 5 times increase); Loans amount to CNY260 million (i.e. a 5.2 times increase); Number of borrowers: 83 (i.e. a 4.1 times increase); NPL ratio reduced to 8%. The bank s branch was awarded a prize from its head office in the last two years. Chengdu CGC: Accumulated guaranteed amount: CNY180 million; Number of clients: 48; Operational income: over CNY3 million; No default; Further outreach. Win-Win

28 Development Trends in the Chinese Credit Guarantee Industry Strengthening of the management of credit guarantees, thereby enhancing the credit guarantee system. Closer cooperation between guarantee companies and banks. Risk sharing will become more widespread. Strengthened international exchanges and cooperation. Focus on improving the legal environment and industry-wide discipline. Increased competition.

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