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Loan Guarantees in Microfinance: Adding Value and Limitations

Core Content

This document explores the role of loan guarantees in microfinance, focusing on how they can add value to microfinance institutions (MFIs) and the challenges they present. It is based on a CGAP/USAID study analyzing 96 loan guarantee transactions from eight guarantor agencies between 1988 and 2005, with the majority occurring after 2000.

Main Points

What is a Loan Guarantee?

• A loan guarantee is a form of credit guarantee that supports a loan from a bank or other lender to a single MFI.
• It functions as insurance for the lender, covering part or all of the credit risk associated with the loan.
• The guarantee is typically issued by specialized organizations or departments within funding agencies.

Why Do Funders Use Loan Guarantees?

• Facilitate access to bank loans: Guarantees help MFIs gain loans from commercial banks that might otherwise consider them too risky.
• Leverage funders' capital: Guarantees allow funders to unlock larger amounts of funding than the value of the guarantee itself.
• Demonstrate creditworthiness: They aim to show the broader banking sector that MFIs are reliable borrowers.

Why Do MFIs Use Guarantees?

• Long-term relationship with local banks: MFIs seek to establish and maintain relationships with commercial banks.
• Funding diversification: Guarantees provide an alternative to traditional funding sources.
• Growth financing: Especially for non-deposit-taking MFIs, guarantees can help finance expansion.
• Prestige from international institutions: Association with global entities enhances credibility.
• Mitigate foreign exchange risk: Guarantees can help MFIs avoid risks from borrowing in foreign currency and lending in local currency.
• Overcome regulatory barriers: In countries with restrictions on foreign borrowing, guarantees enable local financing.

Key Findings from the Study

Benefits

• Improved access to local bank loans: MFIs that were previously unable to secure loans from local banks found it easier with guarantees.
• Reduced foreign exchange risk: 82% of guaranteed loans were in local currency, minimizing exposure to currency fluctuations.
• Regulatory compliance: Guarantees helped MFIs bypass legal restrictions on foreign borrowing and allowed banks to comply with lending regulations.
• Facilitated subsequent lending: Guarantees opened the door for future financing opportunities and helped MFIs build trust with lenders.

Limitations

• High cost for MFIs: Guaranteed loans often came with higher interest rates and collateral requirements, making them expensive.
• Inadequate cost measurement: Guarantors frequently did not account for the full cost of providing guarantees, including appraisal and transaction support.
• Limited contribution to MFI assets: Guaranteed loans typically accounted for less than 5% of an MFI’s total assets.
• No significant increase in bank risk tolerance: In many cases, guarantees did not lead to banks being more willing to lend without them.
• Additional collateral required: For the unguaranteed portion of loans, MFIs often had to provide extra assets.

Conclusion

Loan guarantees have proven to be a useful tool for certain MFIs, particularly small, non-deposit-taking institutions that struggle to attract capital from local or international markets. They can help overcome regulatory barriers, reduce foreign exchange risk, and facilitate access to local bank loans. However, for most MFIs with serious growth ambitions, guaranteed loans are not a viable long-term funding strategy due to their high cost and limited impact on overall asset growth. The effectiveness of loan guarantees depends heavily on the maturity of the MFI and the local financial market.

References

• Flaming, Mark. 2007. "Guaranteed Loans to Microfinance Institutions: How Do They Add Value?" Focus Note 40, Washington D.C.: CGAP, January.