Governments in both emerging and developed markets are increasingly engaging the private sector to help finance and deliver public goods. For government, working with the private sector can reduce the demands on official budgets and improve service delivery.

Guarantees are one of government’s most powerful financing tools for mobilizing private sector participation. They can be decisive for a private investor deciding whether to buy a bond, make a loan, or bid to build a highway.  

Not all guarantees, however, are equally effective at mobilization. In its simplest form, the government provides a “full” guarantee. Although the investor or service provider draws comfort from such a secure safety blanket, full guarantees can eventually undermine the government’s capacity to issue guarantees. The more guarantees issued, the greater the risk that the government cannot honor all of them, and the less the guarantees are worth.

The solution is to “target”. Perhaps local investors are willing to fund the construction of a highway but are unsure that the hoped-for traffic will materialize? The government can guarantee a minimum level of tollway collections. Foreign investors willing to invest in solar power generation but want to ensure that they can eventually transfer their profits to their home countries? Guarantees on currency conversion and transfer can help. There are many other examples, but the unifying point is that targeted guarantees can have an outsized impact. 

A targeted guarantee can also differentiate between types of liabilities. Recent transactions in Sri Lanka illustrate how this works. As part of a 2016 ADB project, called the Sri Lanka Small and Medium-Sized Enterprises Line of Credit Project, $100 million was lent to the Ministry of Finance. The ministry then lent it to 10 participating banks for on-lending to small businesses.

One of the participating banks, a state-owned development bank, faced capital constraints. Without a capital infusion, it would have to curtail its loan growth and consequently its important mandate to lend to small businesses in rural areas where banking services are thin.

To assist this bank, ADB extended another $50 million loan against a government guarantee. However, this loan was structured to qualify as “tier 2” capital. In other words, if the bank were to have financial difficulties, this subordinated loan would be repaid after or at a discount to the bank’s senior obligations, such as uninsured deposits and loans from senior creditors.

  Guarantees can unlock development finance with less risk and debt

In both projects, the same state-owned bank borrowed $1 through an ADB project and then lent $1 to a small or medium-sized enterprise. Under both, the Government of Sri Lanka is committed to repay $1 to ADB for every $1 lent to the state-owned bank if it were to default, and under both, ADB charges a credit margin of 0.50%. The rate is low because ADB is assuming the repayment risk of the Government of Sri Lanka, not the repayment risk of the state-owned bank.

Despite their apparent similarities, the loans are quite different—10.67 times different! Because ADB’s subordinated loan qualifies as tier 2 capital, the state-owned bank can count it toward its regulatory capital requirements. Given the applicable capital requirement in Sri Lanka of 12.5%, one dollar of subordinated loan provides the regulatory capital to extend $8 of risk-weighted assets.

However, risk weighting is not 1:1 and depends on the asset class and local regulatory guidelines. For Sri Lankan banks, $8 of risk weighted assets is the equivalent of $10.67 of small business loans because the Sri Lankan Central Bank applies a 75% risk weighting to such loans. In summary: $1 of an ADB subordinated loan divided by a 12.5% capital requirement divided by a 75% risk weighting equals $10.67 of small and medium-sized enterprises loans.

Financial alchemy? No. In principle, the government has accepted more risk in guaranteeing a subordinated loan. In practice, the Government of Sri Lanka is likely to stand behind the obligations of the state-owned bank, whether senior or subordinated, because of the critical role it plays in extending finance to rural borrowers. Also, a default by any one of the state-owned banks would negatively implicate all the state-owned banks which collectively represent about 40% of Sri Lanka’s banking sector.

Governments around Asia want to continue their partnership with the multilateral banks, but they’re increasingly asking for solutions that minimize the impact on sovereign balance sheets. Using guarantees surgically so that they catalyze more finance without incurring significantly more risk or liabilities is a smart and underutilized tool to deliver on their needs.